Recent Decisions and Rationale for the in Pari Delicto Defense
One of the strongest legal weapons available to audit firms sued by shareholders or creditors foUowing revelations of corporate fraud is the defense of in pari delicto. This legal doctrine, over two centuries old, is grounded in the poHcy that a court should not intercede between two wrongdoers. Consider the foUowing scenarios. These are taken from actual court cases, where the issue was whether an audit firm that was allegedly negHgent in failing to detect fraud, or to detect it soon enough, or assisted the thent in the fraud should be able to bar a plaintiff from recovery because the corporation was at least equally at fault in the wrongdoing:
* The chief executive officer (CEO) of a large U.S. commodities broker aUegedly orchestrated a fraud to hide hundreds of miUions of doUars of the company's uncoUectible debt. Within two months of an initial pubHc offering, the company discloses the fraud and seeks Chapter 11 bankruptcy protection. The trustee acknowledges that company insiders masterminded the fraud, but files claims for fraud, breach of fiduciary duty, and malpractice against several parties, including its accounting firms.
* The CEO and an inner circle of senior officers of a giant insurance company aUegedly orchestrated a variety of fraudulent acts, making the company look more profitable than it really was. After the financial deception is discovered, the stock price plummets and shareholder value declines by more than $3 billion. Shareholders file a lawsuit against the audit firm to recover their losses, claiming that the firm was negHgent in failing to detect the fraud.
* The CEO of a nonprofit corporation engaged in a strategy of aggressive acquisitions. When the strategy failed, high-level officers allegedly misstated the finances. Ultimately, the board discovers the dire financial situation and files for bankruptcy protection. A committee of unsecured creditors aUeges that the auditor coUuded with the corporation's officers to fraudulently misstate the corporation's finances and fries suit against the audit firm for breach of contract, professional negligence, and aiding and abetting a breach of fiduciary duty.
* A bank engaged in a risky mortgage securitization strategy. The failure rate was excessive, and some management members and others made bogus entries. An audit firm is called in after bank regulators discover bookkeeping discrepancies. A clean audit opinion is issued when the bank is actually grossly insolvent A few months later, the bank is closed and the Federal Deposit Insurance Corporation (FDIC) files suit and obtains a judgment against the firm for more than $23 milion for the postaudit losses.
The in pari dericto doctrine is raised in all of these cases. This doctrine is of serious importance to the profession, because, without the defense, an audit firm might potentially be held liable for the entire drop in market capitalization of its public company audit clients. According to a U.S. Treasury report, the average public company common stock capitalization in 2007 was $3.842 billion, and the exposure to an excessive judgment "is unrelated to the scope of any audit error or misconduct, and dramatically dwarfs audit fees" (U.S. Treasury Advisory Committee on the Auditing Profession, Final Report, p. VII:27, October 6, 2008). The Htigation concern is not limited to firms that audit pubHc companies. One indictment or large judgment against a firm could possibly destroy the entire firm, even if it is later overturned (U.S. Chamber of Commerce, "Auditing: A Profession at Risk," January 2006). Audit firms may feel pressured to settle claims with little merit due to these litigation risks.
The in pari delicto doctrine, together with agency law, allows the fraudulent actions of corporate management to be imputed to the corporation if the acts of the corporate agents were not totally adverse to the company and benefited the corporation in some way. In the context of auditing cases, this means that the corporation cannot seek a remedy against the audit firm even if the audit firm negligently failed to detect the fraud. When the doctrine is recognized by the court, the firm may be dismissed from the lawsuit in the early pleading stage. This defense may also extend to bar a third-party plaintiff, such as a shareholder or bankruptcy trustee, who sues on behalf of the corporation. In its pure form, the defense even applies if the auditor colluded in the fraud, as long as the plaintiff was at least equally at fault. The poHcy justifications for this defense in the audit context have been debated in the courts in recent years.
