On September 9, 2008, the United States Court of Appeals for the Third Circuit issued a decision that may impact the ability of auditors to defend against professional malpractice lawsuits. In Thabault v. Chait,1 the Third Circuit affirmed a $182.9 million judgment against PriceWaterhouseCoopers (PwC) for negligent auditing practices.
The lawsuit was brought by Vermont's Insurance Commissioner, who served as receiver for the insolvent Ambassador Insurance Company ("Ambassador"). The lawsuit alleged that Coopers & Lybrand (a national accounting firm which subsequently merged with PriceWaterhouse to form PwC) negligently issued unqualified and favorable audit opinions of Ambassador Insurance Company in 1981 and 1982 with the knowledge that the financial statements were inaccurate and materially understated the company's loss reserves.
In response, PwC argued that it was shielded from liability by application of the in pari delicto doctrine. The doctrine of in pari delicto is an equitable doctrine that states that a plaintiff who has participated in wrongdoing may not recover damages resulting from that wrongdoing.2 The in pari delicto doctrine is based on the policies that courts should not be mediating disputes among wrongdoers and that denying judicial relief to a wrongdoer is an effective deterrent of illegality.3 In certain cases, the improper conduct of a corporate officer is imputed to the corporation and to the plaintiff suing on behalf of the corporation. As a result, the plaintiff is barred from asserting a claim against a third party because the plaintiff is deemed to be at fault for the claim. State law governs whether a corporate officer's misconduct will be imputed to the corporation that is asserting causes of action created by state law.4
Under well-established imputation rules, courts will impute the fraud of an officer to the corporation when the officer commits the fraud (1) in the course of his employment, and (2) for the benefit of the corporation.5 The second part of this test is also sometimes called the "adverse interest exception." This means that fraudulent conduct will not be imputed if the officer's interests were adverse to the corporation and not for the benefit of the corporation. The "adverse interest exception" is itself subject to the "sole actor exception," which provides that if the corporate officer is the sole or controlling officer of the corporation, that officer's conduct is automatically imputed to the corporation regardless of whether it was adverse to the corporation.6
In the Thabault case, the trial court found that Ambassador's CEO committed gross negligence and breached his fiduciary duty to the company. PwC argued that the CEO's improper conduct should be imputed to Ambassador and, as a result, the Commissioner suing on behalf of Ambassador should be barred from suing PwC. The Third Circuit, however, rejected PwC's argument. Relying on a New Jersey Supreme Court decision,7 the Third Circuit held that, under New Jersey law, the party invoking the in pari delicto doctrine is required to be an innocent third party directly defrauded by the corporate misconduct. Further, the Third Circuit recognized an "auditor negligence exception" under New Jersey law which allows a corporation to bring a negligence claim against its auditor for damages caused by that negligence.8 Because PwC was not an innocent victim of Ambassador's corporate misconduct, and because the auditor negligence exception applied, the Third Circuit concluded that PwC was prohibited from invoking the in pari delicto doctrine against the Commissioner.9 In other words, under New Jersey law PwC could not use corporate misconduct as a defense to shield itself from liability.
The Third Circuit's decision is clearly problematic for auditors. By requiring an auditor to be a direct victim of the corporate misconduct, the Third Circuit has made it extremely difficult, if not impossible, for an auditor to invoke the in pari delicto defense under New Jersey law. This decision is also troubling because the "innocent victim" requirement recognized by the Third Circuit appears to be a new requirement at odds with the well-established imputation rules applied in prior in pari delicto cases. The Thabault decision contradicts numerous cases which have allowed auditors to invoke the in pari delicto defense without requiring the auditor to be an "innocent" party. 10
In a recent case applying Pennsylvania law, even the Third Circuit recognized that a requirement that only an innocent party can invoke the in pari delicto doctrine would create "substantial tension" with prior Third Circuit decisions in which the doctrine was invoked to shield a non-innocent party.11
Thus, the Third Circuit's decision in Thabault is a departure from cases in other jurisdictions in which third party professionals accused of professional misconduct have successfully invoked the in pari delicto defense to shield themselves from liability. The good news is that the Thabault decision is limited to New Jersey law. Based on the decision in Thabault, the ability of auditors and other third party professionals to invoke the in pari delicto defense will now very much depend on which state's law is being applied.