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Kirschner v. KPMG LLP

October 21, 2010


The opinion of the court was delivered by: Read, J.

This opinion is uncorrected and subject to revision before publication in the New York Reports.

In these two appeals, plaintiffs ask us, in effect, to reinterpret New York law so as to broaden the remedies available to creditors or shareholders of a corporation whose management engaged in financial fraud that was allegedly either assisted or not detected at all or soon enough by the corporation's outside professional advisers, such as auditors, investment bankers, financial advisers and lawyers. For the reasons that follow, we 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.

I. Kirschner

This lawsuit was triggered by the collapse of Refco, once a leading provider of brokerage and clearing services in the derivatives, currency and futures markets. After a leveraged buy-out in August 2004, Refco became a public company in August 2005 by way of an initial public offering.*fn1 In October 2005, Refco disclosed that its president and chief executive officer had orchestrated a succession of loans, apparently beginning as far back as 1998, which hid hundreds of millions of dollars of the company's uncollectible debt from the public and regulators. These maneuvers created a falsely positive picture of Refco's financial condition.*fn2 In short order, this revelation caused Refco's stock to plummet and RCM, Refco's brokerage arm, to experience a "run" on customer accounts, forcing Refco to file for bankruptcy protection.

In December 2006, the United States Bankruptcy Court for the Southern District of New York confirmed Refco's Chapter 11 bankruptcy plan, which became effective soon thereafter. Under the plan, secured lenders, who were owed $717 million, were paid in full; Refco's bondholders and the securities customers and unsecured creditors of RCM were due to receive 83.4 cents, 85.6 cents and 37.6 cents on the dollar, respectively; and Refco's general creditors with unsecured claims could expect from 23 cents to 37.6 cents on the dollar (see BCD News and Comment, vol. 47, no. 13 [Jan. 16, 2007]; "Refco Exits Bankruptcy Protection," New York Times, Dec. 27, 2006).

The plan also established a Litigation Trust, which authorized plaintiff Marc S. Kirschner, as Litigation Trustee, to pursue claims and causes of action possessed by Refco prior to its bankruptcy filing. The Litigation Trust's beneficiaries are the holders of allowed general unsecured claims against Refco. Any recoveries are to be allocated, after repayment of up to $25 million drawn from certain Refco assets to administer the Trust, on the basis of the beneficiaries' allowed claims under the confirmed plan.

In August 2007, the Litigation Trustee filed a complaint in Illinois state court asserting fraud, breach of fiduciary duty and malpractice against Refco's President and CEO and other owners and senior managers (collectively, "the Refco insiders"); investment banks that served as underwriters for the LBO and/or the IPO; Refco's law firm; two accounting firms that had provided services to Refco; and several customers that participated in the allegedly deceptive loans. According to the Trustee, these defendants all aided and abetted the Refco insiders in carrying out the fraud, or were negligent in neglecting to discover it. A year later, the Litigation Trustee filed a complaint in Massachusetts state court, asserting similar claims against the accounting firm KPMG LLP. Both lawsuits were removed to federal court and transferred to the Southern District of New York for coordinated or consolidated proceedings.

Defendants subsequently moved to dismiss the Litigation Trustee's claims pursuant to Rules 12 (b) (1) and 12 (b) (6) of the Federal Rules of Civil Procedure, and the District Court granted the motion on April 14, 2009. Because the Trustee acknowledged that the Refco insiders masterminded Refco's fraud, the Judge identified as the threshold issue whether the claims were subject to dismissal by virtue of the Second Circuit's Wagoner rule (see Shearson Lehman Hutton v Wagoner, 944 F2d 114, 118 [2d Cir 1991] [bankruptcy trustee does not possess standing to seek recovery from third parties alleged to have joined with the debtor corporation in defrauding creditors]).*fn3 Further, since "[a]ll parties agree[d] that if the Wagoner rule applie[d], the Litigation Trustee lack[ed] standing to assert any of Refco's claims against the defendants," the Judge observed that "the parties' dispute focus[ed] solely on whether the narrow exception to the Wagoner rule -- the 'adverse interest' exception --applie[d]" (Kirschner v Grant Thornton LLP, 2009 WL 1286326, *5, 2009 US Dist LEXIS 32581, *19-20).

Citing Second Circuit cases handed down after our decision in Center v Hampton Affiliates (66 NY2d 782 [1985]), the District Court noted that, in order for the adverse interest exception to apply, "the [corporate officer] must have totally abandoned [the corporation's] interests and be acting entirely for his own or another's purposes... because where an officer acts entirely in his own interests and adversely to the interests of the corporation, that misconduct cannot be imputed to the corporation" (2009 WL 1286326, *5, 2009 US Dist LEXIS 32581, *20 [internal citations and quotation marks omitted]). Further, "[i]n determining whether an agent's actions were indeed adverse to the corporation, courts have identified the relevant issue [as being the] short term benefit or detriment to the corporation, not any detriment to the corporation resulting from the unmasking of the fraud" (2009 WL 1286326, *6, 2009 US Dist LEXIS 32581, *21 [quoting In re Wedtech Corp., 81 BR 240, 242 (SDNY 1987)]).