Arguments in favor of the in pari delicto defense for the auditing profession include, among others, that auditors should be permitted to use it just as other individuals and professionals have done in common law cases for over two centuries. If the defense is not allowed, a crient can shift its primary responsibility to prevent fraud to an outside auditor, resulting in more expansive audits, higher audit fees, and the exclusion of services for high-risk cHents in need of quaHty auditors. Arguments opposing the use of this defense include the notions that innocent victims of harm should be compensated and that legal liability deters wrongful conduct and motivates higher quality audits. This, in turn, may instill confidence in investors as to the quality of audits - or, conversely, the lack of the ability to sue may weaken investor confidence. This view might also stem from perceptions of auditors as "deep pocket" insurers with the duty to detect even the smaUest fraud (see Exhibit 1).
A 2010 New York Court of Appeals opinion addressed the scope and viability of the in pari deHcto doctrine in cases stemming from the American International Group Inc. (AIG) and Refco frauds. A review of the New York court's opinion and its underlying poHcy rationale follows below, as weU as a comparison of the impHcations of this decision to cases from New Jersey and Pennsylvania. Next, there may be a potential surge of litigation applying the in pari deHcto defense to auditors in cases that might develop from the failure of over 380 banks in the last three years. Finally, continued advocacy of the impHcations of litigation and the scope of the in pari delicto defense for the profession is recommended.
A Potent Legal Shield
On January 3, 2011, the Supreme Court of Delaware affirmed the dismissal of the malpractice and breach of contract claims against PricewaterhouseCoopers in Teachers' Retirement System of Louisiana et al. v. PricewaterhouseCoopers LLP, 2011 WL 13545. A few months earlier, on November 18, 2010, the U.S. Court of Appeals for the Second Circuit affirmed the district court's dismissal of a suit brought by the trustee of a bankrupt corporation's litigation trust against KPMG Kirschner v. KPMG LLP, 626 F3d 673 [2d Cir., 2010]). Both of these dismissals against audit firms rested on an important ruling by the New York Court of Appeals that clarified the scope of the in pari deHcto doctrine under New York law Kirschner v. KPMG LLP, 15 NY.3d 446, 938 NJ32d 941 [NY, 2010]). These cases and the subsequent rulings from the New York Court of Appeals are discussed below.
The AIG fraud. The Teachers' Retirement System of Louisiana and the City of New Orleans Retirement System filed shareholder derivative suits in Delaware to recover funds to make AIG whole, claiming AIG's senior officers had orchestrated a variety of fraudulent acts to make the corporation appear more prosperous than it really was, resulting in the issuance of materially misleading financial statements. The misconduct was aUegedly at the direction and under the control of the chairman of the corporation's board of directors, its CEO, and his inner circle of senior officers. The largest alleged act of deception involved a fraudulent $500 million reinsurance transaction that had no substance. Other activities allegedly included avoiding taxes by falsely claiming that workers' compensation poHcies were other types of insurance. After the financial maneuverings were discovered, shareholder equity declined by $3.5 billion.
The plaintiffs did not allege fraud by its audit firm or that the firm conspired with AIG to commit accounting fraud. The plaintiffs did, however, claim that the audit was performed negligently, which resulted in failure to detect or report the fraud perpetrated by AIG's senior officers. The lower court (Court of Chancery in Delaware) held that the acts of the senior officers were imputed to the corporation. Thus, the corporation was in equal fault, and the audit firm's defense of in pari deHcto stood, barring the derivative claims. The plaintiffs appealed to the Delaware Supreme Court, which decided that a resolution depended on significant and unsettled questions of New York law. The Delaware court then followed a special procedure to "certify" the question in March 2010 for resolution by the New York Court of Appeals.
