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Feb 1994

Partial limitation on the risk of RICO liability. (Accountant's Liability)

by Keneally, Kathryn

    Abstract- Sec 1962(c) of the Racketeer Influence and Corrupt Organizations Act prohibits the conduct or involvement in the conduct of an enterprise's operations through a pattern of racketeering activity. RICO is often used against civil defendants because 'racketeering activity' is a broad term that can include mail fraud, wire fraud, certain securities laws' violations and a wide range of other purported fraudulent activities. Time and again the US Supreme Court has attempted to limit the RICO statute's application to civil defendants without harming its potency for Federal prosecutors. The Court's latest attempt, its ruling in the 'Reves v. Ernst & Young' case, narrows the application of RICO to accountants and other professionals. However, it would be prudent for professionals to examine the issues of involvement in the operation and management of an enterprise, and the definition of enterprise.

The U.S. Supreme Court has repeatedly grappled with the interpretation of the RICO statute, in an attempt to define more narrowly its application to civil defendants while leaving intact its potency for prosecutors. The Court's most recent effort, its decision in March of this year in Reves v. Ernst & Young, 113 S. Ct. 1163, 122 L. Ed. 2d 525 (1993), was popularly hailed as limiting the use of RICO against accountants and other professionals. On closer look, however, the Reves decision may do little more than invite clever drafting by plaintiffs, and further complicate RICO litigation. Unfortunately, no meaningful respite from the risks of RICO lawsuits is in sight.

The Reves Decision

Sec. 1962(c) of RICO, the section most frequently used to bring civil RICO actions, makes it a crime to conduct or to participate in the conduct of the affairs of an enterprise through a pattern of racketeering activity. The RICO statute lists certain state and Federal crimes as the type of racketeering activity that may form the required pattern for a RICO violation. Because the racketeering activity can include such broad offenses as mail fraud, wire fraud, certain securities laws' violations, and interstate transportation of stolen property and funds, a large variety of purported acts of fraud can be brought within the RICO statute. Other sections of the RICO statute make it a crime to invest the proceeds of a pattern of racketeering activity in an enterprise, or to acquire an interest in an enterprise through a pattern of racketeering activity, or to conspire to violate any of RICO's provisions.

It is the language of Sec. 1962(c), directed to "conducting" or "participating in the conduct" of an enterprise, which was the focus of the Supreme Court's decision in Reves. The Court stated the issue simply: "The question presented is whether one must participate in the operation or management of the enterprise itself to be subject to liability under this provision." The Court stated its conclusion equally directly: "|We hold that to conduct or participate, directly or indirectly, in the conduct of such enterprise's affairs, one must participate in the operation or management of the enterprise itself."

The Reves decision was certainly good news for Ernst & Young, the accounting firm named as a defendant in the case. Ernst & Young was the successor firm to accountants that had provided services to the Farmer's Cooperative of Arkansas and Oklahoma, Inc. (referred to in the opinion as "the Co-op"). The Co-op retained the predecessor accounting firm in 1981 to perform a financial statement audit, shortly after the Co-op's former general manager and its former accountant were convicted of tax evasion. The general manager had taken loans from the Co-op to finance the construction of a gasohol plant by a company called White Star Fuels. The Co-op's former accountant had also done the accounting work for White Star. Following a lawsuit brought by the Co-op against its former general manager and accountant, a consent decree was entered providing that the Co-op had owned White Flame since early 1980.

It was on this foundation that the accounting firm began its work. A significant issue in the audit was the value of the White Flame gasohol plant. The accounting firm treated the plant as having been owned by the Co-op since the beginning of construction in 1979, and used its fixed asset value. Although the Co-op's 1980 financial statement gave no fixed asset value for the gasohol plant, the former accountant, now a convicted felon, had set a figure of over $4.3 million dollars as White Flame's cost for the plant. Starting with this figure, the accounting firm determined the gasohol plant had a fixed-asset value of $4.5 million. Had the accounting firm instead treated the acquisition of White Flame as a purchase, it would have been required to utilize the fair market value of the gasohol plant, which was below $1.5 million. Based on this analysis, the Co-op was insolvent.

Overstated Value Used

The 1981 and 1982 audit reports were prepared based on the inclusion of the gasohol plant at an asset value of $4.5 million. Although footnotes to the audit reports expressed doubts as to whether the investment in White Flame could ever be recovered and noted that White Flame was operating at a loss, the footnotes did not appear in the condensed financial statement distributed at the Co-op's annual meeting. The accounting firm also failed to disclose to the Co-op that its audit report was based on its decision to treat the gasohol plant as owned by the company since 1979, its utilization of figures set by the convicted former accountant, and the risks inherent in these factors.