The District Court concluded that "[t]his line of precedent foreclose[d] the Litigation Trustee's claims" because the complaint was "saturated by allegations that Refco received substantial benefits from the [Refco] insiders' alleged wrongdoing" (2009 WL 1286326, *6, 2009 US Dist LEXIS 32581, *22). Thus, under the Trustee's own allegations the Refco insiders stole for Refco, not from it -- i.e., "the burden of the [Refco] insiders' fraud was not borne by Refco or its then-current shareholders who were themselves the [Refco] insiders -- but rather by outside parties, including Refco's customers, creditors, and third parties who acquired shares through the IPO" (2009 WL 1286326, *6, 2009 US Dist LEXIS 32581, *24).

In reaching his decision, the Judge rejected as "without merit" the Litigation Trustee's "industrious" interpretation of the Second Circuit's decision in In re CBI Holding Co. v Ernst & Young (529 F3d 432 [2d Cir 2008]), a case where the court held that a bankruptcy court's finding that the adverse interest exception applied was not clearly erroneous. The Judge declined to read a solely "intent-based" standard into CBI because "deferring to a finder-of-fact's choice as to which evidence to credit after a trial, or acknowledging that facts related to intent could contribute to the explication of how a fraud worked and to whose benefit it accrued, does not make the participants' intent the 'touchstone' of the analysis such that it precludes dismissal on the pleadings" (2009 WL 1286326, *7, 2009 US Dist LEXIS 32581, *26). "To hold otherwise," he reasoned, "would be to explode the adverse-interest exception, transforming it from a 'narrow' exception, into a new, and nearly impermeable rule barring imputation" (2009 WL 1286326, *7 n 14, 2009 US Dist LEXIS 32581, *26 n 14). The standard could not depend exclusively on the Refco insiders' subjective motivation, the Judge explained, because "[w]henever insiders conduct a corporate fraud they are doing so, at least in part, to promote their own advantage" (2009 WL 1286326, *7 n 14, 2009 US Dist LEXIS 32581, *28 n 14 [internal citation omitted]).

Having declined the Litigation Trustee's invitation to read CBI to inquire solely into insiders' claimed motivations, without regard to the nature and effect of their misconduct, the District Court revisited the fraud's impact on Refco. He again emphasized that the Trustee's allegations did not establish injury to Refco, because the Refco insiders did not embezzle or steal assets from Refco, but instead sold their holdings in Refco to third parties at fraudulently inflated prices -- i.e., the Refco insiders' benefit came at the expense of the new purchasers of Refco securities, not Refco itself. Critically, "the Trustee must allege, not that the [Refco] insiders intended to, or to some extent did, benefit from their scheme, but that the corporation was harmed by the scheme, rather than being one of its beneficiaries" (2009 WL 1286326, *7, 2009 US Dist LEXIS 32581, *27).

Plaintiffs appealed to the Second Circuit Court of Appeals. After presenting a comprehensive account of the Litigation Trustee's factual allegations and the District Court's decision, the court remarked that the parties seemingly did not dispute several propositions in the lower court's decision, which "appear[ed] to correctly reflect New York law concerning the adverse interest exception" (Kirschner v KPMG LLP, 590 F3d 186, 191 [2d Cir 2009]); specifically, that the adverse interest exception was "a narrow one and that the guilty manager must have totally abandoned his corporation's interests for [the exception] to apply"; and that "whether the agent's actions were adverse to the corporation turns on the short term benefit or detriment to the corporation, not any detriment to the corporation resulting from the unmasking of the fraud" (id. [quoting the District Court's opinion (internal quotation marks omitted)]). Nonetheless, the court observed, "[a]s [the District Court Judge] applied these propositions to the Trustee's allegations,... he interpreted New York law in ways that [brought] the parties into sharp dispute concerning certain aspects of the adverse interest exception"; namely, "the state of mind of the [Refco] insiders and the harm to their corporation" (id.).

The Second Circuit noted that "New York cases seem[ed] to support" the District Court's conclusion that an insider's subjective intent was not the "touchstone" of adverse interest analysis; however, the court added, "other New York cases may be read to make intent more significant" (id. at 192 n 3). In light of the parties' "differing uses of New York cases, coupled with the somewhat divergent language used by the District Court in the pending case and by [the Second Circuit] in CBI, both endeavoring to interpret New York law," the court sought our guidance as to the scope of New York's adverse interest exception (id. at 194). Accordingly, on December 23, 2009 the Second Circuit certified eight questions, inviting us to "focus [our] attention on questions (2) and (3)" (id. at 195), which are "whether the adverse interest exception is satisfied by showing that the insiders intended to benefit themselves by their misconduct"; and "whether the exception is available only where the insiders' misconduct has harmed the corporation," respectively (id. at 194-195).

