In Pari Delicto: Are Auditors Equally At Fault In The Big Fraud Cases?

By • Mar 9th, 2010 • Category: AIG, Fraud, Latest, Pure Content, The Case Against The Auditors

The phrase in pari delicto sounds like something dirty to me.  Maybe I’m still preoccupied with the accusation that I’m producing accounting pornography.

“…the etymology of the term [pornography] is: “Etymology: Greek pornographos, adjective, writing about prostitutes, from porn prostitute + graphein to write; akin to Greek pernanai to sell, porosjourney “

That implies accounting porn is writing about accounting prostitutes. That being the case, then Francine McKenna, Sam Antar, Tracy Coenen and Bob Jensen all engage in accounting porn. They write about the corporate executives and audit firm partners that prostitute their accounting reports in the search for fictitious profits and all too real unearned bonuses. In other words, accounting fraud is accounting prostitution…”

In pari delicto, for those of you not lawyers or legal argument junkies like me, is “Latin for “in equal fault”. It’s a legal term used to indicate that two persons or entities are equally at fault, whether we’re talking about a crime or tort. The phrase is most commonly used by courts when relief is being denied to both parties in a civil action because of wrongdoing by both parties. The phrase means, in essence, that since both parties are equally at fault, the court will not involve itself in resolving one side’s claim over the other, and whoever possesses whatever is in dispute may continue to do so in the absence of a superior claim.”

There are two active cases where this doctrine and defense is being employed by auditors trying to avoid liability for fraud.

In Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP, No. 454, 2009 (Del. March 4, 2010), one of many AIG suits that PwC is involved in directly or indirectly, the Delaware Supreme Court used a procedure provided for under the New York Rules of Court  to certify a question of law to New York’s highest court, the New York Court of Appeals.This matter involves an appeal from the Delaware Court of Chancery regarding the oft-cited AIG case which denied a motion to dismiss claims against the top officials of AIG for breach of fiduciary duty based on Delaware law. However, the claims against the auditor, PwC, were dismissed based on New York law. The Plaintiffs are appealing the Chancery Court’s decision regarding PwC. (Summary borrowed for accuracy from Francis Pileggi at Delaware Litigation.com who alerted me to this most unusual move by the Chancery Court.)

The Court of Chancery held that the claims against PwC were governed by New York law, and that based on the allegations of the Complaint, AIG’s senior officers did not “totally abandon[]” AIG’s interests—as would be required under New York law to establish the “adverse interest” exception to imputation.  Accordingly, the Court of Chancery held that the wrongdoing of AIG’s senior officers is imputed to AIG.3  The Court of Chancery concluded that, once the wrongdoing was imputed to AIG, AIG’s claims against PwC were barred by New York’s in pari delicto doctrine and by the related Wagoner line of standing cases in the United States Court of Appeals for the Second Circuit.

This Court hereby certifies the following question to the New York Court of Appeals:

Would the doctrine of in pari delicto bar a derivative claim under New York law where a corporation sues its outside auditor for professional malpractice or negligence based on the auditor’s failure to detect fraud committed by the corporation; and, the outside auditor did not knowingly participate in the corporation’s fraud, but instead, failed to satisfy professional standards in its audits of the corporation’s financial statements?

The other case where the in pari delicto defense has tied the litigation into knots and caused some stops and starts is in Kirschner v. KPMG LLP et al., case number 09-2020, in the U.S. Court of Appeals for the Second Circuit which is about the Refco fraud. The Second Circuit certified the questions about an exception to the in pari delicto defense.  Now they have two high profile cases against auditors to consider. From Law360.com:

Not one to go down easy, the bankruptcy trustee for Refco Inc. brought his suit implicating Mayer Brown LLP, KPMG LLP and other corporate giants in the massive Refco fraud to a federal appeals court…The U.S. Court of Appeals for the Second Circuit found Monday that trustee Marc S. Kirschner’s fight to revive his claims against the clutch of corporate insiders raised critical unresolved questions concerning the bankruptcy trustee’s standing under New York law to sue third parties for Refco’s fraud.

