KIRSCHNER v. KPMG LLP Nos. 151, 152
15 N.Y.3d 446 (2010)
938 N.E.2d 941
912 N.Y.S.2d 512
MARC S. KIRSCHNER, as Trustee of the REFCO LITIGATION TRUST, Appellant, v. KPMG LLP et al., Respondents, et al., Defendants. TEACHERS' RETIREMENT SYSTEM OF LOUISIANA et al., Derivatively on Behalf of Nominal Defendant AMERICAN INTERNATIONAL GROUP, INC., Appellants, v. PRICEWATERHOUSECOOPERS LLP, Respondent.
Court of Appeals of New York.
Decided October 21, 2010.
Quinn Emanuel Urquhart & Sullivan, LLP, New York City ( Kathleen M. Sullivan , Richard I. Werder, Jr. , Sascha N. Rand , Sanford I. Weisburst , K. McKenzie Anderson , Sarah Rubin and Simona Gory of counsel), for appellant in the first above-entitled action.
Wilmer Cutler Pickering Hale and Dorr LLP, New York City ( Philip D. Anker , Anne K. Small and Jeremy S. Winer of counsel), Winston & Strawn LLP, Chicago, Illinois ( Linda T. Coberly and Bruce R. Braun of counsel), Wilmer Cutler Pickering Hale and Dorr LLP, Washington, D.C. ( Paul R.Q. Wolfson and Daniel P. Kearney, Jr. , of counsel), Clifford Chance US LLP, New York City ( Anthony Candido of counsel), Davis Polk & Wardwell LLP ( Robert F. Wise, Jr. , and Paul Spagnoletti of counsel), King & Spalding LLP ( James J. Capra, Jr. , and James P. Cusick of counsel), King & Spalding LLP, Washington, D.C. ( Kenneth Y. Turnbull of counsel), Marino, Tortorella & Boyle, P.C., Chatham, New Jersey ( Kevin H. Marino and John D. Tortorella of counsel), Williams & Connolly LLP, Washington, D.C. ( John K. Villa , George A. Borden and Craig D. Singer of counsel), and Howrey LLP, New York City ( Kevin A. Burke , Gary F. Bendinger and Sarah D. Abeles of counsel), for respondents in the first above-entitled action.
Cohen & Gresser LLP, New York City ( Lawrence T. Gresser , Nathaniel P.T. Read and Lawrence J. Lee of counsel), for William Wilson Bratton and others, amici curiae in the first above-entitled action.
Paduano & Weintraub LLP, New York City ( Leonard Weintraub and Kathryn L. Bedke of counsel), for Anthony Paduano, amicus curiae in the first above-entitled action.
Goldberg Segalla LLP, Albany ( Matthew S. Lerner of counsel), for DRI—The Voice of the Defense Bar, amicus curiae in the first above-entitled action.
Strook & Strook & Lavan LLP, New York City ( James L. Bernard , Elizabeth H. Cronise , David M. Cheifetz and Hannah Yu of counsel), for M. Todd Henderson, amicus curiae in the first above-entitled action.
Skadden Arps Slate Meagher & Flom LLP, New York City ( Scott D. Musoff and Christos Ravanides of counsel), Ira D. Hammerman , Washington, D.C., and Kevin Carroll for Securities Industry and Financial Markets Association, amicus curiae in the first above-entitled action.
Pachulski Stang Ziehl & Jones LLP, New York City ( Dean A. Ziehl , Harry D. Hochman and Maria A. Bove of counsel), for National Association of Bankruptcy Trustees, amicus curiae in the first above-entitled action.
Grant & Eisenhofer P.A., New York City ( Stuart M. Grant of counsel), Megan D. McIntyre , Wilmington, Delaware, John C. Kairis , Christine M. Mackintosh and Wolf Haldenstein Adler Freeman & Herz LLP, New York City ( Daniel W. Krasner , Eric B. Levine , Peter C. Harrar , Alan A.B. McDowell and Kate M. McGuire of counsel), for appellants in the second above-entitled action.
King & Spalding LLP ( Paul D. Clement , of the District of Columbia bar, admitted pro hac vice, of counsel), Cravath, Swaine & Moore LLP, New York City ( Thomas G. Rafferty , Antony L. Ryan and Samira Shah of counsel), and Connolly Bove Lodge & Hutz LLP, Wilmington, Delaware ( Henry E. Gallagher, Jr. , of counsel), for respondent in the second above-entitled action.
Willkie Farr & Gallagher LLP, New York City ( Kelly M. Hnatt and Derek M. Schoenmann of counsel), Richard I. Miller , General Counsel, American Institute of Certified Public Accountants, and Bradley M. Pryba for American Institute of Certified Public Accountants and another, amici curiae in the first and second above-entitled actions.
Gibson, Dunn & Crutcher LLP, Washington, D.C. ( Douglas R. Cox , Michael J. Scanlon , Jason J. Mendro and Dace A. Caldwell of counsel), for Center for Audit Quality, amicus curiae in the first and second above-entitled actions.
Judges GRAFFEO, SMITH and JONES concur with Judge READ; Judge CIPARICK dissents in a separate opinion in which Chief Judge LIPPMAN and Judge PIGOTT concur.
