Top 35 Networks 2012: Where's the risk?

by Jane Howard, Wragge & Co

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09 Jul 2012

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Weak link

THE VERY LARGEST FIRMS and international networks have faced a barrage of litigation over the past ten years arising from financial scandals ranging from Worldcom to Madoff (claims in relation to which rumble on or are still in the pipeline).

As such, a key concern for so-called umbrella organisations and their member firms remains the extent to which they may be called to account for the breaches of duty of independent members over which, in reality, they have no (or comparatively little) control. But how far is this concern founded in the latest case law, and what can organisations be doing to mitigate potential network risk?

If the local firm has limited professional indemnity insurance (PII), history has shown that claimants will target other, often larger, member firms for any shortfall.

Such claims typically involve bringing other members of the network or association into the litigation via the umbrella organisation. Much of the case law has its origins in the law relating to piercing the corporate veil.

Broadly speaking, this means that whatever the actual corporate structure, courts will hold one corporation liable for the acts of another if, for example, the domination or control of one by the other can be shown.

A common allegation is that the firm being joined to the proceedings dominates or controls the network. Therefore, it also directly or indirectly controls the member firm that is the primary target of the litigation, but whose resources (perhaps as a result of fraud or simply the inadequacy of its PII relative to the claim) are bust.

International umbrella organisations, even though they generally perform a co-ordination and facilitation role and provide no professional services themselves, become a party to the litigation.

This is irrespective of the fact that they typically only carry directors and officers liability insurance (D&O) and defence costs insurance cover.

Implementation of the EU statutory audit directive (eighth directive) in 2008 and the IFAC code of ethics added to the anxiety already felt by many mid-tier networks and associations. This stemmed from concern that network status, although essentially a regulatory issue, necessarily carried with it enhanced litigation risk.

While this caused some to back-pedal , seeking to avoid common branding and other characteristics of network status, many quickly realised that only the most informal of referral arrangements would escape the network definition.

Attempts at resolving tensions within many networks and associations led, in some cases, to the abandonment of the sort of meaningful activities most likely to enhance co-operation and work flows between member firms.

At the same time, the very largest networks, such as those to which the Big Four belonged, continued to embrace the commercial benefits of being part of a fully branded international organisation. One or two went on to forge truly global and carefully structured tie-ups between the largest and/or most sophisticated member firms. This was driven by demand from their multi-national clients for a seamless – or at least a seamlessly managed – global service.

Characteristics that are indicative of network status include the adoption of a common brand and common quality control procedures and policies.

While the presence of these enhanced the prospect of litigation, based on ‘holding out', ‘agency', ‘control' and ‘alter ego' allegations, the balance of the available case law in this area suggests that ultimate liability is unlikely to be found for the actions of the local member firm. The only exception here would be where it can be shown that the network itself, or another member firm, had some actual involvement with, or control over, the work (typically an audit or series of audits) that is the subject matter of the underlying claim.

As Banco Espirito Santo International Ltd v BDO International and its US member firm, BDO Seidman, ultimately demonstrated, the mere potential to exercise management and control over member firms was insufficient reason (without more) to keep the international umbrella organisation in that litigation. Merely having requirements for membership, common audit manuals and quality control procedures, all defining characteristics of networks, should not in isolation be a basis for liability.

That said, claimant lawyers, especially in the US jurisdictions where many of these claims are brought, can be highly inventive. As the Parmalat litigation, which ensnared DDT, GTI and their respective member firms in the US for much of the noughties, demonstrated, claims running to billions of dollars (however unmeritorious) can roll on for many years.

This is especially true in those jurisdictions that encourage class actions and whose courts appear to exercise little control over the embellishment of lengthy statements of case.

Whatever the eventual legal outcome of such cases, significant reputational damage can be incurred en route and needs to be carefully managed. Andersen's demise was not caused by a catastrophic claim, but by its clients voting with their feet, keen to distance themselves from the reputational damage that the collapse of Enron carried in its wake.

Fear of litigation arising simply from the sharing of a common name or other network characteristics associated with co-operation began to subside as more cases were resolved in favour of networks and individual members. This may have been partially assisted by the recognition of the disastrous impact on global capital markets of another Big Four failure. Since the favourable ruling in the BDO case and other similar control liability cases, quality control has become a key focus for networks – it is deemed the best means of seeking to manage, if not eradicate, network risk.

Having publicly announced on websites and in other marketing materials the existence of such quality control programmes, perhaps the new risk area is no longer the existence of such programmes but their adequacy?

In reality, the frequency, consistency and rigour of these programmes vary greatly depending upon the availability of resources. Other than perhaps the largest and most integrated global entities, networks would be well advised not to over-sell the extent of their internal quality review procedures – not least as the ‘control' allegation is bound to be raised in its various statutory and common law guises in future claims.

Overall, however, it is heartening to see a number of networks and associations emerging from the shadows to embrace the commercial upside that membership of a global organisation was always intended to bestow upon its member firms. The alternative is organisational paralysis and a loss of competitive advantage.

While the risks that will always go hand in hand with being a global player cannot be eradicated, they are now better understood.

For many of the networks we advise, containment of litigation risk remains centre stage.

Yet despite this, and more importantly, the fact that these risks are now better understood means that the process of managing them informs rather than drives strategy. Whether the balance achieved here will be upset again by a further wave of litigation remains to be seen.

Jane Howard is a partner in Wragge & Co's professional liability team

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