July 28, 2011 Articles

New York Reaffirms the Vitality of In Pari Delicto

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.

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.

Background


Although often referred to as an equitable doctrine, in pari delicto was articulated as a defense at common law as early as 1760 by Lord Mansfield at King’s Bench. See Thomas v. City of Richmond, 79 U.S. 349, 355 (1870) (citing Smith v. Bromley, 99 Eng. Rep. 441 (K.B. 1760)). As the New York Court of Appeals observed, “[t]raditional agency principles play an important role in an in pari delicto analysis,” 938 N.E.2d at 950, because a court must first determine whether the knowledge of the wrongdoing agent should be imputed to the principal.

Imputation is a question of state law. Prior to 1994, at least in actions by the FDIC as receiver of financial institutions, a body of cases held that “federal common law” governed application of defenses to the FDIC’s claims. In O’Melveny & Myers v. FDIC, the Supreme Court rejected that view, holding that state law “determines whether the knowledge of corporate officers . . . will be imputed to the corporation.” 512 U.S. 79, 83 (1994) (citing Erie R. Co. v. Tompkins, 304 U.S. 64, 78 (1938)). Even if an agent’s knowledge is imputed to the corporation under state law, courts may consider whether in pari delicto should apply to a trustee or receiver bringing the corporation’s claim. That question can implicate state or federal law and depends on the kind of claim asserted.

Where the successor is a bankruptcy trustee or its equivalent, federal law applies, specifically, the Bankruptcy Code’s definition of the property of the estate as “all legal or equitable interests of the debtor in property as of the commencement of the case.” 11 U.S.C. § 541 (a)(1) (emphasis added). As the Third Circuit put it, that statute “prevents courts from taking into account events that occur after the commencement of the bankruptcy case” and requires that courts “evaluate the in pari delicto defense without regard to whether the [plaintiff] is an innocent successor.” Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 357 (3d Cir. 2001). Thus, federal courts have rejected an innocent successor exception in cases involving bankruptcy trustees or their equivalent. See also Nisselson v. Lernout, 469 F.3d 143, 153 (1st Cir. 2006); Official Comm. of Unsecured Creditors of PSA, Inc. v. Edwards, 437 F.3d 1145, 1152 (11th Cir. 2006); Grassmueck v. Am. Shorthorn Ass’n., 402 F.3d 833, 836–37 (8th Cir. 2005); In re Dublin Sec., Inc., 133 F.3d 377, 381 (6th Cir. 1997); In re Hedged-Invs. Assocs., Inc., 84 F.3d 1281, 1285 (10th Cir. 1996).  

State law applies to an action brought by a receiver appointed by a state court. As Justice Stevens noted in his concurring opinion in O’Melveny & Myers v. FDIC, “[i]t would be entirely proper for a state court of general jurisdiction to fashion a rule of agency law that would protect creditors of an insolvent corporation from the consequences of wrongdoing by corporate officers even if the corporation itself, or its shareholders, would be bound by the acts of its agents.” 512 U.S. at 90 (Stevens, J. concurring in the judgment). Indeed, on remand, the Ninth Circuit, applying California law, held that “the FDIC is not barred by certain equitable defenses O’Melveny could have raised against” the bank. FDIC v. O’Melveny & Myers, 61 F.3d 17, 19 (9th Cir. 1995). Oftentimes, however, longstanding state common law treats a receiver as standing in the shoes of the corporation—and thus subject to the same defenses as a defendant could have raised against the corporation prior to receivership. See, e.g.Bohlinger v. Zanger, 117 N.E.2d 338, 341 (N.Y. 1954) (liquidator of insurance company “should not and may not be placed in a better position than the company he takes over and demand that which is not owed”).

The application of in pari delicto to a trustee or receiver also depends on the type of claim asserted. Unlike a common law claim against third-party professionals, which is property of the corporation, a fraudulent transfer claim does not belong to the corporation prior to insolvency. See 11 U.S.C. § 544(a) (trustee’s avoidance powers arise “as of the commencement of the case”). Thus, a bankruptcy trustee’s action to recover such transfers generally is not subject to in pari delictoSee, e.g.In re Wedtech Corp., 88 B.R. 619, 622 (Bankr. S.D.N.Y. 1988) (in exercising avoidance powers, a “trustee acts as a representative of the creditors” and recovery “may not be denied by the pre-petition wrongful conduct of the debtor”). The same is generally true of a receiver. See, e.g.Freeman v. Dean Witter Reynolds, Inc., 865 So. 2d 543, 551 (Fla. Dist. Ct. App. 2003) (distinguishing “claims against third parties to recover damages in the name or shoes of the corporation for the fraud perpetrated by the corporation’s insiders” from claims for “fraudulent transfers”) (citing Scholes v. Lehman, 56 F.3d 750 (7th Cir. 1995)).

Agency Law


In Kirschner, the court of appeals considered three important agency law precedents: the decisions by the Seventh Circuit in Cenco, the New Jersey Supreme Court in NCP, and the Pennsylvania Supreme Court in AHERF.

