Official Committee of Unsecured Creditors of Allegheny Health, Education and Research Foundation v PricewaterhouseCoopers, LLP (3d Cir No 07-1397, May 28, 2010)

CASE SNAPSHOT

An independent auditor was sued by a nonprofit corporation’s official committee of unsecured creditors, for breach of contract, professional negligence, and aiding and abetting a breach of fiduciary duty. The committee claimed damages in excess of $1 billion resulting from the auditor’s alleged collusion with the corporation’s officers to fraudulently misstate the corporation’s finances. At the lower court level, the auditor prevailed on its argument that the fraud of the officers should be imputed to the corporation, thus preventing the corporation—and the committee standing in its stead—from collecting against the auditor because the corporation was as much at fault as the auditor. After obtaining an advisory opinion from the Pennsylvania Supreme Court, the Court of Appeals vacated the District Court’s judgment and remanded the case to the District Court for further findings of fact.

FACTUAL BACKGROUND

The debtor is the Allegheny Health, Education and Research Foundation (AHERF), a nonprofit corporation that provided health care services through 14 hospitals, two medical schools and hundreds of physicians’ practices. Throughout the 1980s, AHERF grew through a program of acquisitions. Unfortunately, AHERF was unable to deliver cost savings and efficiency gains as envisioned, and by 1996, AHERF was suffering substantial operating losses. During this time, independent auditing services were provided by PricewaterhouseCoopers (PWC).

A group of AHERF officers, led by the chief financial officer and operating with the approval of the president and chief executive officer, was alleged to have knowingly misstated AHERF’s finances in the figures they provided to PWC for the 1996 audit. These misstatements were intended to show AHERF as enjoying positive financial conditions, rather than the dire conditions the company was suffering. PWC’s audit failed to reveal the misstatements, and so PWC issued a clean opinion to the Board of Directors of AHERF as to the financial condition of the company. These same circumstances were allegedly repeated in 1997.

By early 1998, the poor financial condition of AHERF became widely known, as suppliers complained directly to board members, and doctors threatened to quit because of a lack of hospital resources. The financial damage was too deep, and in July 1998, AHERF filed a chapter 11 petition for bankruptcy.

In an adversary proceeding, the Official Committee of Unsecured Creditors of AHERF asserted three causes of action against PWC: (1) breach of contract; (2) professional negligence; and (3) aiding and abetting a breach of fiduciary duty. PWC moved for summary judgment, raising seven arguments in its defense. The District Court granted PWC’s motion on the sole ground that the doctrine of in pari delicto—a doctrine that prevents courts from finding for a plaintiff when that plaintiff is as equally at fault as the defendant for the damages incurred—barred the Committee’s claims. Specifically, applying principles of agency law, the District Court found that the wrongdoing of AHERF’s senior management could be imputed to AHERF, and that, because AHERF was also at fault for the misstated financial statements, the doctrine of in pari delicto barred the Committee’s claims. The Committee appealed to the Circuit Court.

Because questions were raised concerning the interaction between the doctrine of in pari delicto and the imputation of an agent’s fraud to his principal under Pennsylvania law, the Circuit Court certified two questions to the state Supreme Court. This case discusses the findings of the Pennsylvania Supreme Court, and the Circuit Court’s decision in light of those findings.

IMPUTING THE OFFICERS’ WRONGDOING TO AHERF

The first question certified to the Supreme Court of Pennsylvania was: “[w]hat is the proper test under Pennsylvania law for determining whether an agent’s fraud should be imputed to the principal when it is an allegedly non-innocent third-party that seeks to invoke the law of imputation in order to shield itself from liability?”

The Pennsylvania Supreme Court responded that the key was whether the defendant dealt with the principal in good faith. The Pennsylvania Supreme Court noted, however, that this underlying principle had different applications depending on whether the plaintiff was proceeding against the auditor under a theory of negligence or collusion.

In the negligence context, the Pennsylvania Supreme Court declared that a third party would generally be able to impute an agent’s bad faith to the principal if that conduct benefitted the principal, but would not be able to impute the agent’s conduct to the principal if the bad acts were only in the agent’s self-interest.  

In the collusion context, the Pennsylvania Supreme Court declared that if the auditor knew of the agent’s bad or unsanctioned acts, the auditor cannot claim to have justifiably relied on the agent’s statements, and no conduct can be imputed to the principal.

In reaching these holdings, the Pennsylvania Supreme Court expressly rejected the auditor’s assertion that secretive falsification of corporate financial information by rogue officers can be regarded as a benefit to the corporation, instead finding that it is in the best interests of a corporation for the governing structure to have accurate (or at the very least honest) financial information.  

Based on the foregoing, the Court of Appeals rejected the District Court’s holding that “any benefit” received by AHERF as a result of the officer’s conduct would result in imputation of that conduct to AHERF. Instead, the Court of Appeals held that, under the new directives provided by the Pennsylvania Supreme Court: (i) “a peppercorn of benefit cannot provide total dispensation to defendants knowingly and substantially assisting insider misconduct that is overwhelmingly adverse to the corporation,” and (ii) as a matter of law, “a knowing, secretive, fraudulent misstatement of corporate financial information is not of benefit to a company.”

IN PARI DELICTO

The second question asked of the Supreme Court was, “does the doctrine of in pari delicto prevent a corporation from recovering against its accountants for breach of contract, professional negligence, or aiding and abetting a breach of fiduciary duty, if those accountants conspired with officers of the corporation to misstate the corporation’s finances to the corporation’s detriment?” The court replied that, as a general matter, the defense is available to auditors. The court pointed out, however, that since imputation is not available as a defense to an auditor that has not dealt in good faith with the principal, collusion between the auditor and corporate officers effectively forecloses the defense of in pari delicto.

CIRCUIT COURT REMANDS THE CASE  

In accord with the guidance from the Pennsylvania Supreme Court, the Circuit Court vacated the grant of summary judgment, and remanded the case to the District Court for further proceedings. Specifically, the Circuit Court instructed that the District Court determine whether the auditor dealt with AHERF in good faith. Furthermore, the District Court was instructed to re-examine the extent of benefit the agents’ conduct conferred to AHERF, and to re-examine the benefit question in light of the Pennsylvania Supreme Court’s holding that secretive, fraudulent misstatements are not a benefit at all to a principal.

PRACTICAL CONSIDERATIONS

By holding that knowing and fraudulent misstatements of corporate financial information by a corporation’s officers do not, as a matter of law, provide a benefit to the corporation, the Pennsylvania Supreme Court has curtailed the circumstances in which those fraudulent misstatements can be imputed to the corporation. This holding thereby increases the likelihood that the corporation itself, or another party standing in its stead, can recover damages from accountants or other professionals for the damages resulting from those misstated financial records.