Teachers' Retirement System of Louisiana and City of New Orleans Employees' Retirement System

This lawsuit is a derivative action brought on behalf of American International Group, Inc. (AIG) by the Teachers' Retirement System of Louisiana and the City of New Orleans Employees' Retirement System (derivative plaintiffs). According to the complaint, senior officers of AIG set up a fraudulent scheme to misstate AIG's financial performance in order to deceive investors into believing that the company was more prosperous and secure than it really was. The complaint further accuses these officers of causing the corporation to avoid taxes by falsely claiming that workers' compensation policies were other types of insurance, and of engaging in "covered calls" to recognize investment gains without paying capital gains taxes. It is also claimed that AIG conspired with other companies to rig markets to subvert supposedly competitive auctions, and that the senior officers exploited their familiarity with improper financial machinations by selling the company's "expertise" in balance sheet manipulation. Specifically, AIG is alleged to have sold to other companies insurance policies that did not involve the actual transfer of insurable risk, with the improper purpose of helping those companies report better financial results; and to have created special purpose entities for other companies without observing the required accounting rules for the similarly improper purpose of helping those companies hide impaired assets. These financial tricks eventually came to light, resulting in serious harm to AIG. Stockholder equity was reduced by $3.5 billion, and AIG was saddled with litigation and regulatory proceedings requiring it to pay over $1.6 billion in fines and other costs.

Derivative plaintiffs do not allege that defendant PricewaterhouseCoopers LLP (PwC) conspired with AIG or its agents to commit accounting fraud. Rather, they contend that, as AIG's independent auditor, PwC did not perform its auditing responsibilities in accordance with professional standards of conduct, and so failed to detect or report the fraud perpetrated by AIG's senior officers. Had it done so, derivative plaintiffs argue, the fraudulent accounting schemes at AIG would have been timely discovered and rectified.

PwC moved to dismiss the action. On February 10, 2009, the Delaware Court of Chancery granted the motion, concluding that New York law applied to the claims and that, under New York law, the claims were barred (In re Am. Intl. Group, Inc., 965 A2d 763 [Del Ch 2009]). Consistent with the way in which the District Court handled the same issues two months later in Kirschner, the Vice Chancellor decided that, under New York's law of agency, the wrongdoing of AIG's senior officers was imputed to AIG and that, based on the allegations in the complaint, AIG's senior officers did not totally abandon AIG's interests such that the adverse interest exception to imputation would apply. Once the wrongdoing was imputed to AIG, the Court of Chancery decided that AIG's claims against PwC were barred by New York's in pari delicto doctrine and the Wagoner rule governing standing.

Derivative plaintiffs appealed. Determining that the appeal's resolution depended on significant and unsettled questions of New York law, on March 3, 2010, the Delaware Supreme Court issued a decision certifying the following question to us:

"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?" (In re Am. Intl. Group, Inc., 998 A2d 280 [Del 2010]).

II. In pari delicto

The doctrine of in pari delicto*fn4 mandates that the courts will not intercede to resolve a dispute between two wrongdoers. This principle has been wrought in the inmost texture of our common law for at least two centuries (see e.g. Woodworth v Janes, 2 Johns Cas 417, 423 [NY 1801] [parties in equal fault have no rights in equity]; Sebring v Rathbun, 1 Johns Cas 331, 332 [NY 1800] [where both parties are equally culpable, courts will not "interpose in favor of either"]). The doctrine survives because it serves important public policy purposes. First, denying judicial relief to an admitted wrongdoer deters illegality. Second, in pari delicto avoids entangling courts in disputes between wrongdoers. As Judge Desmond so eloquently put it more than 60 years ago, "[N]o court should be required to serve as paymaster of the wages of crime, or referee between thieves. Therefore, the law will not extend its aid to either of the parties or listen to their complaints against each other, but will leave them where their own acts have placed them" (Stone v Freeman, 298 NY 268, 271 [1948] [internal quotation marks omitted]).

The justice of the in pari delicto rule is most obvious where a willful wrongdoer is suing someone who is alleged to be merely negligent. A criminal who is injured committing a crime cannot sue the police officer or security guard who failed to stop him; the arsonist who is singed cannot sue the fire department. But, as the cases we have cited show, the principle also applies where both parties acted willfully. Indeed, the principle that a wrongdoer should not profit from his own misconduct is so strong in New York that we have said the defense applies even in difficult cases and should not be "weakened by exceptions" (McConnell v Commonwealth Pictures Corp., 7 NY2d 465, 470 [1960] ["We are not working here with narrow questions of technical law. We are applying ...

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