Cenco Inc. v. Seidman & Seidman
Perhaps the lodestar case on imputation in the professional liability context, Cenco involved a corporation’s cross-claim in a federal securities action against its auditor for failure to detect management’s fraud. 686 F.2d 449 (7th Cir. 1982). Applying Illinois law, Judge Posner affirmed that the fraud should be imputed to the corporation. The court distinguished between a fraud “against” a corporation and a fraud “on behalf of the corporation.” Id. at 456. Because the fraud in Cenco inflated the company’s stock price—thereby allowing it “to buy up other companies on the cheap” and “to borrow money at lower interest rates”—the court reasoned that the company “benefited from the fraud,” even though, after the fraud’s unmasking, the company lost the inflated value of its stock price and was sued. Id. at 451. The court further reasoned that, from a deterrence standpoint, “if the owners of the corrupt enterprise are allowed to shift the costs of its wrongdoing entirely to the auditor, their incentives to hire honest managers and monitor their behavior will be reduced.” Id. at 455.

NCP Litigation Trust v. KPMG LLP, 901 A.2d 871 
In NCP, the New Jersey Supreme Court held that “the imputation doctrine does not bar corporate shareholders from recovering through a litigation trust against an auditor who was negligent . . . by failing to uncover or report [management] fraud.” 901 A.2d 871, 873 (N.J. 2006). The court reasoned that the purpose of imputation is “to protect innocent third parties with whom an agent deals on the principal’s behalf” and that a negligent auditor is not “an innocent party deserving of protection.” Id. at 879, 887. Thus, if the auditor is alleged to have “contributed to the misconduct”—including through mere negligence—the court held that the auditor generally cannot raise imputation as a bar; instead, the auditor may only assert the corporation’s comparative negligence so as to limit the auditor’s liability to losses “directly attributable and proportionate to the auditor’s negligence.” Id. at 887, 890.

Purporting to apply Cenco, the court reasoned that management’s fraud was not for the benefit of the corporation because it “led to the corporation’s ultimate demise”—although Cenco had analyzed the issue based on the benefits the corporation received before the unmasking of the fraud. See id. at 888; Cenco, 686 F.2d at 456. The NCP court also distinguished Cenco because, in its view, any recovery would not benefit wrongdoers but the “innocent” corporate shareholders who were the beneficiaries of the litigation trust—and who had been denied recovery in their federal securities fraud action, which had been dismissed for failure to plead scienter. See 901 A.2d at 885–86 (analogizing “‘innocent’” shareholders to creditors and asserting that imputation does not apply where recovery “would inure to the benefit of creditors”). But see Cenco, 686 F.2d at 455–56 (shareholders delegated monitoring of management to board of directors, which “failed in its responsibility”).

Official Committee of Unsecured Creditors of Allegheny Health Educ. and Research Foundation v. PricewaterhouseCoopers LLP (AHERF)
AHERF involved questions of state law certified to the Pennsylvania Supreme Court by the Third Circuit, following a federal district court’s grant of summary judgment in favor of the auditor on in pari delicto grounds. 989 A.2d 313 (Pa. 2010). The Pennsylvania Supreme Court, characterizing the in pari delicto doctrine as having “roots . . . in equity jurisprudence” and being subject to public policy exceptions, attempted to steer a course between Cenco and NCPId. at 330, 332, 335. Based on “the underlying purpose of imputation, which is fair risk-allocation,” the court held—contrary to NCP—that an allegedly negligent auditor may invoke imputation because it is “the principal who has empowered the agent.” Id. at 335. On the other hand, the court did not agree with “the degree to which [Cenco], in an auditor liability context, prioritizes the policy of incentivizing internal corporate monitoring over . . . fair compensation and deterrence of wrongdoing.” Id. at 332. Thus, the AHERF court held that imputation does not apply in “scenarios involving secretive, collusive activity on the part of the auditor.” Id. at 337.

AHERF’s holding effectively undercuts Cenco’sdistinction between a fraud “on behalf of” and a fraud “against” a corporation in cases of management accounting fraud. Recognizing that the “collusion” exception to imputation derives from Restatement (Third) of Agency § 5.04 (“An Agent Who Acts Adversely To A Principal”), which limits that exception to circumstances where a third party “colludes with the agent in action that is adverse to the principal,” the AHERF court asserted: “Nevertheless, in the collusion scenario—as a matter of law—we regard it to be in the best interests of a corporation for the governing structure to have accurate (or at the very least honest) financial information.” 989 A.2d at 324 n.11 338 (emphasis added). It also raises a question of whether imputation will operate similarly as between plaintiffs and defendants. That is, if management’s fraud is not imputed to the corporation in cases of “secretive, collusive activity,” should the knowledge of the individual third-party professional not be imputed to the professional firm on the same basis—at least absent evidence that the professional firm actually authorized or ratified the individual auditor’s conduct? The Pennsylvania Supreme Court’s “only comment” was that this raised a “complex” question that the court would leave to the federal proceedings. Id. at 339.

