New York Court of Appeals Stands By Corporate Man: In Pari Delicto Prevails

By • Oct 22nd, 2010 • Category: Latest, Pure Content, The Case Against The Auditors

The New York Court of Appeals decided on October 21, 2010, by a vote of 4-3, to “decline to alter our precedent relating to in pari delicto and imputation and the adverse interest exception, as we would have to do to bring about the expansion of third-party liability sought by plaintiffs here.”

The decision is flawed, misguided and strongly biased towards corporate interests rather than shareholder and investor interests. Imputation – a fundamental principle that has outlived its usefulness and that defies common sense and fairness – has been reaffirmed in cases of third-party advisor negligence or collusion.

“A fraud that by its nature will benefit the corporation is not “adverse” to the corporation’s interests, even if it was actually motivated by the agent’s desire for personal gain (Price, 62 NY at 384). Thus, “[s]hould the ‘agent act[] both for himself and for the principal,’ . . . application of the [adverse interest] exception would be precluded” (Capital Wireless Corp. v Deloitte & Touche, 216 AD2d 663, 666 [3d Dept 1995] [quoting Matter of Crazy Eddie Sec. Litig., 802 F Supp 804, 817 (EDNY 1992)]; see also Center, 66 NY2d at 785 [the adverse interest exception “cannot be invoked merely because . . . .(the agent) is not acting primarily for his principal”]). [*12]

New York law thus articulates the adverse interest exception in a way that is consistent with fundamental principles of agency. To allow a corporation to avoid the consequences of corporate acts simply because an employee performed them with his personal profit in mind would enable the corporation to disclaim, at its convenience, virtually every act its officers undertake. “[C]orporate officers, even in the most upright enterprises, can always be said, in some meaningful sense, to act for their own interests” (Grede v McGladrey & Pullen LLP, 421 BR 879, 886 [ND Ill 2008]). A corporate insider’s personal interests — as an officer, employee, or shareholder of the company — are often deliberately aligned with the corporation’s interests by way of, for example, stock options or bonuses, the value of which depends upon the corporation’s financial performance.

And this is ok?

A majority of the New York Court of Appeals bought the self-serving, selfish and unjust arguments of the defendants and their flunky amicus brief toadies supporting criminal corporate fraudsters and, get this, the shareholders of the accounting firms (!!). The New York Court of Appeals abandoned the shareholders and creditors of Refco and AIG for criminals and incompetents.

I could not have imagined more contemptible excuses for judicial cowardice if I were writing this decision for a novel of corporate cronyism to the extreme in a Utopian nirvana for capitalist parasites.

“In particular, why should the interests of innocent stakeholders of corporate fraudsters trump those of innocent stakeholders of the outside professionals who are the defendants in these cases?

…In a sense, plaintiffs’ 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. And, of course, the corporation’s agents [*19]would almost invariably play the dominant role in the fraud and therefore would be more culpable than the outside professional’s agents who allegedly aided and abetted the insiders or did not detect the fraud at all or soon enough. The owners and creditors of KPMG and PwC may be said to be at least as “innocent” as Refco’s unsecured creditors and AIG’s stockholders.

The doctrine’s full name is in pari delicto potior est conditio defendentis, meaning “in a case of equal or mutual fault, the position of the [defending party] is the better one” (Baena, 453 F3d at 6 n 5 [internal quotation marks omitted]).

I have some other names for it:

  • Immunity from Prosecution for the “Duped” theory
  • Incompetent Professional service providers Defense
  • Invocation of Plausible Deniability doctrine

“We are also not convinced that altering our precedent to expand remedies for these or similarly situated plaintiffs would produce a meaningful additional deterrent to professional misconduct or malpractice. The derivative plaintiffs caution against dealing accounting firms a “get-out-of-jail-free” card. But as any former partner at Arthur Andersen LLP — once one of the “Big Five” accounting firms — could attest, an outside professional (and especially an auditor) whose corporate client experiences a rapid or disastrous decline in fortune precipitated by insider fraud does not skate away unscathed. In short, outside professionals — underwriters, law firms and especially accounting firms — already are at risk for large settlements and judgments in the litigation that inevitably follows the collapse of an Enron, or a Worldcom or a Refco or an AIG-type scandal. Indeed, in the Refco securities fraud litigation, the IPO’s underwriters, including the three underwriter-defendants in this action, have agreed to settlements totaling $53 million (www.refcosecuritieslitigation.com). In the AIG securities fraud litigation, PwC settled with shareholder-plaintiffs last year for $97.5 million (www.refcosecuritieslitigationpwc.com). It is not evident that expanding the adverse interest exception or loosening imputation principles under New York law would result in any greater disincentive for professional malfeasance or negligence than already exists . Yet the approach advocated by the Litigation Trustee and the derivative plaintiffs would allow the creditors and shareholders of the company that employs miscreant agents to enjoy the benefit of their misconduct without suffering the harm. [*20]

This argument comes directly from the AICPA’s brief on behalf of the defendants which all but threatened the capitalist system if audit firms were held accountable – including promises of higher audit fees if audit firms were forced to pay more settlements.