OPINION OF THE COURT
In these two appeals, plaintiffs ask us, in effect, to reinterpret New York law so as to broaden the remedies available to creditors or shareholders of a corporation whose management engaged in financial fraud that was allegedly either assisted or not detected at all or soon enough by the corporation's outside professional advisers, such as auditors, investment bankers, financial advisers and lawyers. For the reasons that follow, we decline to alter our precedent relating to in pari delicto, and imputation and the adverse interest exception, as we would have to do to bring about the expansion of third-party liability sought by plaintiffs here.
This lawsuit was triggered by the collapse of Refco, once a leading provider of brokerage and clearing services in the derivatives, currency and futures markets. After a leveraged buyout in August 2004, Refco became a public company in August 2005 by way of an initial public offering.
In December 2006, the United States Bankruptcy Court for the Southern District of New York confirmed Refco's chapter 11 bankruptcy plan, which became effective soon thereafter. Under the plan, secured lenders, who were owed $717 million, were paid in full; Refco's bondholders and the securities customers and unsecured creditors of RCM were due to receive 83.4 cents, 85.6 cents and 37.6 cents on the dollar, respectively; and Refco's general creditors with unsecured claims could expect from 23 cents to 37.6 cents on the dollar (see One Chapter of Refco Saga Closed, 47 Bankr Ct Decisions Wkly News & Comment [No. 13], Jan. 16, 2007, at 2; Refco Exits Bankruptcy Protection, New York Times, Dec. 27, 2006, section C, at 3).
The plan also established a Litigation Trust, which authorized plaintiff Marc S. Kirschner, as Litigation Trustee, to pursue claims and causes of action possessed by Refco prior to its bankruptcy filing. The Litigation Trust's beneficiaries are the holders of allowed general unsecured claims against Refco. Any recoveries are to be allocated, after repayment of up to $25 million drawn from certain Refco assets to administer the Trust, on the basis of the beneficiaries' allowed claims under the confirmed plan.
In August 2007, the Litigation Trustee filed a complaint in Illinois state court asserting fraud, breach of fiduciary duty and malpractice against Refco's president and CEO and other owners and senior managers (collectively, the Refco insiders); investment banks that served as underwriters for the LBO and/or the
Defendants subsequently moved to dismiss the Litigation Trustee's claims pursuant to rule 12 (b) (1) and (6) of the Federal Rules of Civil Procedure, and the District Court granted the motions on April 14, 2009. Because the Trustee acknowledged that the Refco insiders masterminded Refco's fraud, the judge identified as the threshold issue whether the claims were subject to dismissal by virtue of the Second Circuit's Wagoner rule (see Shearson Lehman Hutton, Inc. v Wagoner, 944 F.2d 114, 118 [2d Cir 1991] [bankruptcy trustee does not possess standing to seek recovery from third parties alleged to have joined with the debtor corporation in defrauding creditors]).
Citing Second Circuit cases handed down after our decision in Center v Hampton Affiliates (66 N.Y.2d 782 ), the District Court noted that, in order for the adverse interest exception to
The District Court concluded that "[t]his line of precedent foreclose[d] the Trustee's claims" because the complaint was "saturated by allegations that Refco received substantial benefits from the [Refco] insiders' alleged wrongdoing" (2009 WL 1286326, *6, 2009 US Dist LEXIS 32581, *22). Thus, under the Trustee's own allegations the Refco insiders stole for Refco, not from it—i.e., "the burden of the [Refco] insiders' fraud was not borne by Refco or its then-current shareholders who were themselves the [Refco] insiders—but rather by outside parties, including Refco's customers, creditors, and third parties who acquired shares through the IPO" (2009 WL 1286326, *6, 2009 US Dist LEXIS 32581, *24).
In reaching his decision, the judge rejected as "without merit" the Litigation Trustee's "industrious" interpretation of the Second Circuit's decision in In re CBI Holding Co., Inc. (529 F.3d 432 [2d Cir 2008]), a case where the court held that a bankruptcy court's finding that the adverse interest exception applied was not clearly erroneous. The judge declined to read a solely "intent-based" standard into CBI because
"To hold otherwise," he reasoned, "would be to explode the
Having declined the Litigation Trustee's invitation to read CBI to inquire solely into insiders' claimed motivations, without regard to the nature and effect of their misconduct, the District Court revisited the fraud's impact on Refco. He again emphasized that the Trustee's allegations did not establish injury to Refco, because the Refco insiders did not embezzle or steal assets from Refco, but instead sold their holdings in Refco to third parties at fraudulently inflated prices—i.e., the Refco insiders' benefit came at the expense of the new purchasers of Refco securities, not Refco itself. Critically, "the Trustee must allege, not that the [Refco] insiders intended to, or to some extent did, benefit from their scheme, but that the corporation was harmed by the scheme, rather than being one of its beneficiaries" (2009 WL 1286326, *7, 2009 US Dist LEXIS 32581, *27).
