RICO: has the "ultimate weapon" been crushed?

On the heels of the U.S. Supreme Court decision last March in Reves v. Ernst & Young, some headlines declared outside consultants such as CPAs and attorneys now virtually beyond the reach of the federal Racketeer-Influenced and Corrupt Organizations Act (RICO). The Los Angeles Times went so far as to proclaim, "Lawyers, accountants and other consultants will no longer face triple damages in fraud prosecutions."

If this is true, the Court ruling is indeed significant. Commercial attorneys have viewed RICO as their "ultimate weapon" because defendants face the possibility of enormous litigation costs, liability for the plaintiff s legal fees and the penalty for which RICO is infamous--the potential for an award as much as three times the actual damages found. Not surprisingly, many firms have been persuaded to settle civil RICO suits rather than adjudicate the issues.

But while some hail Reves for allegedly ending the threat of triple-damage liability in fraud cases, a careful reading of the decision reveals the Supreme Court majority simply adopted the district court's position in ruling Ernst & Young had confined itself to the role traditionally performed by outside auditors. Therefore, by definition the auditors took no part in managing or operating the corrupt farmer's cooperative that was at the center of the case.

While the factual findings clearly are favorable to Ernst, it is highly questionable whether Reves has significantly limited CPAs' potential liability for triple damages under RICO.

What the Court ruled. On March 3, the Supreme Court ruled seven to two in favor of Ernst & Young, which as Arthur Young & Company had audited the financial statements of the Farmers Cooperative of Arkansas and Oklahoma, Inc. When the co-op went bankrupt in 1984, noteholders sued the accounting firm for securities fraud and RICO violations. The investors alleged the accountants overvalued the co-op's chief asset--a gasohol plant--to keep the co-op as a client and protect its manager.

The district court granted a summary judgment in favor of Arthur Young on the RICO claim, applying an established test that RICO "requires some participation in the operation or management of the enterprise itself." The court concluded the investors failed to show "anything more than that the accountants reviewed a series of completed transactions, and certified the co-op's records as fairly portraying its financial status...."

On appeal, the Eighth Circuit affirmed the accountants had not participated in the co-op's management sufficiently to be liable under RICO, and this ruling was upheld by the Supreme Court. (See Legal Scene, Jofa, May93, page 24, for additional background on the Reves decision).

Unanswered questions. One must look at this case as the very narrow ruling it is. The only determination made by the Court was that the accountants' conduct was insufficient to meet the "operations or management test," requiring that they be actively involved in management to be liable under RICO. But if a court concludes an outside auditor went beyond the traditional role of auditing, at what point is the operations or management test met?

Given that the American Institute of CPAs Code of Professional Conduct establishes a clear line between management and auditing, Reves may represent little more than the resolution of a factual dispute over whether Ernst, in this case, crossed that line.

To interpret this narrow ruling as a new theory of liability limitation for accountants is wishful thinking. If CPAs conduct audits with less concern about triple-damage liability in civil fraud cases, they are being foolhardy.

Third-party liability--current status? CPAs' liability to third parties essentially is unchanged by the decision. All of the theories that existed before RICO are still viable. Common law theories, such as breach of contract, negligence and fraud, are not affected by Reves. There also are the statutory theories of federal securities fraud (as well as similar actions under state securities laws).

Certainly the favorable result in Reves will curtail civil RICO suits, but nothing in the ruling suggests CPA triple-damage liability under RICO has been eliminated.

Moreover, over half the states have enacted statutes similar to RICO, most of which provide for triple-damage remedies or punitive damages. Other states (such as California and Texas) also have enacted deceptive trade practices statutes that provide plaintiffs' attorneys with powerful triple-damage weapons.

Even if the Supreme Court's ruling does limit RICO's effective use against accountants, the aggregate of the state statutes still provides a veritable arsenal of "ultimate weapons."