Litigation in the wake of corporate frauds is keeping the in pari delicto defense in the news - and its critics apoplectic. The in pari delicto defense bars a corporation whose management committed fraud from suing third parties to cover its losses. Those third parties usually are, of course, the company's auditors, lawyers, and bankers. Most recently, the defense prevented the trustee in the Madoff matter from suing JP Morgan and other big banks that provided services to Madoff's company but did not detect his fraud. And this issue is not going away: Likely current tests for the defense include the various lawsuits over the collapses of MF Global and Colonial Bank, two financial institutions that failed amidst allegations of management wrongdoing.
Critics complain that this defense is unfair to investors. They want to abolish it in cases of management fraud. But the critics should not expect to succeed, and here is why: Their complaint is not about fairness at all; it is, rather, an effort to advance the familiar goal of loss-spreading through litigation. And the legal system already decided, decades ago, that this loss-spreading rationale does not work for economic-damages claims against professionals. Recalling this history can be helpful to defendants who want to assert the in pari delicto defense in future lawsuits.
Fairness and Innocence
The defense is controversial in management-fraud cases because it prevents corporations from suing to cover losses that, while caused by management, are borne by shareholders. This punishes shareholders unfairly, critics say, because those shareholders are personally "innocent" of management's fraud. Nor are the shareholders vicariously responsible for management's actions, critics add, because we cannot realistically expect shareholders in a modern corporation to keep tabs on - to "monitor" - management.
In fact, according to these critics, it is precisely because shareholders cannot monitor management that they hire professionals to act as gatekeepers. Also according to the critics, these gatekeepers owe a duty to the entire public, not only to the corporation that hired them. So it is only fair, the argument goes, for the professionals to cover the shareholders' losses if company management commits a fraud.
To get this done, critics would virtually abolish imputation in corporate settings. Imputation is an agency rule that attributes the conduct of corporate employees to their corporation. Although it is impossible - literally - to conceive of a corporation without imputation, the critics would effectively scrap this venerable rule. In its place, they would give the shareholders (through their litigation representative) the option to accept or reject the effect of corporate employees' conduct. This shift rests on a critical change in the basis of the claims against the professionals: from a grounding in the rights of the corporation to a grounding in the rights of the individual shareholders. And the rights of the shareholders now would rest, not on their collective interest in the corporation, but directly on their individual personal conduct.
Making the professionals pay these shareholder not only would be fair, the critics say, but would have a healthy deterrent effect. And this same deterrence rationale does not apply to the failed-company shareholders because, as we have seen, the critics' theory holds that we cannot expect shareholders to monitor management.
Not Fairness, But Loss-Spreading
This contrast between investors and gatekeepers brings us to the mismatch at the center of the critics' argument: The critics compare the shareholders who own the failed company to the employees who work for the defendant company. This comparison misses the point of the critics' argument, which is to justify shifting losses from one shareholder group to another.
Because that is the point of the exercise, the right comparison is between the two possible choices to bear the loss: the shareholders of the failed company and the shareholders of the professional firm. The New York Court of Appeals explained this in Kirschner v. KPMG LLP, an influential 2010 decision that preserved the in pari delicto defense in New York. The Kirschner court pointed out that the "owners and creditors of" professional firms retained by the failed company "may be said to be at least as 'innocent' as" those of the company whose management committed the fraud. For that reason, the court asked, "Why should the interests of innocent stakeholders of corporate fraudsters trump those of innocent stakeholders of the outside professionals who are the defendants in those cases?"
So the criticism of in pari delicto cannot be explained by fairness. Or by deterrence, either, since by the critics' own theory, the separation of ownership from control absolves shareholders of responsibility for misconduct by company employees. This leaves only one possible reason for the critics' attack on the in pari delicto defense: spreading losses to additional loss-bearers.
This is the old "enterprise liability" theory, the belief that tort law should help injured individuals by shifting their losses to big companies. Law professors developed this theory to help victims who suffered physical injuries sue deep-pocket manufacturers. To that end, the theory knocked down traditional barriers to suits against third parties. This loss-spreading philosophy drove much of the liability revolution of the last century.
