In Pari Delicto Continues to Curtail Financial Fraud Suits Against Professional Service Firms in New York
New York's highest state court has ruled that the in pari delicto affirmative defense shielding accountants, lawyers, underwriters and other professional advisers from third party liability "remain[s] sound" and should be strictly applied. The Court made this ruling on October 21, 2010 in a sharply split decision, answering certified questions raised in two high profile financial fraud cases: Kirschner v. KPMG LLP ("Kirschner") and Teachers' Retirement System of Louisiana v. PricewaterhouseCoopers LLP ("Teachers"). The decision is at odds with recent rulings of the Supreme Courts of New Jersey and Pennsylvania that created additional exceptions to the defense.
This decision is significant because it continues to allow financial fraud lawsuits in New York against third parties only in the most limited of circumstances. Often, where there has been a corporate financial fraud, injured parties seek to recover losses by suing third party professional service organizations (accountants, lawyers, bankers and other advisers) either for negligence in failing to detect the fraud or for outright collusion in the misconduct. Relying heavily on principles of agency law, however, New York's Court of Appeals confirmed that such lawsuits can only proceed in New York when the actions of corporate insiders cannot be imputed to the corporation itself because there is clear adversity between the insider and the corporate entity. This means that most often the misconduct of the corporate insiders will be imputed to the corporation itself and that shareholder-plaintiffs in a derivative action and unsecured creditors in bankruptcy will be treated as wrongdoers who cannot sue other wrongdoers because of the in pari delicto defense.
The Court of Appeals' ruling that there must always be imputation except for cases in which the corporation has been harmed by insiders who are directly adverse to its interests puts New York at odds with some other states that have eased the grip of in pari delicto. Specifically, in 2006, New Jersey's Supreme Court excused the in pari delicto defense in cases of auditor negligence where it is shown that the corporate shareholders are not at fault. And earlier this year, the Pennsylvania Supreme Court precluded in pari delicto in cases where that auditor has not acted in material good faith by colluding with the aberrant manager/insiders.
The upshot of the New York ruling, therefore, may be that shareholder derivative plaintiffs and unsecured creditors in bankruptcy seeking to recover from professional service firms for losses incurred in financial fraud cases will look outside of New York for redress.
In pari delicto is an affirmative defense precluding judicial resolution of disputes between wrongdoers. The defense is shorthand for the longstanding principle of "in pari delicto potior est conditio defendentis" ("in a case of equal or mutual fault, the position of the defending party is the better one.") It is meant to deter illegality by denying judicial relief to an admitted wrongdoer. It is also designed to preserve judicial resources by demanding that courts refrain from hearing cases between wrongdoers.
Application of the in pari delicto defense is affected by principles of imputation under agency law. When a corporate agent acts, the knowledge he or she acquires while acting within the scope of employment is imputed to the corporation. It is presumed that the principal knows and approves of the acts of the agent. This presumption applies even when the agent acts wrongly, shows poor business judgment or even commits fraud.
Like many other states, New York allows for an exception to imputation known as the "adverse interest exception." It provides that an agent's acts will not be imputed to the corporation where the agent "totally abandoned his principal's interests" and acted "entirely for his own or another's purposes." Center v. Hampton Affiliates, 66 N.Y.2d, 782, 784-85 (1985). There is no presumption of imputation in such circumstances because the agent cannot be presumed to have disclosed something that would expose and defeat a fraudulent purpose.
Determining whether in pari delicto shields third party professionals from liability when they do not detect or they actively participate in the fraud committed by corporate insiders depends on whether imputation is presumed or whether, instead, the adverse interest exception suspends the presumption. This issue of the extent to which New York immunizes third party professionals from liability through in pari delicto was raised in certified questions to New York's Court of Appeals by two courts confronting whether to apply the adverse interest exception in corporate financial misconduct cases.
II. The Certified Questions
The certified questions were posed in Kirschner by the federal Second Circuit Court of Appeals as part of litigation in the Refco bankruptcy and in Teachers by the Delaware Supreme Court in connection with a derivative action alleging fraudulent financial misstatements at American International Group ("AIG").
