The In Pari Delicto Defense for Auditors in Professional Negligence Cases: Imputation of Managers’ Unlawful Acts to the Client Firm
Abstract
The Enron scandal, the Sarbanes-Oxley Act and the 2008 financial crisis have resulted in new laws and regulations regarding auditor liability and an evolution of some of the old ones. One of the older laws is the in pari delicto defense: in a lawsuit brought by a corporation alleging that its auditor was negligent in failing to detect a manager’s fraud, the auditor may be able to use that defense if the manager’s fraud is imputable to the company. Since a bankruptcy trustee or a receiver steps into the shoes of the bankrupt company it represents, a similar defense (the Wagoner Rule) may also be applicable if a trustee or a receiver files a negligence lawsuit against the company’s auditor. However, in pari delicto is inapplicable when: (1) the wrongful acts of the manager are so adverse to the corporate client that the manager is deemed to have totally abandoned the corporation for its, or a third party’s, sole benefit (unless the manager is also the sole shareholder, or the company has incurred a short-term benefit because of the fraud); (2) the corporate client had at least one innocent manager or shareholder who could have prevented or stopped the fraud if he had known about it; (3) the auditor does not deal with the corporate client in good faith and engages in unlawful conduct; or (4) the plaintiffs are totally innocent shareholders (but in this case, the in pari delicto defense is still applicable with respect to culpable shareholders). The State of New York has been on the cutting edge in the evolution of the in pari delicto defense, and this defense is strongest there. Other states recognizing the defense include New Jersey, Pennsylvania, and (in dicta) Delaware (only if the company has engaged in actual wrongdoing). Finally, these are examples of recent evolution of in pari delicto: (a) the Sarbanes-Oxley Act’s prohibition of management from interfering with or deceiving the auditor; such statutory violations of management could be used by the auditor at trial in proving the applicability of the in pari delicto defense and (b) the new constraints on off-balance sheet leases, expected to be released shortly by the Financial Accounting Standards Board, may decrease management’s ability to deceive the auditor in the first place.
Appendix: other legal cases
Other cases in which in pari delicto has been advanced as a defense by an auditor alleged to have been negligent include the following, categorized by whether that defense was successful. However, these cases have had less influence on the evolution of that defense. They are listed in chronological order.
Successful In Pari Delicto defense
Ameriwood Industries International Corp. v. Arthur Andersen & Co., 961 F. Supp. 1078 (W.D. Mich. 1997).
In Re Donahue Securities, Inc. v. Munninghoff Lange & Co., Case No. 01-1027, Memo Op. (Bankr. So. Dist. Ohio, Western Div. 2003).
Official Committee of the Unsecured Creditors of Color Tile, Inc. v. Coopers & Lybrand, 322 F.3d 147 (Ct. App., 2d Cir. 2003).
Baena v. KPMG, 389 F.Supp.2d 112 (D. Ct. Mass. 2005).
Christians v. Grant Thornton, 733 N.W.2d 803 (Minn. App. 2007).
Symbol Technologies, Inc. v. Deloitte & Touche, 2008 N.Y. Slip Op. 31759(U) (N.Y. Sup. Ct. Comm. Div., Suffolk Cty. 2007).
In Re Magnesium Corp. of America v. The Renco Group, Inc., 399 B.R. 722 (Bankr. Ct., S.D. N.Y. 2009).
In Re Parmalat Securities Litigation, 659 F.Supp.2d 504 (D. Ct. N.Y., So.Dist. 2009).
Chaikovska v. Ernst & Young, 2010 N.Y. Slip Op. 08483 (N.Y. Sup. Ct. App. Div., 4th Jud. Dept. 2010).
USACM Liquidating Trust v. Deloitte &Touche, Case No. 2: 08-CV-00461-PMP-PAL (U.S. D. Ct. Nev. 2011).
Unsuccessful In Pari Delicto defense
Mosier v. Stonefield Josephson, Inc., Case No. CV 11-2666 PSG (Ex) (U.S. Dist. Ct., Central Dist. Calif. 2011).
In Re Inofin, Inc. v. Tobin & Assoc., Case No. 11-11010-JNF (U.S. Bankr. Ct., D. Mass. 2012).
Peterson v. McGladrey& Pullen, Case No. 10-3770 (U.S. Ct. App., 7th Cir. 2012).
Case, Law and Code References
American International Group, Inc. v. Greenburg, 965 A.2d 763 (Del. Chancery 2009).
