New York high court exonerates advisers for aiding and abetting corporate fraud

by RitaZhao on February 8, 2011

in Diaz Reus News

By Carlos F. Gonzalez, Esq

The Delaware Supreme Court recently affirmed a judge’s order dismissing a derivative action filed against American Inter-national Group’s outside auditor, Price-waterhouseCoopers. Teachers’ Ret. Sys. of La. v. PricewaterhouseCoopers LLP, No. 454-2009, 2011 WL 13545 (Del. Jan. 3, 2011). The high court’s order followed a determination by the New York Court of Appeals that the doctrine of in pari delicto barred a derivative action against a third-party service provider like PwC, regardless of its own negligence. Kirschner v. KPMG LLP, 938 N.E. 2d 941, 2010 WL 4116609 (N.Y. Oct. 20, 2010).

In so ruling, the New York’s highest court applied long-held agency principles that impute knowledge of wrongdoing by corporate officers and directors to the company itself.

NEW YORK SAYS NO EXCEPTIONS

The Kirschner decision is important for several reasons. First, it crystallized New York law with respect to the open question of auditor liability. Indeed, the decision expanded the reach of the in pari delicto defense to other outside advisers and service providers, including attorneys, investments bankers and financial advisers.

Second, the ruling reaffirmed New York’s wooden approach to the application of this defense. The court contemplated no exceptions beyond those rare instances covered by the adverse-inference exception.

Finally, the court highlighted the clear conflict that now exists among New York, New Jersey and Pennsylvania regarding the scope of the in pari delicto doctrine.

BACKGROUND

In 2009 the Delaware Court of Chancery dismissed a derivative action filed by AIG stockholders against the company’s outside auditor, PwC. In re AIG; AIG v. Greenberg et al., 965 A.2d 763 (Del. Ch. Feb. 10, 2009). The stockholder plaintiffs sued to make AIG whole for the harms the company suffered as a result of financial shenanigans orchestrated by an inner circle of AIG officials. This rogue group of officials consisted of various, longtime AIG executives, including chairman and CEO Maurice R. Greenberg.

In their first amended combined complaint, the plaintiffs alleged a series of bad acts by AIG insiders, including:

• Misstating the company’s financial performance by, among other things, engineering transactions with the express goal of inflating the company’s profits and hiding its growing losses.

• Engaging in various tax avoidance schemes.

• Conspiring with other companies to rig markets.

• Exploiting their own knowledge of “improper financial machinations” by selling their expertise in financial manipulation.

When these schemes finally came to light, AIG was forced to restate years of financial statements, which reduced stockholder equity by $3.5 billion. At the time, AIG still faced ongoing litigation and regulatory actions, which had already resulted in payouts of more than $1.6 billion in fines and related costs.

The plaintiffs blamed PwC for a large part of the damages suffered by AIG. But for their malpractice claim, the plaintiffs alleged that PwC would have discovered AIG’s various fraudulent schemes in time to not only stop, but also mitigate their devastating effects.

As evidence of PwC’s malpractice, the plaintiffs cited the auditor’s failure to follow or generally accepted audit standards. In its defense, PwC argued that the in pari delicto doctrine, as applied by New York courts, barred the malpractice and breach-of-contract claims. New York law was involved in the case because most of the alleged financial misconduct that led to AIG’s downfall took place in that state.

Under the New York strain of in pari delicto, PwC explained, auditors would be immunized if their client had top-level managers who knew of or participated in the financial wrongdoing that led to the errors in the auditor-certified financial statements. PwC further maintained that this immunity applied even where the auditor’s performance of its professional duty would have resulted in the detection and avoidance of the fraud that harmed the client.

DELAWARE’S CHANCERY COURT DISMISSES

In reviewing the plaintiffs’ claims, the Chancery Court began with the proposition that New York’s courts have adopted a “very strong version” of in pari delicto. The doctrine is premised on the notion that courts should not have to “sum up accounts” between wrongdoers. Marking the traditional boundaries of this doctrine, the court explained that in pari delicto would require that a corporation be liable for the acts of its directors, officers, employees and agents.

