When corporate finance officers inflate financial statement figures, an innocent auditor, relying on them, may come to grief.
The following fact pattern is fairly classic. Sharp and Slick are respectively the CFO and vice president of finance for Market Corporation (MARC). MARC has enjoyed increasing sales and profits in recent years, but this year business has fallen off sharply. Sharp and Slick concoct a fraudulent scheme, perhaps with some customers, some vendors, or both, to improve MARC's numbers "just for this year." They represent as accurate financial statements containing false numbers to MARC's auditor, Pure, Young, and Naïve, CPAs (PYN). The auditor, unaware of the fraud, has no reason to doubt MARC's highly placed officers. The scheme is clever and well concealed. MARC receives an unqualified opinion from PYN. Because the true facts remain hidden from MARC's shareholders, creditors, and the public, the price of its shares does not decline, its relationship with its lender remains good, and additional credit is extended by suppliers. Sharp and Slick each receive a bonus, a salary boost, and are in line for promotion.
In the following two years as MARC's fortunes decline, Sharp and Slick continue the scheme. Eventually a member of PYN's auditing team discovers and discloses the fraud.
When the dust settles, MARC is a bankrupt memory, civil and criminal actions abound, creditors have been satisfied in whole or in part, and a trust (sometimes designated a committee) has been formed which, on behalf of the shareholders, takes an assignment of any claims MARC may possess. The trust, fixing its eye on PYN's "deep pockets," files a lawsuit asserting professional negligence, and claims that MARC incurred damages based on PYN's failure to uncover the fraud in year one. A second count asserts that not only was PYN negligent, but that it must also have been in collusion with Slick and Sharp.
Legal Issues; Policy Considerations
Because a corporation is an inanimate artificial person acting through its human agents, the knowledge and acts of those agents may be imputed to it. This rule of imputation is based on the law of agency: if the agent, the corporate officer or director, did something or knew something, then the corporation, the principal, may be charged with being aware of it. If Sharp's and Slick's wrongdoing were attributed to MARC, PYN would be able to move to dismiss the complaint on the basis of in pari delicto, a defense which generally bars one wrongdoer from recovering from another. In re Citx Corporation, Inc., 448 F.3d 672 (3d Cir. 2006) at fn. 12. Thus, even had PYN been negligent (the allegation is assumed to be true on an application to dismiss at the pleading stage), it might escape the necessity of a trial, expensive in dollars and time lost, to defend its conduct.
When an agent is acting within the scope of his or her employment for the benefit of the corporation, it is reasonable to attribute the agent's knowledge and acts to the corporate principal. When the officer's wrongful acts are not taken for the corporation, but rather to take from the corporation for the officer's own benefit, the presumption dissolves and the imputation doctrine becomes subject to the "adverse interest exception." When that exception applies, the agent's knowledge is not imputed to the principal thus depriving the auditor of the in pari delicto defense at the pleading stage.
The legal issue is under what circumstances should the acts of the rogue officer not be imputed to the corporation. Courts struggle whether to limit the adverse interest exception solely to those situations where the corporation derives absolutely no benefit ("not even a peppercorn"), or to permit the exception to extend to situations where some degree of benefit arguably inured to the corporation. Often, even though the rogue officer is acting for his or her own interest, the corporation benefits to some degree. For example, when Sharp and Slick provided false numbers, in one sense they were acting for themselves in that each wanted the resulting bonus, salary boost, and promotion, but in another sense they were acting to give MARC the opportunity to recover from a bad year.
As we shall see, courts have dealt with this issue with varying results, and the outcome often depends on the answer to the following question. As between (1) shareholders who were unaware of what the rogue agents were doing but who entrusted them to act, and (2) an auditor who relied and was misled, which should bear any loss resulting from the wrongdoing?
We turn to recent decisions in New Jersey, Pennsylvania, New York, and a federal court to see not only how different courts, but also different jurists sitting on those courts, have responded.
In NCP Litigation Trust v. KPMG LLP, 187 N.J. 353 (2006), the New Jersey Supreme Court decided that innocent plaintiff shareholders were entitled to a trial to determine (1) whether the misled auditor was negligent in performing its agreed duties and (2) the extent to which any negligence proximately contributed to any damage suffered by the corporation and through it, its shareholders. When stated in that benign fashion, the ruling is not remarkable. What commands attention is that the court reached its result by announcing a new "auditor's exception" to the imputation doctrine and treating the adverse interest exception liberally.
In NCP, it was clear that two corporate officers intentionally misrepresented the corporation's financial status to the independent auditing firm. A trust for the benefit of the corporation's shareholders charged that the accounting firm had failed to perform its audits in conformity with generally accepted auditing standards and generally accepted accounting principals, and failed to exercise professional care in the performance of the audit and preparation of the financial statements. The plaintiff claimed that had the auditor not been negligent, the auditor would have detected the fraud (two years before it did discover and disclose the fraud) and thus would have prevented the shareholders' losses. The trial judge imputed the knowledge of the officers' wrongdoing to the corporation and dismissed the action at the pleading stage, ruling that even if the auditor were negligent, it could not be sued unless it intentionally and materially participated in the fraud, a claim not alleged in the complaint.