Plaintiff appealed to the Second Circuit Court of Appeals. After presenting a comprehensive account of the Litigation Trustee's factual allegations and the District Court's decision, the court remarked that the parties seemingly did not dispute several propositions in the lower court's decision, which "appear[ed] to correctly reflect New York law concerning the adverse interest exception" (Kirschner v KPMG LLP, 590 F.3d 186, 191 [2d Cir 2009]); specifically, that the adverse interest exception was "a narrow one and that the guilty manager must have totally abandoned his corporation's interests for [the exception] to apply"; and that "whether the agent's actions were adverse to the corporation turns on the short term benefit or detriment to the corporation, not any detriment to the corporation resulting from the unmasking of the fraud" (id. [internal quotation marks omitted] [quoting the District Court's opinion]). Nonetheless, the court observed, "[a]s [the District Court judge] applied these propositions to the Trustee's allegations,... he interpreted New York law in ways that [brought] the parties into sharp dispute concerning certain aspects of the adverse interest exception"; namely, "the state of mind of the [Refco] insiders and the harm to their corporation" (id.).
Teachers' Retirement System of Louisiana and City of New Orleans Employees' Retirement System
This lawsuit is a derivative action brought on behalf of American International Group, Inc. (AIG) by the Teachers' Retirement System of Louisiana and the City of New Orleans Employees' Retirement System (derivative plaintiffs). According to the complaint, senior officers of AIG set up a fraudulent scheme to misstate AIG's financial performance in order to deceive investors into believing that the company was more prosperous and secure than it really was. The complaint further accuses these officers of causing the corporation to avoid taxes by falsely claiming that workers' compensation policies were other types of insurance, and of engaging in "covered calls" to recognize investment gains without paying capital gains taxes. It is also claimed that AIG conspired with other companies to rig markets to subvert supposedly competitive auctions, and that the senior officers exploited their familiarity with improper financial machinations by selling the company's "expertise" in balance sheet manipulation. Specifically, AIG is alleged to have sold to other companies insurance policies that did not involve the actual transfer of insurable risk, with the improper purpose of helping those companies report better financial results; and to have created special purpose entities for other companies without observing the required accounting rules for the similarly improper purpose of helping those companies hide
Derivative plaintiffs do not allege that defendant PricewaterhouseCoopers LLP (PwC) conspired with AIG or its agents to commit accounting fraud. Rather, they contend that, as AIG's independent auditor, PwC 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's senior officers. Had it done so, derivative plaintiffs argue, the fraudulent accounting schemes at AIG would have been timely discovered and rectified.
PwC moved to dismiss the action. On February 10, 2009, the Delaware Court of Chancery granted the motion, concluding that New York law applied to the claims and that, under New York law, the claims were barred (In re American Intl. Group, Inc., 965 A.2d 763 [Del Ch 2009]). Consistent with the way in which the District Court handled the same issues two months later in Kirschner, the vice-chancellor 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 in the complaint, AIG's 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 Court of Chancery decided that AIG's claims against PwC were barred by New York's in pari delicto doctrine and the Wagoner rule governing standing.
Derivative plaintiffs appealed. Determining that the appeal's resolution depended on significant and unsettled questions of New York law, on March 3, 2010, the Delaware Supreme Court issued a decision certifying the following question to us:
In Pari Delicto
The doctrine of in pari delicto
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. 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. But, as the cases we have cited show, the principle also applies where both parties acted willfully. Indeed, the principle that a wrongdoer should not profit from his own misconduct is so strong in New York that we have said the defense applies even in difficult cases and should not be "weakened by exceptions" (McConnell v Commonwealth Pictures Corp., 7 N.Y.2d 465, 470  ["We are not working here with narrow questions of technical law. We are applying fundamental concepts of morality and fair dealing not to be weakened by exceptions" (emphasis added)]; see also Saratoga County Bank v King, 44 N.Y. 87, 94  [characterizing the doctrine as "inflexible"]).
Traditional agency principles play an important role in an in pari delicto analysis. Of particular importance is a fundamental principle that has informed the law of agency and corporations for centuries; namely, the acts of agents, and the knowledge they acquire while acting within the scope of their authority are presumptively imputed to their principals (see Henry v Allen, 151 N.Y. 1, 9  [imputation is "general rule"]; see also Cragie v Hadley, 99 N.Y. 131 ; accord Center, 66 NY2d at 784). Corporations are not natural persons. "[O]f necessity, [they] must act solely through the instrumentality of their officers or other duly authorized agents" (Lee v Pittsburgh Coal & Min. Co., 56 How Prac 373, 375 [Super Ct 1877], affd 75 N.Y. 601 ). A corporation must, therefore, be responsible for the acts of its authorized agents even if particular acts were unauthorized (see Ruggles v American Cent. Ins. Co. of St. Louis, 114 N.Y. 415, 421 ). "The risk of loss from the unauthorized acts of a dishonest agent falls on the principal that selected the agent" (see Andre Romanelli, Inc. v Citibank, N.A., 60 A.D.3d 428, 429 [1st Dept 2009]). After all, the principal is generally better suited than a third party to control the agent's conduct, which at least in part explains why the common law has traditionally placed the risk on the principal.
Agency law presumes imputation even where the agent acts less than admirably, exhibits poor business judgment, or commits fraud (see e.g. Price v Keyes, 62 N.Y. 378, 384-385  [critical issue is whether agent was acting in furtherance of his duties, regardless of his "selfish motive"]). As we explained long ago, a corporation "is represented by its officers and agents, and their fraud in the course of the corporate dealings[ ] is in law the fraud of the corporation" (Cragie, 99 NY at 134; accord Reynolds v Snow, 10 A.D.2d 101, 109 [1st Dept 1960], affd 8 N.Y.2d 899 ). Like a natural person, a corporation must bear the consequences when it commits fraud (see e.g. Wight v BankAmerica Corp., 219 F.3d 79, 86-87 [2d Cir 2000] [under "fundamental principle(s) of agency," managers' misconduct within the scope of their employment is imputed and "bars a trustee from suing to recover for a wrong that he himself essentially took part in"]).