The trustee alleges outside counsel Mayer Brown, auditors Ernst & Young LLP, [Grant Thornton] PricewaterhouseCoopersLLP, Banc of America Securities LLC and several other insiders are liable for defrauding Refco’s creditors, namely by helping the defunct brokerage conceal hundreds of millions of dollars in uncollectible debt.

Steve Jakubowski, a local Chicago lawyer who writes the Bankruptcy Litigation Blog, sponsored a guest post in January by Catherine Vance, one of the fiercest critics of the “expansive” use of the in pari delicto defense.  He introduces her post this way:

Whatever you may think about the fact that Refco’s outside corporate counsel, Joe Collins, was convicted on 5 criminal counts and sentenced today to 7 years in prison, one has to wonder how the system got so turned upside down on the civil side that while the law firm’s lead lawyer is torched in criminal court, his firm is summarily dismissed from a civil case for precisely the same conduct on a simple motion to dismiss (based on a theory that the Refco trustee lacked standing to bring suit to recover for damages arising from a fraudulent scheme devised and carried out by Refco’s own senior management).  One could argue that this result is unique to the Second Circuit (and the Seventh) because of the Wagoner decision and its progeny (which are not followed in the First, Third, Fifth, Eighth, or Eleventh Circuits).  Even in those circuits, however, management’s wrongful conduct has been imputed to the corporation under the in pari delicto doctrine to just as effectively knock the props out from civil actions involving some of the most spectacular commercial frauds of the century.

Ms. Vance wrote an article entitled, In Pari Delicto, Reconsidered, in which she posited–as none had before–that the in pari delicto doctrine is being inappropriately used by federal courts to supplant traditional tort law defenses that derive from state, not federal, law.

The way I see it, the in pari delicto doctrine is being used like a pair of needle nosed pliers by audit firm defense lawyers to diffuse a bomb – huge liability for some of the biggest frauds in history. The in pari delicto doctrine attempts to pull the auditors’ tails from the fire by excusing any of their guilty acts due to the approval of those acts by potentially equally guilty executives. The law allows these executives to continue to “stand in the shoes” of the shareholder plaintiffs even after their guilt has been determined. The theory is that the executives perpetrated the fraud for the benefit of the corporation and never “totally abandoned” it, as would be required for the “adverse interest” exception.

Auditors who should otherwise be tested on their fulfillment of their public duty are instead getting reprieves because courts have been unwilling to impose the “adverse interest” exception as expansively as they have the in pari delicto defense itself.  How can executives who are successfully sued, been subject to regulatory sanctions or, in the case of the Refco executives, plead guilty to criminal activities, still be considered representatives of the corporation’s interests? They should forfeit the right to stand in the shoes of the corporation’s shareholders in derivative suits and therefore to shield other potentially guilty or negligent parties.

The situation gets complicated in a bankruptcy case such as Refco since, traditionally according to Section 541 of a decision called In re PSA, Inc, “property of the bankruptcy estate consists of all legal or equitable interests of the debtor, including causes of action, as of the commencement of the bankruptcy case. A bankruptcy estate’s causes of action, therefore, as well as the attendant defenses thereto, transfer to the bankruptcy trustee frozen and fixed as they existed at the commencement of the bankruptcy case.  As a result, an “innocent” bankruptcy trustee “stands in the shoes” of the pre-petition debtor and may be unable to prevail on estate causes of action where the pre-bankruptcy debtor participated or was complicit in the wrongful acts upon which the estate attempts to sue.”

A trustee in bankruptcy must have standing to sue anyone on behalf of the creditors and other injured parties.  Unfortunately, this habit of allowing guilty parties to continue to drive the bankruptcy bus by having the actions of the guilty officers “imputed” to the corporation and, therefore, in bankruptcy to the trustee potentially threatens the trustee’s ability to sue “co-conspirators.”

It’s just nuts.

Akin Gump summarizes critics of this line of reasoning this way:

The purpose of the in pari delicto defense, they argue, is to prevent a party who is complicit in wrongdoing from prevailing against their joint actors.  In their view, the intercession of an innocent trustee whose duty it is to maximize the value of the estate for the debtor’s creditors purges the taint of the debtor’s wrongdoing, and that to hold otherwise would simply elevate the legal fiction of section 541 over the purpose of the in pari delicto defense.