The New Jersey Supreme Court majority did not agree. It found that the rationale for imputation in a simple principal-agent relationship breaks down in the context of a corporate audit where the allocation of risk and liability becomes more complicated. Thus it fashioned an "auditor's exception" to the imputation doctrine: by its alleged negligence in conducting the audit the misled auditor can be said to have contributed to the officers' wrongdoing, be barred from invoking the imputation doctrine, and lose the benefit of the in pari delicto defense at the pleading stage.
Although the court's majority did not distinguish between a fraud audit and a standard audit engagement, a deficiency emphasized by a dissenting justice, it said that the accounting firm had "an independent contractual obligation, at a level defined by its agreement with [the corporation], to detect the fraud, which it allegedly failed to do," and that an auditor can be expected to detect fraud that a reasonably prudent auditor, acting within the scope of its engagement, would uncover.
The court also rejected the principle that had been established in Cenco Incorporated v. Seidman & Seidman, 686 F.2d 447 (7th Cir. 1982), where the Seventh Circuit said that because shareholders are ultimately responsible for placing officers in a position to commit wrongdoing, shareholders should not be permitted to recover from accountants who were not complicit in the fraud. Instead the New Jersey court distinguished between shareholders who were aware, or who, through their positions in the corporation, should have been aware of the fraud, and those who were unaware and innocent. Because the first group should not be permitted to recover, any recovery awarded after a trial might be mitigated.
As to the adverse interest exception generally, the court found that inflation of revenues by corporate officers to enable the corporation to continue in business past the point of insolvency could not be considered a benefit to the corporation, and that even if the corporation had received some benefit from its officers' wrongdoing, the adverse interest exception should be applied liberally to avoid imputation. Any benefit to the corporation could be treated as another factor in apportioning damages.
Consequently, in New Jersey, whether the auditor actively participates in the corporate officer's wrongdoing or is simply misled, "innocent" shareholders have the right to attempt to prove at a trial that the auditor committed malpractice.
NCP was followed by Thabault v. Chait, 541 F.3d 512 (3d Cir. 2008), a case tried to a jury before a federal judge sitting in New Jersey. It was based on a claim for damages suffered by an insolvent insurance company as a result of the accountant's alleged negligence. The plaintiff, the Vermont insurance commissioner acting as the corporation's receiver, claimed that the auditor either knew or should have known at the time of its audit that the company was only marginally solvent, that the accountant failed to disclose the company's insolvency, and that instead the accountant negligently issued "unqualified and favorable audit opinions" prolonging the ability of the company to write new insurance policies which the insurance commissioner had to honor following the company's collapse. The court of appeals, citing NCP's "auditor negligence" exception to imputation, affirmed the trial court's refusal to impute to the corporation the finding below that the chief officer had committed gross negligence and breach of fiduciary duty.
Whether the corporation itself has suffered compensable damage and thereby holds an assignable claim is another issue inherent in these cases. The Third Circuit found that the plaintiff had proved damages "under traditional negligence and malpractice principles," and that such traditional damages "do not become invalid merely because they have the effect of increasing a corporation's insolvency." Either a decrease in asset value or an increase in liabilities shown to have resulted from an accountant's negligence are damages for which the corporation may recover whether or not the corporation is insolvent or on the verge of insolvency.
Official Committee of Unsecured Creditors of Allegheny Health, Education and Research Foundation v. PriceWaterhouseCoopers, LLP , 607 F.3d 346 (3rd Cir. 2010), involved a scheme designed by corporate agents to conceal how precarious the company's financial position was. The rogue officers knowingly misstated the company's finances to the auditor. In this case the plaintiff charged not only simply negligence, but also alleged that the auditor knowingly assisted the officers' "by issuing a 'clean' opinion" when the audits "should have brought [the] misstatements to light." The trial court imputed the wrongdoing officers' conduct to the company, applied the in pari delicto doctrine, and granted summary judgment to the auditor. It found the company "was at least as much at fault as" the auditor.
To determine Pennsylvania law, the court of appeals certified two questions to the Pennsylvania Supreme Court. The Pennsylvania court responded first by acknowledging the multiple levels of auditor review, and saying that the auditor's responsibility will depend on the terms of the retention. Official Committee of Unsecured Creditors, etc. v. PriceWaterhouseCoopers, LLP, 989 A.2d 313 (Pa. 2010). It rejected New Jersey's "auditor exception" to the imputation doctrine, ruling that even if the auditor were negligent, the corporate officers' wrongdoing could be imputed to the corporation so long as the auditor had dealt with the corporation in good faith. In allocating the risk, the court expressed the view that imputation creates an incentive for a corporation to choose its agents wisely.
As did the New Jersey court, the Pennsylvania court ruled that falsification of financial information, even though perhaps intended to benefit the corporation, cannot be regarded as a benefit to the corporation, and if the adverse interest exemption could be applied, the misled auditor's ability to invoke the imputation doctrine would be lost.
