JANUARY 2011

 

            On October 21, 2010, New York State’s highest court, the Court of Appeals, decided the case of Kirschner v. KPMG LLP, 2010 WL 4116609, 2010 N.Y. Slip Op. 7415. The case reaffirmed certain limitations under New York law on the ability of corporations and those who sue on their behalf, such as bankruptcy trustees and derivative plaintiffs, to assert claims against professional advisors such as auditors and law firms for allegedly assisting or negligently failing to detect wrongdoing by the corporation’s own management. The case, decided by a sharply divided Court that split 4 to 3, reaffirmed legal doctrines of in pari delicto and imputation that have been a longstanding part of New York jurisprudence.

 

            The Court’s opinion resolved two separate cases that presented similar legal issues. The Kirschner case involved a suit by the bankruptcy trustee of Refco, a company that had filed for bankruptcy after the revelation of substantial financial wrongdoing by its former management. The trustee sued seeking to recover damages on behalf of a litigation trust established in the bankruptcy, from defendants, which included Refco’s former legal counsel, investment bankers, and accounting firms. The trustee’s complaint alleged that these third parties aided and abetted the fraud perpetrated by Refco management, or alternatively, were at least negligent in not discovering the fraudulent conduct. A companion case that the Court decided at the same time, Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP, was a derivative action brought by shareholders of American International Group (AIG), alleging that AIG’s independent auditors were negligent in failing to detect allegedly fraudulent conduct by AIG management.

 

            The defendants in both moved for dismissal. In essence, their position was that because corporate management had allegedly engaged in intentional wrongdoing, representatives of the corporation should not be entitled to recover damages from third parties that had failed to detect that wrongdoing. The Kirschner case was brought in federal court, and the Teachers’ Retirement System case in Delaware state court. However, both of these courts asked the New York Court of Appeals, which has the final word on issues of New York common law, to provide guidance on central legal issues governing the cases.

 

            The Court’s opinion applied and reaffirmed the tort-law concept of in pari delicto. The phrase derives from a longer Latin legal maxim stating that “in a case of equal or mutual fault, the position of the defending party is the better one.” In other words, the courts will not, as a general proposition, decide a claim brought by one wrongdoer against another. For example, a criminal injured while committing a crime cannot sue the police office, and an arsonist who is singed cannot sue the fire department.

 

The second basic legal doctrine governing the cases, the Court held, is the agency-law concept of imputation. Under this doctrine, the acts of agents, and the knowledge they acquire while acting within the scope of their authority, are presumptively imputed to the principals whom they represent. As applied to a corporation, the corporation is deemed to have committed the acts of its management and to know the facts that its managers know.

 

The defendants argued that combining the in pari delicto and imputation doctrines required dismissal of the claims against them. In considering this argument, the Court also addressed an exception to the combination of the in pari delicto and imputation doctrines known as the “adverse interest exception.” This exception applies when the agent is acting solely for its own benefit and at the expense of the principal, such as a fraud committed by the agent against the corporation. However, the court observed, the exception is a narrow one. Where an agent commits a wrongful act in part for its own benefit, but the corporation may benefit from it as well, the Court held, the adverse interest exception does not apply so as to permit later claims by the corporation against third parties.

 

The plaintiffs presented three arguments in favor of allowing their cases to proceed. The first argument was that an agent’s overall intent should be examined to determine whether the insiders (the agents) intended to benefit themselves personally and actually received benefits and/or that the company received only short-term benefits but sustained long-term harm from the conduct in question. The court rejected this suggestion, stating that adopting it would unreasonably restrict the application of the imputation principle and leave the adverse interest exception meaningless since it would encompass virtually every corporate fraud. 

 

Plaintiffs’ second argument was that in other jurisdictions, such as New Jersey and Pennsylvania, the courts have significantly strengthened the adverse interest concept to enhance a plaintiff’s ability to recover from negligent third parties. For example, the Pennsylvania court adopted a view that the agent’s good faith should be examined in order to determine whether the adverse interest concept should apply, while New Jersey requires a comparison of the relative faults of the corporation and its auditors in determining the degree of negligence and apportionment of harm. The New York court declined to follow these precedents. 

 

Finally, the plaintiffs asserted public policy arguments that broadening the adverse interest exception would compensate the innocent shareholders and make outside professionals more responsible for their sins. The court viewed this argument as shielding the innocent stockholders of a corporation from the damage caused by its agents, but at the cost of exposing other equally innocent parties to liability. Outside professionals are already at risk for large settlements in these types of litigation based on other legal theories, the court found, and should not be put at further risk. 

 

Thus, Kirschner imposes significant limitations on the ability of trustees, derivative-suit plaintiffs, and other third parties to assert claims on behalf of a New York corporation against outside professionals alleging failure to detect fraud or other misconduct by management.

 

            If you have any questions concerning this case or other corporate or securities law issues, please contact Martin E. Schloss, Esq., who heads this practice area at Ganfer & Shore, LLP, or your contact at the firm.