New York's highest court has held that the in pari delicto and imputation defenses remain available to a corporation's outside auditor who allegedly failed to detect the malfeasance of the corporation's executives. Kirschner v. KPMG, LLP, and Teachers' Retirement System of Louisiana v. PricewaterhouseCoopers, LLP (October 21, 2010) (Kirschner). The New York Court of Appeals decision reaffirms New York's public policy to limit auditor liability, even where the corporation's innocent employees, stockholders and creditors may have been harmed.
The decision also clarified the exceedingly narrow scope of the "adverse interest exception" to the imputation doctrine under which auditor liability may still exist. The Court reserved this exception for the rare case where a corporate executive's misconduct "benefits only himself or a third party; i.e., where the fraud is committed against a corporation rather than on its behalf," such as "outright theft or looting or embezzlement."
New York's law is now one of the most favorable to auditors and other third party professionals. It is much more protective than New Jersey law, which bars auditors from asserting the imputation defense and leaves the culpability of corporate insiders to be resolved as a matter of comparative fault. See NCP Litigation Trust v. KMPG, LLP, (N.J. 2006).
Kirschner grew out of the collapse of Refco, a leading brokerage and clearing house. Refco was forced into bankruptcy after it was disclosed that its president and chief executive officer hid hundreds of millions of dollars of uncollectible debt from the public and regulators for years, creating a falsely positive picture of Refco's financial condition. A Litigation Trust, established as part of Refco's Chapter 11 bankruptcy plan, brought suit against Refco's third party professionals (its outside auditors, lawyers and investment banks) for aiding and abetting the fraud and failing to discover it. The District Court dismissed the case, finding that such claims were barred under New York's in pari delicto doctrine because Refco's insiders' misconduct was imputed to the corporation. The Litigation Trust appealed the dismissal to the Second Circuit Court of Appeals. Finding New York law on the point unclear, the Second Circuit certified two questions to the New York Court of Appeals as to the scope of New York's adverse interest exception: (1) "whether the adverse interest exception is satisfied by showing that the insiders intended to benefit themselves by their misconduct" and (2) "whether the exception is available only where the insiders' misconduct has harmed the corporation."
In Teachers' Retirement System, a companion appeal decided with Kirschner, a derivative action had been filed on behalf of AIG in Delaware Chancery Court against AIG's outside auditor, PricewaterhouseCoopers (PwC). The derivative plaintiffs alleged that PwC was negligent in its audit and failed to detect or report a fraud perpetrated by AIG's senior officers. The derivative plaintiffs, however, did not allege that PwC conspired with AIG or its officers to commit accounting fraud. The Chancery Court dismissed the claims on the grounds that, since the wrongdoing of AIG's senior officers was imputed to AIG, New York's in pari delicto doctrine barred the claims. On appeal, the Delaware Supreme Court certified one question to the New York high court: whether the in pari delicto doctrine bars a claim against an outside auditor where the auditor "did not knowingly participate in the corporation's fraud," but instead negligently failed to detect the fraud and "failed to satisfy professional standards in its audits of the corporation's financial statements."
In addressing this question, the Court of Appeals discussed the rationale behind New York's in pari delicto doctrine, the imputation doctrine and the adverse interest exception to the imputation doctrine.
The Court noted that the in pari delicto doctrine serves two important public policy purposes: (1) it deters illegality by denying judicial relief to an admitted wrongdoer and (2) it avoids entangling courts in disputes between wrongdoers. The Court emphasized that "the principle that a wrongdoer should not profit from his own misconduct is so strong in New York that the [the court has] said the defense applies even in difficult cases and should not be 'weakened by exceptions.'"
The Court then went on to discuss the important role traditional agency principles play in the in pari delicto doctrine and how engrained the imputation doctrine is in New York law. The Court noted that for over a century, New York courts have found the acts of agents and the knowledge they acquire while acting within the scope of their authority to be presumptively imputed to their principals, even where the agent exhibits poor judgment or commits fraud. The Court stated that this legal presumption does not depend on an ad hoc assessment but instead governs in every case, except where the corporation is the agent's intended victim. The Court explained that "as with in pari delicto, there are strong considerations of public policy underlying this precedent: "imputation fosters an incentive for a principal to select honest agents and delegate duties with care."
Finally, the Court set out the narrow parameters of New York's adverse interest exception to the imputation doctrine. That exception will only apply "where the corporation is actually the victim of a scheme undertaken by the agent to benefit himself or a third party personally, which is therefore entirely opposed (i.e., 'adverse') to the corporation's own interests." Thus, "for the adverse interest exception to apply, the agent 'must have totally abandoned his principal's interests and be acting entirely for his or another's purpose,' not the corporation." After Kirschner, so long as the corporate wrongdoer's conduct benefits the corporation (e.g., enables the business to survive, to attract investors and customers and raise funds for corporate purposes) the exception will not apply.
The Court declined to make the adverse interest exception hinge on "showing that the corrupt insiders intended to benefit themselves personally and actually received personal benefits and/or that the company received only short term benefits but suffered long term harm." The Court noted that "to recast the adverse interest exception in this fashion ... would 'explode' the exception, turning it into a 'nearly impermeable rule barring imputation in every case."
The Court then discussed whether to adopt either the New Jersey rule announced in the NCP Litigation Trust v. KPMG, LLP, 187 N.J. 353 (NJ 2006) or the Pennsylvania rule announced in Official Committee of Unsecured Creditors of Alleghany Health Education and Research Foundation v. PricewaterhouseCoopers, 989 A2d 313 (Pa 2010) (AHERF). Unlike New York, both the New Jersey and Pennsylvania Supreme Courts chose to fashion a exception to traditional agency law that would deny the in pari delicto defense to negligent or otherwise culpable outside auditors (New Jersey) and collusive outside professionals (Pennsylvania).
The New Jersey Supreme Court's NCP decision held that in pari delicto could not be applied in an audit malpractice case because auditors, whether alleged to be negligent or otherwise culpable, were by definition not the kind of "innocent" third parties meant to be protected by the doctrine. Rather than apply the doctrine in a way that would bar many "innocent" parties (including shareholders and creditors) from recovery, the New Jersey rule requires the relative faults of the corporate plaintiff and the auditors to be sorted out as matters of comparative negligence and apportionment by the fact finders.
The Pennsylvania Supreme Court in AHERF took a different approach to the issue. It concluded that the in pari delicto defense would continue to be available in the negligent-auditor context, but that it would be unavailable where an auditor had not acted in good faith or had colluded with corporate executives to defraud their principal.
The New York Court of Appeals rejected both the New Jersey and Pennsylvania rules, finding they would negate the policy reasons behind the in pari delicto defense. In criticizing the New Jersey rule that requires the in pari delicto defense to be treated as a matter of comparative fault, the Court of Appeals observed that "comparative fault contradicts the public purposes at the heart of in pari delicto — deterrence and the unseemliness of the judiciary 'serving as payment of the wages of crime.'"
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.