When corporate officers carry out the everyday activities central to any company's operation and well-being—such as issuing financial statements, accessing capital markets, handling customer accounts, moving assets between corporate entities,
Next, the presumption that agents communicate information to their principals does not depend on a case-by-case assessment of whether this is likely to happen. Instead, it is a legal presumption that governs in every case, except where the corporation is actually the agent's intended victim (see Center, 66 NY2d at 784 ["when an agent is engaged in a scheme to defraud his principal... he cannot be presumed to have disclosed that which would expose and defeat his fraudulent purpose"]). Where the agent is defrauding someone else on the corporation's behalf, the presumption of full communication remains in full force and effect (see 3 Thompson and Thompson, Commentaries on the Law of Corporations § 1778, at 347 [3d ed 1927] ["However applicable the dictum that an agent about to commit a fraud will not announce his intention may be in the case of fraud by an agent upon his own principal, it has no application when the agent, acting in behalf of his principal, or ostensibly so, commits a fraud upon a third person"]).
In sum, we have held for over a century that all corporate acts—including fraudulent ones—are subject to the presumption of imputation (Cragie, 99 NY at 134). And, as with in pari delicto, there are strong considerations of public policy underlying this precedent: imputation fosters an incentive for a principal to select honest agents and delegate duties with care.
Adverse Interest Exception to Imputation
We articulated the adverse interest exception in Center as follows: "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 of interest or because he is not acting primarily for his principal" (Center, 66 NY2d at 784-785 [emphasis added]). 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—outright theft or looting or embezzlement—where the insider's misconduct
The rationale for the adverse interest exception illustrates its narrow scope. As already discussed, the 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 corporation's own interests (see Center, 66 NY2d at 784). Where the agent is perpetrating a fraud that will benefit his principal, this rationale does not make sense.
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 (Price, 62 NY at 384). Thus, "[s]hould the `agent act[ ] both for himself and for the principal,' ... application of the exception would be precluded" (Capital Wireless Corp. v Deloitte & Touche, 216 A.D.2d 663, 666 [3d Dept 1995], quoting In re Crazy Eddie Sec. Litig., 802 F.Supp. 804, 817 [ED NY 1992]; see also Center, 66 NY2d at 785 [the adverse interest exception "cannot be invoked merely because ... (the agent) is not acting primarily for his principal"]).
New York law thus articulates the adverse interest exception in a way that is consistent with fundamental principles of agency. To allow 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, at its convenience, virtually every act its officers undertake. "[C]orporate officers, even in the most upright enterprises, can always be said, in some meaningful sense, to act for their own interests" (Grede v McGladrey & Pullen LLP, 421 B.R. 879, 886 [ND Ill 2009]). A corporate insider's personal interests—as an officer, employee, or shareholder of the company—are often deliberately aligned with the corporation's interests by way of, for example, stock options or bonuses, the value of which depends upon the corporation's financial performance.
Again, because the exception requires adversity, it cannot apply unless the scheme that benefitted the insider operated at the corporation's expense. The crucial distinction is between conduct that defrauds the corporation and conduct that defrauds
The Litigation Trustee suggests that, to the extent that the adverse interest exception requires harm, "bankruptcy is harm enough" and that, whenever the corporation is bankrupt, "it is fair to assume at the pleading stage" that the adverse interest exception applies. But the mere fact that a corporation is forced to file for bankruptcy does not determine whether its agents' conduct was, at the time it was committed, adverse to the company (see e.g. Barnes v Hirsch, 215 App Div 10, 11 [1st Dept 1925] [trustee's claim dismissed where it sought to recover for agents' fraud "practiced on these customers" of debtor rather than debtor itself], affd 242 N.Y. 555 ). Even where the insiders' fraud can be said to have caused the company's ultimate bankruptcy, it does not follow that the insiders "totally abandoned" the company. As we have held when considering whether an agent's acts were a fraud on the principal prompted by "selfish" motives, it "is immaterial that it has turned out that it would have been better" for the agent to have acted differently (Price, 62 NY at 385; see also Restatement [Third] of Agency § 5.04, Comment c ["the fact that an action taken by an agent has unfavorable results for the principal does not establish that the agent acted adversely"]).
Critically, the presumption of imputation reflects the recognition that principals, rather than third parties, are best suited to police their chosen agents and to make sure they do not take actions that ultimately do more harm than good (see Cenco, 686 F2d at 455 ["if the owners of the corrupt enterprise are allowed
Consistent with these principles, any harm from the discovery of the fraud—rather than from the fraud itself—does not bear on whether the adverse interest exception applies. The disclosure of corporate fraud nearly always injures the corporation. If that harm could be taken into account, a corporation would be able to invoke the adverse interest exception and disclaim virtually every corporate fraud—even a fraud undertaken for the corporation's benefit—as soon as it was discovered and no longer helping the company.
