Court Ruling Exempts Third-Party Fraud Liability

Accounting firms, law firms, and other outside advisers to corporations are breathing a sigh of relief, thanks to a long-awaited appeals court ruling in the state of New York that third parties can’t be held liable in cases brought on behalf of companies whose senior management engaged in fraud.

The Oct. 21 decision by the New York Court of Appeals in two consolidated cases—Kirschner v. KPMG and Teachers‘ Retirement System of Louisiana v. PricewaterhouseCoopers—strongly reaffirms the state’s long-standing precedent under the in pari delicto doctrine, meaning “in equal fault.” The decision settles the question of whether shareholders can pin malpractice liability against auditors and other outside advisers who work with companies whose corporate officers commit misconduct. The short answer: no.

Former U.S. solicitor general Paul Clement, now a partner at law firm King & Spalding who represented PwC in one of the cases, says the decision is “very comforting” for all professional advisory firms.

Sylvia

While the case is only binding in New York, it is expected to have consequences across the nation. “You have a court that has a rich history of being cited by other jurisdictions,” says Jack Sylvia, co-chair of Mintz Levin’s securities litigation practice.

The Kirschner case stemmed from a lawsuit filed in the Southern District of New York by Mark Kirschner, the bankruptcy trustee for Refco Litigation Trust, against the brokerage firm’s outside counsel, its former auditor, three investment banks, and many others. According to the allegations, the outside advisers helped former CEO Phillip Bennett conceal the true financial condition of Refco by hiding hundreds of millions of dollars in debt, eventually leading to the company’s bankruptcy.

In Teachers’ Retirement System of Louisiana, shareholders of American International Group brought a lawsuit on behalf of the company, claiming that AIG’s auditor, PwC, was negligent in failing to detect a scheme by which AIG senior officers falsely inflated the company’s financial condition.

“A lot of courts were following this rule of thumb that if a company went down in flames then there had to have been abandonment of that company’s interest. The decision really puts the brakes on that.”

—Robert Schwinger,

Partner,

Chadbourne & Parke

The trial courts in both cases dismissed the claims against the outside advisers, citing the in pari delicto doctrine and the “adverse interest exception,” which holds that a company can’t be held liable where an officer or director “totally” abandons the interest of the company. Without that exception, New York law typically holds that a corporation is responsible for whatever its officers and directors do in the course of their work.

The adverse interest exception is important in these cases, because the plaintiffs tried to argue that shareholders should be allowed to sue outside advisers to recover for an alleged wrong that the company, itself, essentially took part in.

In Kirschner, district court held that the exception didn’t apply, because the trustee acknowledged that Refco received “substantial benefits” from the insiders’ alleged fraud. Likewise, in Teachers’ Retirement System of Louisiana, the court had found that AIG’s officers did not “totally abandon” AIG’s interests to invoke the adverse interest exception.

Schwinger

Where the issue gets tricky, however, is when management engages in fraud for the purpose of making money for investors—essentially making the company the beneficiary of the fraud, says Robert Schwinger, a partner at Chadbourne & Parke. The problem: how to tell apart one situation from the other. “That’s been a tremendous area of dispute among the courts in recent years,” he says.

That’s what the New York Court of Appeals had to answer. Specifically, two of the eight questions in Kirschner were “whether the adverse interest exception is satisfied by showing that the insiders intended to benefit themselves by their misconduct,” and “whether the exception is available only where the insiders’ misconduct has harmed the corporation.”

COURT DECISION

The following excerpt from Kirschner v. KPMG details the courts’ decisions:

The District Court concluded that “[t]his line of precedent foreclose[d] the Litigation Trustee’s claims” because the complaint was “saturated by allegations that Refco received substantial benefits from the [Refco] insiders’ alleged wrongdoing” (2009 WL 1286326, *6, 2009 US Dist LEXIS 32581, *22). Thus, under the Trustee’s own allegations the Refco insiders stole for Refco, not from it—i.e., “the burden of the [Refco] insiders’ fraud was not borne by Refco or its then-current shareholders who were themselves the [Refco] insiders—but rather by outside parties, including Refco’s customers, creditors, and third parties who acquired shares through the IPO” (2009 WL 1286326, *6, 2009 US Dist LEXIS 32581, *24).

In reaching his decision, the Judge rejected as “without merit” the Litigation Trustee’s “industrious” interpretation of the Second Circuit’s decision in In re CBI Holding Co. v Ernst & Young (529 F3d 432 [2d Cir 2008]), a case where the court held that a bankruptcy court’s finding that the adverse interest exception applied was not clearly erroneous. The Judge declined to read a solely “intent-based” standard into CBI because “deferring to a finder-of-fact’s choice as to which evidence to credit after a trial, or acknowledging that facts related to intent could contribute to the explication of how a fraud worked and to whose benefit it accrued, does not make the participants’ intent the ‘touchstone’ of the analysis such that it precludes dismissal on the pleadings” (2009 WL 1286326, *7, 2009 US Dist LEXIS 32581, *26). “To hold otherwise,” he reasoned, “would be to explode the adverse-interest exception, transforming it from a ‘narrow’ exception, into a new, and nearly impermeable rule barring imputation” (2009 WL 1286326, *7 n 14, 2009 US Dist LEXIS 32581, *26 n 14). The standard could not depend exclusively on the Refco insiders’ subjective motivation, the Judge explained, because “[w]henever insiders conduct a corporate fraud they are doing so, at least in part, to promote their own advantage” (2009 WL 1286326, *7 n 14, 2009 US Dist LEXIS 32581, *28 n 14 [internal citation omitted]).

