New York s Highest Court Rejects Liability for Third-Party Professionals Who Allegedly Assist Corporate Officers Alleged Fraud

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1 Alert New York s Highest Court Rejects Liability for Third-Party Professionals Who Allegedly Assist Corporate Officers Alleged Fraud October 27, 2010 In an important decision last week, the New York Court of Appeals reaffirmed limits on the ability of corporations and those who sue on their behalf (such as bankruptcy trustees and derivative plaintiffs) to bring claims against professional advisors, including auditors and law firms, for allegedly assisting or failing to detect wrongdoing by the corporation s own management. The 4-3 opinion reinforced centuries-old doctrines of in pari delicto and imputation in response to questions regarding New York law that were certified by the U.S. Court of Appeals for the Second Circuit and the Delaware Supreme Court. The Court of Appeals rejected approaches by Pennsylvania and New Jersey courts and confirmed that these common-law doctrines remain valid defenses to claims on behalf of a corporation against its outside advisors. Background At issue were application of the in pari delicto doctrine, which often is asserted as a defense when a corporation s outside professionals are sued on behalf of the corporation, and its intersection with the agency principle of imputation. Under the in pari delicto doctrine, courts will not intervene in disputes between two wrongdoers. Under agency principles, acts by corporate officers generally are imputed to their principal the corporation. Pursuant to these theories, neither a corporation nor others acting on its behalf may assert claims based on its officers alleged fraud where that fraud is imputed to the corporation itself, unless certain exceptions apply. Questions concerning this rule and its exceptions were certified to the Court of Appeals of New York from Kirschner v. KPMG LLP, 1 pending before the Second Circuit, and Teachers Retirement Sys. of Louisiana v. PricewaterhouseCoopers LLP, 2 pending before the Delaware Supreme Court, as discussed below. Kirschner v. KPMG, LLP was brought by Refco Inc. s Chapter 11 bankruptcy trustee, Marc Kirschner (the Refco Trustee ), against Refco s law firm, investment bankers and accounting firms, among others, alleging that these third parties aided and abetted Refco management s fraud or, alternatively, were negligent in not discovering the allegedly fraudulent conduct. 3 Judge Lynch in the U.S. District Court for the Southern District of New York dismissed the Refco Trustee s claims. Judge Lynch concluded that bankruptcy trustees cannot sue third parties that allegedly conspired with the debtor corporation to defraud creditors (i.e., under the so-called Wagoner rule). Judge Lynch also found F.3d 186 (2d Cir. 2009) A.2d 280 (Del. 2010). 3 Slip Opinion for Kirschner v. KPMG LLP, et al. (No. 151) and Teachers Retirement System of Louisiana v. Pricewaterhouse Coopers LLP (No. 152), at 3-4 (N.Y. Oct. 21, 2010) [hereinafter Kirschner Opinion ].

2 that the narrow exception to the Wagoner rule the adverse interest exception did not apply. Specifically, he held that the exception applies only when the corporate officers act entirely in their own interest and totally abandon the corporation s interests. Judge Lynch rejected the argument that the adverse interest analysis turns on management s subjective intent (i.e., whether management intended to benefit itself instead of the corporation), reasoning that when management commits corporate fraud, it always intends to benefit personally. As such, the exception would never permit imputation of management wrongdoing to the corporation. 4 The Refco Trustee appealed Judge Lynch s decision to the U.S. Court of Appeals for the Second Circuit, which sought guidance from New York s Court of Appeals on questions of interpretation and application of New York common law, including: (1) whether the adverse interest exception is satisfied by showing that the insiders intended to benefit themselves by their misconduct; and (2) whether the exception is available only where the insiders misconduct has harmed the corporation. 5 Teachers Retirement System of Louisiana v. Pricewaterhouse Coopers LLP is a derivative action brought by AIG shareholders ( AIG Shareholders ) in Delaware state court alleging that AIG s independent auditors were negligent in failing to detect fraud perpetrated by AIG s management. The Delaware Chancery Court dismissed the action, concluding that the claims were barred under New York law. Specifically, the court found that the complaint did not allege that the AIG officers had totally abandoned AIG s interests in connection with the purported fraud. As such, the alleged fraud was imputed to the corporation and the AIG Shareholders claims were barred by the in pari delicto doctrine and the Wagoner rule. On appeal, the Delaware Supreme Court sought guidance from New York s Court of Appeals regarding the in pari delicto doctrine and the allegations against AIG s auditors. 6 Court of Appeals Opinion In response to the certified questions from these two actions, the Court of Appeals summarized New York law relating to in pari delicto and traditional agency principles. The Court of Appeals observed that for more than a century, New York courts have recognized that all corporate acts including fraudulent ones are subject to the presumption of imputation. 7 Accordingly, strong public policy considerations underscore this rule, namely, that imputation fosters an incentive for a principal to select honest agents and delegate duties with care. 8 The Court of Appeals also stressed that the adverse interest exception must be construed narrowly because allowing a corporation to avoid the consequences of corporate acts simply because an employee performed them with his personal profit in mind would enable the corporation to disclaim... virtually every act its officers undertake. 9 Therefore, the exception only applies where fraud undertaken by management benefits management at the corporation s expense. That is, the agent must have totally abandoned his principal s interest and be acting entirely for his own or another s purposes, not the corporation s. 10 Where the corporation received any benefit (including short-term benefits) from the alleged fraud, the exception does not apply. 11 The Refco Trustee and the AIG Shareholders (together, Appellants ) advanced three main arguments for a broader adverse interest exception: (1) management s subjective intent in carrying out alleged fraud should be the touchstone of the analysis and any short-term benefits the corporation receives should not prevent 4 Kirschner Opinion at Id. at 9-10 (citation omitted). 6 Kirschner Opinion at Kirschner Opinion at (citation omitted). 8 Id. at Id. at Id. at 19 (internal citations and quotations omitted). 11 Id. ( So long as the corporate wrongdoer s fraudulent conduct enables the business to survive to attract investors and customers and raise funds for corporate purposes this test is not met. ) Schulte Roth & Zabel LLP. All Rights Reserved. 2

