United States: New York Court Invokes In Pari Delicto Doctrine To Protect Third-Party Professionals

On October 21, 2010, the New York Court of Appeals issued an important ruling that significantly limits the ability of corporations and those who stand in their shoes (e.g., a bankruptcy trustee or a derivative plaintiff) to assert claims against third-party professionals for assisting or failing to detect wrongdoing by the corporation's own management.

Background

This important ruling, Kirschner v. KMPG LLP, 2010 WL 4116609 (N.Y. Oct. 21, 2010), was the result of two consolidated proceedings that were separately certified to the New York Court of Appeals to resolve unsettled questions of New York law.

• Kirschner v. KMPG LLP (Refco)
  
  This case arose after the financial collapse of Refco, a former leading provider of brokerage services in currency and future markets. After Refco filed for bankruptcy, the trustee brought claims against the corporate insiders who were involved in the fraudulent schemes that led to the corporation's bankruptcy. The trustee also asserted claims against third-party professionals such as Refco's auditors, its outside counsel, and three investment banks. The trustee alleged that these professional defendants either assisted in the fraud or were negligent in failing to discover it.
• Teachers' Retirement System of Louisiana v. PricewaterhouseCoopers LLP (AIG)
  
  This case was a derivate action brought on behalf of American International Group (AIG) against AIG's independent auditor, PricewaterhouseCoopers (PwC). According to the complaint, PwC failed to detect or report fraudulent actions by senior officers of the corporation. The plaintiffs alleged that, had PwC performed its auditing responsibilities in accordance with professional standards of conduct, the fraudulent accounting schemes at AIG would have been timely discovered and rectified.

The Court Reaffirmed Traditional Agency Principles and the Doctrine of In Pari Delicto

The doctrine of in pari delicto serves as a complete bar to an action asserted by a plaintiff who is at fault for the wrongdoing giving rise to the plaintiff's claim. When this doctrine is applied to corporations, agency principles play an important role. According to agency law, the acts of agents, and the knowledge they acquire while acting within the scope of their authority, are presumptively imputed to the principals. Thus, in the case of a corporation, the acts performed by its management—including fraudulent acts—are imputed to the corporation.

Applying these principles, the court in Kirschner upheld the dismissal of the claims against the third-party professionals in both of the consolidated appeals. In both cases, the fraudulent actions of the corporate insiders were imputed to their respective corporations and, as a result, the in pari delicto doctrine prevented them from suing third parties. In reaching its conclusion, the court emphasized that making principals responsible for the actions of their agents fosters an incentive for principals to select honest agents and monitor them.

The Court Declined to Expand Third Party Liability by Broadening the Adverse Interest Exception to the In Pari Delicto Doctrine

The in pari delicto doctrine is subject to an exception—the adverse interest exception—which provides that when an agent is acting adversely to the interests of the principal (in this case the corporation), the agent's wrongdoing will not be imputed to the principal. The court in Kirschner reaffirmed prior New York decisions holding that for the adverse interest exception to apply, the agent must have "totally abandoned" the principal's interests and have acted "entirely" for his own or another's purpose.

The Refco trustee, however, argued that the adverse interest exception should apply in Kirschner because the actions of the Refco officers resulted in the bankruptcy of the corporation, which is adverse to the corporation's interests. The court rejected the trustee's arguments, concluding that "the mere fact that a corporation is forced to file for bankruptcy does not determine whether its agents' conduct was, at the time it was committed, adverse to the company." The court pointed out that "any harm from the discovery of the fraud—rather than from the fraud itself—does not bear on whether the adverse interest exception applies;" otherwise, the "narrow exception" would apply in almost every case, as "disclosure of corporate fraud nearly always injures the corporation." The court clarified that "[s]o long as the corporate wrongdoer's fraudulent conduct enables the business to survive—to attract investors and customers and raise funds for corporate purposes," the adverse interest exception is applicable. Even a temporary short-term benefit suffices.

The plaintiffs also argued that the corporate officers' actions should not be imputed to the corporation because those officers were acting—at least in part—in their own personal interest. But the court clarified that the corporate officers' subjective intent is not relevant to any analysis of the applicability of the adverse interest exception. "Corporate officers, even in the most upright enterprises, can always be said, in some meaningful sense, to act for their own interests." Making intent determinative would reduce the adverse interest exception to "a dead letter because it would encompass every corporate fraud prompting litigation."

Finally, the court was not persuaded by the plaintiffs' public-policy arguments, which suggested that it was inequitable to use imputation and in pari delicto principles to deny recovery to innocent stakeholders of Refco and AIG. The court asked, "why should the interests of innocent stakeholders of corporate fraudsters trump those of innocent stakeholders of the outside professionals who are the defendants in these cases?" The court also reasoned that expanding liability to third-party professionals would not produce a meaningful additional deterrent to professional misconduct, observing that professional third parties already face the risk of liability from suits brought by other constituents such as corporate shareholders.

Implications

Kischner reduces the potential for bankruptcy trustees and others that stand in the shoes of a company to assert claims against third-party professionals for damages resulting from the fraud or misconduct of the company's own management.

It also serves to counterbalance decisions from other states that can be read as making it easier for corporate plaintiffs (or those acting on their behalf) to shift the responsibility for their own agents' misconduct to third parties.

Additional information

You can find the full text of the New York Court of Appeals decision at http://www.courts.state.ny.us/CTAPPS/decisions/2010/oct10/151-152opn10.pdf.

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.