The doctrine, however, has other uses. As the Chancery Court explained, New York and other states have used these same agency principles to bar companies from suing third parties who may have conspired with insiders to commit tortious or illegal acts in their official capacities. Because the wrongdoing is imputed to the corporation, the court said, third parties alleged to have conspired with corporate insiders may raise in pari delicto as a defense.

Thus, the court explained, if the misconduct attributed to AIG’s insiders were imputed back to the company itself, and if AIG is found to be as or more guilty than its auditor, AIG would be barred from recovering against PwC.

The court next considered whether the insiders’ conduct here could be imputed to AIG. While New York courts have applied the principles of imputation and in pari delicto “firmly,” they do allow a narrow exception where “the agent [has] totally abandoned his principal’s interests and [is] acting entirely for his own or another’s purposes.”

This so-called adverse-interest exception is “extremely narrow.” Under New York law, the court explained, the exception “cannot be invoked merely because [an agent] has a conflict of interest or because he is not acting primarily for his principal.” Indeed, the Chancery Court noted, New York courts have found that knowledge may be imputed so long as the company benefited “to any extent” from the agent’s actions. Moreover, those courts have rejected the “innocent insider” exception, which would limit the use of the in pari delicto defense in situations where there were independent directors without knowledge of wrongdoing.

In reviewing the plaintiffs’ complaint, the court cited several allegations that rebutted the adverse-interest exception. The com-plaint alleged that AIG’s insiders did not perpetrate the various fraud schemes solely for their benefit. The court further noted that the complaint’s allegations made clear that AIG’s chairman and CEO, along with his subordinates, wanted AIG to benefit from the misconduct. Indeed, the insiders would derive their gains by the artificially high revenues, reported earnings and stock price their schemes facilitated.

Because the plaintiffs failed to plead the necessary allegations to bring their claims within the adverse-interest exception, the Chancery Court ruled that the wrongdoing committed by AIG’s directors, officers and employees would be imputed to AIG. Accordingly, the in pari delicto doctrine barred the malpractice and breach-of-contract claims against PwC.

THE CERTIFIED QUESTION

Because the Chancery Court determined that New York law supplied the rule of decision, and because New York’s highest court had not yet definitively ruled on the question of auditor liability, the Delaware Supreme Court certified the following question to the New York Court of Appeals:

Would the doctrine of in pari delicto bar a derivative claim under New York law where a corporation sues its outside auditor for professional malpractice or negligence based on the auditor’s failure to detect fraud committed by the corporation; and, the outside auditor did not knowingly participate in the corporation’s fraud, but instead, failed to satisfy professional standards in its audits of the corporation’s financial statements?

At the time, the New York Court of Appeals had already accepted related questions from the 2nd U.S. Circuit Court of Appeals. Kirschner v. KPMG LLP, 922 N.E. 2d 898 (N.Y. 2010). New York’s high court ultimately accepted both certified questions and issued a decision that closely hewed to the Delaware Chancery Court’s reasoning in dismissing the complaint against PwC.

THE NEW YORK COURT ANSWERS

From the outset, the New York high court made it clear that it would not “broaden the remedies available to creditors or shareholders of a corporation whose management engaged in financial fraud that was allegedly assisted or not detected at all or soon enough by the corporation’s outside professional advisers, such as auditors, investment bankers, financial advisers and lawyers.” The court grounded its decision on traditional agency principles, noting that they were dispositive of the in pari delicto analysis.

Critically, the court reaffirmed the funda-mental principle that the acts of agents, and the knowledge they acquire while acting within the scope of their authority, are presumptively imputed to their principals. The application of this doctrine, the court continued, would render corporations equally liable for the acts of their officers or agents. That particular acts were not authorized would not change the analysis. And just in case there were any doubts as to whether the court might consider deviating from this long-standing doctrine, the New York Court of Appeals stressed that this principle had informed the law of agency and corporations for centuries.