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.

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.”

Are sufficient remedies truly available to shareholders and investors if the states abandon them, too?  

As we know, the case could not be brought under federal securities laws since the PSLRA bars private actions for aiding and abetting a fraud. Stuart Grant, the attorney for the AIG shareholders, told me in September: Congress has not yet seen fit to amend this law to give private parties the same rights to hold third parties liable for fraud as the SEC has.”

Courts have not always seen the logic of separating the auditors from the executives of companies they audit.  The audit firm defense lawyers have created a defense I call the, “We were duped!” defense that, to me, is an embarrassing, ridiculous and disingenuous attempt at evading liability.

The gist of it is: “We did the best we could but as auditors we are dependent on management and their truthful representations to do a good audit.  If they lie to us, what can we do?  We are as much victims as the shareholders.”

In another example of roadblocks to private rights of action in fraud and accounting malpractice cases, an ancient former SEC Chairman recently joined others who have played “Charley McCarthy” to the audit industry’s “Edgar Bergen.”

Former Chairman [Rod] Hills also urged the SEC to create a safe harbor for an auditor’s professional judgment. He emphasized that a plaintiff should not have the right to question an auditor’s professional judgment if the SEC and the PCAOB are happy with that judgment.

The last time I heard this one – that auditors should not be held accountable to investors for their “judgment” – it was positioned as a necessity in the event the US adopted IFRS.

Made me nauseous.

In the UK, the Big 4 have even convinced the “next tier” firms to beg for limitations on liability for the Big 4.  GT and BDO must have given up on ever bulking up enough to compete with the Big 4. Maybe they’re jockeying for a buyout.  Will we see more consolidation  – allowing Big 4 firms to buy BDO and GT, for example – rationalized by regulators as a way to insulate the industry from catastrophic claims?

Unfortunately, in the US, all of these concerns are addressed via the “too few to fail” policy – no large firm will be indicted by the federal government for criminal offenses, but civil penalties and sanctions will be meted out to culpable individuals only and only after many years of investigation when the story and the deterrent effect have been significantly diluted.Civil penalties against audit firms as a whole will be severely rationed.  The private right of action against audit firms will be constrained by the PSLRA, the Stoneridge decision, obdurate judges, and archaic legal doctrines that perpetuate the“we can be duped because we are simply humble bean counters and bookkeepers” defense. Settling cases rather than going to trial means juries and the general public will never see “how the sausage is made.”

It’s shameful.

My only consolation for this huge disappointment – actually, I’m disgusted but some might claim I am hysterical in my condemnation of status quo perpetuation disguised as thoughtful judgment – is that three judges dissented.

Judge Ciparick dissents in an opinion in which Chief Judge Lippman and Judge Pigott concur:

“It is axiomatic that the adverse interest exception requires a showing of harm to the principal, but the premise that even an illusory benefit to a principal can serve to defeat the adverse interest exception to imputation misses the point. As the Second Circuit noted in CBI Holding, a “corporation is not a biological entity for which it can be presumed that any act which extends its existence is beneficial to it” (529 F3d at 453, citing Bloor v Dansker, 523 F Supp 533, 541 [SD NY 1980]). Indeed, “prolonging a corporation’s existence in the face of ever increasing insolvency may be ‘doing no more than keeping the enterprise perched at the brink of disaster'” (id., quoting Mirror Group Newspapers v Maxwell Newspapers, Inc., 164 BR 858, 869 [Bankr SD NY 1994]). As was borne out here, in the case of Refco, insider fraud that merely gives the corporation life longer than it would naturally have is not a true benefit to the corporation but can be considered a harm. The majority’s assertion that any corporate insider fraud that “enables the business to survive” defeats the adverse interest exception (majority op., at 19) would, as alleged here, condone the actions of the defendants…

Moreover, in the corporate context where the fraud committed by corrupt insiders is either enabled by, joined in, or goes unnoticed by outside “gatekeeper” professionals, the use of these simple agency principles in such a manner has been rightfully criticized (see NCP Litigation Trust v KPMG LLP, 901 A2d 871, 879, 187 NJ 353, 366 [2006], quoting Morris, [*24]Clarifying the Imputation Doctrine: Charging Audit Clients with Responsibility for Unauthorized Audit Interference, 2001 Colum Bus L Rev 339, 353 [2001])…Indeed, these simplistic agency principles as applied by the majority serve to effectively immunize auditors and other outside professionals from liability wherever any corporate insider engages in fraud.

