Court Rules on Question of Wrongdoing Companies Seeking Damages From Auditors

Editor’s note: This is a report from AICPA General Counsel and Secretary Richard I. Miller, Esq.

The New York Court of Appeals held recently that the in pari delicto (literally, “in equal fault”) defense is a complete bar to recovery of damages by a wrongdoing corporation against its outside auditors, regardless of whether the auditors actively colluded in the fraud with management or were merely negligent in failing to uncover it. 

Moreover, the court held, it does not matter if the wrongdoing insiders intended to benefit themselves through increased compensation or stock value, or if the discovery of the fraud ultimately forced the company into bankruptcy. As long as the company benefited from the fraud in any way, the insiders’ conduct will be imputed and the company will not be permitted to recover.

The decision by New York’s highest court reflected policy considerations outlined in an amicus brief filed jointly by the AICPA and the New York State Society of CPAs (NYSSCPA). The Court’s decision came down on questions of law certified from two different courts—the U.S. Second Circuit in Kirschner v. KPMG LLP, 590 F.3d 186 (2009), cert. granted, 2010 WL 152134, 2010 N.Y. Slip Op. 00364 (N.Y. Jan. 19, 2010) (“Refco”) and the Supreme Court of Delaware in Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP, 14 N.Y.3d 796, 925 N.E.2d 930, 899 N.Y.S.2d 127 (N.Y. Mar 30, 2010) (“AIG”).

The Refco case involved allegations by the trustee of a bankrupt derivatives brokerage, Refco Group Ltd., that the company’s senior management, aided by its outside auditors (KPMG) and legal and financial advisers, perpetrated a massive fraud to artificially inflate the company’s reported results and conceal its deteriorating financial condition. According to the complaint, the illusion of a thriving company created by the fraud allowed the Refco insiders to sell their large stakes in the company at inflated prices through a leveraged buyout and, ultimately, an initial public offering. The AIG case involved similar allegations by the shareholders of the insurance giant against its auditors (PwC) after a massive fraud perpetrated by AIG’s management came to light.

Generally speaking, because a corporation cannot sue a third party with whom it is in pari delicto, it is barred from recovering from its outside auditors damages it sustained as a result of misconduct by managers where that misconduct is imputed to the corporation. Both the Refco trustee and the AIG shareholder plaintiffs argued, among other things, that the misconduct of those companies’ respective managers should not be imputed because the managers had sought to benefit themselves through increased compensation or inflated stock value, and therefore were acting adversely to their employers.

Both plaintiffs also sought to overturn decades of New York jurisprudence by asking the court to limit the scope of the imputation doctrine based on the nature of the defendant’s alleged conduct (as certain other courts have done), and to replace the in pari delicto defense altogether with a damages-shifting principle whereby liability (and damages) would be apportioned between the company and its auditors according to their respective levels of culpability, as decided by the jury after trial.

Court of Appeals Judge Susan Phillips Read—writing for a 4–3 majority—rejected each argument. Instead, the court reaffirmed that, to avoid imputation, the agent must have totally abandoned the corporation’s interest, and clarified that the focus of the inquiry should be the impact of the fraud on the corporation, and not the subjective intent of the managers. The Court explained that “[s]o long as the corporate wrongdoer’s fraudulent conduct enables the business to survive—to attract investors and customers and raise funds for corporate purposes—[the adverse interest exception to imputation] is not met.” The Court also held that in pari delicto is a complete bar to recovery regardless of whether the auditors are alleged to have colluded with management or merely to have acted negligently.

The AICPA submitted an amicus brief jointly with the NYSSCPA advocating for precisely the holding that the court ultimately reached. The AICPA’s arguments focused on long-standing New York law, and also raised public policy concerns relating to deterrence—specifically, that management is in the best position to prevent corporate fraud and any limitations on imputation will reduce a company’s incentives to police its management, and that auditors already have sufficient incentives to ensure audit quality—and the potentially devastating effect on the accounting profession of expanded auditor liability.Each of these policy considerations was explicitly recognized by the court, suggesting that the AICPA’s arguments may have helped shape the divided court’s decision. The joint brief of the Institute and the NYSSCPA was drafted by Kelly Hnatt and Derek Schoenmann of the law firm Willkie Farr & Gallagher LLP.