In a 4-3 decision issued on October 21, 2010, the New York Court of Appeals answered certified questions in two cases involving allegations of professional negligence and misconduct. The first question came from the U.S. Court of Appeals for the Second Circuit in Kirschner v. KPMG LLP, 590 F.3d 186 (2d Cir. 2009), a lawsuit arising out of the Refco bankruptcy. The Second Circuit sought guidance as to "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." The second question came from In re American International Group, Inc., 998 A.2d 280 (Del. 2010), a lawsuit arising out of AIG's allegedly fraudulent scheme to inflate its financial performance. The Delaware Supreme Court sought guidance as to whether the principle of in pari delicto bars a derivative claim 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 if the outside auditor did not knowingly participate in the corporation's fraud.
The New York Court of Appeals examined the public policy underlying both the in pari delicto and the adverse interest principles. With regard to in pari delicto, the court reaffirmed New York's strong commitment to the policy of denying judicial relief to an admitted wrongdoer and avoiding entangling the courts in disputes between wrongdoers. Accordingly, the doctrine applies even in very difficult cases and should not be "weakened by exceptions." With regard to the adverse interest exception, the court stated that "strong considerations of public policy" have led to the century-old rule that "corporate acts—including fraudulent ones—are subject to the presumption of imputation." Imputation "fosters an incentive for a principal to select honest agents and delegate duties with care." Following that policy, the court stated that the adverse interest exception applies only in very narrow cases, such as outright theft, looting, or embezzlement, where the action is committed against the corporation rather than on its behalf.
Turning to the cases at hand, the court refused to accept the plaintiffs' invitation to broaden or revise the adverse interest exception and doctrine of in pari delicto. The court found no reason that "the interests of innocent stakeholders of corporate fraudsters" should "trump those of innocent stakeholders of the outside professionals who are the defendants." The court recognized that "outside professionals—underwriters, law firms, and especially accounting firms—already are at risk for large settlements and judgments that inevitably follow" from corporate scandals. Accordingly, broadening or revising either principle would not result in any greater disincentive for professional malfeasance or negligence than what currently exists. The court ruled that (1) the adverse interest exception is not satisfied by showing that the insiders intended to benefit themselves by their misconduct; (2) the exception is available only where the insiders' fraud itself—as opposed to the discovery of the fraud—has harmed the corporation; and (3) the principle of in pari delicto bars a derivative claim against outside professionals who merely failed to detect a fraudulent scheme by corporate insiders.
The court expressly declined to follow the approach of the New Jersey Supreme Court in NCP Litigation Trust v. KPMG LLP, 187 N.J. 353 (2006), which called for the fact-finder to assess the relative fault of the company and its shareholders in comparison to the fault of the auditors. The New York Court of Appeals also declined to adopt the reasoning of the Pennsylvania Supreme Court in Official Committee of Unsecured Creditors of Allegheny Health Education & Research Foundation v. PricewaterhouseCoopers LLP, 989 A.2d 313 (Penn. 2010), and 607 F.3d 346, 348 (3rd Cir. 2010), which required an inquiry into whether the auditor "dealt with the principal in good faith." In a footnote, the court observed that in pari delicto is an affirmative defense, but it could be resolved on the pleadings in an appropriate case.
The dissent, authored by Judge Ciparick, objected to the majority's policy rationale and asserted that the majority had effectively created "a per se rule that fraudulent insider conduct bars any actions against outside professionals by derivative plaintiffs or litigation trustees for complicitous assistance to the corrupt insider or negligent failure to detect the wrongdoing." The dissent contended that "insider fraud that merely gives the corporation life longer than it would naturally have is not a true benefit to the corporation but can be considered a harm" and agreed with critics who have argued that the application of simple agency principles in this context could create inappropriately severe results that "serve to effectively immunize auditors and other outside professionals from liability wherever any corporate insider engages in fraud." The dissent maintained that it is "in the public's best interest to maximize diligence and thwart malfeasance on the part of gatekeeper professionals," without acknowledging the majority's point that such a policy merely shifts the costs of litigation and any settlements or judgments from the innocent stakeholders of corporate fraudsters to the innocent stakeholders of the outside professionals, which ultimately results in the costs being borne by the public. Opinion.