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Highest New York Court Strengthens Limits on Auditor Liability for Corporate Fraud

October 2010

On October 21, 2010, New York's highest court, the New York State Court of Appeals, issued an opinion strengthening, and unambiguously reaffirming, the viability of the in pari delicto doctrine in limiting the liability of independent auditors and other outside professionals. The court found that the "adverse interest" exception to the general imputation principles underpinning the in pari delicto doctrine and related federal Wagoner doctrine is particularly narrow in scope under New York law. Generally, the court's clarification of New York law provides that independent auditors may benefit from imputation to a corporation under the two doctrines so long as the agents' actions do not completely deviate from the corporation's interests. The decision is an important clarification of New York law and a clear limit on auditor liability in the context of corporate fraud.

In pari delicto and the Wagoner doctrine

Both the in pari delicto and Wagoner doctrines are used as shields against liability of outside professionals. In pari delicto, Latin for "in equal fault," is a centuries-old legal theory barring a plaintiff from recovering from a defendant where each party is at fault. At its heart is the idea that a court should not intervene in a dispute between co-wrongdoers. The Wagoner doctrine, originating in the federal courts in 1991, provides that a corporation or its representative, typically a trustee, lacks standing to bring claims against third parties when the plaintiff corporation is also at fault. In determining whether a plaintiff corporation is also at fault, courts apply agency law.

Traditionally, a corporation is said to act through its agents. Because the corporation benefits from the actions of its agents, agency law provides that the corporation should be liable for the actions, including misconduct, of its agents. In other words, the actions and conduct of the agents are imputed to the corporation. In New York, it is presumed that actions by corporate employees and management are imputed to the corporation. However, the "adverse interest" exception may preclude imputation of an agent's actions if those actions were adverse to the corporation's interests.

As a result of the October 21 decision, the Second Circuit and New York's highest state court now unequivocally hold that the exception only applies when a third party "totally abandons" the interests of a corporation and is acting entirely for his own or another's benefit.

The New York Court of Appeals issued its decision in response to certified questions in two cases, Kirschner v. KPMG LLP and Teachers' Retirement System of Louisiana v. PricewaterhouseCoopers LLP. The following is a link to the Court of Appeals decision:

Kirschner and Teachers' Retirement System of Louisiana

In Kirschner, the president and CEO of Refco, a financial services firm, orchestrated a succession of loans hiding hundreds of millions of dollars of the company's uncollected debt. Refco's bankruptcy litigation trust brought suit against Refco's independent auditors, lawyers and investment banks for failing to detect Refco's fraud. The trustee alleged fraud, breach of fiduciary duty and malpractice on the part of certain third parties, including its independent auditor, KPMG. The U.S. Court of Appeals for the Second Circuit certified questions to the New York Court of Appeals to ascertain the scope of the adverse interest exception in the context of these auditor defendants.

Specifically, the Second Circuit asked the Court of Appeals (1) whether the exception is satisfied by showing that the agents intended to benefit themselves by their misconduct and (2) whether the exception is only available where the agents' misconduct has harmed the corporation.

In the companion case, Teachers' Retirement System of Louisiana, the plaintiffs alleged that PricewaterhouseCoopers LLP was negligent in its audit and failed to detect a massive fraud committed by officers of AIG. The massive fraud involved AIG's senior officers setting up a fraudulent scheme to misstate AIG's financial performance in an effort to deceive investors regarding the company's prosperity. The plaintiffs allege that PwC, as AIG's independent auditor, did not perform its auditing responsibilities in accordance with professional standards of conduct and failed to detect or report the officers' misconduct. The Delaware Court of Chancery dismissed the claims, holding that any wrongdoing by AIG's officers was imputed to the corporation under in pari delicto and the Wagoner doctrine. On appeal, the Delaware Supreme Court certified the question to the New York Court of Appeals, asking whether the in pari delicto doctrine bars a claim against an outside auditor that did not knowingly participate in the corporation's fraud.

The court's analysis

In response to the certified questions, the New York Court of Appeals found that imputation is a well-founded principle of corporate jurisprudence, such that corporate agent wrongdoing will be imputed to the corporation, and the adverse interest exception is very narrow. The exception is only available in those cases of outright theft from the corporation, looting, or embezzlement from the corporation, i.e., where the fraud is committed against the corporation rather than on its behalf.

To illustrate the breadth of this rationale, the New York Court of Appeals quoted its prior cases wherein it stated that the corporate agent "must have totally abandoned his principal's interests and be acting entirely for his own or another's purposes, not the corporation's." (Emphasis in original). The New York Court of Appeals went on to note that as long as there is some benefit to the corporation by the agents' actions, the adverse interest exception will not hold.

The New York Court of Appeals then addressed each of the arguments advanced to undercut the adverse interest exception limitations. First, the court rejected a blanket rule that conduct by an agent that ultimately resulted in the corporation's bankruptcy was necessary to the corporation. The court reasoned that even if the acts ultimately caused a bankruptcy, the agent still may not have "totally abandoned" the company's interests. The New York Court of Appeals then emphasized the distinction between a fraud that injures the corporation and a fraud whose discovery injures the corporation. In the former, the adverse interest exception is more likely to be found. Next, the New York Court of Appeals addressed and rejected a less stringent rule whereby the adverse interest exception would not apply when the company received only short term benefits, but suffered harm in the long run due to the fraud. The court rejected this approach, saying that a company involved in a fraud always faces long term losses.

The New York Court of Appeals then discussed two recent decisions by the New Jersey and Pennsylvania high courts. In New Jersey, the court created a specific exception to the adverse interest rule for claims against corporate auditors. In Pennsylvania, the high court created a broader exception applying to all outside professionals based on whether they acted in good faith. As explained by New York's highest court, both the New Jersey and Pennsylvania cases rested upon equitable principles that the New York court found unpersuasive.

First, the New York court rejected the argument that corporate fraud suits actually benefit innocent shareholders, not corporate wrongdoers. The New York court noted that the defendant outside professionals also have innocent stakeholders. Thus, the level of innocence is not determinative. Next, the New York court rejected the argument that expanding liability would create deterrents to professional malpractice or misconduct. As the court noted, "outside professionals – underwriters, law firms and especially accounting firms – already are at risk for large settlements and judgments in the litigation that inevitably follows the collapse of an Enron, or a WorldCom or a Refco or an AIG-type scandal." As a result, no additional deterrent is warranted.

The sum of the decision by the New York Court of Appeals is that the corporation, not the outside professionals, should bear the burden of fraudulent corporate agents.

Dissent

Judge Ciparick dissented from the majority opinion, arguing that such a strict rule would be unfair. Judge Ciparick noted that audited financial statements are the primary source of investor information. Thus, it is in the public's interest to maximize diligence and thwart malfeasance by outside professionals, especially auditors. She argues that the majority's decision is not good public policy. However, her approach was rejected by the majority.

Impact

This decision is significant both in its clarification of New York law and its limitation on auditor liability in the context of corporate fraud. As a result of this decision, in pari delicto is affirmed as a powerful defense whose availability on pre-answer/pre-discovery motions should bode well for outside professionals. This decision by New York's highest court is a significant and positive development for independent auditors.

For more information, please contact Thomas Manisero at thomas.manisero@wilsonelser.com or 914.872.7229 or Peter J. Larkin at peter.larkin@wilsonelser.com

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