Having established its firm commitment to a robust application of the imputation and in pari delicto doctrines, the court turned to the adverse-interest exception. If the in pari delicto doctrine is broad in its application, the adverse-interest exception caters to a very narrow set of circumstances. To come within the exception, the New York Court of Appeals confirmed, “the agent must have totally abandoned his principal’s interests and be acting entirely for his own or another’s purposes.”

Moreover, the appellate court noted that the exception could not be invoked “merely because [the agent] has a conflict of interest or because he is not acting primarily for his principal.” As the court explained, “[t]his most narrow of exceptions” applied to cases of outright theft, looting or embezzlement, where the fraud was committed against the corporation and only benefited the agent or a third party.

Having laid the foundation for its analysis, the court considered the various modifications proposed by the plaintiffs in these consolidated appeals. First, the court addressed the suggestion that it adopt a rule wherein the insiders’ intent would control the application of in pari delicto.

Under this proposal, a short-term, illusory benefit to the company would not defeat the adverse-interest exception. The question for the courts would be whether “corrupt insiders intend[ed] to benefit themselves at the company’s expense.” To meet the exception, a plaintiff would have to show 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.”

Rejecting the proposal, the court noted that adopting such a rule would limit imputation to fraudsters so inept that they could gain no personal benefit from their fraudulent conduct. Such a rule, the court warned, would swamp the exception.

Next, the court considered the rules adopted by the New Jersey and Pennsylvania supreme courts. The rule in New Jersey would deny the in pari delicto defense to negligent or culpable outside auditors, while Pennsylvania would bar collusive professionals from asserting the defense. In New Jersey, the court noted, the fact finder would be left to sort out the relative faults of the company/shareholders and the auditors as a matter of comparative negligence and apportionment. Under Pennsylvania law, the in pari delicto defense would not be available where an auditor had not proceeded in “material good faith.”

The New York Court of Appeals declined to follow any of these approaches on the ground that they would render the adverse-interest exception “beside the point.” For the same reason, the court also declined to adopt a comparative-negligence standard under which the in pari delicto defense would not act as a complete bar to recovery.

A QUESTION OF PUBLIC POLICY

In the end, the New York Court of Appeals viewed the consolidated cases before it as “reduc[ing] down to whether, and under what circumstances,” it would “choose to reinterpret New York common law to permit corporations to shift responsibility for their own agents’ misconduct to third parties.” On this front, the court questioned why the interests of innocent stakeholders of corporate fraudsters would trump those of innocent stakeholders of the outside professionals.

The court noted that the stockholder plaintiffs’ proposals could be viewed as creating a double standard whereby innocent stakeholders of a corporation’s outside professionals could be held responsible for the sins of their agents, while the innocent stakeholders of the corporation simply walked away.

The unfairness of such a result would be compounded by the fact that the corporation’s agents likely played the dominant role in committing the fraud. This, the court explained, would make them more culpable than the outside professional’s agents who aided and abetted the insiders or simply failed to detect the fraud.

Beyond the bare inequality of raising the interests of one group of innocent actors over another, the New York Court of Appeals cited the issue of deterrence. In its analysis, expanding the remedies available to plaintiffs would not produce a meaningful additional deterrent to professional misconduct or malpractice.

Citing the demise of accounting firm Arthur Andersen, the court noted that an outside professional whose corporate client experiences a rapid or disastrous decline due to insider fraud would never skate away unscathed. To the contrary, the court noted that a relaxation of the in pari delicto defense would actually allow the corporation that employs wrongdoers to escape their agents’ misconduct without any concomitant harm.

Ultimately, the court concluded that the doctrines of in pari delicto and imputation remained sound. The proposals offered by the plaintiffs for modifying this well-established doctrine did not outweigh the public policies underlying the defense of in pari delicto and the stability in the law that its continuing application represented.

AN ALTERNATE ENDING

That New York law would prove dispositive of the PwC litigation was never a foregone conclusion. As noted above, PwC challenged the plaintiffs’ claims of malpractice and negligence on the ground that the in pari delicto doctrine, as applied in New York, barred the lawsuit. In its decision, the Delaware Chancery Court noted that the plaintiffs largely avoided challenging PwC regarding the appropriate choice of law.

