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From the Pages of The Pomerantz Monitor: Defendants Escape Liability for Failing to Detect, and Stop, Massive Frauds at Refco and AIG

By Carolyn Moskowitz

As Anthony Maul reports in the latest issue of The Pomerantz Monitor, creditors and investors rely on outside auditors to keep their corporate clients honest. So when those creditors or investors discover that one of those corporations has perpetrated a massive fraud right under the auditors? noses, they get angry. One path to redress is to bring a suit on behalf of the corporation seeking recovery for the auditor?s violation of its professional and contractual obligations to the company. 

But such claims often encounter a serious obstacle: the doctrine of ?in pari delicto,? which means that recovery is barred where the plaintiff is just as much at fault as the defendant. A derivative suit is brought on behalf of the company; so if the company is equally at fault as the auditor, it can?t recover against the auditor for failing to stop its own bad behavior. Moreover, in the event the company has gone bankrupt, the bankruptcy trustee stands in the company?s shoes; so a suit by the trustee against auditors can face the same weakness. 

Recently, in Kirschner v. KPMG, New York?s highest state court resolved certified questions regarding the effect of in pari delicto on suits against auditor defendants in two cases arising from scandals involving Refco and AIG. In both cases, the complaint alleged that senior executives perpetrated massive financial frauds and that auditors failed to stop them. In each case, the auditors ? KPMG in the Refco case, and PriceWaterhouseCoopers in the AIG case ? raised the in pari delicto defense, claiming that company insiders were the ones primarily responsible for the fraud, and that the company cannot recover against someone else for failing to stop them. The fact that a case is brought by a trustee, or by outside investors, rather than the company itself, doesn?t change that fact, because the plaintiffs ?stand in the shoes? of the company and are subject to all the defenses that could be asserted against the company.

In both the Refco and AIG cases, the plaintiffs argued that these insiders were not acting to benefit the company when they committed this fraud but were out only to benefit themselves. Therefore, they said, the insiders were pursuing interests ?adverse? to the interest of the company, and the company should not be held responsible for their actions.    

This may sound like an abstruse legal argument, but it has serious practical consequences for investors and creditors. When massive frauds like this (allegedly) occur, directors and officers liability insurance policies may not cover the damages. Unless the insider wrongdoers are extremely wealthy, the only way to recover for the injuries suffered is from third parties who may share responsibility for the wrongdoing. If the wrongdoing of these insiders bars recovery from third parties, the company cannot be made whole. 

Both the Second Circuit Court of Appeals and the Delaware Supreme Court asked the New York Court of Appeals to decide the scope of this so-called ?adverse interest? exception to the in pari delicto defense. Adverse interest is typically found to exist only where the officer or director ?totally abandons? the company?s interests in undertaking such actions. Lawyers and judges have long been confused about what constitutes ?total abandonment? of a principal?s interests. 

Take, for example, a situation where an insider does something to inflate the company?s financial results, not to benefit the company but in order to increase his own bonus or achieve some other personal end. The fraud temporarily helps the company, by enhancing its reported financial results, but the real motivation is to help the insider; and at the end of the day the fraud is uncovered and the company is damaged. Has the wrongdoer ?totally abandoned? the interests of the company? The Court of Appeals says no.

In its opinion, the Court of Appeals held that the adverse interest exception applies only when the insiders? actions have the immediate effect of harming the company. Where the conduct actually benefits the company (even if only in the short term) the exception does not apply. Thus, in our hypothetical example, the adverse interest exception would not apply because at first corporate results are improved, which benefits the company. If, on the other hand, the insider simply steals a few million dollars from the corporate safe, with the immediate effect of harming the company, the employee would have totally abandoned the interests of the company, the adverse interest exception would apply, the wrongful acts would not be attributed to the corporation, and the outside security firm charged with guarding the safe could be sued for negligence. 

The Court of Appeals based its holding that the adverse interest exception applies only where corporate agents commit fraud against rather than for the corporation on the rationale-for-agency principles themselves:

[T]he presumption that an agent will communicate all material information to the principal operates except in the narrow circumstance where the corporation is actually the victim of a scheme undertaken by the agent to benefit himself or a third party personally, which is therefore entirely opposed (i.e. ?adverse?) to the corporations own interests. Where the agent is perpetrating a fraud that will benefit his principal, this rationale does not make sense.

Full post as published by PomTalk on January 18, 2011 (boomark / email).