Seeking An Equitable Outcome: NY State Court of Appeals Hears In Pari Delicto Cases

The New York State Court of Appeal will hear two cases, back to back, on Tuesday, September 14th that will have a direct and significant impact on auditors.

The in pari delicto defense prevents a plaintiff who is also at fault from recovering damages from a defendant.

“This scheduling by the courts is no coincidence. Two cases – one referred by a state Supreme Court, Delaware, the other by the 2nd Circuit Court of Appeals, a federal court – meant New York could no longer ignore the issue.” said Stuart Grant, in an interview this past weekend.

Grant is the attorney who will argue for the Teachers’ Retirement System of Louisiana and City of New Orleans Employees Retirement System in a case against PricewaterhouseCoopers LLP.

This is an AIG Crisis One case. According to comments from Grant & Eisenhofer on the case:

The auditor in this case – PricewaterhouseCoopers – is accused of failing to detect large-scale fraud at AIG related to alleged accounting manipulations and sham transactions that go back to 1999.  PwC won dismissal of the suit in the trial court by arguing that because AIG employees committed the fraud that PwC failed to spot, AIG was “in pari delicto” with PwC (translation:  at mutual fault) and therefore could not bring a claim.

Auditors have used similar defenses to avoid malpractice liability in a number of other cases, including a suit against Grant Thornton LLP by the bankruptcy trustee of Refco, Inc., which will be addressed at the same September 14 hearing.  This will mark the New York high court’s first opportunity to decide whether New York law recognizes this defense as an outright bar to auditor malpractice liability.  PwC knows well how high the stakes are, and has engaged former U.S. Solicitor General Paul Clement (now with King & Spalding) to plead its case.

Making the argument for investors is Stuart Grant of leading shareholder and corporate governance law firm Grant & Eisenhofer, who says the outcome of the hearing will have significant public policy ramifications.  “Corporations hire accounting firms and pay them huge fees to look for fraud by company employees.  If an auditor can overlook fraud but escape malpractice liability by blaming the company for committing the fraud in the first place, then where is the accountability for the auditor?  The company would have no recourse against the auditor, no matter how egregious the auditor’s conduct.”

Kirschner v KPMG et al is the Refco case that is referenced above. This case also presents the possibility of an “in pari delicto” defense for audit firms. Kathleen M. Sullivan of Quinn Emanuel will argue the case for Kirschner, the Refco Trustee, before the court.  The defendants – which include KPMG, Grant Thornton, PwC, and EY – are represented by Philip D. Anker (who represents Banc of America Securities) and Linda T. Coberly (who represents Grant Thornton) will argue before the Appeals Court on behalf of all the defendants. December 23, 2009: “The trustee alleges outside counsel Mayer Brown, auditors Ernst & Young LLP, PricewaterhouseCoopers LLP, Banc of America Securities LLC and several other insiders are liable for defrauding Refco’s creditors, namely by helping the defunct brokerage conceal hundreds of millions of dollars in uncollectible debt.

The district court dismissed the trustee’s lawsuit in May for lack of standing, holding that the insiders’ alleged fraud and malpractice is directly imputed to Refco.

Now, the trustee contends the lower court erred in ascribing the insiders’ wrongdoing to Refco because the accused parties qualify for the “adverse interest” exception to imputation, having abandoned Refco’s interest in perpetrating the fraud. Specifically, the trustee maintains that the adverse interest exception should be applied because the insiders intended only to benefit themselves by their misconduct and that harm to Refco need not be alleged, according to the ruling…“We conclude that the issues concerning imputation and adverse interest exception raise question of New York law as to which considerable uncertainty exists,” the Second Circuit said. “We therefore certify to the New York Court of Appeals questions the answer to which will govern our ultimate disposition of this appeal.”

I wrote about both cases – Kirschner v. KPMG LLP et al and Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP in a March 9, 2010 post, In Pari Delicto: Are Auditors Equally At Fault In The Big Fraud Cases?

The way I see it, the in pari delicto doctrine is being used like a pair of needle nosed pliers by audit firm defense lawyers to diffuse a bomb – huge liability for some of the biggest frauds in history. The in pari delicto doctrine attempts to pull the auditors’ tails from the fire by excusing any of their guilty acts due to the approval of those acts by potentially equally guilty executives. The law allows these executives to continue to “stand in the shoes” of the shareholder plaintiffs even after their guilt has been determined. The theory is that the executives perpetrated the fraud for the benefit of the corporation and never “totally abandoned” it, as would be required for the “adverse interest” exception.

