July 28, 2011 Articles

New York Reaffirms the Vitality of <i>In Pari Delicto</i>

Third parties may be able to assert a fraud claim free from imputation-based defenses, but they may not recover in negligence against those professionals.

By Kenneth Y. Turnbull and J. Emmett Murphy

In Kirschner v. KPMG LLP, 938 N.E.2d 941 (N.Y. 2010), the New York Court of Appeals held that the in pari delicto doctrine bars corporations—and those standing in their shoes—from recovering against third-party professionals where corporate insiders perpetrate a fraud on the corporation’s behalf, regardless of whether those third parties allegedly were negligent or intentionally aided and abetted the fraud. Id. at 948, 949, 959. The doctrine translates: “In a case of equal or mutual fault . . . the position of the [defending] party . . . is the better one.” Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 306 (1985) (internal quotes and citations omitted).

The court of appeals responded to certified questions from two courts. First, in Kirschner v. KPMG LLP, the Second Circuit certified questions of New York law regarding the scope of the adverse interest exception to the general rule that management’s knowledge is imputed to the corporation. See Kirschner v. KPMG LLP, 590 F.3d 186 (2d Cir. 2009). Those questions arose in two cases related to the collapse of Refco Inc., a brokerage firm that filed for bankruptcy in 2005 after the revelation of management’s fraud in which a litigation trustee sought to recover from Refco’s outside accounting firms, attorneys, and other third parties that allegedly participated in or failed to detect the Refco insiders’ fraud. See Kirschner v. Grant Thornton LLP, 2009 WL 1286326 (S.D.N.Y. May 6, 2009); Kirschner v. KPMG LLP, 2009 WL 1010060 (S.D.N.Y. April 14, 2009). Following the court of appeals’ response to the certified questions, the Second Circuit affirmed dismissal. 626 F.3d 673 (2d Cir. 2010). Second, in Teachers’ Retirement System of La. v. PricewaterhouseCoopers LLPthe Delaware Supreme Court certified the question of whether the in pari delicto doctrine bars a derivative claim brought by AIG shareholders against an independent auditor for its allegedly negligent failure to detect fraud perpetrated by AIG insiders. See In re Am. Int’l Group, Inc., 965 A.2d 763 (Del. Ch. 2009) (dismissing claim against auditor); 998 A.2d 280 (Del. 2010) (certifying questions).

Following the court of appeals’ response to the certified questions, the Delaware Supreme Court affirmed dismissal. No. 454, 2011 WL 13545 (Del. Jan. 3, 2011) (table decision at 11 A.3d 228). Together, these cases raised fundamental questions: As a matter of agency law, when is management’s knowledge imputed to the corporation? And even if knowledge is imputed, should the doctrine of in pari delicto bar the corporation’s claim based on that imputed knowledge where a derivative plaintiff or a successor, such as a litigation trustee, asserts it?

The court of appeals held that imputation is presumed, regardless of the state of mind of the third-party professional, and that the adverse interest exception to this presumption is narrow. The court rejected the reasoning of the highest courts of New Jersey and Pennsylvania, which in different ways have limited the application of in pari delicto, at least in cases involving auditors. And, significantly, the court of appeals explained the policy basis for not exempting litigation trustees or derivative shareholder plaintiffs from the ordinary application of imputation-based defenses.

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