On October 21, 2010, the New York Court of Appeals (the Appeals Court), New York’s highest appellate court, addressed two appeals, and then issued an important ruling regarding the parameters of the affirmative defense of in pari delicto in suits against outside auditors, holding that the doctrines of in pari delicto and imputation are a complete bar to recovery when the corporate wrongdoer’s actions are imputed to the company.
The Doctrines of In Pari Delicto and Imputation
The doctrine of in pari delicto has been a part of New York common law for over two hundred years, and prevents courts from interceding to resolve a dispute between two wrongdoers (i.e., a corporation and a third party). Since a corporation acts only through its agents, the availability of the in pari delicto defense revolves around the scope of the imputation doctrine; i.e., the presumption that a corporation must be generally responsible for the acts of its authorized agents, regardless of whether the actions are unauthorized. Only in instances where the agent has totally abandoned the corporation’s interests and is acting entirely for his own purpose does an exception to imputation arise: the “adverse interest” exception. This exception is designed to avoid ambiguity where there is a benefit to both the insider and the corporation, and reserves this exception for those cases where the insider’s misconduct benefits only himself or a third party.
In recent years, there has been much debate over the parameters of imputation, and whether the in pari delicto defense should be available to outside professionals, such as auditors, that are alleged to have been negligent or even to have participated in the fraud.
Kirschner v. KPMG, LLP
The Kirschner lawsuit resulted from the 2005 collapse of Refco, a leading provider of brokerage and clearing services. In October 2005, Refco disclosed that, as early as 1998, its president and chief executive officer had orchestrated a series of loans that ultimately hid millions of dollars of uncollectible debt from public and regulator view. These maneuvers, of course, created a falsely positive picture of Refco’s financial condition, and as a result of the disclosure, Refco was required to file for bankruptcy protection.
When Refco’s plan of reorganization was confirmed in December 2006, a Litigation Trust was established. The Litigation Trust, through the Litigation Trustee (Mr. Kirschner), was authorized to pursue claims and causes of action possessed by Refco prior to the bankruptcy filing. In August 2007, the Litigation Trustee filed a complaint in Illinois state court asserting fraud, breach of fiduciary duty and malpractice against not only Refco’s president and CEO and other managers and owners (collectively, the Refco Insiders), but also against investment banks that served as underwriters for the 2004 leveraged buyout and two accounting firms that provided services to Refco. The Litigation Trustee asserted that these defendants either aided and abetted the Refco Insiders in carrying out the fraud, or were negligent in failing to discover the fraud. A year later, the Litigation Trustee filed a similar complaint in Massachusetts state court, asserting similar claims against KPMG LLP. Both lawsuits were removed to federal court and transferred to the Southern District of New York for consolidated proceedings.
The defendants moved to dismiss the Litigation Trustee’s claims, and the court identified the threshold issue as whether the claims were subject to dismissal pursuant to the Second Circuit’s Wagoner rule, which essentially states that a bankruptcy trustee does not possess standing to seek recovery from third parties alleged to have joined with the debtor corporation in defrauding creditors. Further, if the Wagoner rule applied, then the issue was solely whether the narrow exception to the Wagoner rule – the “adverse interest” exception – was applicable. The district court noted that the adverse interest exception applied only if the corporate wrongdoer had totally abandoned the company’s interests and had acted entirely for his own or another’s purpose (because only in those circumstances could the officer’s misconduct not be imputed to the corporation). The district court concluded that, because the complaint was filled with allegations regarding the substantial benefits that Refco received from the Refco Insiders’ alleged wrongdoing, case law precedent foreclosed the claims of the Litigation Trustee against the defendants. In so doing, the district court declined to expand the adverse interest exception to require an inquiry solely into the insiders’ claimed motivations, without regard to the nature and effect of their misconduct, as advocated by the Litigation Trustee: “the Trustee must allege, not that the [Refco] insiders intended to, or to some extent did, benefit from their scheme, but that the corporation was harmed by the scheme, rather than being one of its beneficiaries” (2009 WL 1286326, *7, 2009 US Dist LEXIS 32581, *27).
The Litigation Trustee appealed to the Second Circuit Court of Appeals, which certified certain questions to the Appeals Court, including “whether the adverse interest exception is satisfied by showing that the insiders intended to benefit themselves by their misconduct”; and “whether the exception is available only where the insiders’ misconduct has harmed the corporation.”
Teachers’ Retirement System of Louisiana and City of New Orleans Retirement System v. PricewaterhouseCoopers LLP (PwC)
This lawsuit was a derivative action brought on behalf of American International Group, Inc. (AIG) by the Teachers’ Retirement System of Louisiana and the City of New Orleans Employees’ Retirement System. The complaint alleged that senior officers of AIG set up a fraudulent scheme to misstate AIG’s financial performance in order to deceive investors. The derivative plaintiffs also alleged that PwC, as independent auditor, did not perform its auditing responsibilities in accordance with professional standards, and failed to detect or report the fraud.