Auditors who should otherwise be tested on their fulfillment of their public duty are instead getting a reprieve because courts have been unwilling to impose the “adverse interest” exception as expansively as they have the in pari delicto defense itself.  How can executives who are successfully sued, been subject to regulatory sanctions or, in the case of the Refco executives, plead guilty to criminal activities, still be considered representatives of the corporation’s interests? They should forfeit the right to stand in the shoes of the corporation’s shareholders in derivative suits and therefore to shield other potentially guilty or negligent parties.

The situation gets complicated in a bankruptcy case such as Refco [becasue a] trustee in bankruptcy must have standing to sue anyone on behalf of the creditors and other injured parties.  Unfortunately, this habit of allowing guilty parties to continue to drive the bankruptcy bus by having the actions of the guilty officers “imputed” to the corporation and, therefore, in bankruptcy to the trustee potentially threatens the trustee’s ability to sue “co-conspirators.”

It’s just nuts.

I was also quoted in California Lawyer Magazine regarding the auditors obligation to assess fraud risk and adjust their audit program accordingly.

“Auditing firms are supposed to be evaluating corporate governance, not just acting as bookkeepers. There are very thorough fraud risk checks under [Statement on Auditing Standards No.] 99 designed to spot red flags. This is very basic stuff, unrelated to the internal controls requirements of Sarbanes-Oxley.”

The brief prepared by Grant for the Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP hearing on Tuesday afternoon is, in my opinion, spectacular.

To me the most interesting aspect of this case is that Grant argues right off the bat that an in pari delicto defense is not applicable to these facts.  The Teachers’ Retirement System plaintiffs are not alleging the same wrongdoing by PwC as was alleged for the AIG executives.  The plaintiffs, in a shareholders’ derivative claim that is brought on behalf of the corporation AIG, can not be found “equally at fault” if we are talking about different bad acts.

PwC’s sin is alleged to be accounting malpractice.  The Teachers’ Retirement System plaintiffs allege PwC committed accounting malpractice because PwC performed such a miserable audit they didn’t even know the executives were committing the numerous examples of wrongdoing those executives were eventually held liable for.

Interestingly, the Vice Chancellor of the Delaware Court of Chancery told the Teachers’ Retirement System of Louisiana plaintiffs that if they had alleged instead that PwC consciously aided and abetted wrongdoing by AIG insiders, the Court would’ve have had no problem hearing the case as a breach of fiduciary duty under Delaware state law.

As we know, the case could not be brought under federal securities laws since the PSLRA bars private actions for aiding and abetting a fraud and, Grant emphasized to me, “Congress has not yet seen fit to amend this law to give private parties the same rights to hold third parties liable for fraud as the SEC has.”

I know. I know.

From the Brief for Appellants, Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP, page 23:

Moreover the defense only applies if the parties were also particeps criminis – i.e. partners in crime. In other words, it is not available unless the parties also served as co-conspirators or accomplices in the same alleged wrongdoing. This rule, which dispositively resolves the certified question, is longstanding and well-established under New York law.  See Tracy, 14 N.Y. at 181.

Nailed it. How could the court come to any other conclusion?

Unfortunately, Grant’s brief has to continue for forty-seven more pages because courts have not always seen the logic of separating the auditors from the executives of companies they audit.  The audit firm defense lawyers have created a defense I call the, “We were duped!” defense that, to me, is an embarrassing, ridiculous and disingenuous attempt at evading liability.

The gist of it is: “We did the best we could but as auditors we are dependent on management and their truthful representations to do a good audit.  If they lie to us, what can we do?  We are as much victims as the shareholders.”

The Teachers’ Retirement System v PwC case is being closely watched by the accounting industry, says The Financial Times.  PwC is also a defendant in the Kirschner v KPMG et al (Refco) case. The American Institute of Certified Public Accountants, the New York State Society of CPAs and the Center for Audit Quality – all of them non-independent trade groups that lobby for the audit industry – have filed briefs supporting the accountancy firm’s arguments.

