Corporate Law - Principal's Liability for Agent's Conduct - New York Court of Appeals Clarifies Standard for Imputability of an Agent's Fraudulent Conduct to Its Principal in the Context of an in Pari Delicto Defense - Kirschner V. KPMG LLP
The common law of agency has long played a fundamental role in a wide range of business transactions. However, in the era of complex organizational structures and the outsourcing of core operations, the adaptability of that law to modern corporate realities is being put to the test. Doctrines like imputation, which under certain circumstances attributes the actions of an agent to its principal, (1) and in pari delicto, an equitable defense that prevents recovery by one party against another where both bear responsibility for the wrongdoing at issue, (2) can now combine to produce undesirable results. Accounting firms, law firms, and other providers of professional services--often referred to as "gatekeepers" (3)--have employed these principles in tandem to defend against suits by their corporate clients. Typically gatekeepers raise such a defense against claims that they either conspired to commit fraud with or negligently failed to discover fraud by a client to the detriment of that client's shareholders, creditors, or both. (4) Recently, in Kirschner v. KPMG LLP (5) (Kirschner), the New York Court of Appeals determined that, as a matter of New York law, a corporation defrauded by its managers may not recover from its gatekeepers who either participated in the fraud or negligently failed to detect it. (6) While the Court of Appeals was correct to consider how its decision would influence the incentives of corporate actors and deter wrongdoing generally, it failed to account adequately for how these considerations might differ when applied in the context of a large, publicly traded corporation.
Kirschner disposed of questions of state law certified to the New York Court of Appeals with respect to two underlying cases: Kirschner v. KPMG LLP (7) (Kirschner II), and Teachers' Retirement System of Louisiana v. PricewaterhouseCoopers LLP. (8) In Kirschner II, Refco, a publicly traded financial services firm, declared bankruptcy after disclosing that its controlling shareholder-officers had concealed Refco's uncollectible receivables by fraudulently manipulating the firm's balance sheet for several years. (9) A court-established litigation trust subsequently sued several parties on Refco's behalf, including the firm's senior management, as well as a law firm and three accounting firms that allegedly had either assisted Refco managers in perpetrating the fraud or negligently failed to uncover it. (10) In Teachers' Retirement System, two stockholders of insurance and financial services giant AIG brought a derivative action against the company's independent auditor. The derivative plaintiffs alleged that, among other illegal actions, senior AIG officials fraudulently misled investors into believing that the corporation was worth billions of dollars more than it actually was worth at the time. (11) As for PricewaterhouseCoopers's role in the fraud, the plaintiffs claimed that the firm would have detected the scheme but for its negligent "fail[ure] to perform its auditing responsibilities in accordance with professional standards of conduct." (12)
In both underlying cases, the trial courts determined that, under New York law, (13) in pari delicto barred the plaintiffs' claims against both corporations' gatekeepers. Both courts noted--without dispute from the litigants--the general presumption that the actions and knowledge of an agent within the scope of the agency relationship are imputed to the principal. (14) Thus, if the fraudulent acts of Refco's and AIG's officers were attributable to their respective employers, in pari delicto would prohibit recovery. However, the Teachers' Retirement System plaintiffs argued that imputation should not apply because they had established the applicability of New York's "adverse interest" exception to imputation--an exception that applies when "the agent [has] totally abandoned his principal's interests and [is] acting entirely for his own or another's purposes." (15) Both trial courts found that the exception did not apply, (16) and the plaintiffs appealed. …