3 application of the exception; (2) New York should follow Pennsylvania and New Jersey courts that carve out exceptions that permit shareholders and creditors to recover from third-party professionals; and (3) public policy supports compensating innocent shareholders and imposing liability on negligent third-party professionals. The Court of Appeals rejected each of these arguments, as discussed below. (1) Subjective Intent and Illusory Benefits The Court of Appeals refused to read the Second Circuit s decision in In re CBI Holding Co. v. Ernst & Young 12 to mean that management s intent to benefit itself is the touchstone and a short term, illusory benefit to the company does not defeat the adverse interest exception. 13 Instead, the Court of Appeals read CBI as consistent with prevailing New York law, specifically noting that CBI found that its management had benefited from its alleged fraud through bigger bonuses and continued control over the company, had totally abandoned the corporation s interests, and that the company suffered harm as a result because management s continued plundering of the corporation s assets deprived the corporation of the opportunity to sell equity for value just 10 months before it eventually filed for bankruptcy. The Court of Appeals concluded that adopting Appellants reading of CBI would limit imputation to fraudsters so inept they gain no personal benefit and unexposed frauds, which is another way of saying the adverse interest exception would become a dead letter because it would encompass every corporate fraud prompting litigation. 14 (2) Pennsylvania and New Jersey Precedent on In Pari Delicto and the Adverse Exception The Court of Appeals also rejected approaches to imputation and in pari delicto adopted by Pennsylvania and New Jersey courts, as articulated in Official Comm. Of Unsecured Creditors of Allegheny Health Educ. and Research Fund v. Pricewaterhouse Coopers LLP ( AHERF ) 15 and NCP Litig. Trust v. KPMG LLP ( NCP ), respectively. 16 In AHERF, corporate management allegedly misstated AHERF s finances in information provided to AHERF s outside auditors. Following AHERF s bankruptcy, unsecured creditors sued the auditors on AHERF s behalf claiming, among other things, that the audits should have uncovered the fraudulent scheme and that by issuing clean opinions, the auditors knowingly assisted the officers misconduct. Eventually, the Pennsylvania Supreme Court weighed in on the appropriate test under Pennsylvania law for deciding whether imputation [was] appropriate when the party invoking that doctrine [was] not conceded to be an innocent third party, but an alleged co-conspirator in the agent s fraud. 17 It held that imputation (and therefore the in pari delicto defense) was unavailable where an auditor had not proceeded in material good faith. 18 Similarly, in NCP, a litigation trustee established by Physician Computer Network s ( PCN ) bankruptcy plan brought a negligence action against PCN s auditor for failing to uncover corporate officers fraud in a timely manner. PCN s auditor raised in pari delicto as an affirmative defense. The New Jersey Supreme Court held that when an auditor is negligent within the scope of its engagement, the imputation doctrine does not prevent [innocent] corporate shareholders from seeking to recover. 19 Therefore, the New Jersey rule calls for relative faults of the company/shareholders and auditors to be sorted out by the fact finder as matters of comparative negligence and apportionment F.3d 432 (2d Cir. 2008). 13 Kirschner Opinion at Id. at A.2d 313 (Pa. 2010) N.J. 353 (2006). 17 Kirschner Opinion at 28 (quoting AHERF, 2008 WL , at *4 (3rd Cir. 2008)). 18 Id. (quoting AHERF, 989 A.2d at ) (emphasis added). 19 Kirschner Opinion at 26 (quoting NCP, 187 N.J. at 384.). 20 Id Schulte Roth & Zabel LLP. All Rights Reserved. 3