The Reves case was a class action, and the plaintiffs consisted of certain noteholders of the Co-op. The plaintiffs claimed that the accountants had conducted the affairs of the Co-op through a pattern of racketeering activity consisting of acts of mail fraud and securities fraud |Arthur Young & Co. v. Reves, 937 F.2d 1310, 1323-24 (8th Cir. 1991), aff'd, Reves v. Ernst & Young, 113 S. Ct. 1163, 122 L. Ed. 2d 525 (1993). Holding that liability under RICO's Sec. 1962(c) is limited to those who "participate in the operation or management of the enterprise itself," the Court concluded that the accounting firm's conduct remained that of an "outsider" and did not rise to the level of management participation. The Court thus dismissed the RICO claim against the accounting firm.

The Reves decision tells accountants that, if they maintain their role as outsiders to an entity, and plaintiffs later depict that entity as a RICO enterprise under Sec. 1962(c), the accountants will nonetheless escape RICO liability. Indeed, considering the acts taken by the accounting firm in Reves itself, which the Eighth Circuit Court of Appeals depicted as "reprehensible," its exoneration of RICO liability is certainly noteworthy.

Two Problematic Areas

Professionals should be aware of two areas of potential limitations to the Reves decision, however. First, a professional may go further than the accounting firm did in Reves, and find himself or herself in fact part of the management of the entity named as an enterprise. Second, and perhaps more insidious, under the RICO statute it is possible and even common for plaintiffs to plead an entirely different kind of enterprise, an "association in fact" enterprise, and thereby bring the outside professional back into RICO's reach.

Involvement in the Operation and Management. An accountant who is the employee of a company, or its chief financial officer, may find himself or herself held to be participating in its operation or management. Similarly, a professional who serves as a company's director may find it difficult to escape potential RICO liability. Even an outside accountant who oversteps traditional accounting functions may find that a court has determined that he or she went too far in becoming involved in a company's management.

Notably, the Reves decision does not limit liability to the upper levels of management. Thus the Court observed: "An enterprise is 'operated' not just by upper management but also by lower-rung participants in the enterprise who are under the direction of upper management." The Court also noted that outsiders might still find themselves considered part of the operation of a company through acts taken to direct its activities, giving as an illustration that "an enterprise also might be 'operated' or 'managed' by others 'associated with' the enterprise who exert control over it as, for example, by bribery." Also, the Reves Court expressly declined to adopt a stricter standard, which had been promulgated by the District of Columbia Circuit, requiring a showing of "significant control" over the enterprise.

The Definition of Enterprise. An enterprise is defined in the RICO statute as including "any individual, partnership, corporation, association, or other legal entity, and any union or group of individuals associated in fact although not a legal entity" |18 U.S.C. Sec. 1961(4). Courts interpreting RICO have recognized two basic types of enterprises: entity enterprises, which consist of corporations, partnerships, or other legally recognized entities, and so-called association-in-fact enterprises. It is the latter, the association-in- fact enterprise, which provides plaintiffs with the opportunity to craft pleadings that will attempt end-runs around the Reves holding.

The association-in-fact enterprise has its roots in the U.S. Supreme Court's decision in United States v. Turkette |452 U.S. 576 (1981). The alleged enterprise in Turkette was exactly the type of organization that the RICO statute seemed to have been drafted to eradicate. The defendants in Turkette were alleged to be a group of individuals associated in fact for the purpose of engaging in narcotics trafficking, arson, insurance fraud, bribery, and corruption. The Court in Turkette held that an association that performs only illegal acts and which has not infiltrated or attempted to infiltrate a legitimate enterprise may still itself be an enterprise sufficient to allow a RICO claim to be brought against its members.

The Court in Turkette cautioned the enterprise element of a RICO offense must be proven apart from the racketeering acts. The Court opined that an enterprise will be evidenced by the existence of an ongoing organization, whose associates function as a continuing unit. The Court noted, however, that the proof used to establish the racketeering acts may "coalesce" with the proof of the existence of the enterprise.

The Turkette decision's definition of an association-in-fact enterprise has led some courts to conclude that an enterprise need not consist of much more than the organization necessary to carry out the racketeering acts. Thus the Second Circuit Court of Appeals, whose jurisdiction includes New York, Connecticut, and Vermont, has held that an association-in-fact enterprise can be nothing more than a group of jockeys and bettors joined for the purpose of fixing horse races |United States v. Errico, 635 F.2d 152, 156 (Id Cir. 1980), cert. denied, 453 U.S. 911 (1981). More recently, the Second Circuit has stated that "the existence of an association in fact is often times more readily proven by "what it does rather than by an abstract analysis of its structure" |United States v. Coonan, 938 F.2d 1553, 1559 (2d Cir. 1991), cert. denied, 112 S. Ct. 1486 (1992).

The broad application in a civil case of this definition for an enterprise can be seen in the decision in Cullen v. Maraiotta |811 F.2d 698, 730-31 (2d Cir.), cert. denied, 483 U.S. 1021 (1987). In Cullen, the plaintiffs alleged that the County of Nassau in New York, the Town of Hempstead, Nassau County Republican Committee, and the Town of Hempstead Republican Committee coerced employees of the county and town to make contributions to the two Republican committees. At trial, the jurors were instructed that "'|any combination of two or more of the defendants charged may constitute an enterprise.'" This instruction was cited with approval by the Second Circuit on appeal. Further, the Second Circuit found that an entity can be named as both part of the association-in-fact enterprise and sued as a defendant in an action.

