UK: The Further Rise Of The “Illegality Defence” In Corporate Fraud Cases

Last Updated: 8 October 2009
Article by James Roberts and Ivan Wilkinson

The latest ruling in the US Parmalat litigation has dismissed claims against Grant Thornton and Bank of America on the grounds that the claimant Parmalat companies were themselves involved in the underlying frauds. Coming so soon after the decision of the UK House of Lords in Stone & Rolls v Moore Stephens, this further raises the profile of the "illegality defences" available to professionals sued in the context of corporate frauds, both in the UK and the US – a welcome development in today's difficult economic climate.

Background

Parmalat is, notoriously, the Italian dairy conglomerate which collapsed in December 2003, following the discovery of a massive fraud. In order to keep the company going, to conceal their own wrongdoings, and maintain the inflow of investment, insiders at Parmalat created a web of fictitious transactions and dubious off-shore entities, resulting in multi-billion dollar overstatements of the group's net assets.

Numerous lawsuits have followed both as class actions under US securities legislation and also brought by various Parmalat companies themselves, at the instance of the office-holders now running them, following reorganisation/insolvency procedures.

These have included claims against Bank of America (BoA) which advised on many of Parmalat's financing and restructuring transactions, and which was alleged to have been complicit in the fraud.

Claims have also been made against Grant Thornton International (GTI) and the US member firm of Grant Thornton (GT US), arising from the audit of Parmalat by the Italian member firm of Grant Thornton (GT Italy). Although the alleged wrongdoing was that of GT Italy, plaintiffs have claimed that GTI and GT US are vicariously liable for GT Italy's acts.

Earlier this year, GTI and GT US sought to have various claims against them summarily dismissed on the basis that they could not be held vicariously liable for the work of GT Italy. The judge, however, refused to dismiss the claims on a summary judgment basis, ruling that there was enough evidence potentially to justify findings that both: (a) GT Italy was an agent of GTI, because the latter controlled how GT Italy performed the Parmalat audit; and (b) GTI was in turn an agent of GT US, because the latter had significant power and control over GTI. The cases against both GTI and GT US were therefore allowed to proceed to trial.

That ruling was consistent with the earlier US rulings relating to Banco Spirito Santo (2008) and Parmalat (January 2009), in which the US courts refused, for similar reasons, summarily to dismiss claims against, respectively, the international umbrella organisations BDO International BV (BDOI) and Deloitte Touche Tohmatsu1. In the Banco Spirito Santo case, BDOI was, however, in July of this year successful at trial in persuading a Florida jury that it did not have a principal-agency relationship with the network's US firm, BDO Seidman, and hence that BDOI was not vicariously liable for a $521.7m award made against the US firm. But because that issue was decided by a jury, there is no written judgment recording the reasons for the decision, and it is difficult to predict how other accountancy organisations would fare at trial on different facts - and with different juries.

The new ruling

Last month, New York judge Lewis Kaplan dismissed, on an entirely different basis, claims brought on behalf of two Parmalat companies against BoA and GTI/GT US. The defendants were successful in obtaining summary judgment based on the US law doctrine "in pari delicto" which prevents a party from suing others for a wrong in which it has itself participated. More specifically:

  • where the plaintiff is a company, this defence is based on the argument that misconduct by the company's agent, committed in the scope of his employment, must be attributed to the company; but
  • there is an exception, known as the "adverse interest rule" which provides that the misconduct will not be attributed to the principal (the company) where the agent's actions are adverse to the interests of the principal.

Importantly, many US states do not apply the adverse interest exception in situations where the agent's actions, however selfinterested, also conferred some benefit on the principal. In other words they only apply the exception in situations where the agent totally abandoned the principal's interests.

Judge Kaplan held (applying Illinois and North Carolina law) that in this case Parmalat's employees and officers had been conducting the work of Parmalat by growing and expanding the business, and that the Parmalat employees' fraudulent activities should be attributed to the claimant companies themselves. He therefore ruled that the claims against both BoA and GTI/GT US should fail because of the "in pari delicto" principle.

In coming to this conclusion, the judge rejected the plaintiffs' arguments that "looting" and squandering by company officers and employees of even a small portion of the corporate assets would be sufficient to establish the adverse interest exception. He ruled that an employee may steal from a company while also doing the company's business and that to accept the plaintiffs' argument "would gut the "in pari delicto" defense altogether".

Whilst this ruling is likely to be of assistance to auditors, and other professionals, facing US claims from their client companies, it should be noted that the "in pari delicto" principle is only likely to be effective as a defence to claims brought by the client company itself, but not in the context of shareholder class actions.

Comparison with the UK position

The above invites comparison with the recent UK House of Lords decision in Stone & Rolls v Moore Stephens, in which the defendant auditors were also: (a) sued by a company which had been subject to fraudulent management; (b) successful in arguing that the fraudulent activities of individuals running the company should be attributed to the company itself; and hence (c) held not to be liable because of a principle that the company could not claim losses arising from its own wrongful acts.

That said, there are many differences between the law relating to professional liability in, respectively, England and the US. It is especially notable, in the present context, that the "illegality" principle, as applied to claims against auditors under UK law, is much narrower than the "in pari delicto" principle applied by Judge Kaplan:

  • The UK House of Lords suggests that the illegality principle will only apply in relation to claims against auditors of companies both managed and owned exclusively by the fraudster. In other words, in the case of "one man companies" where the directing mind and will of the company is also its owner, and where there are in effect no honest individuals (either as owners or management) to whom the auditor could have reported the fraud.
  • On the other hand, the US "in pari delicto" principle, as applied in Parmalat, is much wider, since it can potentially be applied in the context of bigger corporate entities, including those with some "innocent" management and/or shareholders, provided that the employees' fraudulent acts did at least in some respect serve the company (rather than representing a total abandonment of the company's interests).

Although the illegality defence is narrower under UK law, there are nevertheless other considerable benefits for professionals under UK law, such as the general absence in the UK of any shareholder right of action against auditors. In the UK, it would simply not have been possible to bring the parallel Parmalat shareholder class action that will continue in the US unaffected by this latest strike out.

Implications

The possibility of fraud in client companies is clearly one of the biggest liability risks facing both auditors and other professional advisors, as recessionary conditions both unmask existing frauds and act as a stimulus for new ones. According to the latest KPMG fraud barometer, over 160 cases of serious fraud came to court in the first half of this year with a total value of £636 million. This is the highest number of cases in a six month period in the 21 year history of the barometer, which shows just how much truth lies behind the now well known Warren Buffet quote about swimming naked when the tide goes out.

Judge Kaplan's recent decision, therefore, provides good news for audit firms. It demonstrates the availability of a valuable extra line of defence in US corporate fraud cases, and one which, for the largest audit firms, will be particularly welcome given the ongoing uncertainty about the involvement and exposure of accountants' umbrella organisations.

Transatlantic legal comparisons can be intriguing, if not always wholly instructive. However, whilst the UK "illegality" principle as applied by the House of Lords in Stone & Rolls, is considerably narrower than the equivalent US defence that succeeded in the Parmalat case, it should not be ruled out as a valuable weapon for those defending UK professionals facing unmeritorious claims. Given the huge squeeze on the economy at present, and given that there are over two million UK companies and 8,000 firms auditing those companies, the experience of "one man" companies riddled with fraud is, unfortunately, unlikely to be unique to Stone & Rolls.

Footnote

1 See previous BLG briefing note dated February 2009,

"Are umbrellas stormproof?", available on our website.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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