The Refco fraud. About three months earlier, in December 2009, the U.S. Court of Appeals for the Second Circuit had certified a similar question involving the scope of the in pari delicto doctrine to the New York Court of Appeals. The Kirschner matter involved Refco, previously a provider of brokerage and clearing services in the derivatives, currency, and futures markets. In August 2005, Refco disclosed that its president and CEO had orchestrated a series of loans that hid hundreds of millions of dollars of the company' s uncollectible debt. Refco filed for Chapter 11 bankruptcy protection. The bankruptcy trustee, Kirschner, filed claims for fraud, breach of fiduciary duty, and malpractice against many parties, including several Refco senior managers and other owners, as well as Refco's law firm, accounting firms, and several customers. The parties moved to dismiss the claims. The trustee acknowledged that the Refco insiders masterminded Refco's fraud. The parties agreed that the Second Circuit's decision in Shearson Lehman Hutton Inc. v. Wagoner (944 F.2d 114, 118 [2d Cir. 1991]) applied. Wagoner held that a trustee does not have legal standing to sue (the ability to initiate a lawsuit) when the acts of the corporate wrongdoers are imputed to the corporation. Thus, the issue depended on whether, under New York law, the acts of the Refco corporate insiders could be imputed to Refco. The lower court held that the acts could be imputed to Refco and dismissed the suit against the auditors. Upon dismissal, the plaintiff appealed to the Second Circuit which, in turn, certified questions to the New York Court of Appeals.
The N.Y. Court Ruling
The New York Court of Appeals reviewed the certified questions from both lawsuits and issued an opinion on October 21, 2010, that was of major significance to accounting firms. The court had essentially been asked by the plaintiffs to reinterpret and broaden New York law to make remedies available to creditors or shareholders of a corporation whose management was engaged in financial fraud and whose auditors, investment bankers, lawyers, financial advisors, or other advisors either allegedly assisted with the fraud or did not detect the fraud (Kirschner, 2010). The AICPA and the NYSSCPA jointly filed a brief of amici curiae (friends of the court) discussing the implications if the court eviscerated the defense of in pari delicto in claims by or on behalf of companies whose senior managers engaged in fraud. The amici brief argued that eliminating the doctrine would expand auditor liability disproportionately to the auditor's ability to detect and prevent fraud (p. 1). The brief also argued that because litigation is so expensive, a firm might have to settle claims with little merit, resulting in higher audit fees. This could also take away a key incentive for companies to police their own managers (p. 24). Furthermore, accountants may be more selective about cHents, affecting the clients in greatest need of quaHty auditors (p. 27). The amici brief argued the foUowing three main points:
* The defense should be based solely on the conduct of the wrongdoing insiders and not on the state of mind of the auditor-defendants.
* The exception to the doctrine, based on adverse interest of the insiders, should apply only when the agent has "totally abandoned" the interests of the corporation.
* The doctrine should not be replaced by comparative negligence.
The New York Court of Appeals was apparently persuaded by the position of the defendants and their amici brief and agreed with aU three points. The court explained that the doctrine of in pari deHcto has been part of the common law for over two centuries and requires courts not to intercede to resolve a dispute between two wrongdoers. The court asserted that this doctrine serves the following important public poricy purposes:
* it deters illegality by denying relief to an admitted wrongdoer.
* It avoids involving the courts in disputes between wrongdoers Kirschner, p. 950).
Adverse interest exception. Agency principles are involved because a corporation acts through its officers and employees, and the acts of agents within the scope of their authority are presumed to be imputed to their principals. This includes actions that are unauthorized, actions where the agent shows poor judgment, or even actions where the agent commits fraud Kirschner, pp. 950-951). Actions within the scope of the agent's authority include everyday activities central to the company's operations, such as issuing financial statements, moving assets between corporate entities, and entering into contracts.
But there is an exception to imputing the acts of an agent to the company. The court, quoting from an eariier case, explained this adverse interest exception: "To come within the exception, the agent must have totally abandoned his principal's interests and be acting entirely for his own or another's purposes" Kirschner, p. 952). This narrow exception can be appHed to cases where the insider's misconduct benefits only himself or a third party and is committed against the corporation, such as embezzlement or outright theft. Conduct that defrauds others for the benefit of the corporation would not fall within this exception, even if the fraud is ultimately revealed and later harms the corporation. Although the trustee in Kirschner tried to claim that bankruptey classifies as a harm that should trigger the adverse interest exception, the court said this was not relevant (p. 953).
