Case Study: Kirschner V. KPMG

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1 Portfolio Media. Inc. 860 Broadway, 6th Floor New York, NY Phone: Fax: Case Study: Kirschner V. KPMG Law360, New York (November 10, 2010) -- On Oct. 21 a divided New York Court of Appeals issued an important ruling in two consolidated appeals dismissing claims against accountants, investment banks and other professionals.[1] In so doing, the court solidified a long-standing New York precedent holding that, except in narrow circumstances, fundamental principles of agency law and the equitable doctrine of in pari delicto (literally, in equal fault ) will operate to bar claims brought by or on behalf of a corporation against its professionals for participating in, or for failing to detect and prevent, the corporation s own wrongdoing. The Kirschner decision arises from two consolidated proceedings before the court of appeals. The first originates from the collapse and bankruptcy of Refco Inc. and certain of its affiliates (collectively, Refco) in the fall of The second originates from a derivative action brought by shareholders of American International Group Inc. Marc Abrams The Refco Appeal On behalf of Refco s bankruptcy estates, a liquidation trust filed a complaint in Illinois state court alleging claims for fraud and breach of fiduciary duty against Refco s controlling officer - shareholders and senior management (the Refco insiders) arising from an alleged prebankruptcy scheme to artificially inflate Refco s financial condition by concealing hundreds of millions of dollars in uncollectible debt. The liquidation trustee also asserted claims against the investment banks, law firms and Terence McLaughlin accountants that had assisted Refco in its prepetition leveraged buyout and initial public offering as well as the accounting firm that audited Refco s financial statements during the prepetition period. The liquidation trustee alleged that each of the professionals either aided and abetted the Refco insiders in perpetrating the fraudulent scheme or breached a duty to Refco by failing to detect and prevent that scheme. After removing the proceeding to federal court and transferring it to the U.S. District Court for the Southern District of New York, the professionals moved to dismiss the complaint. The district court granted the motion, premising its ruling on the Wagoner rule of standing, which derives its name from the landmark decision Shearson Lehman Hutton v. Wagoner, 944 F.2d 114 (2d Cir. 1991), and its progeny.[2] Distilled to its essence, the Wagoner rule holds that when a bankrupt corporation has joined with a third party in defrauding its creditors, the trustee cannot recover against the third party for the damage to the creditors. 1

2 The Wagoner rule derives from the fundamental principle of agency pursuant to which the misconduct of an agent (i.e., a member of corporate management) within the scope of its employment will normally be imputed to the principal (i.e., the corporation). Courts recognize a narrow exception to this rule of imputation, again grounded in the law of agency, under circumstances where it can be shown that the wrongdoing agent has totally abandoned the interests of the principal and has acted entirely for the agent s own benefit. Commonly known as the adverse interest exception, this exception stems from the recognition that an agent acting entirely for its own interests and adversely to the interests of the principal is not likely to disclose its actions to the principal. The district court found that the Refco insiders alleged wrongful conduct was imputable to Refco (and, by extension, the liquidation trustee). In perpetrating the scheme to conceal Refco s uncollectible debts, the Refco insiders did not totally abandon Refco s interests because [t]he complaint is saturated by allegations that Refco received substantial benefits from the insiders alleged wrongdoing. Put differently, the district court found that the gravamen of the [liquidation] trustee s allegation s is not that the [Refco insiders] stole assets from Refco, but rather that the [Refco insiders ] fraudulent scheme was to steal for Refco to inflate the value of Refco s interests on behalf of Refco itself by maintaining the illusion that Refco was fast growing, highly profitable and able to satisfy its substantial working capital needs without having to borrow money. In analyzing the adverse interest exception, the district court rejected what it characterized as an industrious interpretation of the Second Circuit s decision in In re CBI Holding Co. Inc., 529 F.3d 432 (2d Cir. 2008). The liquidation trustee argued that CBI Holding stands for the proposition that the adverse interest exception looks principally to the intent of the managers engaged in misconduct. According to the liquidation trustee, if the wrongdoing agents fundamentally intend to benefit themselves, the adverse interest exception is satisfied regardless of whether, in the process, the corporate principal also obtains some benefit from the wrongdoing. The district court rejected this assertion, observing that the critical inquiry is not what the wrongdoing agents intend, but rather whether the corporate principal is harmed by the wrongdoing (i.e., whether the conduct is adverse to the principal). The liquidation trustee appealed the dismissal to the U.S. Court of Appeals for the Second Circuit. Confronted by the question of whether, in light of its precedent in CBI Holding and other district court rulings, to consider a wrongdoing agent s intent in determining the applicability of the adverse interest exception, the Second Circuit sought guidance from New York s highest court by certifying the following questions (among others): 1) whether the adverse interest exception is satisfied by showing that the insiders intended to benefit themselves by their misconduct; 2) whether the exception is available only where the insiders misconduct has harmed the corporation; 3) if harm is required, whether the analysis of such harm may include any detriment to a corporation resulting from the eventual unmasking of the misconduct; and 4) whether the exception is precluded where the misconduct conferred some benefit upon the corporation. As discussed below, the Court of Appeals decision makes clear that the answers to these questions are: no, yes, no and yes, respectively. The AIG Appeal Certain AIG stockholders sued Maurice R. Greenberg and other senior officers of AIG (the AIG insiders) derivatively, alleging that the AIG insiders fraudulently inflated AIG s financial condition by billions of dollars. 2