But let’s have the AICPA and the NYSSCPAs tell us in their own words, from their amici brief filed in support of PwC in the Teachers’ Retirement System case and of four audit firms – KPMG, Grant Thornton, PwC, And EY  – in the Refco case:

It is widely accepted that company management is in the best position, and has primary responsibility, to ensure the accuracy of its financial statements. See Rift, 834 P.2d at 762. Yet the Court’s acceptance of Appellants’ arguments would permit a company whose corporate culture likely incubated fraud (by, for example, tying management’s compensation to aggressive performance targets) to shift responsibility for the resulting fraud to its outside auditors, who were in fact among its principal victims.25

As discussed above, it would thus remove a key incentive for companies to police their own management. Paradoxically, then, the positions Appellants advocate as a way to promote accountability by auditors would reduce the accountability of audit clients, those first in the line of defense against misconduct by management.

25 See, e.g., Michael R. Young, Accounting Irregularities And Financial Fraud, Chap. I (3d ed. 2006) (explaining that financial fraud typically begins with overly aggressive performance targets set by the board and/or management).

Michael Young is no stranger to defending the auditors.  He’s one of their top shills. PwC is no stranger to the “We were duped,” defense. PwC’s former global chairman, Sam DiPiazza, used it in reference to Satyam while two of their partners sat in jail.

On the Satyam scam, DiPiazza said: “What we understand is that this was a massive fraud conducted by the (then) management , and we are as much a victim as anyone. Our partners were clearly misled.”

I’m sure PwC will throw in pari delicto, as well as every other old dirty legal shoe in the closet, at the New York courts re: Satyam to distract the judge from Pwc’s potential culpability.

Grant does a great job in his brief, also, of putting shareholders first when it comes to deciding matters of law with regard to auditors.  He reminds the judges of the auditors’ public duty. Grant cites the preeminent case that describes the role of an auditor above and beyond any financial arrangement facilitated by the aduit committee on behalf of the firm’s true client, the shareholders:

U.S. v Arthur Young & Co., 465 U.S. 805, 817-818 (1984)

…By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public. This “public watchdog” function demands that the accountant maintain total independence from the client at all times, and requires complete fidelity to the public trust. To insulate from disclosure a certified public accountant’s interpretations of the client’s financial statements would be to ignore the significance of the accountant’s role as a disinterested analyst charged with public obligations.

When deciding whether auditors were fraudsters or just too dumb to see a fraud being perpetrated under their nose  – neither excuse should be too attractive to a profession that gets paid for their independence, integrity and unique expertise – Grant believes the conclusion should not be drawn at the pleading stage.  Auditors should have to prove to a jury who exactly “duped” them, how they were “duped”, and to what extent they were truly “duped.”

Maybe that’s why the auditors always settle.  It’s not that hard to swallow your pride and call yourself and your firm a stooge in a one-off preliminary court proceeding or a foreign newspaper.  It’s much more painful when you’re forced to prove your incompetence conclusively in US open court.

Mr. Grant noted that there has never been a definitive ruling by the New York Court of Appeals on this issue. “This case has huge implications for the auditing industry as well as shareholder derivative litigation,” Mr. Grant said. “What auditors are asking for is a ‘get-out-of-jail-free’ card that they can play every time their corporate client sues them for failing to detect fraud by a corporate manager.  But detecting that kind of fraud is exactly what the client hired them to do.  There needs to be some accountability.  If they acted properly, let them have their day in court where they can prove it, but don’t foreclose the company from bringing the suit in the first place.”

The brief prepared by the AICPA and NYSSCPAs uses hyperbole, scare tactics and highly emotional language about potential threats to the viability of the profession and the potential for higher fees or restricted access to services for companies if the questions are decided in favor of the appellants.  It’s all in service to auditors and their business interests. There’s nothing about protecting shareholders.  There’s nothing about the auditors’ public duty.  It’s about protecting the status quo.  The one that’s worked so well for us leading up to the financial crisis.

“…auditors already have “a great deal of incentive to ensure accurate reporting,” and very little incentive to permit or assist management fraud. Baena, 453 F.3d at 9; see also In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1427 n.7 (9th Cir. 1994) (“It is highly improbable that an accountant would risk surrendering a valuable reputation for honesty and careful work by participating in a fraud merely to obtain increased fees.”).”