Now, critics of in pari delicto would apply enterprise liability to help shareholders who lose their money because of management fraud. These critics would fully embrace enterprise-liability's methods - in particular, by discarding rules that are fairly clear in advance and replacing them with outcomes chosen to spread losses after an accident occurs. They would, in short, replace legal rules with social policy. Thus the critics' replacement of the imputation rule, which empowers parties to divvy up responsibility in advance, with a kind of "put-option," which can be exercised after we know there has been a loss. This put-option would permit the shareholders' representative to disavow specific actions of the corporation's employees - and do so selectively, with the benefit of hindsight.
History: Enterprise Liability
So far, the critics' arguments for abolishing in pari delicto have not succeeded. States have refused to change their imputation laws (with limited exceptions), and a U.S. Senate bill that would have made this change through the Bankruptcy Code could not even get a vote in committee.
This futility should be no surprise. Investors already tried enterprise-liability arguments, back when they wanted to expand the circle of third-party professionals that could be the target of direct claims. Those arguments failed.
Here is the back story. It was in the 1950s and 1960s that courts began to apply enterprise-liability arguments to impose liability on third parties in physical-injury cases - involving car crashes, workplace accidents, and defective products. Investors saw these successes and argued that this theory should make the jump from physical injuries and physical products to economic losses and professional services.
The archetypal plaintiff was an investor who had lost money after buying stock based on audited financial statements that were wrong. The investor was looking for a solvent third party and, most often, wanted to sue the accounting firm that had audited the financial statements. The question was the nature of the connection that the investor must have with the professional firm to have the right to sue. Until the late 1960s, investors could sue only if they had a contract with the professional firm or else a similar link of "near privity." In the 1970s and early 1980s, some states relaxed this requirement, though they still required something like near privity to sue.
For a while, three or four states went further - though even that expansion still required some direct connection with the professional, in the form of personal reliance on the professional's statement. Those states extended third-party liability for direct claims to the widest scope it ever reached: to investors who the professionals should foresee would actually rely on audited financial statements.
The high-water mark was a 1983 decision by the New Jersey Supreme Court, H. Rosenblum Inc. v. Adler, which applied enterprise liability with the zeal of a convert. The court equated financial statements to a consumer product that had physically injured its user; it explained that the loss could be "more easily distributed and fairly spread by imposing it on the accounting profession;" and it asserted that the defendant firm could "pass the cost of insuring against the risk onto its customers, who in turn could pass the cost onto the entire consuming public." The court even said that requiring the accounting firm to pay damages "would shift the loss" from "innocent" investors and creditors to the "one responsible for the loss."
Despite - or because of - the court's revolutionary fervor, Rosenblum was a bridge too far for professional liability. The legislature reversed the decision and returned New Jersey to a near-privity standard. More broadly, by the early 1990s what had looked like a trend of expanding liability came to a halt.
Forecast: Bleak for Enterprise Liability, Bright for In Pari Delicto
Yet Rosenblum is the model for today's critics of in pari delicto. Just as Rosenblum scrapped the near-privity requirement because it stood in the way of loss-spreading, today's critics of in pari delicto would eliminate imputation and ignore the corporate form because they stand in the way of that same loss-spreading goal.
It is unlikely that this argument can succeed. Critics of in pari delicto would extend the enterprise-liability theory further than even Rosenblum did: Today's critics would justify claims brought for the benefit of individuals who had not personally relied on the professional firm but, instead, owned shares in a corporation that had retained it.
Critics of in pari delicto have struggled to ground this change in traditional agency law, but they have identified nothing in that body of law that waives the imputation rule for the purpose of spreading losses. Nor have they found any comfort in corporations law, because nothing there recognizes loss-spreading as an excuse to ignore the corporate form.
Also like earlier advocates of enterprise liability, recent critics of in pari delicto have not explained why the loss-spreading rationale makes sense in economic-loss cases to begin with: why professional firms would be good at spreading investor losses to the wider economy; why professional firms would be good insurers of investors who range from widows to hedge funds; and maybe most of all, why loss-spreading justifies requiring "innocent" shareholders of one company to bear losses caused by the managers of an entirely different business.
Effective defense advocates should press the critics of in pari delicto to answer these questions. First, though, defense counsel should explain that the critics' attacks on the in pari delicto defense are about loss-spreading, not fairness.
By Andrew J. Morris, Morvillo LLP
Andrew Morris is a partner in Morvillo's Washington, D.C., office. He is a former federal prosecutor and served in the U.S. Department of Justice's Office of Professional Responsibility.
This article was originally published by Securities Law 360 on September 11, 2013.
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