Important policy concerns militate against the strict application of these agency principles. There can be little doubt that the role played by auditors and other gatekeepers serves the public as well as the corporations that contract for such services. Investors rely heavily on information prepared by or approved by auditors, accountants, and other gatekeeper professionals. Corporate financial statements, examined by ostensibly independent auditors, “are one of the primary sources of information available to guide the decisions of the investing public” (United States v Arthur Young & Co., 465 US 805, 810-811 [1984]). It is, therefore, in the public’s best interest to maximize diligence and thwart malfeasance on the part of gatekeeper professionals (see generally Coffee, Jr., Gatekeeper Failure, 84 Boston U L Rev at 345-346 [“public policy must seek to minimize the perverse incentives that induce the gatekeeper not to investigate too closely”]; Shapiro, Who Pays the Auditor Calls the Tune?: Auditing Regulations and Clients’ Incentives, 35 Seton Hall L Rev 1029, 1034 [2005] [the purpose of audits is to “provide some independent assurance that those entrusted with resources are made accountable to those who have provided the resources”]).

Moreover, it is unclear how immunizing gatekeeper professionals, as the majority has effectively done, actually incentivizes corporate principals to better monitor insider agents. Indeed, it seems that strict imputation rules merely invite gatekeeper professionals “to neglect their duty to ferret out fraud by corporate insiders because even if they are negligent, there will be no damages assessed against them for their malfeasance” (Pritchard, O’Melveny Meyers v FDIC: Imputation of Fraud and Optimal Monitoring, 4 Sup Ct Econ Rev 179, 192 [1995]).

Thank you Judges Ciparick, Lippman and Pigott for your wisdom and common sense in disagreeing with this travesty.

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11 Responses »

  1. […] are named as additional defendants in private lawsuits against Lehman executives.  But the New York Court of Appeals in a 4-3 opinion refused to hold the auditors responsible for frauds perpetrated by management in […]

  2. Interesting post! I just put up an analysis of this case by Kevin Miller of Alston & Bird on PLI’s Securities Law Practice Center. Here is a link if you want to check it out: http://bit.ly/a4nn4P

  3. […] company’s executives, the story is that the auditor was duped. That’s because the judges say it’s usually not possible for anyone else to be guilty when company executives do bad things. It’s especially hard when there’s been a […]

  4. […] a few – is also in bed with the US Treasury. What challenges they may face can be beat off using archaic legal doctrines that say if the executives are fraudsters, the company is, therefore, also a fraudster and has no […]

  5. “A fraud that by its nature will benefit the corporation is not “adverse” to the corporation’s interests, even if it was actually motivated by the agent’s desire for personal gain (Price, 62 NY at 384). Thus, “[s]hould the ‘agent act[] both for himself and for the principal,’ . . . application of the [adverse interest] exception would be precluded” (Capital Wireless Corp. v Deloitte & Touche, 216 AD2d 663, 666 [3d Dept 1995] [quoting Matter of Crazy Eddie Sec. Litig., 802 F Supp 804, 817 (EDNY 1992)]; see also Center, 66 NY2d at 785 [the adverse interest exception “cannot be invoked merely because . . . .(the agent) is not acting primarily for his principal”]). [*12]

    New York law thus articulates the adverse interest exception in a way that is consistent with fundamental principles of agency. To allow a corporation to avoid the consequences of corporate acts simply because an employee performed them with his personal profit in mind would enable the corporation to disclaim, at its convenience, virtually every act its officers undertake. “[C]orporate officers, even in the most upright enterprises, can always be said, in some meaningful sense, to act for their own interests” (Grede v McGladrey & Pullen LLP, 421 BR 879, 886 [ND Ill 2008]). A corporate insider’s personal interests — as an officer, employee, or shareholder of the company — are often deliberately aligned with the corporation’s interests by way of, for example, stock options or bonuses, the value of which depends upon the corporation’s financial performance.

    How it can be argued that fraud benefited Lehman Brothers or New Century and many others? They went out of business. If the fraud had been reported earlier, the corporation may have been saved. I think in the case of Lehman, its clear that management wasn’t taking actions to benefit the corporation’s interests, they were taking actions that were adverse to the corporation’s interests.

    If there were cases where corporate officers hide losses to preserve a corporation’s credit line or to avoid being in default of a credit line, maybe it can be argued that the officers interest aligned with the company. But that is not often the case.

  6. […] And they’re still fighting litigation from AIG shareholders from 2001-2005 era.  But they’re winning in court lately, and so they may feel more optimistic about their chances of coming through all this with a “good […]

  7. […] spite of a recent opinion by the New York State Court of Appeals in the AIG shareholders’ case against PwC, Grant argued PwC should also be held accountable for […]

  8. […] spite of a recent opinion by the New York State Court of Appeals in the AIG shareholders’ case against PwC, Grant argued PwC should also be held accountable for […]

  9. […] spite of a recent opinion by the New York State Court of Appeals in the AIG shareholders’ case against PwC, Grant argued PwC should also be held accountable […]

  10. […] delicto and the theory of imputation. We recently saw this defense used effectively to shoot down two cases against auditors under New York law – Teachers Retirement System of Louisiana v. PwC (a vintage AIG case) and Kirschner v. KPMG […]

  11. […] are named as additional defendants in private lawsuits against Lehman executives.  But the New York Court of Appeals in a 4-3 opinion refused to hold the auditors responsible for their role in frauds perpetrated by […]

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