Maybe they haven’t seen the fees AIG pays PwC. Suits that have since been settled against PwC and AIG management claimed that, “AIG’s standing as one of PwC’s biggest and most lucrative clients — it paid some $136.6 million for services between 2000 and 2003 alone — compromised the close scrutiny the auditor was expected to exercise. “PwC’s receipt of substantial audit and non-audit fees impaired its independence and objectivity.”

PwC is such a good buddy to AIG that they’re still the auditors, in spite of being sued repeatedly by their client, AIG shareholders.  For the 2008 fiscal year, a really tough one for AIG if you recall, PwC charged AIG $131 million for just one year. I think that’s starting to be the kind of money that makes most folks willingly abandon any independence and objectivity and live with being called “dupes” and “stooges.” PwC’s US firm, their New York office, the key partners on the engagement and the global firm overall would certainly feel the financial and emotional pain of losing AIG as a client.

The argument that slow and weak sanctions by the SEC, even slower secret disciplinary proceedings by the PCAOB, private causes of action against auditors neutered by the PSLRA and by the Stoneridge decision, and the tendency of some judges to see the auditors as mere bookkeepers there to serve management will somehow act as a deterrent to auditor bad acts is naive at best and cruel at its worst.

The auditors and their excuses throw a sucker punch at the public investor when we can least afford another painful blow. We have a system where we can sue audit firms but we can not bring them to justice.  I hope the New York State Court of Appeals takes a long hard look at this perverse result and returns the law to the ideals of U.S. v Arthur Young (1984).

Addendum September 21, 2010:  The law firm Orrick does a great job summarizing these two cases in the Weekly Auditor Liability Bulletin on September 17, 2010.  They also have a link to all the briefs, including all amicus curiae briefs filed in both cases.

12 replies
  1. Dennis Howlett
    Dennis Howlett says:

    There is something deeply flawed in a judicial system that seems able to set aside or ignore what I have always understood to be the fundamental principle for undertaking an audit: stand in the shoes of the uninformed investor as a check and balance against unscrupulous management. Is it not time that someone explained in plain English what is happening here? Surely it cannot be that difficult? The alternative is that we have a system of audit that does not reflect what investors are led to believe but which equally gives sloppy auditors a right to a free pass. I’d argue that in itself constitutes a fraud because in essence it means that regardless of what principles are laid down for the practical audit execution, they can, for all subsequent purposes sit back and do nothing, collect fees and still not be successfully sued.

    A cynic might say that represents a new form of transaction: get paid for not providing a service. That’s a new one on me – no wonder so many find the profession attractive. Who wouldn’t when you can confidently do nothing in the face of fraud and come out free, clear and paid anyway? Yet another interpretation might be that the principles currently applied are an active disincentive to detect fraud. How else can you sustain the ‘we were duped too’ defence?

  2. Francine
    Francine says:

    @Dennis Howlett

    Some might argue that the settlements and pending litigation and their growing dollar figure are punishment enough. Problem is you can sue them but you can’t bring them to justice. The current system and the settlement extracted are still not enough disincentive to allowing poor quality, repeat mistakes and ethical lapses. The firms do a cost benefit analysis of audit failure. If I can make $100 million a year for 20 years from several clients and only pay $90 million when I get sued once ever so often years, why not keep doing what I’m doing?

  3. David
    David says:

    I read the AICPA’s response with respect to the client controlled environment. Let’s look at what the AICPA is really saying – Audits are a complete waste of time and money. Isn’t the society’s job to stand up for the value of the profession and the benefits of an audiit? I don’t think its to defend each firm that fails to detect fraud because they accept ridiculous answers from the client. Or falters on an audit because it value stheir “business interests” over their responsibilities. I do not think the society should spend its resources protecting auditors that don’t do what they are supposed to do.

    If you accept the AICPA/NYSCPA rationale, then here is my plan. Let’s not require certified audits for public companies. And, tell banks not to require them for their clients. Why? Because the AICPA thinks that there are severe limitations to the process that limit the value of an audit. After all, did the shareholders of AIG benefit from the $131 million paid to PWC. Did the shareholders of Lehman and creditors of Lehman benefit from the audits conducted? I don’t think they benefitted at all. So if the AICPA/NYSCPA rationale is correct, you could do American business a big favor and cut costs by not requiring CPA firms to certify financial statements.

Trackbacks & Pingbacks

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