3 The plaintiffs also sued AIG s auditor for malpractice and breach of contract on the theory that the auditor failed to detect, report and prevent the AIG insiders wrongdoing. Virtually all the defendants, including the auditor, moved to dismiss. Vice Chancellor Leo Strine reluctantly granted the auditor s motion to dismiss, holding that under applicable New York law, the claims were barred because the AIG insiders wrongdoing was imputed, by operation of agency law, to AIG itself. The vice chancellor further concluded that the adverse interest exception was unavailable because the AIG insiders did not totally abandon the interests of AIG. In that regard, the vice chancellor found that the complaint is replete with ways in which AIG itself can be thought to have benefited from the fraudulent schemes, even if those benefits turned out to be short-lived once the fraud was discovered. [3] Following an appeal, the Delaware Supreme Court concluded that the matter involved significant and unsettled questions of New York law and certified the following question to the Court of Appeals: Would the doctrine of in pari delicto bar a derivative claim under New York law where a corporation sues its outside auditor for professional malpractice or negligence based on the auditor s failure to detect fraud committed by the corporation; and the outside auditor did not knowingly participate in the corporation s fraud, but instead failed to satisfy professional standards in its audits of the corporation s financial statements? The Court of Appeals answered that question: Yes, assuming the adverse interest exception does not apply. New York Court of Appeals Decision and its Implications Writing for a narrow 4-3 majority, Judges Susan Read, Victoria Graffeo, Robert Smith and Theodore Jones upheld the dismissal of the claims against the professionals in both the consolidated appeals. Judges Carmen Ciparick, Jonathan Lippman and Eugene Pigott dissented. As a threshold matter, the Court of Appeals highlighted the analytical distinction between the Wagoner standing rule and New York s common law doctrine of in pari delicto. The Wagoner rule derives in significant part from federal bankruptcy law and is a prudential limitation on standing under federal law. However, the Wagoner rule is not part of New York law except as it reflects the in pari delicto principle, and in New York, in pari delicto is an affirmative defense, not a matter of standing. As an affirmative defense, a professional defendant raising in pari delicto as a bar to a claim bears the burden of proof. In contrast, the Wagoner standing rule places the burdens of pleading and proof on the plaintiff. The distinction, however, may be more technical than practical. The majority opinion expressly observes that in pari delicto may be resolved on the pleadings. Indeed, the Kirschner majority opinion itself affirms dismissals at the pleading stage. The majority opinion next reaffirms in no uncertain terms the principles of New York law that have long operated to bar claims by guilty corporations against their professionals: --The in pari delicto doctrine serves the important public policy of deterring illegality by depriving judicial relief to admitted wrongdoers, thereby ensuring that they do not profit by their own wrongdoing. --Fundamental tenets of agency law require that the acts of agents and the knowledge they acquire while acting within the scope of their authority be presumptively imputed to their principals. 3

4 --A corporation can only act through its agents and must... be responsible for the acts of its authorized agents even if particular acts were unauthorized. --The presumption that agents communicate information to their principals does not depend on a case-by-case assessment of whether it 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 (i.e., in cases where the narrow adverse interest exception applies). -- 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. But in contrast, where the agent is defrauding someone else on the corporation s behalf, the presumption of full communication remains in full force and effect. --To come within the adverse interest 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. --The adverse interest exception is reserved for the most narrow [of] cases outright theft or looting or embezzlement where the insider s misconduct benefits only himself or a third party, i.e., where the fraud is committed against a corporation rather than on its behalf. In addition to reaffirming long-standing principles, the Court of Appeals also brought clarity to two disputed aspects of the law: 1) what kind of harm to the corporate principal does the adverse interest exception require; and 2) to what extent does the wrongdoing agent s subjective intent have any bearing on the applicability of that exception. First, the court clarified 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 is inapplicable. Even a short-lived benefit suffices. It is immaterial whether the wrongdoing agent s conduct proves harmful to the corporate principal in the long term. Because all frauds prove to be harmful when they are finally revealed, allowing harm attributable to the revelation of the fraud to be determinative would explode the exception, turning it into a nearly impermeable rule barring imputation in every case. Second, the court clarified that a wrongdoing agent s subjective intent is not relevant to any analysis of the applicability of the adverse interest exception. Corporate officers, even in the most upright enterprises, can always be said, in some meaningful sense, to act for their own interests. Making intent determinative would limit imputation to fraudsters so inept they gain no personal benefit, which would, in turn, reduce the adverse interest exception to a dead letter because it would encompass every corporate fraud prompting litigation. Finally, accounting professionals will be particularly satisfied by the majority s flat rejection of the contention (advanced by the dissent and accepted by the New Jersey and Pennsylvania Supreme Courts) that, as matter of equity, the imputation and in pari delicto principles should be applied more flexibly against a third-party gatekeeper such as an outside auditor. The majority was not persuaded that doing so is, in fact, more equitable. The court noted that any liability imposed on a professional would ultimately be borne by its own stakeholders who are no more or less innocent than the stakeholders of the wrongdoing corporation itself. The majority doubted that the interests of innocent stakeholders of corporate fraudsters [should] trump those of innocent stakeholders of the outside professionals. 4