Ameriwood Industries International Corp. v. Arthur Andersen & Co., 961 F. Supp. 1078 (W.D. Mich. 1997).
Baena v. KPMG, 389 F.Supp.2d 112 (D. Ct. Mass. 2005).
Bechtle v. Master, Sidlow&McCudden, 766 F.Supp.2d 549 (D. Ct. Pa. 2011).
Bullmore v. Ernst & Young Cayman Islands, 20 Misc.3d 667, 861 N.Y.S.2d 578, 2008 NY Slip Op 28238 (N.Y. Sup. Ct., 2008).
Cenco, Inc. v. Seidman&Seidman, 686 F.2d 449 (7th Cir. 1982).
Center v. Hampton Affiliates, 66 N.Y. 2nd 782, 784 (1985).
Chaikovska v. Ernst & Young, 2010 N.Y. Slip Op. 08483 (N.Y. Sup. Ct. App. Div., 4th Jud. Dept. 2010).
Christians v. Grant Thornton, 733 N.W.2d 803 (Minn. App. 2007).
Friedman v. Anderson, 23 A.D.3d 163 (1st Dept. 2005).
Holley v. Jackson, 158 A.2d 803, 808 (Del. Ch. 1959).
In re American International Group, Inc. v. Greenberg, Consolidated Derivative Litigation (“AIG I”), 965 A.2d 763, 824 (Del. Ch. 2009).
In re American International Group, Inc. v. Greenberg, Consolidated Derivative Litigation (“AIG II”), 976 A.2d 872 (Del. Ch. 2009).
In Re Donahue Securities, Inc. v. Munninghoff Lange & Co., Case No. 01-1027, Memo Op. (Bankr. So. Dist. Ohio, Western Div. 2003).
In re HealthSouth Corp. S’holdersLitig., 845 A.2d 1096, 1108 (Del. Ch. 2003).
In Re Inofin, Inc. v. Tobin & Assoc., Case No. 11-11010-JNF (U.S. Bankr. Ct., D. Mass. 2012).
In Re Magnesium Corp. of America v.The Renco Group, Inc., 399 B.R. 722 (Bankr. Ct., S.D. N.Y. 2009).
In re NM Holdings Co. v. Deloitte &Touche, 405 B.R. 830, 859 (B.R., E.D. Mich., So.Div. 2008).
In Re Parmalat Securities Litigation, 659 F.Supp.2d 504 (D. Ct. N.Y., So.Dist. 2009).
Kirschner v. KPMG, 15 N.Y. 3d 446 (N.Y. Ct. App. 2010).
Kristina Denise Enterprises v. Arnold, 41 A.D.3d 788 (2nd Dept. 2007).
Maheshwari v. New York, 2 N.Y. 3rd 288, 295 (2004).
Mosier v. Stonefield Josephson, Inc., Case No. CV 11-2666 PSG (Ex) (U.S. Dist. Ct., Central Dist. Calif. 2011).
NCPLitig. Trust v. KPMG, 901 A.2d 871 (N.J. 2006).
Official Comm. of Unsecured Creditors of Allegheny Health, Educ. & Research Found. v. PriceWaterhouse Coopers, 607 F.3d 346, 350 (3d Cir. 2010) (ALLEGHENY I)
Official Comm. of Unsecured Creditors of Allegheny Health Educ. & Research Found. v. PriceWaterhouse Coopers, 989 A.2d 313, 328 (Pa. 2010) (ALLEGHENY II)
Official Comm. of Unsecured Creditors of Color Tile, Inc. v. Coopers & Lybrand, 322 F.3d 147 (Ct. App., 2d Cir. 2003).
O’Melveny & Myers v. FDIC, 512 U.S.79, 114 S.Ct. 2048, L.Ed. (1994).
Peterson v. McGladrey& Pullen, Case No. 10-3770 (U.S. Ct. App., 7th Cir. 2012).
Sacher v. Beacon Associates Management Corp., 2010 N.Y. Slip Op. 50826(U), N.Y. Sup. Ct. (Nassau Cty.) 2010.
Sarbanes-Oxley Act of 2002 (“SOA”), Pub. Law 107-204 (http://www.law.cornell.edu/jureeka/index.php?doc=USPubLaws&cong=107&no=204); 116 Stat. 745 (http://www.gpo.gov/fdsys/granule/STATUTE-116/STATUTE-116-Pg745/content-detail.html). The most relevant parts of the SOA to this article are §§ 101-109, 201-204, 206, 301-303 and 401.
