Kirschner Decision

In a 4-3 decision,[1] New York’s highest court rejected requests by a litigation trustee and derivative plaintiff (collectively, the “plaintiffs”) to broaden liability against third-party auditors, accountants, investment bankers, attorneys and other professionals on claims they assisted corporate insiders in defrauding shareholders and creditors. Two separate—but related—cases were at issue. The first involved the 2006 Refco bankruptcy filing and the second was a derivative action brought on behalf of AIG by two different retirement systems.

Refco
In August 2007, the trustee filed a complaint in Illinois state court, asserting fraud, breach of fiduciary duty and malpractice against Refco executives, an investment bank, a law firm, two accounting firms and several customers that participated in or were negligent in not discovering allegedly deceptive loans that led to the bankruptcy filing. A year later, the trustee filed a complaint in Massachusetts state court, asserting similar claims against KPMG. Both lawsuits were removed and consolidated to the Southern District of New York, and the defendants’ motion to dismiss the claims was granted. The issue was whether the claims were subject to dismissal by virtue of the Second Circuit’s Wagoner[2] rule, which states that the bankruptcy trustee does not possess standing to seek recovery from third parties alleged to have participated with the corporation in defrauding creditors. The judge observed that “the parties’ dispute focused solely on whether the narrow exception to the Wagoner rule—the ‘adverse interest’ exception—applied.” For this exception to apply, “the [corporate officer] must have totally abandoned [the corporation’s] interests in acting entirely for his own or another’s purposes…because where an officer acts entirely in his own interests and adversely to the interests of the corporation, that misconduct cannot be imputed to the corporation.” The district court concluded that because the complaint was “saturated by allegations that Refco received substantial benefits from the insiders—alleged wrongdoing,” precedent foreclosed the trustee’s claims. Plaintiffs appealed to the Second Circuit Court of Appeals, which certified the issue to the New York Court of Appeals, asking whether the adverse interest exception was 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.

Derivative Action Brought on Behalf of AIG by Two Retirement Systems
In the second lawsuit, the derivative plaintiffs did not allege that defendant PricewaterhouseCoopers LLP (PwC) conspired with AIG or its agents to commit accounting fraud, but as AIG’s independent auditor, it did not perform its auditing responsibilities in accordance with professional standards of conduct, and so failed to detect or report the fraud perpetrated by AIG senior officers. The Delaware Chancery Court granted PwC’s dismissal motion, concluding that New York law applied and barred the claims. The court decided that under New York’s law of agency, the wrongdoing of AIG’s senior officers was imputed to AIG and that, based on the allegations, AIG senior officers did not totally abandon AIG’s interests such that the adverse interest exception to imputation would apply. Once the wrongdoing was imputed to AIG, the chancery court decided that AIG’s claims against PwC were barred by New York’s in pari delicto doctrine and the Wagoner rule governing standing. The derivative plaintiffs appealed and the Delaware Supreme Court certified the following question to the New York Court of Appeals:

Would the doctrine of in pari delicto bar a derivative claim under New York law where corporation sues its outside auditor for professional malpractice or negligence based on the auditor’s failure to detect fraud committed by the corporation; and, the outside auditor did not knowingly participate in the corporation’s fraud, but instead, failed to satisfy professional standards in its audits of the corporation’s financial statements?

In Pari Delicto
The doctrine of in pari delicto mandates that the courts will not intercede to resolve a dispute between two wrongdoers. The court of appeals stated that the doctrine serves important public policy purposes. First, denying judicial relief to an admitted wrongdoer deters illegality. Second, in pari delicto avoids entangling courts in disputes between wrongdoers. The justice of the in pari delicto rule is most obvious where a willful wrongdoer is suing someone who is alleged to be merely negligent.

Imputation
The court found that traditional agency principles play an important role in an in pari delicto analysis. The acts of agents and the knowledge they acquire while acting within the scope of their authority are presumptively imputed to their principals. Therefore, strong public policy considerations exist as it fosters an incentive for a principal to select honest agents and delegate duties with care.

Adverse-Interest Exception to Imputation
New York courts have held that “[t]o come within the exception, the agent must have totally abandoned his principal’s interest in the acting entirely for his own or another’s purposes. It cannot be invoked merely because he has a conflict of interest or because he is not acting primarily for his principal.” This rule avoids ambiguity where there is a benefit to both the insider and the corporation, and reserves this most narrow of exceptions for those cases where the insider’s misconduct benefits only the insider or a third party. Thus, should the agent act for himself or herself and for the principal, the exception would be precluded. The fact that an agent’s action has unfavorable results for the principal does not establish that the agent acted adversely. Fraud on behalf of the corporation is not the same thing as fraud against it.

Subjective Intent and Illusory Benefits
The plaintiffs first asked that the adverse-interest exception depend on whether “corporate insiders intend to benefit themselves at the company’s expense” to be “alleged and proved by showing that the corrupt insiders intended to benefit themselves personally and actually receive personal benefits and/or that the company received only short-term benefits but suffered long-term harms.” The court disagreed, stating that the exception would then be a “nearly impermeable rule barring imputation” in every case.

Pennsylvania and New Jersey Approaches
The plaintiffs urged the court to take the approach to in pari delicto and imputation adopted by the New Jersey Supreme Court in 2006 or the Pennsylvania Supreme Court in 2010. These decisions were both animated by considerations of equity—the notation that although the plaintiffs stood in the shoes of the principal malefactors, any recovery they achieved from the defendant accounting firms, which would allege to have been either negligent or complicit—would, in fact, only benefit innocent shareholders or unsecured creditors and should not be barred by in pari delicto.

Comparative Fault
The court quickly dismissed the plaintiffs argument that any in pari delicto defense should be part of an apportionment of fault because it would marginalize the adverse interest exception.

Public Policy
The court reduced this case down to whether they should reinterpret New York common law to permit corporations to shift responsibility for their own agents’ misconduct to third parties as a matter of public policy in order to compensate the innocent and deter third-party professional misconduct and negligence. The plaintiffs argued that although they stand in the shoes of the corporate malefactors, any recovery will benefit blameless, unsecured creditors and shareholders at the expense of defendants who allegedly assisted the fraud or were negligent. The court questioned why the interests of innocent stakeholders of corporate fraudsters trump those of innocent stakeholders of the outside professional defendants, and found that the outside professionals—underwriters, law firms and especially accounting firms—were already at risk for large settlements and judgments in the litigation that inevitably follow a corporate collapse. It was not evident that expanding the adverse interest exception or loosening imputation principals under New York law would create any greater disincentive for professional malfeasance than already exists. The court found that the principles of in pari delicto and imputation with its narrow adverse interest exception, embedded in New York law, remain sound including maintaining the “stability and fair measure of certainty which are prime requisites in any body of law.”

Dissent
The dissent held that New York shall allow an exception to the in pari delicto doctrine for especially egregious cases. “The majority opinion effectively precludes litigation by derivative corporate plaintiffs or litigation trustees to recover against negligent or complicit outside actors—even where the outside actor, hired to perform essential gatekeeping and monitoring functions, actively colludes with the corrupt corporate insiders.”