On behalf of the unsecured creditors in the Refco bankruptcy, the litigation trustee brought lawsuits against Refco's inside senior management but also against its outside accounting firms, law firm and investment bankers concerning allegedly deceptive loans that caused the company's stock to plummet. The trustee claimed that the outside defendants aided and abetted Refco insiders in committing fraud or in negligently failing to discover it. The lawsuits were coordinated in the Southern District of New York.
The district court dismissed the claims against the outside defendants on grounds that the adverse interest exception did not apply, thereby imputing the insiders' corporate misconduct to the corporation and barring the claims based on the in pari delicto defense. The court reasoned that the adverse interest exception could only apply where the corporate officers had totally abandoned the corporation's interests and acted entirely for their own personal benefit. Here, however, the complaint was replete with allegations that the company itself received substantial benefits from the insiders' alleged wrongdoing. In other words, the trustee's own allegations pled that the insiders stole for Refco not from it.
The district court rejected arguments that the Second Circuit requires only inquiry into the insiders' intent in determining whether the adverse interest exception applies. Were the insiders' subjective motivation to be the "touchstone" of the analysis, the court explained, the adverse interest exception would be transformed from a "narrow exception into a new and nearly impermeable rule barring imputation." Rather, the critical concern is not whether the insiders intended to benefit from the scheme but whether the corporation was harmed by the scheme as opposed to being one of its beneficiaries.
On appeal, the Second Circuit sought guidance from New York's Court of Appeals as to the scope of the adverse interest exception. Specifically, the federal court sought to have two questions answered: (1) whether the adverse interest exception is satisfied by showing that the insiders intended to benefit themselves by their misconduct; and (2) whether the exception is available only where the insiders' misconduct has harmed the corporation.
In Teachers, AIG shareholders instituted a derivative action in Delaware Chancery Court, alleging that senior AIG officers fraudulently schemed to deceive investors about the company's financial soundness and security. They also alleged that AIG's independent auditor, PricewaterhouseCoopers ("PwC"), failed to detect the fraud in compliance with professional auditing standards and, therefore, committed malpractice.
The Chancery Court dismissed the claims against PwC, finding them barred under the governing New York law. The Court imputed wrongdoing committed by senior AIG officers to the company because the complaint's allegations did not show that the AIG insiders had totally abandoned the company's interests and, thus, that the adverse interest exception could not apply.
The derivative plaintiffs appealed. Like the Second Circuit in Kirschner, the Delaware Supreme Court sought guidance about New York law by certifying the following question to New York's highest court:
Would the doctrine of in pari delicto bar a derivative claim under New York law where a corporation sues its outside auditor for professional malpractice or negligence based on the auditor's failure to detect fraud committed by the corporation and the outsider auditor did not knowingly participate in the corporation's fraud, but instead, failed to satisfy professional standards in its audits of the corporation's financial statements.
III. Court of Appeals Opinions
The Court of Appeals split 4-3 in favor of strict application of in pari delicto. The majority opinion refused to interpret the adverse interest exception more broadly or to adopt additional exceptions to the in pari delicto defense that have been embraced by the Supreme Courts of New Jersey and Pennsylvania.
A. Majority Opinion
The majority emphasized that the adverse interest exception is "narrow in scope." It read closely earlier New York case law that restricted the exception to cases in which the agent "totally abandoned" the principal's interests and in which the agent was "acting entirely for his own or another's purpose." In other words, the majority explained, the adverse interest exception cannot apply "where there is a benefit to both the insider and the corporation, and reserves this most narrow of exceptions for those cases – outright theft or looting or embezzlement – where the insider's misconduct benefits only himself or a third party." In short, for the adverse interest exception to apply, the fraud must have been committed "against" the corporation and not benefit the corporation at all.
The majority reasoned that a fraud benefitting the corporation is necessarily not adverse to the corporation even if it were motivated by an insider's personal gain. According to the majority, the "adversity" requirement means in practical terms that the adverse interest exception does not apply, there is imputation and in pari delicto will bar claims against third parties "[s]o long as the corporate wrongdoer's fraudulent conduct enables the business to survive – to attract investors and customers and raise funds for corporate purposes."