Schacht v. Brown, 711 F.2d 1343 (7th Cir. 1982).
Securities and Exchange Commission, Staff Report No. 2005-91 on Off-Balance Sheet Arrangements, Special Purpose Entities and Related Issues; https://www.sec.gov/news/press/2005-91.htm.
Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, 118 (2d.Cir. 1991).
Symbol Technologies, Inc. v. Deloitte &Touche, 2008 N.Y. Slip Op. 31759(U) (N.Y. Sup. Ct. Comm. Div., Suffolk Cty. 2007).
Symbol Technologies, Inc. v. Deloitte &Touche, 69 A.D.3rd 191 (2nd Dept. 2009).
Teachers’ Retirement System of Louisiana v. PriceWaterhouseCoopers, 998 A.2d 280 (Del. 2010).
Thabault v. Chait, 541 F.3d 512, 526 (3d.Cir. 2008).
USACM Liquidating Trust v. Deloitte &Touche, Case No. 2: 08-CV-00461-PMP-PAL (U.S. D. Ct. Nev. 2011).
General References
Arens, A. A., R. J. Elder, & M. S. Beasley. (2012). Auditing and assurance services: An integrated approach (14th ed., pp. 104–105). Harlow, England: Pearson Education.Search in Google Scholar
Epstein, B. J. (2013). Accounting for leases: Off-balance sheet lease arrangements about to become extinct. AuditorLiability.com. Retrieved December 4, 2013 from http://www.auditorliability.com/fact-sheets/accounting-for-leases-off-balance-sheet-lease-arrangements-about-to-become-extinctSearch in Google Scholar
Financial Crisis Inquiry Commission. (2011). Press Release. Retrieved January 27, 2011 from http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_conclusions.pdfSearch in Google Scholar
Koniak, S. P., G. M. Cohen, D. A. Dana, & T.Ross. (2010). How Washington abetted the bank job. New York Times. Retrieved April 3, 2010 from http://www.nytimes.com/2010/04/04/opinion/04koniak.htmlSearch in Google Scholar
Pritchard, A. C. (1995). O’Melveny & Myers v. FDIC: Imputation of fraud and optimal monitoring. Supreme Court Economic Review, 4, 179–200.10.1086/scer.4.1147083Search in Google Scholar
Shepard, C. M. (2012). Note, “Corporate wrongdoing and the in pari delicto defense in auditor malpractice cases: A new approach”. Washington and Lee Law Review, 69, 275, 325–327.Search in Google Scholar
Slovik, P. (2012). Systemically important banks and capital regulation challenges. Paris, France: OECD Publishing. OECD Economics Department Working Papers, No. 916. Retrieved from http://www.oecdilibrary.org/docserver/download/5kg0ps8cq8q6.pdf?expires=1396863840&id=id&accname=guest&checksum=7DDC4C7A40C25BC996D5E2723F53145FSearch in Google Scholar
Thomas, C. W. (2002, April). The rise and fall of Enron. Journal of Accountancy. Retrieved from http://www.journalofaccountancy.com/Issues/2002/Apr/TheRiseAndFallOfEnron.htmSearch in Google Scholar
Zucchi, K. (2013). CFA, Understanding off-balance sheet financing. Investopedia. Retrieved July 15, 2013 from http://www.investopedia.com/articles/investing/071513/understanding-offbalance-sheet-financing.aspSearch in Google Scholar
©2015 by De Gruyter
Articles in the same Issue
- Frontmatter
- Research Articles
- Alternative Banking and Theory
- Extraterritorial Discovery in Aid of Execution and State Immunity: Case Comment on Republic of Argentina v. NML Capital, Ltd., 573 U.S. ___ (2014)
- The In Pari Delicto Defense for Auditors in Professional Negligence Cases: Imputation of Managers’ Unlawful Acts to the Client Firm
- Book Review
- Isabelle Huault and Christelle Richard: Regulation Writ Large: A Comment on Huault and Richard’ “The Discreet Regulator”
Articles in the same Issue
- Frontmatter
- Research Articles
- Alternative Banking and Theory
- Extraterritorial Discovery in Aid of Execution and State Immunity: Case Comment on Republic of Argentina v. NML Capital, Ltd., 573 U.S. ___ (2014)
- The In Pari Delicto Defense for Auditors in Professional Negligence Cases: Imputation of Managers’ Unlawful Acts to the Client Firm
- Book Review
- Isabelle Huault and Christelle Richard: Regulation Writ Large: A Comment on Huault and Richard’ “The Discreet Regulator”
