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In Pari Delicto, the Adverse Interest Exception and the Alleged Failure to Uncover Fraudulent Activity

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  • Posted on: Oct 14 2019

In Pari Delicto, the Adverse Interest Exception and the Alleged Failure to Uncover Fraudulent Activity

The doctrine of in pari delicto has been a part of the common law for at least two centuries. Kirschner v. KPMG LLP, 15 N.Y.3d 446 (2010), citing  Woodworth v. Janes, 2 Johns Cas 417, 423 (N.Y. 1800) (parties in equal fault have no rights in equity); Sebring v. Rathbun, 1 Johns Cas 331, 332 (N.Y. 1800) (where both parties are equally culpable, courts will not “interpose in favour of either”). It requires the court to refrain from resolving a dispute between two wrongdoers.

As the Court of Appeals explained more than 70 years ago:

[N]o court should be required to serve as paymaster of the wages of crime, or referee between thieves. Therefore, the law will not extend its aid to either of the parties or listen to their complaints against each other, but will leave them where their own acts have placed them.

Stone v. Freeman, 298 N.Y. 268, 271 (1948) (internal quotation marks omitted).

The doctrine (i.e., that a wrongdoer should not profit from his own misconduct) “is so strong in New York” that the Court of Appeals has held that it “applies even in difficult cases and should not be ‘weakened by exceptions.’” Kirschner, 15 N.Y.3d at 464, quoting McConnell v. Commonwealth Pictures Corp., 7 N.Y.2d 465, 470 (1960); see also Saratoga County Bank v. King, 44 N.Y. 87, 94 (1870) (characterizing the doctrine as “inflexible”).

Agency Law and the Principle of Imputation

“Traditional agency principles play an important role in an in pari delicto analysis.” Kirschner, 15 N.Y.3d at 465. In this regard, “of particular importance” is the principle of imputation – that is, “the acts of agents, and the knowledge they acquire while acting within the scope of their authority are presumptively imputed to their principals.” Id. (citations omitted). Thus, the law “presumes imputation even where the agent acts less than admirably, exhibits poor business judgment, or commits fraud.” Id. (citation omitted).

The foregoing applies equally to corporations. Corporations act through their officers or other duly authorized agents. Id. (citation omitted). Thus, although corporations are not natural persons, they are, nonetheless, responsible for the acts of their authorized agents even if the acts were unauthorized. Id. (citation omitted). As the Court of Appeals “explained long ago, a corporation [like a natural person] ‘is represented by its officers and agents, and their fraud in the course of the corporate dealings[ ] is in law the fraud of the corporation.’” Id., quoting Cragie v. Hadley, 99 N.Y. 131, 134 (1885). See also Wight v. BankAmerica Corp., 219 F.3d 79, 86-87 (2d Cir. 2000) (under “fundamental principle(s) of agency,” managers’ misconduct within the scope of their employment is imputed and “bars a trustee from suing to recover for a wrong that he himself essentially took part in”).

Likewise, “[w]hen corporate officers carry out the everyday activities central to any company’s operation and well-being—such as issuing financial statements, accessing capital markets, handling customer accounts, moving assets between corporate entities, and entering into contracts—their conduct falls within the scope of their corporate authority.” Kirschner, 15 N.Y.3d at 465-66 (citation omitted). “And where conduct falls within the scope of the agents’ authority, everything they know or do is imputed to their principals.” Id. at 466.

In every case, the law presumes that agents “communicate information to their principals.” Id. This is so “except where the corporation is actually the agent’s intended victim.” Id., quoting Center v. Hampton Affiliates, 66 N.Y.2d 782, 784 (1985) (“when an agent is engaged in a scheme to defraud his principal . . . he cannot be presumed to have disclosed that which would expose and defeat his fraudulent purpose”). However, “[w]here the agent is defrauding someone else on the corporation’s behalf, the presumption of full communication remains in full force and effect. Id. (citations omitted).

Adverse Interest Exception to Imputation

As with most rules, there are exceptions. With the in pari delicto doctrine, the Court of Appeals has recognized “adverse interest” to be an exception to the rule. “‘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.” Kirschner, 15 N.Y.3d at 466, quoting Center, 66 N.Y.2d at 784-785 (emphasis added). The exception “avoids ambiguity where there is a benefit to both the insider and the corporation, and reserves this most narrow of exceptions for those cases—outright theft or looting or embezzlement—where the insider’s misconduct benefits only himself or a third party; i.e., where the fraud is committed against a corporation rather than on its behalf.” Id. at 466-67. Thus, where “the agent is perpetrating a fraud that will benefit his principal,” as opposed to himself/herself (which is “adverse” to the principal), the exception will not apply. Id. at 467. In the context of fraud, therefore, the exception will not be invoked where the fraud benefits the corporation, because “[a] fraud that by its nature will benefit the corporation is not ‘adverse’ to the corporation’s interests.” Id. This is so “even if [the fraud] was actually motivated by the agent’s desire for personal gain.” Id. (citations omitted).