Finally, to focus on harm from the exposure of the fraud would be a step away from the requirement of adversity. Generally, a fraud will suit the interests of both a company and its insiders for as long as it remains a secret (sometimes a considerable number of years, as was the case with Refco), and leads to negative consequences for both when disclosed.
The Litigation Trustee and the derivative plaintiffs encourage us to broaden the adverse interest exception or revise New York precedents relating to in pari delicto or imputation for reasons of public policy—specifically, as they put it, to recompense the innocent and make outside professionals (especially accountants) responsible for their negligence and misconduct in cases of corporate fraud. Although they do not stress the point, their proposals to revise imputation rules are limited to in pari delicto cases. No one disputes that traditional imputation principles, including a narrowly confined adverse interest exception, should remain unchanged—indeed, are essential—in other contexts. For example, in a suit against Refco or AIG by an innocent victim of the frauds, no one would suggest that the wrongful acts of the corporate insiders could not be attributed to their principals. Instead, the Litigation Trustee and the derivative plaintiffs advance various ways for us to reformulate New York law where in pari delicto is in issue. All their proposals push the adverse interest exception up to, if not beyond, the point of extinction. We next explore these proposals and consider whether our precedent remains anchored in sound public policy and workable.
Subjective Intent and Illusory Benefits
First, the Litigation Trustee advocates that we "adopt the rule of CBI, under which the insiders' intent is the touchstone and a short term, illusory benefit to the company does not defeat the adverse interest exception." The derivative plaintiffs similarly argue that analysis of the adverse interest exception should focus on the agent's overall intent.
As an initial matter, it is not entirely clear that CBI stands for any such far-reaching "rule." CBI held that plaintiff Bankruptcy Services, Inc. (BSI), CBI's successor under its bankruptcy plan, possessed standing by virtue of the adverse interest exception to assert claims against its outside accountants arising from their performance of pre-bankruptcy audits of CBI. This was so because "[t]he bankruptcy court's finding that CBI's management `was acting for its own interest and not that of CBI' [was] not clearly erroneous and constitute[d] the `total abandonment' of [the] corporation's interests necessary to satisfy the adverse interest exception" (CBI, 529 F.3d 432, 438 ). In particular, the bankruptcy court found as a matter of fact that "the fraud was perpetrated for the purpose of obtaining a bigger bonus for [CBI's president and CEO and principal shareholder], and to preserve [his] personal control over the company" (id. at 449). Further, the bankruptcy court found as a matter of fact that CBI would have sold for almost $28 million as late as October 1993, about 10 months before it declared bankruptcy (id. at 453). The ongoing plundering practiced by its president, and not flagged by the accountants as early as the bankruptcy court determined it should have been, deprived the company of this opportunity to sell equity for value.
Giving a broad reading to the Second Circuit's opinion in CBI, the Litigation Trustee asks us to make availability of the adverse interest exception depend upon whether "corrupt 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 received personal benefits and/or that the company received only short term benefits but suffered long term harm" (emphasis added). To recast the adverse interest exception in this fashion, as the District Court pointed out, would "explode" the exception, turning it into a "nearly impermeable rule barring imputation" in every case (Kirschner v Grant Thornton LLP, 2009 WL 1286326, *7 n 14, 2009 US Dist LEXIS 32581, *27-28 n 14 ). This is so because fraudsters are presumably not, as a general rule,
The NCP and AHERF Rules
Alternatively, the Litigation Trustee urges us to take the approach to in pari delicto and imputation adopted by the New Jersey Supreme Court in 2006 (NCP Litig. Trust v KPMG LLP, 187 N.J. 353, 901 A.2d 871 ) (supported by the derivative plaintiffs as well), or the Pennsylvania Supreme Court earlier this year (Official Comm. of Unsecured Creditors of Allegheny Health Educ. & Research Found. v PricewaterhouseCoopers, LLP, 989 A.2d 313 [Pa 2010] [hereinafter AHERF]). Our sister states fashioned carve-outs from traditional agency law in cases of corporate fraud so as to deny the in pari delicto defense to negligent or otherwise culpable outside auditors (New Jersey) and collusive outside professionals (Pennsylvania). Thus, the adverse interest exception, while not abolished, is again rendered beside the point.
In the NCP case, two corporate officers of Physician Computer Network, Inc. (PCN), a publicly traded company that developed and marketed health care-related software, intentionally misrepresented PCN's financial status to investors and to the company's accounting firm, KPMG. After KPMG uncovered the fraud by spotting and reporting certain accounting irregularities, PCN's fortunes quickly sank, leading to bankruptcy and significant investor losses. Various shareholder groups filed lawsuits against PCN and the two corporate wrongdoers, and garnered cash settlements.
In addition, the NCP Litigation Trust was set up pursuant to PCN's confirmed bankruptcy plan for the purpose of pursuing causes of action for the benefit of corporate shareholders. The Trust filed suit against KPMG, alleging as follows: "KPMG negligently failed to exercise due professional care in the performance of its audits and in the preparation of the financial statements and audit reports. Had KPMG not performed negligently, and had it instead exercised due care, it would have detected PCN's fraud and prevented the losses PCN suffered" (187 NJ at 363, 901 A2d at 876-877).