The plaintiffs wanted the New York Court of Appeals to broaden the exception as a matter of public policy to "recompense the innocent and make outside professionals (especially accountants) responsible for their negHgence and misconduct in cases of corporate fraud" Kirschner, p. 954). They claimed this would benefit blameless unsecured creditors (as in the case of Refco) and shareholders (as in the case of AIG) at the expense of defendants who allegedly assisted the fraud or were negligent; however, the court did not find the argument compelling and said the equities were not quite that clear. The court asked:
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? The costs of Htigation and any settlements or judgments would have to be borne, in the first instance, by the defendants' blameless stakeholders; in the second instance, by the public. ... 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 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 aU 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. Kirschner, p. 958).
Thus, the New York Court of Appeals refused to broaden the adverse interest exception, keeping the in pari delicto doctrine strong and viable in the context of auditing cases. The court also refused to adopt the trustee Kirschner's suggestion to utilize comparative fault rather than allow the in pari deHcto defense to be a total bar to recovery, as New Jersey has done. FoUowing this opinion, on November 18, 2010, the U.S. Court of Appeals for the Second Circuit affirmed the district court's dismissal of the trustee's suit against KPMG and others. Likewise, the Delaware Supreme Court affirmed the dismissal of the claims against PricewaterhouseCoopers on January 3, 2011. (The Delaware court also refused to apply Delaware law, which the plaintiffs beHeved would have provided a different result.)
Implications for the Profession
This lawsuit represents a big victory for firms whose claims are or will be governed by New York law because the New York Court of Appeals refused to broaden the "adverse interest" exception to the in pari delicto defense. If the court had broadened the exception, as argued by the plaintiffs, then the misconduct of a corporation's officers would not be imputed to the corporation, and any advisors who were professionally negHgent in failing to discover the fraud could be held liable. The way the New York Court of Appeals framed the question was advantageous to the outside advisor: "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?" Kirschner, p. 958).
But other states and courts interpreting federal laws have developed differing interpretations of the in pari deHcto defense. Courts in New Jersey and Pennsylvania in the Third Circuit have considered the state of mind of the defendant-auditor. For example, the Pennsylvania Supreme Court considered a case involving a failed acquisition strategy of a nonprofit healthcare services company. The company's CEO had engaged in a program of aggressive acquisitions in order to build an "integrated delivery system" of physician practices, medical schools, and hospitals, but the strategy failed. A group of highlevel officers allegedly misstated the corporation's finances in figures provided to their independent audit firm in order to conceal the dire financial situation. The committee of unsecured creditors alleged that the auditor colluded with the officers. The board claimed that they did not intervene to stop the CEO from continued acquisitions, based on the issuance of "clean" audit opinions. Following the filing of a Chapter 11 bankruptcy petition, the audit firm was sued for breach of contract, professional negligence, and aiding and abetting a breach of fiduciary duty. In ruling on the issue of the in pari delicto defense, the court asserted that a negligent auditor could assert the defense, but not an auditor who secretly colluded with he principal.
The New Jersey Supreme Court went further in crafting an exception that prevents auditors from utilizing the defense against innocent shareholders. The auditor may now only raise the defense in New Jersey against shareholders who were engaged in the fraud, should have been aware of it or who owned large blocks of stock providing some ability to oversee the company's operations. Exhibit 2 shows a comparison between New Jersey, New York, and Pennsylvania law and the resulting implications for the audit profession.
In Pari Delicto and Failed Banks
Many courts will consider whether equitable reasons exist that weigh against allowing the in pari delicto defense as a bar to recovery. Courts might find important policy considerations that they equitably believe should prevent the defense. One such instance might occur in the context of a Federal Deposit Insurance Corporation (FDIC) receiver who files claims of malpractice on behalf of a failed bank.
In the last three years, 389 banks have failed (FDIC, "Bank Failures in Brief," for 2009, 2010, and 2011 [through December 16, 2011], www.fdic.gov). When a bank fails, the FDIC steps in as receiver, with all the rights and powers of the failed institution (Elizabeth V. Tanis and Drew D. Dropkin, "Asserting Imputation-Based Defenses in Actions Brought by the FDIC as Receiver for a Failed Depository Institution," Accountants' Liability: Litigation and Issues in the Wake of the Financial Crisis, ALI-ABA, 2011). This includes the right to file malpractice claims against the former auditor. The FDICs team of investigators and attorneys examines potential professional liability claims for every failed institution. Following the savings and loan (S&L) crisis of the 1980s, the FDIC was able to recover approximately $1.15 billion from accounting malpractice actions (Tanis and Dropkin 2011).