5 The majority was also troubled by the 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. At Least One Unanswered Question Remains Without doubt, the Kirschner decision is both significant and beneficial to professionals who render service to enterprises that are later revealed to have been victimized by management malfeasance. However, the decision leaves at least one question unanswered. Several courts applying either the federal Wagoner rule or New York s in pari delicto doctrine have recognized a counterexception to the adverse interest exception commonly known as the sole actor exception. This counter-exception is available where the wrongdoing agent and the principal are one and the same such as, for example, where the wrongdoing agent is the sole shareholder of the corporation (thereby providing an independent basis for imputation to the principal regardless of whether the agent s conduct was adverse ). To make matters worse, a number of courts have recognized an exception to the sole-actor exception where there are innocent decision makers at the corporation who could have acted to thwart the sole actor/ agent s wrongful conduct. This doctrine has been aptly dubbed the innocent decision maker exception. These concepts are best illustrated with an example. Imagine a situation in which a bankruptcy trustee sues an accounting firm for having failed to prevent prebankruptcy embezzlement by the company s CEO (who is the sole shareholder). The ordinary rule of imputation would not be applicable because, under the Court of Appeals ruling in Kirschner, embezzlement is adverse to the corporate principal, thus triggering the adverse interest exception. However, the sole-actor counter-exception would be applicable because the wrongdoing agent, as sole shareholder of the corporation, is one and the same as the principal. In a last-ditch effort to prevent dismissal, the bankruptcy trustee could invoke the innocent decision maker rule to prevent imputation on the theory that there were innocent decision makers (other members of management, directors, etc.) who could have stopped the fraud. One can see, immediately, the cascade of questions that arise. Are these innocent decision-makers truly innocent given that they did not, in fact, prevent the fraud? Are they impotent given the sole shareholder s ability to dictate every corporate decision (and replace them if they do not conform)? Can these questions be resolved at the pleading stage or do they require discovery? Mindful of the struggles that courts have endured grappling with this controversial innocent decision maker rule, the Second Circuit invited the court of appeals to provide guidance by certifying the following question: if the adverse interest exception were otherwise available, would it be precluded by the sole actor rule? The Court of Appeals declined to address this subject directly in the Kirschner opinion. However, its views on the subject can be inferred. The Kirschner decision is driven by the court s unwavering reaffirmation of fundamental agency and imputation principles. Because the sole actor rule is nothing more than a further extension of basic agency principles (i.e., where the agent and the principal are one and the same, the knowledge and acts of the one are the knowledge and acts of the other), it is likely that the court of appeals would recognize the sole actor counter-exception to the adverse interest exception. 5

6 Conversely, and for the same reason, it is doubtful that the Court of Appeals would recognize the so-called innocent decision-maker subexception. The court would likely conclude that the existence or nonexistence of other agents and their degree of innocence is entirely irrelevant because the concededly guilty agent s conduct is, in all events, imputed to the corporation by virtue of the guilty agent s identity with the principal. While these conclusions are safe interpretations of the Court of Appeals views, certainty will have to await future case law development in the wake of the Kirschner ruling. --By Marc Abrams (pictured) and, Willkie Farr & Gallagher LLP Marc Abrams (mabrams@willkie.com) is a partner in the New York office of Willkie Farr & Gallagher and co-chairman of the firm's business reorganization and restructuring department. Terence K. McLaughlin (tmclaughlin@willkie.com) is a litigation partner in the firm's New York office. The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients or Portfolio Media, publisher of Law360. [1] See Kirschner v. KPMG, Nos. 151, 152, 2010 WL , 2010 N.Y. Slip Op (2010). [2] See, e.g., Hirsch v. Arthur Andersen & Co., 72 F.3d 1085 (2d Cir. 1995); In re The Mediators Inc., 105 F.3d 822 (2d Cir. 1997); Wight v. BankAmerica Corp. 219 F.3d 79 (2d Cir. 2000); Official Committee of the Unsecured Creditors of Color Tile Inc. v. Coopers & Lybrand LLP, 322 F.3d 147 (2d Cir. 2003); In re Bennet Funding Group Inc., 336 F.3d 94 (2d Cir. 2003); In re CBI Holding Co. Inc., 529 F.3d 432 (2d Cir. 2008). [3] In a lengthy footnote, the vice chancellor was critical of New York s application of agency law and the in pari delicto doctrine in the specific context of independent auditors. 6