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January 13, 2011

Court of Appeals Refuses to Expand In Pari Delicto to Allow Third-Party Liability

The Court of Appeals recently re-examined the centuries-old doctrine of in pari delicto, a doctrine that arises in disputes amongst two parties, each of whom has engaged in malfeasance. The scenario that spurred this contemporary analysis involves corporations whose officers have engaged in some sort of wrongdoing that was not detected soon enough by third-party gatekeepers, such as accounting firms and law firms. "The doctrine's full name is in pari delicto potior est condition defendentis, meaning 'in a case of equal or mutual fault, the position of the [defending party] is the better one'." Kirscher v. KPMG LLP and Teachers' Retirement System of Louisiana v. Pricewater-house Coopers, LLP, 2010 NY Slip Op. 7415; 2010 NY Lexis 2959 (Court of Appeals 2010), respectively.

The Court analyzed this in a decision involving two cases: one brought by a litigation trustee of a bankrupt corporation (Kirschner); the other a derivative action on behalf of creditors and shareholders of a corporation whose management has engaged in financial fraud (Teachers' Retirement System of Louisiana). Recent decisions in New Jersey (NCP Litig. Trust v. KPMG LLP, 187 NJ 353; 901 A2d 871 (2006)) and Pennsylvania (Official Comm. of Unsecured Creditors of Alleghany Health Educ. and Research Found. v. PricewaterhouseCoopers LLP, 2008 US App LEXIS 18823 (3d Cir. 2008)) in favor of plaintiff's actions against third parties in similar cases apparently inspired plaintiffs to test the waters in New York.

The New York Court of Appeals refused to expand this doctrine to allow shareholders to recover against gatekeepers that either assisted in the commission of the fraud or did not detect such fraud soon enough, or at all. Its reasoning can be summarized concisely by Judge Desmond, who said, "no court should be required to serve as paymaster of the wages of crime, or referee between thieves. Therefore, the law will not extend its aid to either of the parties or listen to their complaints against each other, but will leave them where their own acts have placed them." Stone v. Freeman, 298 NY 268, 271 (1948). Also, "a criminal who is injured committing a crime cannot sue the police officer or security guard who failed to stop him; the arsonist who is singed cannot sue the fire department."

This principal is so strong under New York law that the Court has said the defense should not be "weakened by exceptions." The end result is that there will be no third-party gatekeeper liability under New York law in such cases.

Traditional agency and imputation principals play an important role in an in pari delicto analysis, which is understood to foster an incentive for principals/corporations to select honest agents (officers) and delegate duties with care. The acts of agents, and the knowledge they acquire while presumably acting within the scope of their authority, are presumptively imputed to their principals. Thus, "[t]he risk of loss from the unauthorized acts of a dishonest agent falls on the principal that selected the agent." Agency law "presumes imputation even where the agent acts less than admirably, exhibits poor business judgment, or commits fraud."

The presumption that agents communicate information to their principals is a legal presumption that governs in every case except in the narrow circumstance where a 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 (adverse) to the corporation's own interests." This rationale makes no sense when the agent is perpetrating a fraud that will benefit its principal.

Thus, the adverse interest exception to the doctrine of in pari delicto, which has traditionally been interpreted narrowly in New York, further contemplates that:

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. It cannot be invoked merely because he has a conflict or because he is not acting primarily for his principal.

Further, "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." Similarly, when a corporation experiences a short-term gain from the actions of the wrongdoer, this is clearly not adverse, in spite of any ensuing negative fallout. Even if the agent's actions led to unfavorable results for the principal corporation, this does not by itself establish that the agent acted adversely.

Thus, when a CFO "pads" books to make a corporation look more valuable than it is and this knowledge comes out, leading to a drop in the value of the corporation, this is a negative result, but it does not satisfy the requirements of in pari delicto because the agent did not act solely in his own interests and adversely to the corporation at the time of the malfeasance. This is so in spite of the negative ramifications of his or her actions. Even the unintended result of forcing the corporation into bankruptcy is not sufficient to establish the adverse interest exception.

In pari delicto is also grounded in the public policy concerns articulated by Judge Desmond. The well-settled principle of law underlying this contemporary analysis is the fact that "principals, rather than third parties, are best suited to police their chosen agents." Thus there is an incentive for a principal to choose agents carefully and to use care in delegating functions to them.

One of the justifications of expanding in pari delicto to allow third-party liability is "to recompense the innocent and make outside professionals responsible for their negligence and misconduct in cases of corporate fraud." The abovementioned cases in New Jersey and Pennsylvania were animated by considerations of equity, specifically, the notion that although the plaintiffs stood in the shoes of the principal malefactors, any recovery achieved from defendant accounting firms would, in effect, only benefit innocent shareholders or unsecured creditors, and thus should not be barred by in pari delicto.

The Court's response to this argument was, "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?" In other words, plaintiffs' proposals may create a double standard whereby the innocent stakeholders of the corporation's outside professionals are held responsible for the wrongs of their errant agents while the innocent stakeholders of the corporation itself are not charged with knowledge of their wrongdoing agents.

In response to the fear that outside consultants are receiving a "get-out-of-jail-free" card, the Court noted that outside professionals (and organizations) whose corporate clients experience a rapid or disastrous decline in fortune precipitated by insider fraud do not skate away unscathed. Outside professionals are already at risk for large settlements and judgments in the litigation that inevitably follows the collapse of a corporation like Enron.

For this and other reasons, it is not clear to the Court that expanding the adverse interest exception or loosening imputation principals under New York law would result in any greater disincentive for professional malfeasance or negligence than already exists. However, it is clear that expanding in pari delicto, imputation, and adverse interest would allow creditors and shareholders of companies that employ miscreant agents to enjoy the benefits of their misconduct without suffering any harm. Thus, the "principals of in pari delicto and imputation, with its narrow adverse interest exception, which are imbedded in New York law, remain sound," ensuring the "stability and fair measure of certainty which are prime requisites in any body of law." That said, Justice Ciparick wrote a dissenting opinion, citing the public policy arguments raised in the abovementioned New Jersey and Pennsylvania cases.

If you require further information regarding the information presented in this Legal Alert and its impact on your organization, please contact any of the members of the Practice Area.


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