November 3, 2010

New York Court of Appeals clarifies critical issues in the context of suits by companies against their auditors for failing to prevent management fraud. 

In a recent decision shaped by an amicus brief Willkie submitted on behalf of the AICPA and the NYSSCPA, the New York Court of Appeals has clarified the scope of  the imputation doctrine, the in pari delicto defense, and the "adverse interest" exception in the context of suits by companies against their auditors for failing to prevent management fraud.  The result is a major victory for accounting professionals. 

The decision came on questions certified by two different courts – the Second Circuit in Kirschner v. KPMG LLP, 590 F.3d 186 (2d Cir. 2009), cert. granted, 2010 WL 152134, 2010 N.Y. Slip Op. 00364 (N.Y. Jan. 19, 2010) ("Refco"), and the Supreme Court of Delaware in Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP, 14 N.Y.3d 796, 925 N.E.2d 930, 899 N.Y.S.2d 127 (N.Y. Mar 30, 2010) ("AIG").  Both the Refco Trustee and the AIG shareholder plaintiffs argued that the misconduct of those companies’ respective managers should not be imputed to their companies because the managers had sought to benefit themselves through increased compensation or inflated stock value, and therefore were acting adversely to their employers.  Both plaintiffs also asked the Court to limit the scope of the imputation doctrine based on the nature of the defendant’s alleged conduct, as certain other courts have done.   

In a 4-3 decision, the Court of Appeals rejected those arguments.  Instead, the Court held that to avoid imputation to the company, the managers  must have "totally abandon[ed]" the company's interest.  The Court also clarified that the focus of the inquiry should be the impact of the fraud on the company and not the subjective intent of the managers. Moreover, it does not matter if the managers intended to benefit themselves through increased compensation or stock value, or if the company suffered long-term harm (even bankruptcy) when the fraud was discovered – as long as the company benefited from the fraud in any way (such as by a short-term increase in stock price), the managers' conduct will be imputed.  Finally, the Court broke with several other high courts in holding that in pari delicto is a complete bar to recovery regardless of whether the auditors are alleged to have colluded with management or merely to have acted negligently. 

Willkie’s amicus participation in this case continues the firm's decades-long involvement in virtually all significant accounting issues addressed by the courts.  The matter was handled by partner Kelly Hnatt and associate Derek Schoenmann.