The Kirschner Decision


In a 4–3 opinion authored by Judge Read, the New York Court of Appeals reaffirmed that in pari delicto “has been wrought in the inmost texture of [New York’s] common law for at least two centuries” and that it “survives because it serves important public policy purposes”—namely, deterring illegality and avoiding entangling courts in disputes between wrongdoers. 938 N.E.2d at 950.

Imputation 
The court explained that imputation is a legal presumption that the agent will communicate information to the principal, which “does not depend on a case-by-case assessment of whether this is likely to happen” and applies “except where the corporation is actually the agent’s intended victim.” Id. at 951. The presumption of imputation is justified not only as an incentive for the principal to monitor the agent, but also a basic building block of corporate liability: “Like a natural person, a corporation must bear the consequences when it commits fraud.”

As to the adverse interest exception, the court embraced Cenco’s “crucial distinction . . . between conduct that defrauds the corporation and conduct that defrauds others for the corporation’s benefit.” Id. at 952 (citing Cenco). Citing its precedent from 1885, the court of appeals explained that this distinction is nothing new: A “corporation ‘is represented by its officers and agents, and their fraud in the course of the corporate dealings [ ] is in law the fraud of the corporation.’” Id. at 951 (quoting Cragie v. Hadley, 99 N.Y. 131, 134, 1 N.E. 537 (1885)).

The court of appeals held that the adverse interest exception applies only where the agent “‘totally abandoned’” the principal’s interest and was acting “entirely for his own or another’s purpose.” Id. at 953 (quoting Center v. Hampton Affiliates, Inc., 66 N.Y.2d 782, 784-85; 488 N.E.2d 828 (1985)) (emphasis in original). It rejected the argument that, under In re CBI Holding Co., 529 F.3d 432 (2d Cir. 2008), the total abandonment test turns on whether the agent intended to benefit himself. Appearing to limit that decision’s interpretation of New York law to the facts of that case, the court of appeals held that such an intent-to-benefit-self test would convert the adverse interest exception “into a ‘nearly impermeablerule barring imputation’ in every case” because “fraudsters are presumably not, as a general rule, motivated by charitable impulses.” Id. at 954–55 (quoting federal district court decision). Instead, adversity turns on whether the fraud “by its nature will benefit the corporation” prior to its disclosure. Id. at 952. The harm from disclosure should not be taken into account, otherwise a corporation would be able to “disclaim virtually every corporate fraud—even a fraud undertaken for the corporation’s benefit—as soon as it was discovered and no longer helping the company.” Id. at 953. In sum, the adverse interest exception is reserved for cases of “outright theft or looting or embezzlement.” Id. at 952.

In pari delicto


The court described in pari delicto as an affirmative defense—not a standing doctrine, but nonetheless a defense that “may be resolved on the pleadings in a state court action in an appropriate case.” Id. at 946 n.3. In this context, the court characterized the standing rule in Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114 (2d Cir. 1991), as “a prudential limitation on standing under federal law” that derives “in significant part from federal bankruptcy law” rather than New York law. This defense applies based on imputation without exceptions premised on the defendant’s conduct or status as a so-called gatekeeper. Id. at 959 n.6.

The court of appeals characterized both NCP and AHERF as “animated by considerations of equity” because—although the plaintiffs in those cases “stood in the shoes of the principal malefactors” legally—the decisions were based on the notion that recovery would benefit only “innocent shareholders or unsecured creditors.” Id. at 957. The court was unpersuaded by the equities, however, because defendants also have “innocent stakeholders” who, along with the public, would bear the costs of settlements, judgments, and litigation:

    [P]laintiffs’ proposals may be viewed as creating a double standard whereby the innocent stakeholders of the corporation’s outside professionals are held responsible for the sins of their errant agents while the innocent stakeholders of the corporation itself are not charged with knowledge of their wrongdoing agents.

Id. at 958. In sum, the court of appeals enforced the legal status of trustees and derivative shareholders as standing in the shoes of the corporation, thereby preserving the distinction between first-party and third-party claims. Under Kirschner’s reasoning, a trustee cannot enjoy the benefit of privity while escaping, based on the interests of third parties, the burden of imputation. That is simply the corollary of the proposition that, generally, 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. Indeed, in Sykes v. RFD Third Ave. 1 Assocs., LLC., a case heard the same day as Kirschner, the New York Court of Appeals held that longstanding privity limitations barred third-party negligent misrepresentation claims. 938 N.E.2d 325, 326 (N.Y. 2010).

 

Kenneth Y. Turnbull and J. Emmett Murphy are with King & Spalding LLP.

 

Editor's Note: King & Spalding LLP represents PricewaterhouseCoopers LLP (PwC) in Kirschner v. Grant Thornton LLP, and Paul D. Clement, then a partner with King & Spalding LLP, argued on behalf of PwC before the New York Court of Appeals in Teachers' Retirement System of La. v. PricewaterhouseCoopers LLP.