New York Court of Appeals Confirms Robust In Pari Delicto Defense

November 01, 2010

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 advisers (such as auditors, lawyers and investment bankers) against claims made on behalf of the company that the outside advisers 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 adviser.

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 advisers 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 adviser. The court observed, for example, that the owners and creditors of the outside advisers — 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 advisers 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 advisers.

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 advisers such as auditors, lawyers and investment bankers may be well advised to use New York choice-of-law provisions in their engagement agreements.

For more information about the subject matter of this alert, please contact the lawyers listed below:

Dale E. Barnes, Co-chair, Securities Litigation, 415.393.2522

Jordan D. Hershman, Co-chair, Securities Litigation, 617.951.8455

Jeffrey Q. Smith, Co-chair, Financial Institutions Litigation, 212.705.7566

P. Sabin Willett, Partner, Financial Restructuring, 617.951.8775

Matthew J. Lawson, Counsel, Financial Institutions Litigation, 212.705.7569

This article was originally published by Bingham McCutchen LLP.