Alert > Financial Restructuring / Financial Institutions Litigation / Securities Litigation
New York Court of Appeals Confirms Robust In Pari Delicto Defense
In Kirschner v. KPMG LLP, et al. (“Kirschner”), and Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers, LLP (“Teachers’ Retirement System”), the New York Court of Appeals recently acknowledged that a robust in pari delicto
defense protects a company’s outside professional advisors (such as
auditors, lawyers and investment bankers) against claims made on behalf
of the company that the outside advisors either assisted in or
wrongfully failed to detect financial fraud committed by the company’s
management.
The Underlying Cases
In Kirschner and Teachers’ Retirement System,
New York’s highest court answered questions certified by the Second
Circuit Court of Appeals and the Delaware Supreme Court. Kirschner
involved a financial fraud carried out by corporate officers of Refco,
Inc., who later pleaded guilty to criminal charges. A litigation trustee
pursued claims that Refco’s outside investment banking, accounting and
law firms aided and abetted the fraud. The district court dismissed the
trustee’s claims under the Second Circuit’s Wagoner rule,
which provides that a bankruptcy trustee lacks standing to recover from
third parties alleged to have joined with the debtor corporation in
defrauding creditors. See Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, 118 (2d Cir. 1991).
In Teachers’ Retirement System, institutional investors
derivatively claimed on behalf of American International Group, Inc.
(“AIG”) that PricewaterhouseCoopers, LLP failed to detect or report
fraud perpetrated by AIG’s senior officers. The trial court held under
New York law that the wrongdoing of AIG’s senior officers was imputed to
AIG itself and dismissed the claims under the doctrine of in pari delicto and the Wagoner rule.
On appeal of these two cases, the Second Circuit and the Delaware
Supreme Court asked the New York Court of Appeals to clarify New York
law as to the in pari delicto doctrine: most specifically,
the extent to which the “adverse interest” exception to the common law
rule of imputation can be applied to defeat an in pari delicto defense asserted by an outside professional advisor.
The Context
Under the doctrine of in pari delicto, courts will not
intercede to resolve a dispute between two wrongdoers. Disputes often
arise over the question of imputation, that is, the extent to which the
acts of insiders should be deemed the acts of the corporate entity
itself, particularly in the context of bankruptcy cases, where the
trustee and his successors take the corporation’s rights, and are
subject to its limitations as well. Recent decisions in the Second
Circuit, including CBI Holdings 529 F.3d 432 (2d. Cir.
2008), had broadened the so-called “adverse interest” exception to
the doctrine, ruling that an insider’s acts might not be imputed to the
corporation where there was a showing of an intention to benefit the
insider himself. Under this line of cases, the corporate representative
might proceed with litigation, unencumbered by the in pari delicto defense.
Imputation Is Generally Presumed
The Court of Appeals has now greatly retrenched this exception, reaffirming a robust in pari delicto
defense. Its decision begins by noting the strong public policy
favoring the defense: “This principle has been wrought in the inmost
texture of our common law for at least two centuries,” and it applies
even “where both parties acted willfully.” The court then confirmed that
imputation is generally presumed. “[W]here the conduct falls within the
scope of the agents’ authority, everything they know or do is imputed
to their principals.” Imputation applies “even where the agent acts less
than admirably, exhibits poor business judgment, or commits fraud.”
The Adverse Interest Exception Is Narrow
The court then noted that while an “adverse interest” exception exists, it is a narrow one. Quoting its prior decision in Center v. Hampton Affiliates, Inc.,
66 N.Y.2d 782, 784-85, 97 N.Y.S.2d 898, 900 (1985), the court
emphasized that the adverse interest exception applies only where the
insider acts at the expense of the corporation. He “must have totally abandoned his principal’s interests and be acting entirely
for his own or another’s purposes.” The court then clarified that “this
most narrow of exceptions” is reserved for “those cases — outright
theft or looting or embezzlement — where the insider’s conduct benefits
only himself or a third party.”
The question, then, is not intent — it is whether or not the acts
complained of were at the expense of the corporation. The fraud in
Refco, for example, induced investors to provide new capital to the
company (and by extension benefited the insiders’ equity holdings). That
kind of showing is now clearly insufficient to activate the exception
to in pari delicto. The court also declined to adopt
carve-outs from traditional agency law fashioned by New Jersey and
Pennsylvania courts to deny the in pari delicto defense to a
company’s outside professional advisors under certain circumstances. In
reaching these conclusions, the Court of Appeals dismissed as
“speculative” an argument that public policy favored the relaxation of
the adverse interest exception where innocent investors would otherwise
be denied recovery against a more culpable outside advisor. The court
observed, for example, that the owners and creditors of the outside
advisors — who would ultimately bear the loss of any judgment — are
at least as “innocent” as the shareholders and creditors of the company
where the fraud was committed.
Implications of the Court’s Decision
The decision provides significant comfort to advisors sued by
distressed companies, and in particular by bankruptcy and litigation
trustees who succeed to the rights of such companies. In pari delicto is now a robust defense under New York law. The court’s decision confirms that “[t]he principles of in pari delicto
and imputation. . .remain sound” in New York, notwithstanding decisions
from other jurisdictions that have weakened them in suits against
outside professional advisors.
While the in pari delicto doctrine is an aspect of tort
law, contracts may provide a relevant factor in choice-of-law disputes.
Accordingly, outside advisors such as auditors, lawyers and investment
bankers may be well advised to use New York choice-of-law provisions in
their engagement agreements.
This alert was authored by Bingham securities litigation partner
Dale Barnes, financial restructuring partner Sabin Willett and
financial institutions litigation counsel Matthew Lawson. For more
information about the subject matter of this alert, please contact the
lawyers listed below:
Dale E. Barnes, Co-chair, Securities Litigation
dale.barnes@bingham.com, 415.393.2522
Jordan D. Hershman, Co-chair, Securities Litigation
jordan.hershman@bingham.com, 617.951.8455
Jeffrey Q. Smith, Co-chair, Financial Institutions Litigation
jq.smith@bingham.com, 212.705.7566
P. Sabin Willett, Partner, Financial Restructuring
sabin.willett@bingham.com, 617.951.8775
Matthew J. Lawson, Counsel, Financial Institutions Litigation
matthew.lawson@bingham.com, 212.705.7569
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