The AHERF case involved a nonprofit operator of health care facilities, which embarked upon an aggressive campaign to acquire hospitals, medical schools and physicians' practices in pursuit of an integrated health care delivery system. This business model did not produce the anticipated cost savings and income streams, though, and by 1996 AHERF was losing money. AHERF's chief executive and financial officers allegedly knowingly misstated AHERF's finances in figures they provided to the organization's outside auditor, Coopers and Lybrand (now PwC) in 1996 and 1997 to hide the corporation's substantial operating losses.
AHERF filed for bankruptcy in July 1998, and a committee of unsecured creditors, acting on the debtor's behalf, then brought claims against AHERF's insiders as well as PwC in federal district court. The claims against PwC alleged professional negligence, breach of contract, and aiding and abetting the breach of fiduciary duty by the AHERF officers. The committee's theory was that PwC's audits in 1996 and 1997 should have brought management's misstatements to light, but rather than issuing an adverse opinion as generally accepted accounting principles (GAAP) and generally accepted accounting standards (GAAS) required, PwC knowingly assisted in the corporate insiders' misconduct by issuing "clean" opinions. As a result, the committee contended, AHERF's board of trustees was under the false impression that AHERF was in relatively good financial shape and so did not call a halt to the CEO's acquisition binge until it was too late to save the corporation.
The District Court granted PwC's motion for summary judgment, finding no material issue of fact excepting the wrongdoing
The Pennsylvania Supreme Court first rejected the approach taken by New Jersey, concluding that "the best course ... for Pennsylvania common law [was] to continue to recognize the availability of the in pari delicto defense ..., via the necessary imputation, in the negligent-auditor context" where the plaintiff's culpability was equal to or greater than the defendant's (AHERF, 989 A2d at 335). But as to the issue of auditor collusion presented by the Third Circuit's certification, the court took a different view, holding that imputation (and therefore the in pari delicto defense) was unavailable where an auditor had not proceeded in material good faith (id. at 336-338).
The NCP and AHERF decisions were both animated by considerations of equity—the notion that although the plaintiffs stood in the shoes of the principal malefactors, any recovery they achieved from the defendant accounting firms—which were alleged to have been either negligent or complicit—would, in fact, only benefit innocent shareholders or unsecured creditors and so should not be barred by in pari delicto. The Pennsylvania Supreme Court reflected this sentiment when it said that it would be "ill-advised, if not perverse" to "apply[ ] imputation as against AHERF" because that "would result in the corporation being charged with knowledge as against a third party whose agents actively and intentionally prevented those in AHERF's governing structure who were non-participants in the fraud from acquiring such knowledge" (AHERF, 989 A2d at 336).
Finally, the Litigation Trustee suggests that any in pari delicto defense "should not be a total bar to recovery, but at most a basis for apportionment of fault and damages as between the defendant and the company's successor trustee" under CPLR 1411. The derivative plaintiffs go even further, claiming that in pari delicto was abolished when the Legislature enacted CPLR 1411 in 1975. As PwC points out, though, there is no reason to suppose that the statute did away with commonlaw defenses based on intentional conduct, such as in pari delicto, although we could presumably reinterpret New York common law in this area to provide for comparative fault, as New Jersey has done. The effect again would be to marginalize the adverse interest exception. And, of course, comparative fault contradicts the public policy purposes at the heart of in pari delicto—deterrence and the unseemliness of the judiciary "serv[ing]
This case reduces down to whether, and under what circumstances, we choose to reinterpret New York common law to permit corporations to shift responsibility for their own agents' misconduct to third parties. The Litigation Trustee and the derivative plaintiffs, with whom the dissent agrees, ask us to do this as a matter of public policy in order to compensate the innocent and deter third-party professional (and, in particular, auditor) misconduct and negligence.
On the first point, the Litigation Trustee and the derivative plaintiffs urge us to consider that, although they both stand in the shoes of corporate malefactors, any recovery they achieve will, in fact, benefit blameless unsecured creditors (in the Refco case) and shareholders (in the AIG case) at the expense of defendants who allegedly assisted the fraud or were negligent. They ask us to broaden the adverse interest exception and create exceptions to imputation along the lines adopted by the courts in NCP and AHERF, and endorsed by the dissent, in the interests of fairness. We are not persuaded, however, that the equities are quite so obvious. 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 litigation 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 (see Securities & Exch. Commn. v Tambone, 597 F.3d 436, 452-453 [1st Cir 2010, Boudin, J., concurring] ["No one sophisticated about markets believes that multiplying liability is free of cost. And the cost, initially borne by those who raise capital or provide audit or other services to companies, gets passed along to 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
We are also not convinced that altering our precedent to expand remedies for these or similarly situated plaintiffs would produce a meaningful additional deterrent to professional misconduct or malpractice. The derivative plaintiffs caution against dealing accounting firms a "get-out-of-jail-free" card. But as any former partner at Arthur Andersen LLP—once one of the "Big Five" accounting firms—could attest, an outside professional (and especially an auditor) whose corporate client experiences a rapid or disastrous decline in fortune precipitated by insider fraud does not skate away unscathed. In short, 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. Indeed, in the Refco securities fraud litigation, the IPO's underwriters, including the three underwriter defendants in this action, have agreed to settlements totaling $53 million (www.refcosecuritieslitigation.com). In the AIG securities fraud litigation, PwC settled with shareholder plaintiffs last year for $97.5 million (www.aigsecuritieslitigationpwcsettlement.com). It is not evident that expanding the adverse interest exception or loosening imputation principles under New York law would result in any greater disincentive for professional malfeasance or negligence than already exists.