Having declined the Litigation Trustee’s invitation to read CBI to inquire solely into insiders’ claimed motivations, without regard to the nature and effect of their misconduct, the District Court revisited the fraud’s impact on Refco. He again emphasized that the Trustee’s allegations did not establish injury to Refco, because the Refco insiders did not embezzle or steal assets from Refco, but instead sold their holdings in Refco to third parties at fraudulently inflated prices—i.e., the Refco insiders’ benefit came at the expense of the new purchasers of Refco securities, not Refco itself. Critically, “the Trustee must allege, not that the [Refco] insiders intended to, or to some extent did, benefit from their scheme, but that the corporation was harmed by the scheme, rather than being one of its beneficiaries” (2009 WL 1286326, *7, 2009 US Dist LEXIS 32581, *27).

Plaintiffs appealed to the Second Circuit Court of Appeals. After presenting a comprehensive account of the Litigation Trustee’s factual allegations and the District Court’s decision, the court remarked that the parties seemingly did not dispute several propositions in the lower court’s decision, which “appear[ed] to correctly reflect New York law concerning the adverse interest exception” (Kirschner v KPMG LLP, 590 F3d 186, 191 [2d Cir 2009]); specifically, that the adverse interest exception was “a narrow one and that the guilty manager must have totally abandoned his corporation’s interests for [the exception] to apply”; and that “whether the agent’s actions were adverse to the corporation turns on the short term benefit or detriment to the corporation, not any detriment to the corporation resulting from the unmasking of the fraud” (id. [quoting the District Court’s opinion (internal quotation marks omitted)]). Nonetheless, the court observed, “[a]s [the District Court Judge] applied these propositions to the Trustee’s allegations, . . . he interpreted New York law in ways that [brought] the parties into sharp dispute concerning certain aspects of the adverse interest exception”; namely, “the state of mind of the [Refco] insiders and the harm to their corporation” (id.).

The Second Circuit noted that “New York cases seem[ed] to support” the District Court’s conclusion that an insider’s subjective intent was not the “touchstone” of adverse interest analysis; however, the court added, “other New York cases may be read to make intent more significant” (id. at 192 n 3). In light of the parties’ “differing uses of New York cases, coupled with the somewhat divergent language used by the District Court in the pending case and by [the Second Circuit] in CBI, both endeavoring to interpret New York law,” the court sought our guidance as to the scope of New York’s adverse interest exception (id. at 194). Accordingly, on December 23, 2009 the Second Circuit certified eight questions, inviting us to “focus [our] attention on questions (2) and (3)” (id. at 195), which are “whether the adverse interest exception is satisfied by showing that the insiders intended to benefit themselves by their misconduct”; and “whether the exception is available only where the insiders’ misconduct has harmed the corporation,” respectively (id. at 194-195).

Source

Court of Appeals: Kirschner v. KPMG (Oct. 21, 2010).

In Teachers Retirement System, the question before the court was whether in pari delicto bars a company from suing its outside auditor for negligence not because it participated in a fraud, but rather because it failed to live up to professional standards and missed the fraud entirely.

On appeal, the defendants had argued that the courts shouldn’t apply in pari delicto so strictly, but rather should consider certain exceptions. In a 4-3 decision, however, the court reiterated the narrow scope of the adverse interest exception, finding that it applies only to circumstances where an officer or director “totally abandons” the company’s interests and acts “entirely” against it; a common example is embezzlement.

The court also found that the employee’s motivation—whether for the benefit of the company or himself—isn’t relevant. The issue, rather, is whether the fraud boosted the company’s financial results, even if only in the short term.

“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,” the court said. “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.”

Not Completely Settled

The ruling doesn’t leave third parties in the clear entirely. With its decision, the court parted ways with findings by the high courts of New Jersey and Pennsylvania, both of which have recently expanded their interpretations of in pari delicto to allow such suits in corporate fraud cases. And while strengthening its own law, the New York Court of Appeals decision goes against the findings of other jurisdictions. “A lot of courts were following this rule of thumb that if a company went down in flames then there had to have been abandonment of that company’s interest,” Schwinger says. “The decision really puts the brakes on that.”

Several judges on the New York Court of Appeals agreed with that move. In a dissent, Judge Carmen Beauchamp Ciparick voiced fears that the majority’s decision serves to “effectively immunize auditors and other outside professionals from liability wherever any corporate insider engages in fraud,” she wrote.

The majority opinion’s finding fails to give outside advisers any incentive to monitor the conduct of corporate executives, which is “in the public’s best interest to maximize diligence and thwart malfeasance on the part of gatekeeper professionals,” she added.

Legal experts also say the decision will make it easier for outside advisers to get these cases thrown out at an earlier stage in litigation. Rather than put the burden of proof on defendants to show their case is strong enough to hold up in court, as is typically the case, the decision puts that burden of proof on plaintiffs in cases challenging the in pari delicto doctrine.

Hurd

Susan Hurd, a partner with law firm Alston & Bird, says the ruling is likely to have a chilling effect on third-party fraud claims in state courts. “It makes it harder for people to bring these state law claims, which they have a lot of incentive to do, given how difficult it is to make these claims in federal court,” she says. Specifically, federal securities law states that third parties cannot be held responsible in private suits for “aiding and abetting” securities fraud.

“The law [outside advisers] have been relying on remains in tact,” says Sylvia. More broadly, however, legal experts agree the court’s ruling sweeps away with it a number of the issues surrounding the in pari delicto defense that have so divided federal and lower state courts in recent years.