Association In Fact Opens Door

The broad definition of an association-in-fact enterprise, as demonstrated by the decision in Cullen and similar cases, opens the door for pleadings by plaintiffs in civil RICO cases to avoid the limitations of the Reves opinion. Suppose that, instead of naming the Co-op as the enterprise, the Reves plaintiffs had alleged that all the original defendants, including the accounting firm, had formed an association-in- fact enterprise. The accounting firm would no longer be the outsider depicted in the Supreme Court opinion in providing only accounting services to the entity Co-op that retained its services.

Perhaps the plaintiffs in Reves did not allege an association-in-fact enterprise because the Eighth Circuit Court of Appeals, the jurisdiction in which the complaint in Reves was filed, has had a higher standard for defining such an enterprise than the standards of courts like the Second Circuit. In an early decision, the Eighth Circuit interpreted the decision in Turkette as requiring three elements be proven for an association-in-fact enterprise to be sustained: 1) the associates have a common and shared purpose; 2) the enterprise functions as a continuing unit; and 3) the enterprise has an ascertainable structure distinct from that inherent in the conduct of the pattern of racketeering activity |United States v. Bledsoe, 674 F.2d 647, 665 (8th Cir.), cert. denied, 459 U.S. 1040 (1982). Under this standard, an association in fact that has no more organizational structure than that necessary to commit the crimes with which its members are charged should not be sustained.

A Recent Decision

Other Circuits have been divided between the Eighth Circuit test and the more liberal Second Circuit interpretation of an association-in-fact enterprise. Consider, however, a more recent decision in the Eighth Circuit, which suggests how broadly even the Eighth Circuit standard may be read. In Atlas Pile Driving Co. v. DiCon Financial Co., 886 F.2d 986 (8th Cir. 1989), the plaintiffs were two subcontractors. They alleged that the defendants, two individuals and the companies that they formed, engaged in a scheme to defraud subcontractors. The plaintiffs alleged that the enterprise was an association in fact comprised of five companies that directly or indirectly were controlled by the two individual defendants. Two of the companies that were named as part of the association in fact were also named as defendants.

The Eighth Circuit held that it was permissible to name these companies as part of the association-in-fact enterprise and at the same time hold them liable as defendants. The Court then considered the standard set forth in Bledsoe. Noting that the association-in-fact enterprise included legitimate businesses, the Court found that the non-criminal activity of the legitimate businesses provided the organizational structure required by the Bledsoe standard.

Under the reasoning of Atlas Pile Driving, a plaintiff may assert that an accountant or an accounting firm is part of an association-in-fact enterprise, and then point to the routine business activities of the accountant or firm to show the requisite elements of an enterprise apart from the alleged racketeering acts.

A case decided shortly after the Reves decision is informative. In Brown v. LaSalle Northwest National Bank, 1993 U.S. Dist. LEXIS 5652 (N.D. Ill. April 26, 1993), the plaintiff alleged that the defendant engaged in fraudulent conduct by omitting from loan documents certain provisions that the FTC required be included, with the purported intent of failing to inform the plaintiff and others of their rights and risks. The RICO enterprise was alleged to be an association of corporate subsidiaries, including the defendant bank, all of which shared a common parent. The defendant in Brown cited the Reves decision in its motion to dismiss. The court disagreed, holding that the alleged scheme was an affair of the association-in-fact enterprise, and that the named defendant had sufficient control over the scheme. The case shows an early and simple example of the manner in which pleading an association-in-fact enterprise may be used to limit the application of Reves.

The Risk Still Exists

In Reves, the Supreme Court reviewed the legislative history of the RICO statute, and noted its stated purpose of providing a weapon against the infiltration, control, and operation of legitimate businesses by organized crime. This purpose is met when the enterprise is the entity that has allegedly been victimized by the organized criminal activity. In Turkette, the Supreme Court interpreted RICO to sustain an enterprise that consists of an association in fact formed for wholly illegitimate purposes. To the extent that this interpretation extends RICO's reach to organized crime families, drug cartels, and the like, it is hard to suggest that the original intent of the RICO statute has not been met.

Conversely, the Supreme Court and the lower courts have shown repeated distaste for the application of RICO to common law fraud and other commercial disputes that provide the grist for civil RICO litigation. The holding in Reves was a reasoned effort to limit this use of the RICO statute. Reves, however, was an entity enterprise case.

The broad definition of an association-in-fact enterprise, beginning in the Turkette holding, and the convolutions of that definition in cases such as Cullen, Atlas Pile Driving, and Brown show the risks still posed to accountants and other professionals under the RICO statute. In future cases, courts should be called upon not to allow the association-in-fact enterprise to be used as a pleading gambit by plaintiffs seeking to avoid the spirit as well as the language of the Reves holding.

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