The principles of in pari delicto and imputation, with its narrow adverse interest exception, which are embedded in New York law, remain sound. The speculative public policy benefits advanced by the Litigation Trustee and the derivative plaintiffs to vindicate the changes they seek do not, in our view, outweigh the important public policies that undergird our precedents in this area or the importance of maintaining the "stability and fair measure of certainty which are prime requisites in any body of law" (Loughran, Some Reflections on the Role of Judicial Precedent, 22 Fordham L Rev 1, 3 ). We are simply not presented here with the rare case where, in the words of former Chief Judge Loughran, "the justification and need" for departure from carefully developed legal principles are "clear and cogent" (id.). Finally, to the extent our law had become ambiguous, today's decision should remove any lingering confusion.
Accordingly, the certified questions in Kirschner v KPMG LLP and Teachers' Retirement Sys. of La. v PricewaterhouseCoopers LLP should be answered in accordance with this opinion, including in Kirschner that certified question (2) should be answered "No" and certified question (3) should be answered "Yes"; and that in Teachers' Retirement Sys. of La., the certified question should be answered "Yes," assuming the adverse interest exception does not apply.
CIPARICK, J. (dissenting).
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 corrupt corporate insiders. In my view, the agency law principles upon which the majority rests its conclusions ignore complex assumptions and public policy that compel different conclusions than those reached by the majority. Accordingly, I respectfully dissent.
As an important threshold matter, the majority acknowledges that under New York law, in pari delicto is an affirmative defense, not a matter of standing (see majority op at 459 n 3).
To be sure, even an affirmative defense can, as the majority observes, be decided on the basis of the facts as alleged in the complaint (see e.g. Donovan v Rothman, 302 A.D.2d 238, 239 [1st Dept 2003] [holding Supreme Court properly dismissed plaintiffs' claim on the basis of in pari delicto]). However, to the extent that the majority opinion can be read to suggest that this is the preferable result, or that a pre-answer motion alleging in pari delicto should always result in a dismissal, I respectfully disagree. On a pre-answer motion to dismiss, a court must take as true the allegations of the complaint and give the plaintiff the benefit of every favorable inference that may be drawn from the complaint or from submissions in opposition to the motion (see Matter of Graziano v County of Albany, 3 N.Y.3d 475, 481 ; 511 W. 232nd Owners Corp. v Jennifer Realty Co., 98 N.Y.2d 144, 152 ; Prudential-Bache Sec. v Citibank, 73 N.Y.2d 263, 266 ). Where complex, fact-based issues abound, pre-answer dismissal should be an exception, not the rule (see e.g. Morgado Family Partners, LP v Lipper, 19 A.D.3d 262, 263 [1st Dept 2005]; see also In re Adelphia Communications
In pari delicto is a long-established tenet of law that instructs courts to refrain from intervening in a dispute between two parties at equal fault (see e.g. Woodworth v Janes, 2 Johns Cas 417, 423 [Sup Ct 1800]; Stone v Freeman, 298 N.Y. 268, 271 ; see also Baena v KPMG LLP, 453 F.3d 1, 6 [1st Cir 2006] [in pari delicto "prevent(s) a deliberate wrongdoer from recovering from a co-conspirator or accomplice"]; see also id. at 6 n 5). The majority, quoting McConnell v Commonwealth Pictures Corp. (7 N.Y.2d 465, 470 ), opines that the doctrine of in pari delicto should apply "even in difficult cases" and "should not be `weakened by exceptions'" (majority op at 464). However, those decisions that have characterized the principle as "inflexible" (see Saratoga County Bank v King, 44 N.Y. 87, 94 ) or "not to be weakened" (McConnell v Commonwealth Pictures Corp., 7 N.Y.2d 465, 470 ) have recognized that the doctrine is premised on concepts of morality, fair dealing and justice (see McConnell, 7 NY2d at 470; Saratoga, 44 NY at 94; see also Bateman Eichler, Hill Richards, Inc. v Berner, 472 U.S. 299, 306-307  [under the "classic formulation" of in pari delicto "(t)here may be on the part of the court itself a necessity of supporting the public interests or public policy in many cases, however reprehensible the acts of the parties may be"]). It is therefore clear that the concept of in pari delicto is not a rigid concept, incapable of shaping itself to the particulars of an individual case.
Before the in pari delicto doctrine can be applied to circumstances such as those presented here, the actions of the corrupt insider/agent must be found to be attributable to the corporate entity/principal. As the majority observes, the agency law rule
An agent's actions and knowledge cannot be imputed to the principal, however, if the "agent is engaged in a scheme to defraud his principal, either for his own benefit or that of a third person" (id.). In such circumstances, "the presumption that knowledge held by the agent was disclosed to the principal fails because he cannot be presumed to have disclosed that which would expose and defeat his fraudulent purpose" (id.). This adverse interest exception can apply in circumstances where a corrupt corporate insider acts for its own benefit, rather than for the benefit of its principal. The majority rejects the premise that the adverse interest exception should depend on a "case-by-case assessment of whether" an agent is likely to communicate information to its principal (majority op at 466). Rather, the majority observes that considerations of public policy—including incentivizing the selection of honest agents and careful delegation of duties—require strict imputation. Moreover, the majority reasons that a limited application of the adverse interest exception—where virtually any benefit to the corporation/principal will defeat the exception—serves the same purposes (see majority op at 468-469), and rejects plaintiffs' arguments that an agent's intent is relevant to the adverse interest analysis. The majority also concludes that the adverse interest exception requires a showing of harm, and rejects plaintiffs' argument that benefits to the principal which are merely illusory do not defeat the exception.
