Kevin Schlosser Authors, "First Department Analyzes Adverse Interest Exception to In Pari Delicto Defense"

When corporate entities act, they do so only through individuals – namely the employees, officers and directors. So when a corporate entity is involved in fraudulent conduct, it is the individuals who perpetrate that fraud on behalf of the corporate entity. Legal consequences flow from these basic concepts. For one, officers, directors and employees who carry out a fraud on behalf of a corporation are personally liable (in addition to the corporate entity itself) for any monetary harm the fraud causes others to sustain. See my post. On the other hand, a corporate entity that has committed fraud is generally not permitted to sue those who participated in the fraud on behalf of that corporate entity or those who allowed it to happen. Courts reason that since the corporate entity can only act through individuals, the fraud of the corporate entity is in effect that which the individuals committed on its behalf. Thus, the corporate wrongdoer cannot sue equal wrongdoers who perpetrated the fraud on behalf of the corporate entity. This doctrine prohibiting a corporate entity from suing those who participate in a fraud on its behalf is known as in pari delicto. The full name of this Latin phrase is in pari delicto potior est conditio defendentis, meaning: “In a case of equal or mutual fault, the position of the [defending party] is the better one.” Kirschner v KPMG LLP, 15 N.Y.3d 446, 464 n. 4 (2010), quoting Baena v KPMG LLP, 453 F3d 1, 5 (1st Cir 2006). In my prior post, I explained this doctrine and the leading Court of Appeals case that discussed it in depth. Adverse Interest Exception The context in which the in pari delicto defense arises most often is when a trustee (a liquidating trustee or trustee in bankruptcy for example) or shareholder (in a derivative action) seeks to assert claims on behalf of the corporation against those who were supposed to prevent the fraud from occurring or for uncovering it to avoid loss, such as outside auditors or accountants. An exception to the defense arises when the individuals who committed the fraud allegedly in their corporate capacities were in fact acting solely in their own interests and not in the interest of the corporation. In that context, the individuals are deemed to have acted only on their own behalf and not for the corporate entity because they were acting solely to benefit themselves in committing the fraud. New First Department Case A new decision of the Appellate Division, First Department explores the contours of this “adverse interest” exception in affirming the lower court’s decision denying the defendants’ motion for summary judgment attempting to defeat the exception. In Conway v Marcum & Kliegman LLP, 2019 NY Slip Op 07338 (1^st Dep’t Decided October 10, 2019), plaintiffs were the liquidators of several hedge funds and sued the hedge funds’ auditors for accounting malpractice, alleging that the defendants failed to uncover fraudulent activity by the funds’ investment managers. A prior motion to dismiss the case based upon this defense was denied and upheld on a prior appeal. The Court framed the issue on this appeal as follows:

The issue before us is whether the adverse interest exception to the equitable defense of in pari delicto bars the defense in this case (see Kirschner v KPMG LLP, 15 NY3d 446 [2010]). We find 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, that preclude summary dismissal of the complaint on the ground of the in pari delicto defense.

The Court found issues of fact existed as to whether the funds’ managers were acting solely in their own behalf (for which the exception to the defense would apply) or for the benefit of the funds (for which the in pari delicto defense would bar the claim) when committing the wrongful fraudulent acts. In describing the adverse interest exception, the Court noted:

“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” (id. at 466 [internal quotation marks omitted]). The exception is applied only where the fraud is committed “against a corporation rather than on its behalf” (id. at 467). “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” (id. at 468). Thus, we conclude that the mere continuation of a corporate entity does not per se constitute a benefit that precludes application of the adverse interest exception.

Applying the legal concepts to the facts, the Court observed:

[R]eliance 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.

The other purported “benefits” cited by defendants are also insufficient to show that the adverse interest exception is inapplicable, as there exist factual questions as to whether the funds were beneficiaries, rather than victims, of the investment managers’ fraud (see e.g. Whitney [*2]Group, LLC v Hunt-Scanlon Corp., 106 AD3d 671 [1st Dept 2013] [reversing the grant of summary judgment to a defendant where issue of fact existed whether an alleged benefit to the plaintiff was actually a benefit at all]). Further, any purported benefit flowing to plaintiffs must be tied to “wrongful” conduct by defendants (Allied Irish Banks, P.L.C. v Citibank, N.A., 2015 WL 4104703, *9, 2015 US Dist LEXIS 88221, *29 [SD NY, June 30, 2015]).

Commentary Courts endeavor to avoid rewarding wrongful or fraudulent conduct by closing the courthouse doors to wrongdoers seeking legal redress through the justice system. Thus, a corporate wrongdoer, acting through individuals perpetrating a fraud on its behalf, cannot sue those individual wrongdoers. This is the essence of the in pari delicto defense. When the individuals have committed the fraud solely to benefit themselves, acting adversely to the corporate entity, however, the defense does not apply to bar the claim on behalf of the corporate entity. The “wrong” in such circumstances is considered that of the individuals and not the corporate entity. Click here for Kevin Schlosser's blog.