15 N.Y.3d 446 (2010)

Under New York law, the doctrine of in pari delicto prevents a corporation from recovering against a third party for damages resulting from the corporation’s own wrongdoing, unless the adverse interest exception applies, requiring that the agent has totally abandoned the corporation’s interests, acting entirely for their own purposes.

Summary

In the wake of the Refco and AIG scandals, the Court of Appeals addressed whether corporations could sue their auditors for failing to detect internal fraud. The court reaffirmed the in pari delicto doctrine, which prevents wrongdoers from seeking relief in court. The court explained imputation, where an agent’s actions are attributed to the principal, and the adverse interest exception, where the agent acts entirely against the principal’s interest. The court held that absent total abandonment by the agent to the principal’s interest, the corporation is barred from suing third parties for wrongs that the corporation itself participated in, furthering the policy that corporations should monitor their agents.

Facts

Refco, a brokerage firm, collapsed after revealing fraudulent loans orchestrated by its CEO, which had hidden massive debt. A Litigation Trust was created to pursue claims on behalf of Refco’s creditors. AIG was found to have defrauded investors into thinking they were more secure and prosperous than they really were.

The Litigation Trustee sued Refco’s executives, investment banks, law firms, accounting firms, and customers, alleging they aided and abetted the fraud or were negligent in not discovering it. Shareholders of AIG brought a derivative action accusing AIG officers of misstating AIG’s financial performance.

Procedural History

The District Court dismissed the Litigation Trustee’s claims, citing the Second Circuit’s Wagoner rule, finding the trustee lacked standing due to Refco’s participation in the fraud and that the adverse interest exception didn’t apply. The Delaware Court of Chancery dismissed the AIG derivative action on similar grounds. The Second Circuit and the Delaware Supreme Court certified questions to the New York Court of Appeals regarding the scope of the adverse interest exception and the applicability of in pari delicto.

Issue(s)

1. Whether the adverse interest exception to imputation is satisfied by showing that the insiders intended to benefit themselves by their misconduct?

2. Whether the adverse interest exception is available only where the insiders’ misconduct has harmed the corporation?

3. 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?

Holding

1. No, because the agent must totally abandon the principal’s interest and act entirely for their own purposes.

2. Yes, because the fraud must be committed against the corporation, not on its behalf.

3. Yes, because in pari delicto applies when a corporation, through its agents, is equally culpable with the defendant.

Court’s Reasoning

The court reasoned that the in pari delicto doctrine prevents courts from resolving disputes between wrongdoers. Agency principles dictate that an agent’s actions are imputed to the principal. The adverse interest exception is narrow and applies only when the agent has “totally abandoned” the principal’s interest. The court rejected the argument that intent alone is sufficient; the fraud must be against the corporation, not merely for its benefit. The court emphasized that principals are best suited to monitor their agents and that any harm from the discovery of the fraud does not bear on whether the adverse interest exception applies.

The court stated, “To come within the exception, the agent must have totally abandoned his principal’s interests and be acting entirely for his own or another’s purposes. It cannot be invoked merely because he has a conflict of interest or because he is not acting primarily for his principal”.

The court declined to broaden the adverse interest exception, noting the potential for a double standard where stakeholders of corporations are absolved while stakeholders of third-party professionals are held responsible. The court was not convinced that expanding remedies would meaningfully deter professional misconduct and found that existing legal and regulatory frameworks already provide disincentives. The court concluded that maintaining stability in the law outweighed the speculative benefits of altering precedent.