It is axiomatic that the adverse interest exception requires a showing of harm to the principal, but the premise that even an illusory benefit to a principal can serve to defeat the adverse interest exception to imputation misses the point. As the Second Circuit noted in CBI Holding, a "corporation is not a biological entity for which it can be presumed that any act which extends its existence is beneficial to it" (529 F3d at 453, quoting In re Investors Funding Corp. of N.Y. Sec. Litig., 523 F.Supp. 533, 541 [SD NY 1980]). Indeed, "[p]rolonging a corporation's existence in the face of ever increasing insolvency may be `doing no more
Moreover, in the corporate context where the fraud committed by corrupt insiders is either enabled by, joined in, or goes unnoticed by outside "gatekeeper" professionals,
Important policy concerns militate against the strict application of these agency principles. There can be little doubt that the role played by auditors and other gatekeepers serves the public as well as the corporations that contract for such services. Investors rely heavily on information prepared by or approved by auditors, accountants, and other gatekeeper professionals. Corporate financial statements, examined by ostensibly independent auditors, "are one of the primary sources of information available to guide the decisions of the investing public" (United States v Arthur Young & Co., 465 U.S. 805, 810-811 ). It is, therefore, in the public's best interest to maximize diligence and thwart malfeasance on the part of gatekeeper
Moreover, it is unclear how immunizing gatekeeper professionals, as the majority has effectively done, actually incentivizes corporate principals to better monitor insider agents. Indeed, it seems that strict imputation rules merely invite gatekeeper professionals "to neglect their duty to ferret out fraud by corporate insiders because even if they are negligent, there will be no damages assessed against them for their malfeasance" (Pritchard, O'Melveny Meyers v FDIC: Imputation of Fraud and Optimal Monitoring, 4 Sup Ct Econ Rev 179, 192 ).
For these and other reasons, our sister courts in New Jersey and Pennsylvania have carved out exceptions or limitations to the imputation and in pari delicto rules. In NCP Litig. Trust v KPMG LLP (187 N.J. 353, 901 A.2d 871 ), the Supreme Court of New Jersey held that "when an auditor is negligent within the scope of its engagement, the imputation doctrine does not prevent corporate shareholders from seeking to recover" (187 NJ at 384, 901 A2d at 890). That court explained its rationale for adopting such a rule as follows: "A limited imputation defense will properly compensate the victims of corporate fraud without indemnifying wrongdoers for their fraudulent activities. To the extent that shareholders are innocent of corporate wrongdoing, our holding provides just compensation to those plaintiffs" (id.).
In explaining its newly-drawn good faith exception or limitation on the rules of imputation and in pari delicto, the Supreme Court of Pennsylvania observed that
Accordingly, that court drew a "sharp distinction between those who deal in good faith with the principal-corporation in material matters and those who do not" (id.). Ultimately, the court continued to "recognize the availability of the in pari delicto defense (upon appropriate and sufficient pleadings and proffers), via the necessary imputation, in the negligent-auditor context" (id.). As to auditor collusion, however, the Pennsylvania Supreme Court explained that "the ordinary rationale supporting imputation breaks down completely in scenarios involving secretive, collusive conduct between corporate agents and third parties . . . because imputation rules justly operate to protect third parties on account of their reliance on an agent's actual or apparent authority" (id. at 336).
In conclusion, I do not quarrel with the majority's statements of the applicable principles of agency law. Rather, my departure is from the majority's rigid application of those principles to cases by litigation trustees and derivative plaintiffs against gatekeeper professionals for enabling corporate insider fraud by colluding in or failing to detect such fraud. I agree with the litigation trustee and the derivative plaintiffs that no equitable basis exists for holding that litigation trustees or derivative plaintiffs are in pari delicto with culpable outside professionals. Indeed, in my view, the weight of the equities favors allowing
Accordingly, I would answer the certified questions from both the Second Circuit and the Delaware Supreme Court in accordance with this writing.
In Kirschner v KPMG LLP: Following certification of questions by the United States Court of Appeals for the Second Circuit and acceptance of the questions by this Court pursuant to section 500.27 of the Rules of Practice of the New York State Court of Appeals (22 NYCRR 500.27), and after hearing argument by counsel for the parties and consideration of the briefs and the record submitted, certified questions answered in accordance with the opinion herein.
In Teachers' Retirement Sys. of La. v PricewaterhouseCoopers LLP: Following certification of a question by the Supreme Court of Delaware and acceptance of the question by this Court pursuant to section 500.27 of the Rules of Practice of the New York State Court of Appeals (22 NYCRR 500.27), and after hearing argument by counsel for the parties and consideration of the briefs and the record submitted, certified question answered in accordance with the opinion herein.
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