In any case, the auditor could not gain the benefit of the imputation doctrine if it were complicit in the wrongdoing.
Based on the opinion of the Pennsylvania Supreme Court, the Third Circuit remanded the case to the district court to determine (1) whether the auditor dealt in good faith with the corporation or colluded with the wrongdoing agents and (2) whether the adverse interest exception would apply even if there were no collusion.
The philosophical question of which of two "innocent" parties should bear the loss created by a long gone rogue officer is illustrated in the majority and minority opinions that sharply divided New York's highest court in Kirschner v. KPMG LLP, 15 N.Y.3d 446 (Ct. App. 2010). The court was responding to questions certified to it from both the Second Circuit Court of Appeals and the Delaware Supreme Court. In one of the two cases it had been acknowledged that the wrongdoers were acting for the benefit of the corporation. In the other it was acknowledged that the auditor at worst was merely negligent and not in collusion with the wrongdoers. The basic issue was whether the adverse interest exception should be applied strictly or liberally.
The four judge majority began by taking note of the facts of business life. Preparation and approval of financial statements is part of the normal everyday activity of corporate management; it is within the scope of the authority of appropriate corporate officers. Further, the interests of corporate officers are often aligned with those of the corporation; the value of perquisites such as stock options and bonuses depends upon the corporation's health and survival. The majority also recognized that corporate agents' wrongdoing often provides the corporation a short-term benefit, allowing the business to survive, and enabling it to attract investors and customers that raise funds for corporate purposes. The fact that the corporation may eventually file for bankruptcy does not mean that the wrongful acts, at the time they were committed, were not for the benefit of the corporation.
The majority ruled that New York should continue to apply the adverse interest exception strictly to those cases where the agent has totally abandoned the corporation's interest and is acting entirely for his or her own benefit. To apply it more liberally would render the adverse interest exception meaningless. Moreover, a narrow application avoids the court having to deal with the troublesome ambiguity inherent where both the corporation and its officer benefit to one degree or another. In the majority's view, the principals of the corporation, rather than the third-party auditor, are "best-suited to police their chosen agents."
According to the three judge dissenting opinion, the majority had created a per se rule that bars actions in New York by corporations against outside professionals when corporate agents have engaged in wrongdoing, and permits imputation even when the accountant actively colludes with the corrupt corporate insider.
On January 3, 2011, the Delaware Supreme Court, based on the New York court's opinion, affirmed the Delaware Court of Chancery's dismissal of the case before it.
Misled accountants fare well under federal securities laws when the issue is limited to an allegedly negligent audit that may have aided and abetted wrongdoing. In Public Employees' Retirement Association of Colorado v. Deloitte & Touche LLP, 551 F.3d 305 (4th Cir. 2009), corporate personnel perpetrated frauds that resulted in an overstatement of earnings on the corporation's financial reports. The accounting firm was at first deceived, but ultimately uncovered the fraud. The Fourth Circuit said that to hold the accounting firm liable under federal law there must be a strong inference that the accountants acted with an intent to deceive, manipulate, or defraud. The claim could be dismissed at the pleading stage if, from the pleadings, the inference that the accountant was misled and acted innocently, even if somewhat negligently, is greater than the inference that the accountant acted with the required scienter. A federal judge sitting in New Jersey had applied similar reasoning to the NCP facts when, prior to the state court action, the NCP shareholder trust had sued KPMG in federal court alleging securities fraud violations.
Liability for intentional wrongdoing, as when an auditor actively participates in collusion with the rogue officers, does not offend. It is no easy task, however, to ascertain the point at which innocent justifiable reliance crosses into actionable negligence. One cannot deny the court's statements in In re Sunpoint Securities, Inc., 377 B.R. 513, 555 (Bankr. E.D. Tex. 2007): "The idea that fraud by a company's management is not reasonably foreseeable to an auditor is, of course, preposterous. Auditors are hired to provide reasonable assurance that a client's financial statements are free from material misstatement, whether occasioned by error or fraud." Nonetheless, even the New Jersey court allowed that auditors cannot be expected to catch every instance of corporate fraud. Few of us are infallible, and even the most careful auditor can be hoodwinked. In the Deloitte case, the Fourth Circuit observed: "It is not an accountant's fault if its client actively conspires with others in order to deprive the accountant of accurate information about the client's finances." Nor is it unreasonable to grant auditors the presumption of professional integrity in performing their engagements. As the New York majority concluded, tilting the scales against auditors will not result in greater incentive not to be negligent. It is also fair to say, however, that tilting the scales against shareholders will not result in their being more circumspect in their choice of managers--if indeed shareholders in large corporations have a meaningful choice.
By essentially requiring a trial on an allegation of auditor negligence, the New Jersey decision appears extreme. Whether the bent of other courts will be toward the shareholders or the auditor will turn on whether shareholders' are able to allege specific red flag transactions as a basis for the negligence claim and how the pleadings depict the comparative innocence of the parties.