In Kirschner, the Court of Appeals underscored the point that the exception requires adversity:

Again, because the exception requires adversity, it cannot apply unless the scheme that benefitted the insider operated at the corporation’s expense. The crucial distinction is between conduct that defrauds the corporation and conduct that defrauds others for the corporation’s benefit. “Fraud on behalf of a corporation is not the same thing as fraud against it” (Cenco Inc. v Seidman & Seidman, 686 F2d 449, 456 [7th Cir 1982]), and when insiders defraud third parties for the corporation, the adverse interest exception is not pertinent. Thus, as we emphasized in Center, for the adverse interest exception to apply, the agent “must have totally abandoned his principal’s interests and be acting entirely for his own or another’s purposes,” not the corporation’s (Center, 66 NY2d at 784-785 [emphasis added]). So long as the corporate wrongdoer’s fraudulent conduct enables the business to survive—to attract investors and customers and raise funds for corporate purposes—this test is not met (Baena, 453 F3d at 7 [“A fraud by top management to overstate earnings, and so facilitate stock sales or acquisitions, is not in the long-term interest of the company; but, like price-fixing, it profits the company in the first instance”]).

Kirschner, 15 N.Y.3d at 467-68.

Notably, “any harm from the discovery of the fraud—rather than from the fraud itself—does not bear on whether the adverse interest exception applies.” Id. at 468.  The Court of Appeals reasoned that “[t]he disclosure of corporate fraud nearly always injures the corporation. If that harm could be taken into account, a corporation would be able to invoke the adverse interest exception and disclaim virtually every corporate fraud—even a fraud undertaken for the corporation’s benefit—as soon as it was discovered and no longer helping the company.” Id. at 468.

The foregoing principles were recently considered by the Appellate Division, First Department in Conway v. Marcum & Kliegman LLP, 2019 N.Y. Slip Op. 07338 (1st Oct. 10, 2019) (here). There, the Court held that issues of fact surrounding application of the adverse interest exception precluded dismissal of the action on summary judgment grounds.

Conway involved an accounting malpractice action in which the plaintiffs, the liquidators of several hedge funds, alleged that the defendants failed to uncover fraudulent activity by the funds’ investment managers. The issue before the Court was whether “the adverse interest exception to the equitable defense of in pari delicto bar[red] the defense in th[e] case.” Slip Op. at *1.

The motion court held that the exception did not apply and granted summary judgment to the defendants.  The First Department reversed, holding that “plaintiffs raised issues of fact as to the adverse nature of their interests vis-a-vis those of their agents, the funds’ investment managers,” sufficient to “preclude summary dismissal of the complaint on the ground of the in pari delicto defense.”

In the motion court, defendants argued, among other things, that the adverse interest exception did not apply because the fraudulent activities of the funds’ investment managers benefited the funds. Defendants maintained that their audits of the funds’ financial statements allowed the funds to remain a going concern much longer than if no audit was performed. According to defendants, the audits allowed the investment managers to restructure the funds, thereby allowing investors to move their investments into another fund and limit their ability to redeem their money. As such, the audits allowed the funds the opportunity to survive, even for a short period of time, which, defendants claimed, was a benefit that made the adverse interest exception inapplicable.

The First Department rejected this argument:

Moreover, reliance on speculation about the benefits to be derived from the continued existence of an entity is inconsistent with the analysis of the adverse interest exception in Kirschner. It may be possible in every case to construct a hypothetical scenario where the company teetering on the brink of insolvency because of its agent’s fraud meets with an opportune circumstance that allows it to resume legitimate business operations. Permitting such speculation would render the adverse interest exception meaningless. Further, an ongoing fraud and a continued corporate existence may harm a corporate entity: The agent may prolong the company’s legal existence so that he can continue to loot from it, as appears to have been the case here.

Slip Op. at *1.

The Court also found that “[t]he other purported ‘benefits’ cited by defendants [such as deferred incentive fees and reinvested management fees] [were] also insufficient to show that the adverse interest exception [was] inapplicable, [because] there [were] factual questions as to whether the funds were beneficiaries, rather than victims, of the investment managers’ fraud.” Id.

Takeaway

The in pari delicto doctrine serves two important public policy purposes. First, it deters illegal activity by denying judicial relief to an admitted wrongdoer. Second, it conserves judicial resources because it avoids entangling courts in disputes between wrongdoers. Kirschner, 15 N.Y.3d at 464. Notwithstanding, the doctrine will not bar an action when an agent totally abandons his/her principal’s interests and acts entirely for his/her own purposes or those of another (i.e., the agent’s acts are “totally” adverse to the principal). Id. at 466.

In Conway, Defendants were unable to persuade the Court that the investment managers acted solely for the funds’ benefit. As such, denial of summary judgment was deemed appropriate.

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