In Pari Delicto: Can A Law Make It Go Away?

Pete Brush at did a story last week about a story about whether (and how) lawmakers in New York State, and maybe Washington DC, could legislate a solution to court rulings that have sharply limited the power of trustees to recover from fraudulent corporate actors. The issue became acute again as a result of the recent ruling in favor of banks against the Madoff SIPA trustee. It’s going to heat up again as trustees try to hold auditor PwC responsible for the failure of its clients MF Global and Colonial Bank.

I’ve written extensively about in pari delicto and, in particular, the “adverse interest exception”. Recent interpretations of the law, especially in New York State,  limit of the opportunities for shareholders to hold auditors, as third-parties, accountable for fraud.

The New York Court of Appeals decided on October 21, 2010, by a vote of 4-3, to “decline to alter our precedent relating to in pari delicto and imputation and the adverse interest exception, as we would have to do to bring about the expansion of third-party liability sought by plaintiffs here.”

The decision is flawed, misguided and strongly biased towards corporate interests rather than shareholder and investor interests. Imputation – a fundamental principle that has outlived its usefulness and that defies common sense and fairness – has been reaffirmed in cases of third-party advisor negligence or collusion.

“A fraud that by its nature will benefit the corporation is not “adverse” to the corporation’s interests, even if it was actually motivated by the agent’s desire for personal gain (Price, 62 NY at 384). Thus, “[s]hould the ‘agent act[] both for himself and for the principal,’ . . . application of the [adverse interest] exception would be precluded” (Capital Wireless Corp. v Deloitte & Touche, 216 AD2d 663, 666 [3d Dept 1995] [quoting Matter of Crazy Eddie Sec. Litig., 802 F Supp 804, 817 (EDNY 1992)]; see also Center, 66 NY2d at 785 [the adverse interest exception “cannot be invoked merely because . . . .(the agent) is not acting primarily for his principal”]). [*12]

New York law thus articulates the adverse interest exception in a way that is consistent with fundamental principles of agency. To allow a corporation to avoid the consequences of corporate acts simply because an employee performed them with his personal profit in mind would enable the corporation to disclaim, at its convenience, virtually every act its officers undertake. “[C]orporate officers, even in the most upright enterprises, can always be said, in some meaningful sense, to act for their own interests” (Grede v McGladrey & Pullen LLP, 421 BR 879, 886 [ND Ill 2008]). A corporate insider’s personal interests — as an officer, employee, or shareholder of the company — are often deliberately aligned with the corporation’s interests by way of, for example, stock options or bonuses, the value of which depends upon the corporation’s financial performance.

And this is ok?

A majority of the New York Court of Appeals bought the self-serving, selfish and unjust arguments of the defendants and their flunky amicus brief toadies supporting criminal corporate fraudsters and, get this, the shareholders of the accounting firms (!!). The New York Court of Appeals abandoned the shareholders and creditors of Refco and AIG for criminals and incompetents.

I could not have imagined more contemptible excuses for judicial cowardice if I were writing this decision for a novel of corporate cronyism to the extreme in a Utopian nirvana for capitalist parasites.

“In particular, why should the interests of innocent stakeholders of corporate fraudsters trump those of innocent stakeholders of the outside professionals who are the defendants in these cases?

…In a sense, plaintiffs’ proposals may be viewed as creating a 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. And, of course, the corporation’s agents [*19]would almost invariably play the dominant role in the fraud and therefore would be more culpable than the outside professional’s agents who allegedly aided and abetted the insiders or did not detect the fraud at all or soon enough. The owners and creditors of KPMG and PwC may be said to be at least as “innocent” as Refco’s unsecured creditors and AIG’s stockholders.

The doctrine’s full name is in pari delicto potior est conditio defendentis, meaning “in a case of equal or mutual fault, the position of the [defending party] is the better one” (Baena, 453 F3d at 6 n 5 [internal quotation marks omitted]).

I have some other names for it:

  • Immunity from Prosecution for the “Duped” theory
  • Incompetent Professional service providers Defense
  • Invocation of Plausible Deniability doctrine

Pete Brush quotes me in his piece:

The exception under the in pari delicto doctrine for holding third parties liable for executive lawbreaking comes only when the executives can be shown to have acted in ways that are adverse to the company’s interests.

The so-called “adverse interest exception” has been pared back instead of expanded, according to accountant Francine McKenna, an author who has been critical of the Refco decision.

“You don’t usually find cases like embezzlement — where executives have set aside the interests of the corporation — in these matters,” she said. “What you usually find are other kinds of bad behavior like failing to disclose financial irregularities.”

The rulings have left fraud victims with little recourse but to go to court privately, according to Furth, which means they have little financial leverage unless the fraud is so huge — and the recovery so tempting — that powerful lawyers will take up the case on their behalf.

“It sort of undermines the bankruptcy process,” he said.