The majority dispensed with various arguments for a more flexible approach to in pari delicto. The litigation trustee in Kirschner maintained that the existence of the bankruptcy itself should be considered sufficiently harmful to the corporation so as to allow for the adverse interest exception. The majority rejected this argument because "the mere fact a corporation is forced to file for bankruptcy does not determine whether its agents' conduct was, at the time it was committed, adverse to the company."
Both the litigation trustee and the derivative plaintiffs proposed that the agent's intent be the touchstone of adverse interest exception analysis because an "illusory benefit to the company should not defeat the adverse interest exception." They formulated a test that permits the adverse interest exception where it is "alleged and proved by showing that the corrupt insiders intended to benefit themselves personally and actually received personal benefits and/or that the company received only short term benefits but suffered long term harms." The majority dismissed this approach as rendering the adverse interest exception a "dead letter" since "a company victimized by fraud is always likely to suffer long-term harm once the fraud becomes known."
The majority also rejected approaches taken by the New Jersey Supreme Court in NCP Litig. Trust v. KPMG LLP, 187 N.J. 353 (NJ 2006) and the Pennsylvania Supreme Court in Official Comm. of Unsecured Creditors of Allegheny Health Educ. and Research Fund v. PricewaterhouseCoopers LLP, 989 A.2d 313 (Pa. 2010) ("AHERF"). Based on these decisions, both New Jersey and Pennsylvania have carved out additional exceptions to the in pari delicto defense.
New Jersey now excludes from the in pari delicto defense certain cases in which the outside auditor was negligent. In those circumstances, "when an auditor is negligent within the scope of its engagement, the imputation doctrine does not prevent corporate shareholders from seeking to recover." NCP, 187 N.J. at 384. New Jersey limits these circumstances to cases in which the corporate shareholders are innocent. Imputation would still apply in cases in which the shareholders themselves engaged in fraud. It also applies where the shareholders should have been aware of the fraud because of their role in the company or where shareholders owned large blocks of stock investing them with the authority to oversee operations. Consequently, "the New Jersey rule calls for the relative faults of the company/shareholders and auditors to be sorted out by the fact finder as matters of comparative negligence and apportionment."
In AHERF, the federal Third Circuit certified questions to the Pennsylvania Supreme Court seeking clarification of "the appropriate test under Pennsylvania law for deciding whether imputation [was] appropriate when the party invoking that doctrine [was] not conceded to be an innocent third party but an alleged co-conspirator in the agent's fraud." The Pennsylvania Supreme Court answered that imputation – and, thus, in pari delicto – is not available where an auditor has not acted in material good faith. Based on this answer, the Third Circuit determined that when a third party colludes with an agent to defraud the principal "Pennsylvania law requires an inquiry into whether the third party dealt with the principal in good faith." AHERF Creditors' Comm. v. PricewaterhouseCoopers, 607 F.3d 346, 348 (3d Cir. 2010).
The majority interpreted the New Jersey and Pennsylvania exceptions as animated by principles of equity. That is, even though the plaintiff-agents in those cases stood in the shoes of the principal-malefactors, any recovery they received from negligent or complicit third party accounting firms would be fair and not subject to the in pari delicto defense because they would only benefit innocent shareholders or unsecured creditors. As a matter of public policy, the litigation trustee and derivative plaintiffs asked New York's highest court to embrace similar exceptions "in order to compensate the innocent and deter third-party professional (and, in particular, auditor) misconduct and negligence."
The majority rejected the request. It wrote: "We are not persuaded, however, that the equities are quite so obvious. In particular, why should the interests of innocent stakeholders of corporate fraudsters trump those of innocent stakeholders of the outside professionals who are the defendants in these cases?" The court characterized the proposed exceptions as creating a double standard in which innocent stakeholders of the outside professionals are held responsible for the agents' wrongdoing but the innocent stakeholders of the corporation are not charged with knowledge of the wrongdoing. Specific to the case before it, the majority concluded, "[t]he owners and creditors of KPMG and PwC may be said to be at least as ‘innocent' as Refco's unsecured creditors and AIG's stockholders."