PwC moved to dismiss the action, and in February 2009 the Delaware Court of Chancery granted the motion, on the grounds that under New York law, the claims were barred. Specifically, the court found that the wrongdoing of AIG’s senior officers was imputed to AIG, and that, based on the allegations in the complaint, these officers did not totally abandon AIG’s interests such that the adverse interest exception to imputation would apply. Thus, once the wrongdoing was imputed to AIG, the claims against PwC were barred by New York’s in pari delicto doctrine and the Wagoner rule. The derivative plaintiffs appealed, and upon the determination that the appeal’s resolution depended on unsettled questions of New York law, the Delaware Supreme Court certified the question to the appeals court.
Subjective Intent and Illusory Benefits
The Litigation Trustee first advocated that the insiders’ intent be the primary consideration, and that short-term benefit to the company would not defeat the adverse interest exception, based on his reading of the Second Circuit’s opinion in In re CBI Holding Co. v. Ernst & Young, 529 F.3d 432 (2d Cir. 2008).
In the CBI case, the Second Circuit found that the plaintiff had standing via the adverse interest exception to assert claims against the corporation’s accountants arising from prepetition audits, as the fraud was perpetrated by the wrongdoers in order to obtain bigger bonuses and preserve the status quo regarding management of the company. Thus, the Litigation Trustee argued, the adverse interest exception should depend upon whether the insiders intended to benefit themselves, to the detriment of the company, which is to be proven by showing that the wrongdoers received personal benefits and/or that the company received only short-term benefits but suffered long-term damages.
Succinctly considering this argument, the Court of Appeals noted that the Litigation Trustee’s proposed rule would essentially render the adverse interest exception available in all corporate fraud cases, stating that: “fraudsters are presumably not, as a general rule, motivated by charitable impulses, and a company victimized by fraud is always likely to suffer long-term harm once the fraud becomes known.”
The Rules of NCP and AHERF
Alternatively, the Litigation Trustee argued that the Court of Appeals should approach in pari delicto and imputation in the manner of the New Jersey Supreme Court in 2006 or the Pennsylvania Supreme Court in 2010.
In the cases of NCP Litig. Trust v. KPMG LLP, 187 N.J. 353 (N.J. 2006) and Official Comm. of Unsecured Creditors of Allegheny Health Educ. and Research Found. v. PricewaterhouseCoopers LLP, 989 A.2d 313 (Pa. 2010), both New Jersey and Pennsylvania developed carve-outs from agency law in cases of corporate fraud, in order to deny the defense of in pari delicto to negligent auditors (NCP) and collusive outside professionals (AHERF).
In the NCP case, two corporate officers intentionally misrepresented the publicly traded company’s financial status to investors and to KPMG. When KPMG uncovered and reported the fraud, the company filed for bankruptcy, resulting in significant losses for investors. Ultimately, the litigation trust brought suit against KPMG for negligence in failing to exercise due care in performing the audits and preparing financial statements. KPMG argued in pari delicto as an affirmative defense, but the New Jersey Supreme Court held that the doctrine of imputation does not prevent the shareholder from seeking to recover against a negligent auditor, though the shareholders must have been innocent to avoid the imputation defense. Thus, the resulting New Jersey rule requires an analysis of comparative fault and apportionment of responsibility.
In the AHERF case, the chief executive and financial officers of a nonprofit operator of health care facilities allegedly intentionally misstated the company’s financials to PwC, its outside auditors, in order to cover up substantial operating losses. After bankruptcy was filed, the creditors’ committee, acting on the debtor’s behalf, sued PwC and alleged negligence, aiding and abetting and breach of contract. The district court granted PwC’s motion for summary judgment, finding that the doctrine of in pari delicto applied. On appeal, the Third Circuit certified questions to the Pennsylvania Supreme Court regarding the test for determining when imputation was appropriate. The Pennsylvania Supreme Court found that imputation (and therefore the in pari delicto defense) was not available where the auditor did not proceed in material good faith. In light of this opinion, the Third Circuit held that when a third party, such as an auditor, colludes with agents to defraud the principal, Pennsylvania law requires an inquiry as to whether the third party dealt with the principal in good faith.
Noting that the rulings in both cases were motivated by equitable considerations, the Court of Appeals nonetheless found that such carve-outs essentially render moot the adverse interest exception.
Finally, the Litigation Trustee argued that the in pari delicto defense should not be a total bar to recovery, but instead should serve as the basis for apportionment of fault and damages. However, the Court of Appeals held that the application of a standard of comparative fault contradicts the public policy purpose behind in pari delicto.
With this ruling, the appeals court stood firm in its application of in pari delicto and imputation, reaffirming that in New York, responsibility for fraudulent or other wrongful actions of corporate agents falls squarely on the corporation, except in circumstances where the agents act in a manner that immediately and directly harms the corporation (such that imputation does not apply). Thus, in situations where the fraud or other misconduct has benefited the corporation, at least in the immediate aftermath, the corporation and other derivative plaintiffs (such as bankruptcy trustees or litigation trusts) will be barred from recovering against outside professionals.