The Keystone case. In a West Virginia case arising from a failed mortgage securitization strategy, the FDIC, as receiver for the First National Bank of Keystone, sued an audit firm for professional malpractice, alleging negligence in the performance of its audit (Grant Thornton LLP v. Federal Deposit Insurance Corp., 2011 WL 2420264 [C.AAW.Va., 2011]). In 1992, Keystone began an investment strategy involving the securitization of highrisk mortgage loans, pooling these loans into groups and setting interests in the pool through underwriters to investors. The pooled loans were serviced by third-party loan services, such as Advanta. Keystone retained residuals, receiving payments only after all other investors and expenses were paid. The residuals were shown on Keystone's books as an asset and this asset represented a significant portion of Keystone's book value. By 1998, Keystone had securitized over 120,000 loans with a total value in excess of $2.6 billion.
But the failure rate was excessive. Keystone's valuation of the residuals was greater than their market value. Some members of management and others made bogus entries, falsifying Keystone's books, in order to conceal the failure of the securitizations from directors, shareholders, depositors, and regulators. The Office of the Comptroller of the Currency (OCQ noted the irregular bank records and began an investigation. The OCC required Keystone to hire a nationally recognized independent accounting firm to audit the bank's mortgage banking operations, specifying that the firm needed to determine the appropriateness of the bank's accounting for purchased loans and all securitizations. Keystone then hired Grant Thornton, which characterized the audit as maximum risk. The auditor made a crucial error, however, when she failed to obtain written confirmation of a purported oral representation from Advanta.
The auditor called Advanta and claimed that the Advanta representative confirmed on the phone that she had located a pool of mortgages owned by Keystone. The Advanta representative sent an e-mail just minutes later stating the loans were not owned by Keystone, but by another banking entity. Unfortunately, the auditor chose to rely on the oral statement even though it conflicted with the written evidence. Because the $236 million mortgage portfolio was about one-quarter of the bank's claimed assets, this was significant The audit firm issued a clean audit opinion on April 16, 1999, but the financial statements overstated Keystone's assets by $515 million - in reality, tins meant the bank was grossly insolvent The OCC discovered the discrepancies in August and it closed the bank on September 1, 1999. Had the audit firm discovered the fraud in April, ttie bank would have been closed by April 21, 1999, according to the court opinion. The losses incurred by the bank from two days after the issuance of the audit report until the time the bank was closed in September amounted to over $23 rnilhon.
Grant Thornton did not challenge the district court's finding that it was negligent in the conduct of its audit, but instead argued that its negligence was not the proximate (legal) cause of Keystone's losses. The audit firm had wanted to raise the defense that the bank's management was an intervening and superseding cause of postaudit losses in the lower court because some of the bank's management took actions to impede the audit, such as rewording the confirmation letters so that loans owned by another bank would also be included. The appellate court did not find that the management's actions in attempting to continue the fraud were an intervening and superseding cause, because the continued fraudulent conduct by the bank's management was not unforeseeable. The audit firm's expert conceded that it was foreseeable from the standpoint of a reasonably prudent auditor that the failure to discover fraud would result in the continuation of the fraud (Grant Thornton, p. 4). The firm also unsuccessfully contended that this finding of proximate cause would make them the insurer; however, the court reasoned this was a unique situation where the audit firm was called in specifically after irregularities were discovered and the lower court had reasonably lirnited the audit firm's damages to the period following issuance of its audit report.
In addition, Grant Thornton argued that it should have been aUowed to offer claims or defenses, including comparative or contributory negUgence and the in pari deHcto doctrine. Because the FDIC was collecting on assets of a failed institution, the Grant Thornton case inferred that the duty of the FDIC should be to the pubHc and not the former officers and directors of the failed institution; thus, the U.S. Court of Appeals for the Fourth Circuit interpreted West Virginia law to hold that the doctrine would not apply. The Fourth Circuit held that the audit firm was liable for the postaudit losses.