Likewise, the majority was not persuaded that embracing the New Jersey and Pennsylvania exceptions would operate as a meaningful additional deterrent to professional misconduct or malpractice. It observed that "outside professionals – underwriters, law firms and especially accounting firms – already are at risk for large settlements and judgments in the litigation that inevitably follows the collapse of an Enron, or a Worldcom or a Refco or an AIG-type scandal."
Finally, the majority rebuffed the proposal to treat in pari delicto not as a total bar to recovery but as a basis for apportionment of fault and damages consistent with the comparative negligence principles provided for in New York's CPLR § 1411.
In sum, the majority answered the certified questions as follows:
- The adverse interest exception is not satisfied by showing that the insiders intended to benefit themselves by their misconduct;
- The adverse interest exception is available only where the insiders' misconduct has harmed the corporation;
- Assuming the adverse interest exception does not apply, the doctrine of in pari delicto bars a derivative claim under New York law where a corporation sues its outside auditor for professional malpractice or negligence based on the auditor's failure to detect fraud committed by the corporation; and, the outside auditor did not knowingly participate in the corporation's fraud, but instead, failed to satisfy professional standards in its audits of the corporation's financial statements.
B. The Dissent
The dissent lamented that the ruling would effectively preclude derivative plaintiffs and litigation trustees in corporate fraud situations from suing negligent or complicit outside professional service operations even where the outside actors actively colluded with corrupt corporate insiders.
As a threshold matter, the dissent emphasized that in pari delicto is an affirmative defense. If the majority's decision were read to create a per se rule prohibiting derivative plaintiffs and litigation trustees from suing outside professionals for collusion with corrupt corporate insiders or for negligent failure to detect the wrongdoing, this "hard-line stance" would run afoul of basic pleading and proof burdens. While an affirmative defense may be decided by the facts plead in the complaint, the facts and inferences must inure to plaintiff's benefit on a pre-Answer motion and where the issues are complex and fact-based, dismissal should be an exception, not the rule.
Moreover, the doctrine of in pari delicto is premised on concepts of morality, fair dealing and justice. Thus, the defense should not be viewed as "a rigid concept, incapable of shaping itself to the particulars of an individual case." Instead, the dissent explained, before invoking in pari delicto, it must be determined that the insiders' actions are attributable to the corporate entity. Notwithstanding the presumption of imputation under agency law, there still needs to be a showing of harm to the principal and not every supposed short term benefit is actually beneficial to the corporation's existence. For example, prolonging a corporation's existence when confronted with an inevitable and increasing insolvency "is not a true benefit to the corporation but can be considered a harm." All that rigid application of in pari delicto accomplishes is to immunize auditors and other outside professionals from liability even where the corporate insider has engaged in fraud.
The dissent also identified important policy concerns weighing against a strict application of in pari delicto. Auditors and other outside professionals are essentially "gatekeepers" serving not just the corporation that contracted its services but the public as well. Investors, in particular, rely heavily on these outside professionals and their work as a verification or guide in an investment decision. According to the dissent, "[i]t is, therefore, in the public's best interest to maximize diligence and thwart malfeasance on the part of gatekeeper professionals." By immunizing these gatekeeper professionals, the dissent warns, the majority has invited them to neglect their responsibility of ferreting out insider fraud. Instead, the dissent would have adopted the carve out exceptions to the in pari delicto defense embraced by the Supreme Courts of New Jersey and Pennsylvania for cases involving corporate insider fraud enabled by complicit or negligent gatekeeper professionals.
Unlike recent New Jersey and Pennsylvania Supreme Court decisions curtailing the scope of the in pari delicto affirmative defense, New York's highest court has recommitted to strict application of that defense. As a result, third party professional service firms are generally protected from corporate financial fraud cases under New York law and can only be sued where the misconduct of corporate insiders is not imputed to the corporation because the insiders' interests are completely adverse to those of the corporation.
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