4 In Kirschner, the New York Court of Appeals recognized that equity considerations compelled the NCP and AHERF decisions since any recovery would benefit innocent shareholders or unsecured creditors, even if those parties were technically standing in the shoes of the principal malefactors, and should not be barred by in pari delicto. The majority rejected these approaches in Kirschner, however, stating that while the New Jersey and Pennsylvania approaches may not completely abolish the adverse interest exception, it is rendered beside the point. 21 (3) Public Policy The Court of Appeals also rejected public policy arguments that broadening application of the adverse interest exception would compensate the innocent and make third-party professionals responsible for their negligence in failing to detect fraudulent conduct. 22 The court noted that Appellants did not argue that imputation should not apply where a completely innocent victim of management s fraud sues corporate management. Nor did they argue that the adverse interest exception should be broadly construed in such cases. As such, their arguments are essentially confined to situations implicating the in pari delicto doctrine. The Court of Appeals was fearful that adopting Appellants position would create 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. 23 Further, the court reasoned that imposing liability on third-party professionals would provide no additional deterrence to professional malpractice or misconduct, since outside professionals underwriters, law firms, and especially accounting firms already are at risk for large settlements and judgments in the litigation that inevitably follows the collapse of an Enron, or a Worldcom or a Refco or an AIG-type scandal. 24 Dissenting Opinion The Court of Appeals dissenting opinion, delivered by Judge Ciparick on behalf of herself and two concurring judges, disagrees with the majority s willingness, in their view, to: allow dismissal... at this early stage of litigation based on agency principles and public policy, effectively creating a per se rule that fraudulent insider conduct bars any actions against outside professionals by derivative plaintiffs or litigation trustees for complicitous assistance to the corrupt insider or negligent failure to detect the wrongdoing. 25 The dissenters align themselves with the AHERF and NCP decisions 26 discussed above. They criticize the majority s application of simplistic agency principles, and suggest that the majority s decision effectively immunizes auditors and other third-party professionals from liability whenever corporate management engages in fraud. They also stress that important public policy considerations militate against the strict application of these agency principles, 27 noting, for example, investors reliance on information prepared or approved by auditors, accountants, and other gatekeeper professionals. Immunizing such so-called gatekeepers only invites them to neglect their professional duties, they assert. 28 For these reasons, the dissenters argue, New Jersey and Pennsylvania courts carved out exceptions to the imputation and in pari delicto doctrines for negligent or otherwise culpable outside auditors (New Jersey) or collusive third-party professionals (Pennsylvania). 21 Id. at Id. at Id. at Id. at Id. (dissent) at Id. (dissent) at Id. (dissent) at Id. (dissent) at Schulte Roth & Zabel LLP. All Rights Reserved. 4

5 Importance of Kirschner The majority s decision imposes significant limits on the ability of bankruptcy trustees, derivative plaintiffs and others to assert claims on behalf of a corporation against outside professionals for allegations of fraud or misconduct by the corporation s management. The decision stands in contrast to rulings by other states, including Pennsylvania and New Jersey, that make it easier for plaintiffs in such cases to disclaim the misconduct of corporate insiders in suits against outside advisors. Given the importance of New York law, Kirschner is likely to have a significant impact on an area of litigation that has proliferated in recent years. Authored by Richard J. Morvillo, Jeffrey F. Robertson, and Vivi Mazarakis. If you have any questions concerning this Alert, please contact your attorney at Schulte Roth & Zabel or one of the authors. Washington, DC Schulte Roth & Zabel LLP 1152 Fifteenth Street, NW, Suite 850 Washington, DC fax New York Schulte Roth & Zabel LLP 919 Third Avenue New York, NY fax London Schulte Roth & Zabel International LLP Heathcoat House, 20 Savile Row London W1S 3PR +44 (0) (0) fax U.S. Treasury Circular 230 Notice: Any U.S. federal tax advice included in this communication was not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal tax penalties. This information has been prepared by Schulte Roth & Zabel LLP ( SRZ ) for general informational purposes only. It does not constitute legal advice, and is presented without any representation or warranty as to its accuracy, completeness or timeliness. Transmission or receipt of this information does not create an attorney-client relationship with SRZ. Electronic mail or other communications with SRZ cannot be guaranteed to be confidential and will not (without SRZ agreement) create an attorney-client relationship with SRZ. Parties seeking advice should consult with legal counsel familiar with their particular circumstances. The contents of these materials may constitute attorney advertising under the regulations of various jurisdictions Schulte Roth & Zabel LLP. All Rights Reserved. 5