Ms. Vance reminds us in her treatise that in pari delicto was ushered into modern bankruptcy jurisprudence as a part of the deepening insolvency discussion. I’ve written about deepening insolvency many times as it relates to the auditors who, by continuing to provide false and negligent clean audit opinions, allow a company to go deeper and deeper into debt and ruin, thereby significantly diminishing any remaining value for stakeholders once the gig is up.

The deepening insolvency arguments have been shot down by no less than Judge Posner whose pernicious pragmatism forces him to engage in the self-delusion that helping companies remain “viable” via fraud doesn’t hurt anyone.  This fantasy presupposes the company to be a person and not the embodiment of the goals and objectives, hopes and dreams, faith and trust of the shareholders, employees, creditors, and community that count on it to continue legally and honorably instead.   I suppose a Supreme Court that allows corporations to donate money to political campaigns in an exercise of their inalienable constitutional rights would not find this idea so strange.

When Francis Pileggi sent me the update on the AIG case, Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP, he asked me how I thought the New York Court of Appeals would rule. Given that there are two very similar cases facing the court on the in pari delicto doctrine, both with significant implications for future suits against auditors in fraud cases, I am hoping the justices consider the public interest carefully.  If they do, I hope they will see that there is no public interest served in shielding additional guilty parties when a massive fraud is perpetrated  against shareholders and other stakeholders.

For PwC, there is a significant implication for their Satyam fraud suits in New York courts.  How much better does it get than to have your client and several of his executives in jail too, having confessed to the fraud for which you are also accused by shareholders in a derivative suit of being complicit?

BTW: Grant and Eisenhofer P.A is co-lead Plaintiffs’ counsel for the consolidated Satyam securities class action and the Plaintifff’s counsel on Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP.  To be honest, I think the filings for Satyam are still quite “rustic” on the PwC International firm and related issues.

I am not optimistic.  I have seen too many cases decided on esoteric points of archaic law that serve no purpose but to stroke the justice’s egos and to perpetuate the false hope of the sham auditor’s opinion.

I appeal to the New York Court of Appeal to do right.

Otherwise…

Quis custodiet ipsos custodes?

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15 Responses »

  1. The problem is the stupid, incompetent, venal SEC. The SEC should tell the Big 87654 they will not assert such a defense in civil litigation or will have their SEC practice rights revoked. Then again, the SEC shills for the Big Three rating agencies, among others. And the beat goes on. We have absurd cases like Stonerridge coming fromt the Supremes, yet in criminal law we still have Pinkerton liability. Amazing.

  2. The reality is that an audit can not detect fraud. Maybe a forensic audit could, but no one ways wants to pay that bill. Therefore if the expectation is to detect fraud, then the PCAOB/SEC should change the auditing standards along with requiring public companies to have a anti-fraud program that they need to disclose and certify to in the 10-K, or we should just stop doing audits. But to cry, like this silly blog does, that the auditors are trying to scam the system, is wholly irresponsible. I see lots of whining and complaining, but I offer solutions.

  3. Jimmy Page is awesome.

    Not sure what solutions you’ve offered, 2. I think the more accurate statement is, “An audit is not likely to detect fraud.” I’m sure that most audit partners/directors have a story or two where fraud was detected, and I’ve heard several second-hand in my short time in audit, but yes, our way of doing business stacks the odds against us. It appears you think the best course is to throw up your hands because the only alternative is a costly, ineffective regulatory cluster. I disagree.

    Now I don’t believe it’s reasonable to expect audits to detect all fraud, and in two years of reading this blog I’ve not seen that view expressed by Francine or any guest bloggers. But let’s get back to the fact an audit is not likely to detect fraud in the first place. Are there reasons we should have known about “accounting irregularities” if the auditors showed even basic competence? There are, and many of those cases are discussed here, even if you see it as “whining and complaining.”