In what the Chancery Court characterized as a “rather weak attempt to avoid New York law,” the plaintiffs argued that PwC’s liability related to the internal affairs of a Delaware corporation and thus Delaware’s internal-affairs doctrine controlled. Yet, as the Chancery Court pointed out, the internal-affairs doctrine has very specific applications. The “doctrine governs the choice-of-law determinations involving matters peculiar to corporations, that is, those activities concerning the relationship inter se of the corporation, its directors, officers and shareholders.”

Although PwC’s auditing role related to AIG’s internal affairs, the Chancery Court noted that PwC was not part of AIG. Rather, AIG employed PwC as a contractual agent to carry out certain duties for the company. While recognizing the important role an auditor plays in a company, the court warned that “a simple appeal” to the internal-affairs doctrine would not be sufficient to permit Delaware to impose its law on claims brought against auditors or other third-party contractors of a Delaware-chartered corporation.

Consistent with Delaware precedent, the Chancery Court then applied the “most significant relationship” test as outlined in the Restatement (Second) of Conflict of Laws to determine whose law applied. In so doing, the court noted that the complaint did not allege any facts regarding where PwC performed its work for AIG.

Nevertheless, the court explained that a “fair reading” of the complaint and the documents it incorporated indicated that PwC performed most of its audit services in New York and did not perform any acts in Delaware relevant to the claims at issue. Additionally, the court noted that the plaintiffs failed to allege that PwC and AIG contracted or negotiated in Delaware. Finally, the court found that the place of AIG’s injury would also favor New York.

Although the Chancery Court ruled that New York law applied, it did so reluctantly. Delaware has a substantial policy interest in protecting investors in its corporations, as well as others. Given this important obligation, the court expressed concern over the fact that the law of another state could render an outside auditor immune for failure to perform duties essential to ensuring that Delaware corporations complied with their legal obligations.

Finally, the court noted that the result it reached could have been different if the plaintiffs had accused PwC of aiding and abetting breaches of fiduciary duty. To sustain such a claim under Delaware law, the court explained, the allegations in a complaint would have to support an inference that the defendant knowingly helped a fiduciary breach her duties.

Had the plaintiffs pleaded that PwC acted as a knowing accomplice in serious breaches of fiduciary duty injuring a Delaware corporation, Delaware’s policy interests would likely have trumped any competing concerns. If a professional auditor acted as a knowing accomplice to injure a Delaware corporation, it would be difficult for Delaware to “give way.”

CONCLUSION

There are now at least three state supreme court decisions discussing the proper application of the in pari delicto defense. While reasonable people may disagree as to the practicality of one decision over another, each court has laid out a series of compelling legal and public policy arguments in support of their rulings.

The New York Court of Appeals is certainly correct in noting that the rights of one group of innocent stakeholders should not be prioritized over those of another group of equally innocent stakeholders. But that does not end the debate. If anything, the New York court’s analysis only leads to more questions.

While it is true that similarly situated stakeholders should be treated equally, there is no reason to believe that stakeholders in companies and their outside service providers are in fact equal. It may be that the proper point of analysis is not the relative innocence of one group of stakeholders over another. Perhaps the courts should consider the risks assumed by competing groups of stakeholders. In the context of a derivative action against a third-party auditor or other service provider, it may not be unreasonable to prioritize the interests of one group of so-called innocent stakeholders over another.

Auditors, by virtue of the important role they play as “gatekeepers,” owe an important duty to the company. Critically, auditors are tasked with the careful review of a company’s transactions, accounting and recordkeeping, among other things. That is not an easy or risk-free job, but it is one for which the auditor is handsomely rewarded.

One could argue that the risk assumed by the auditor necessarily exposes its stakeholders to a larger share of responsibility for fraud committed by corporate insiders. Indeed, some may conclude that it is because the auditor’s role is to detect (and stop) fraud that its stakeholders should expect to assume a greater risk as compared to the client company’s innocent stakeholders.

Regardless of how the in pari delicto defense is ultimately applied, stockholders, corporate officers and employees, and third-party service providers will greatly benefit from greater uniformity in the law.

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