January 31, 2017 Practice Points

The <i>In Pari Delicto</i> Defense in an Accountants' Liability Action: A Changing Dynamic

The Southern District of New York reached a curious conclusion.

By Anthony J. Constantini

Assume that a business entity, admittedly charged with the responsibility for generating its own financial statements, concludes that its financial statements are consistent with accounting policies that the entity itself derived. Assume further that the entity determined that its self-derived accounting policies were consistent with Generally Accepted Accounting Principles (GAAP) and that it presented those policies to its auditors, who agreed with the entity’s conclusion as long as certain conditions were met. Then assume further that despite the good faith of both the entity and the auditor, the policies were not, in fact, in accordance with GAAP, and their implementation was damaging to the entity and others. While obviously both the entity and the auditor would both be at least potentially liable to anyone who relied on the financial statements to his or her detriment, the question remains of whether the entity, or its successor in interest, can recover all or part of its damages against the auditors who negligently agreed with the entity with respect to the entity’s negligently prepared financial statements and ultimately issued an audit report opining that the financial statements were prepared in accordance with GAAP.

In many jurisdictions, the in pari delicto doctrine precludes such a suit if the entity’s representatives made deliberate false statements that the auditor negligently failed to detect. Indeed, the in pari delicto doctrine would prohibit such a suit where the auditor deliberately conspired with his or her client to present false financial statements. Why should the result be any different if both the client and the auditor were negligent?

While the instinctive answer might be that the latter situation should not be treated any differently, that is not the conclusion reached by a federal district judge, interpreting New York law, in the recent case of MF Global Holdings Ltd. v PricewaterhouseCoopers LLP, No. 14-cv-2197, 2016 WL 4197062 (S.D.N.Y. Aug. 4, 2016). This article considers the wisdom of the judge’s approach.

The case was instituted by the plan administrator of the entity, which had become bankrupt. There was no question that the plan administrator was a successor in interest and therefore charged with the prior acts of the entity’s representatives as long as those acts were not adverse to the corporate interests. Because there was no question of adversity, the court readily recognized that the successor was responsible for the prior acts of the entity.

The court traced the history of the accounting policies in question and it was abundantly clear that the policies had been developed, over a long gestation period, by the entity’s financial officers. It was also abundantly clear that the auditors were only consulted after the generation of the policies but that the auditors, after careful consideration, agreed that the policies were consistent with GAAP. The court also held, on a summary-judgment motion, that there was no credible evidence that anyone had engaged in a deliberate fraud. In these circumstances, the court held that New York’s in pari delicto rule did not apply and denied the auditor’s motion for summary judgment.

The court’s holding was based on its view that the New York in pari delicto rule only applied where the plaintiff could be shown to be responsible for intentional wrongdoing. Whether or not the court correctly read New York law, the wisdom of such a result should still be open to debate.

Assuming that the court was correct in its interpretation, it should be remembered that the in pari delicto rule was developed in an era where most jurisdictions recognized the contributory-negligence rule. In other words, a negligent party, such as MF Global, was barred from recovering damages against another negligent party, such as Pricewaterhouse, because of the plaintiff’s contributory negligence. Thus, the entity negligently generating its financial statements could not recover against its auditors whether its fault was deliberate (in pari delicto) or negligent (contributory negligence).

The adoption of the comparative-negligence rule in a number of jurisdictions changes that dynamic. Although still barred from recovering if it made deliberate misrepresentations, an audit client could now recover part of any loss if a comparative-negligence rule applied. Is that wise?

Such a result would certainly contravene applicable accounting and auditing standards, which make clear that the client’s management is primarily responsible for the fair presentation of its financial statements. Indeed, no audit report even issues unless the client recognizes, in writing, the responsibility it has. A judicial result, like the MF Global opinion, seriously undermines this professional tenet because it allows the client to shift some of its responsibility to the auditor. While it can be argued that such a shift in responsibility would make the auditor more vigilant, it can also be argued that the lesser vigilance of the client, who has far better access to information than the auditor, is not a worthwhile price to pay.

In justifying its decision, the MF Global court said that imposition of an in pari delicto defense in these circumstances would effectively free the auditor from its own negligence. But it would not. The auditor would be just as responsible as he or she had always been to third parties, such as investors or lenders. The question is whether the auditor should be responsible to the client for negligently not putting a hold on the negligence that originated with the client.


Anthony J. Constantini is a partner with Duane Morris LLP in New York, New York.


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