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In pari delicto: does the doctrine protect auditors from liability?

if a corporate officer or other employee commits fraud, should the corporation or its shareholders be permitted to successfully sue an auditor for failing to detect die fraud--even if the auditor was negligent? A legal concept dial has Mown below die radar might oiler auditors some cover when facing such claims.

Under the doctrine of in pari delicto ("in equal fault"), an auditor cannot lie held liable for negligently failing lo detect wrongdoing or lor even participating in die wrongdoing if the corporation also participated at least equally. The courts do not permit wrongdoers to profit from their own misconduct.

An auditor's success in using the in pari delicto defense varies significantly, depending on the applicable law of the stale in which die lawsuit is filed.

Imputing Wrongdoing and the Adverse Interest Exception

If a corporation's agents--such as directors, officers or other employees--participate in die wrongdoing, their conduct can be imputed lo die corporation as if the corporation itself had acted wrongfully.

However, a corporation may avoid imputation of its agent's wrongful acts, and the in pari delicto defense, wilh die "adverse interest exception." which relieves the corporation of imputed acts not performed for the benefit of die corporation.

For example: An employee who steals or embezzles from a corporation acts adversely lo die corporation's own interests and. therefore, such wrongdoing cannot be imputed lo the corporation.

On die other hand, if an employee falsifies financial statements to maintain or increase the value of die corporation's stock then, arguably, die corporation derives a benefit from die wrongdoing which can be imputed to it even if the employee also benefits.

Kirschner and Other Jurisdictions

In die last four years, live major court decisions have addressed die auditor's use of in pari delicto lo defend against liability.

In Kirschner v, KPMG, the New York Court of Appeals determined that New York law allows an auditor to assert the defense where a corporation benefitted from iis officer's undetected fraudulent acts. The litigation trustee of a bankrupt company. String on behalf of die company, alleged that KPMG wrongfully failed lo uncover uncollectible debts concealed by the company's president and CEO: For the adverse interest exception to apply and prevent ill pari delicto, the wrongdoing officer would have bad to totally abandon the corporation's best interests and act solely for his own benefit.

A Delaware court applied New York law in dismissing a case againsl an auditor asserting in pari delicto. In a second and identical ease brought againsl nonauditors, die court applied Delaware law and again dismissed die case on the basis of in pari delicto--stopping short of what it perceived io be the extent of New York law: Full immunization of auditors againsl liability.

In a New Jersey lawsuit brought by shareholders, in pari delicto could not be used by auditors who participated in the alleged Wrongdoing out of fairness in innocent shareholders' who were not in a position to know of or prevent die wrongdoing. However, die court explained that in pari delicto could have been asserted against shareholders who participated in die fraud, should have been aware of it or owned enough stock to influence the company's operations.

A federal conn in Pennsylvania recognized in pari delicto, but examined whether die adverse interest exception prevented imputation of the wrongdoing. The deciding factor was dial die auditor acted materially in good faith i.e.. did not know that die corporate agent was not authorized and was acting contrary to die best interests of the corporation).

In an Illinois case, all members of upper-level management were die wrongdoings; therefore, die wrongdoing was imputed to the company in a lawsuit brought by shareholders. Even though die individuals personally profited, die adverse interest exception was rejected because the wrongdoings were stealing "for" die company from outsiders in a Ponzi scheme, not "from" die company.

California

The first ease in California in which an auditor asserted the in pari delicto defense began in 2011. Two hedge fund managers starting a business allegedly hired an accounting firm to verify the track record of a potential new partner and uncover any of dhe prospective partner's prior misconduct or known hand. Irregularities and fabricated accounts were not discovered, and investors lost millions of dollar from investments made by the new partner on behalf of the hedge fund.

The trial court denied the auditor's motion to dismiss. The court accepted the plaintiffs position that imputation of wrongdoing requires involvement by more participants in the company than merely the new partner. Therefore, in pari delicto could not he used against innocent parties. The case proceeded to trial, but was settled in 2013.

Predictions for In Pari Delicto

The following fictitious examples involve Bea Zee, CFO of Alpha Corporation, and

its auditor, public accounting firm Midtown. Assume Midtown negligently failed to detect any wrongdoing. Could in pari delicto be successfully used if the firm is sued?

Example 1: Zee embezzled $2 million from Alpha for personal gain. No other agents or employees were involved. Based on the recent case decisions described above, in pari delicto would not be successful in New York. New Jersey. Illinois. Pennsylvania. Delaware and California. Zee's wrongdoing would not be imputed to Alpha because of the adverse interest exception. Zee acted solely for her own personal gain with disregard for the best interests of the corporation.

Example 2: Zee falsified financial Statements to inflate Alpha's earnings and increase the market value of its stock. No other agents or employees were involved. While Midtown's in pari delicto defense would likely be rejected in New Jersey. Pennsylvania and California. It may be successful in New York, Delaware and Illinois, where the adverse interest exception would not apply because Alpha benefitted from Zee's fraudulent act.

Example 3: Alpha's entire management team participated in the falsification of Alpha's financial statements. Midtown would likely be able to successfully assert in pan delicto in New York. Delaware, Pennsylvania, Illinois and California In these jurisdictions, the fraud would be imputed to the corporation because of the magnitude of management's involvement--thereby relieving the auditor of liability. The outcome in New Jersey might turn on whether the plaintiffs are shareholders and innocent of any wrongdoing

Conclusion

Does in pari delicto protect the auditor from legal liability? The answer depends on the jurisdiction and who benefits from the wrongdoing When successfully used, in pari delicto has spared the auditor from a potentially large monetary judgment. Therefore, plaintiffs seeking damages against auditors arising from corporate wrongdoing might engage in forum shopping and, for example, bypass New York for a more favorable jurisdiction.

Despite a California trial court's rejection, the issue as to whether an auditor ran Successfully assert the in pari delicto defense is still undetermined under California law. However, even a light breeze may indicate which direction the wind will blow.

Does in pari delicto protect the auditor from legal liability? The answer depends on the jurisdiction and who benefits from the wrongdoing.

BY EARL WEISS, KIREN DOSANJH ZUCKER AND RAZMIK KAJBERUNI

Earl Weiss and Kiren Dosanjh Zucker are accounting professors at California State University, Northridge, where Razmik Kajberuni is an accounting student. They can be reached at earl.weiss@csun.edu, kiren.dosanjh.zucker@csun.edu and razmik.kajberuni.442@my.csun.edu.
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Title Annotation:liabilityprotection
Author:BY EARL WEISS, KIREN DOSANJH ZUCKER AND RAZMIK KAJBERUNI
Publication:California CPA
Geographic Code:1U9CA
Date:Jan 1, 2014
Words:1206
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