    There are problems with the way we audit, period. I personally think we’re too checklist-happy, and we can’t see the forest for the trees. In any case, people insist on hiding behind the fact that we cannot detect all fraud, to rationalize the Keystone Cop routine we’ve seen on many large audits. My solution would simply involve scrutinizing audit failures more closely, and instead of making excuses for them, figure out what we can do to avoid similar mistakes. If we’ve done that in good faith, then we can go on about how “an audit is not designed to detect all fraud …”

  4. Stupid questions asked by a stupid person, but:

    What exactly IS designed to detect fraud? That would be a shorter list than itemizing everything that isn’t.
    What does the signed opinion represent? Is it just the firm standing behind its public report, or does the firm assume
    legal accountability, and can waive the stick of “we won’t sign unless you provide….or else its our neck!”
    (sarcasm is honestly NOT intended, but you untangle gordian knots with swords, babe.)

    SEC, didn’t that start as a shill in the first place so Joe Kennedy could stay in Roosevelt’s inner circle? The SEC
    let Huron stay open even with the AA precedent. If the SEC hasn’t stepped up by now, they aint gonna.

    Peekaboo was a nice try, maybe if they reported to the GAO instead of the SEC, there would be less WTF.

    Sneak one last one in, the american stalwarts at Perot Systems / Dell said they were sorry even though
    they didn’t do it. Just return the money and we’ll forget the whole thing, wink.
    http://www.sec.gov/news/press/2010/2010-2.htm

    fyi SEC annual budget http://www.sec.gov/foia/docs/budgetact.htm

    SEC as big brother http://www.sec.gov/foia/docs/

    clout is still clout, guess The Song Remains the Same………..Les Paul Sunburst and all.

  5. Is the whole LEH thing a fraud? I don’t think so. To me, after reading the report, it is simply someone at LEH did something stupid. And E&Y, on the other hand, pretended that they never seen it happening.

    Here I what I read from an article “What about Lehman’s auditor, Ernst & Young? In interviews with Valukas the firm essentially claims it did nothing wrong but that it only tacitly acquiesced in the Repo 105 accounting, agreeing with its theoretical construction but never evaluating or blessing actual transactions. Nor did Ernst & Young ever audit a Repo 105 transaction or assess the impact of the volume of them on the balance sheet. ”

    “Agreeing with its theoretical construction but never evaluating or blessing actual transactions” – that is the best answer E&Y could come up with…

    I am so sad I am in this industry…

  6. […] the corporation, EY may be able to try what PwC and Grant Thornton/PwC and EY have tried in the AIG and Refco cases coming before the New York Court of Appeals.  Unless those questions are resolved in favor of the plaintiff’s.  If so, EY will not be […]

  7. […] In Pari Delicto: Are Auditors Equally At Fault In The Big Fraud Cases? […]

  8. […] The auditors. […]

  9. […] are part of the problem not the solution. PwC has been a defendant in multiple AIG  lawsuits and continues to be named along side executives accused of fraud in new […]

  10. […] talking about auditors’ responsibility for detecting fraud under SAS 99 and the doctrine of “in pari delicto” as it relates to the AIG case against PwC currently under review by the New York Court of Appeals. […]

  11. […] Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP in a March 9, 2010 post, In Pari Delicto: Are Auditors Equally At Fault In The Big Fraud Cases? The way I see it, the in pari delicto doctrine is being used like a pair of needle nosed […]

  12. […] I wrote in March of this year: “The deepening insolvency arguments have been shot down by no less than Judge Posner whose pernicious pragmatism forces him to engage in the self-delusion that helping companies remain “viable” via fraud doesn’t hurt anyone.  This fantasy presupposes the company to be a person and not the embodiment of the goals and objectives, hopes and dreams, faith and trust of the shareholders, employees, creditors, and community that count on it to continue legally and honorably instead.   I suppose a Supreme Court that allows corporations to donate money to political campaigns in an exercise of their inalienable constitutional rights would not find this idea so strange. […]

  13. […] FDIC, as a receiver in bankruptcy, will stand in the shoes of the failed bank corporation. The in pari delicto doctrine is based on common law agency principles. The acts of fraudster bank executives are […]

  14. […] facts making it a slam-dunk against the auditors, the guilt of the executives may give auditors the in pari delicto defense. The FDIC seems to have anticipated […]

  15. […] the massive scheme but, on the other hand, “the guilt of the executives may give auditors the in pari delicto defense.”  As such, when it was filed, the case was not considered a “slam dunk” for the […]

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