Contributed by Sunny Singh
In response to certified questions regarding whether the in pari delicto doctrine, which precludes aiding and abetting claims against advisors and consultants by a corporation that has committed fraud, has become or should be relaxed in New York, the New York Court of Appeals recently responded with a resounding no. See Kirschner v. KPMG LLC, et. al., 2010 N.Y. Lexis 2959 (N.Y. Oct. 21, 2010). The issue was presented in a lawsuit brought by the litigation trustee appointed under Refco Inc’s confirmed chapter 11 plan against certain advisors to Refco, including investment banks, law firms and two accounting firms, alleging that all of these defendants aided and abetted Refco insiders in committing fraud. The SDNY granted the defendants’ motion to dismiss holding that the trustee lacked standing to pursue the claims under the doctrine of in pari delicto.
The in pari delicto doctrine generally stands for the proposition that courts will not interject themselves into disputes between two wrongdoers and is rooted in the public policy purpose of deterring illegality by denying judicial relief to an admitted wrongdoer. As interpreted by the Second Circuit in Shearson Lehman v Wagoner, the doctrine has been applied to limit the standing of bankruptcy debtors or their trustees to seek recovery from third parties alleged to have joined with the debtor in fraud. Because a corporation can only act through its agents, the fraudulent acts of the corporation’s agents are imputed to the corporate debtor, and, as a result, the corporation – or a bankruptcy trustee charged with the duty of pursuing the debtor’s claims – lacks standing to recover from third parties who allegedly aided and abetted the corporate insiders in committing the fraud.
There is an exception to in pari delicto and the Wagoner rule known as the “adverse interest exception.” Where an agent of the corporation is acting entirely for his own purposes and totally abandons his principal’s interests, the agent’s actions will not be imputed to the corporation. The exception is grounded in basic principles of agency law. If the agent has acted on behalf of the corporation to defraud others that results in a benefit to the corporation, it is presumed that the corporation has knowledge of the fraud and must bear its consequences. If, however, the insider’s actions are entirely for his own benefit and harm the corporation in the short term (not just from the unmasking of the fraud), then it cannot be presumed that the agent disclosed the fraud to the corporation. In that instance, the corporation is a victim of the fraud. In sum, to satisfy the adverse interest exception, it must be shown that the officers stole from the corporation, not that the stole for it.
Refco Inc. was a leading provider of brokerage and clearing services in the derivatives, currency and futures markets. In October 2005, Refco disclosed that its president and chief executive officer had orchestrated a succession of loans that hid hundreds of millions of dollars of the company’s uncollectible debt from the public and regulators. Shortly thereafter, Refco’s stock plummeted and its brokerage arm experienced a run on customer accounts causing Refco to file for chapter 11 protection. Refco’s chapter 11 plan was confirmed and the litigation trustee was appointed to pursue Refco’s claim to maximize recoveries for Refco’s general unsecured creditors. In August 2007, the litigation trustee brought an action against Refco’s president and CEO and certain other insiders of Refco alleging that they defrauded the company. The litigation trustee also sued advisors to the company alleging that they aided and abetted Refco’s insiders in committing the fraud. After finding that the complaint was filled with allegations that Refco received substantial benefits from the wrongdoing of its insiders, the district court dismissed the claims against the third-party defendants under the doctrine of in pari delicto. On appeal, the Second Circuit certified questions to the New York Court of Appeals to opine on the scope of the adverse interest exception under New York law and whether it should be expanded.
The Refco trustee raised a number of arguments to broaden the scope of the adverse interest exception, all of which were rejected. The trustee argued that there should be an exception to in pari delicto if the insiders intended to benefit themselves in any way irrespective of whether the actions of the insiders also resulted in a short term benefit to the corporation. The court rejected this, finding that the exception would swallow the rule. Effectively, so long as there was a long term harm to the corporation, which is almost always the case where fraud is unmasked, the exception would always be satisfied because in every instance of fraud, insiders will act primarily to benefit themselves.
The court also rejected the Refco trustee’s invitation to follow recent decisions by the New Jersey and Pennsylvania Supreme Courts that expanded the exceptions to the in pari delicto defense. In NCP Litig. Trust v. KPMG, two corporate insiders intentionally misrepresented the company’s financials to investors as well as to the company’s accounting firm, KPMG. After PCN’s chapter 11 plan was confirmed, the litigation trustee sued KPMG alleging that KPMG was negligent in detecting the irregularities during its audit and had KPMG exercised due care, it would have detected the fraud and could have prevented PCN’s losses. KPMG asserted in pari delicto as an affirmative defense. The New Jersey Supreme Court found that “when an auditor is negligent within the scope of its engagement, the imputation doctrine does not prevent corporate shareholders from seeking to recover.” Id. at 384. To be clear, however, the corporate shareholders must be innocent, and the auditor could still assert the “imputation defense” where the shareholders also engaged in the fraud or if the shareholders arguably possessed the ability to oversee the company’s operations by way of their ownership or control of the company.
Similarly, in Allegheny Health, AHERF’s chief executive and financial officers had knowingly misstated the company’s financials to hide its operating losses. After the company filed for bankruptcy, AHERF’s unsecured creditors’ committee sued PwC and alleged that PwC’s audits should have brought the management’s misstatements to light, but rather than issuing an adverse opinion, PwC issued “clean” opinions. In response to certified questions from the Third Circuit, the Pennsylvania Supreme Court held that imputation was not available where an auditor had not proceeded in material good faith.
The New York Court of Appeals rejected the Refco trustee’s arguments to shift the responsibility of a corporation’s agents’ misconduct to third parties. The Refco trustee urged the court that although he stands in the shoes of the corporation, any recovery that is achieved will benefit blameless unsecured creditors and shareholders at the expense of defendants who allegedly assisted the fraud or were negligent. But the court was not persuaded that the equities so clearly favor the trustee, asking rhetorically, “[W]hy 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?” 2010 N.Y. LEXIS 2959, at *41. The court also rejected the trustee’s argument that expanding the adverse interest exception would deter misconduct or fraud by third party defendants. Noting the demise of Arthur Anderson LLP after the Enron scandal, the court found that outside professionals are already adequately deterred from negligent and fraudulent conduct and expanding the adverse interest exception would not further this purpose.
The decision is a firm reminder that although the in pari delicto doctrine may produce harsh results, particularly for creditors of a corporation that has failed due to the fraudulent acts of its officers, it remains the law in New York and the exceptions to its application are limited.