Insights. An audit firm can be Hable for the losses resulting from the faUure to discover the continuing fraud by bank management under West Virginia law after regulators have insisted on an audit According to the outcome of this case, a reasonably prudent auditor should have foreseen that a bank's management would continue to perpetrate the fraud. Relying on an oral confirmation that contradicts a written confirmation is a crucial error. Furthermore, if a firm undertakes an audit after regulatory bank officials noticed irregularities in the reports and demanded an audit under West Virginia law it is at risk for continuing losses if the audit is negligently performed.
The decision in Grant Thornton also shows that, under some interpretations, the in pari delicto defense may not be aUowed if regulators have stepped in to collect assets for the failed institution. This stems from O'Melveny & Myers v. FDIC (512 U.S. 79), a 1994 Supreme Court decision ruling that state law determines whether the knowledge of the institution's officers or employees can be imputed to the institution and then to the FDIC. The vast majority of states have not yet addressed this issue, however, and this unsettled area of law might become a batUe area "if and when the FDIC files accounting malpractice actions arising out of the bank and thrift failures of the Great Recession" (Tanis and Dropkin 2011).
Looking to the Future
The in pari deHcto doctrine acts as a powerful legal shield for an audit firm when state or federal law allows its use. Depending on the jurisdiction, an audit firm may be able to assert the defense and be dismissed at the early pleading stage of the lawsuit Arguments in favor of this defense in this context are that an audit firm should not be uniquely disabled from using this defense; however, exceptions to the legal defense create ambiguity and can possibly intensify the number of claims filed. Taking a case to trial with uncertain legal outcomes is risky because of the possibility of a huge judgment that could destroy the firm.
WhUe the likelihood of such an effect can be debated, the systemic risks arising from Htigation involving rogue corporate officers could conceivably affect the long-term insurabüity and stability of the auditing profession. Market losses suffered by a large company that becomes insolvent often greatly exceed the total capital of its auditing firm. A suit for damages in the amount of the loss could devastate an audit firm. According to the U.S. Treasury Advisory Committee on the Auditing Profession's final report, "No audit firm is too big to fari," and the loss of one of the larger firms would have repercussions throughout the global capital markets (October 6, 2008, p. 11:5). Firms are already at risk for large judgments through a variety of civü and criminal legal claims. In addition, the Sarbanes-Oxley Act of 2002 (SOX) imposed more stringent regulatory requirements. Thus, the deterrent effect of allowing shareholders, receivers, and trustees to sue in the corporate fraud context may only be minimal. As the Kirschner court noted, "any former partner at Arthur Andersen LLP ... could attest an outside professional (and especially an auditor) whose corporate thent experiences a rapid or disastrous decline in fortune precipitated by insider fraud does not skate away unscathed" (p. 953). In jurisdictions where the issue is unsettled, persuasive advocacy of the impHcations on the audit profession wiU remain important if the defense is not aUowed or is narrowed.
Finally, a November 2011 decision in a case stemming from the Madoff Ponzi scheme raised the issue of a Securities Investor Protection Act (SEPA) trustee's standing to sue on behalf of creditor claims against third parties Picard v. JPMorgan Chase & Co, 2011 WL 5170434 [S.D.N.Y 2011]). In its ruling, the U.S. District Court for the Southern District of New York maintained that the in pari delicto defense asserted by the JPMorgan defendants did apply in this instance Exhibit 4). This is a case to watch during 2012 for an appeal and a ruling from the Second Circuit Court of Appeals, which wül help assess the impact on the scope of the trustee's standing and the interplay with the in pari delicto defense for outside advisors.
The decision in Grant Thornton also shows that under some interpretations, the in pari delicto defense may not be allowed if regulators have stepped in to collect assets for the failed institution.
Sandra S. Benson, JD, is an assistant professor in the department of accounting at Middle Tennessee State University, Murfreesboro, Tenn.