On June 22, 2006, the First Circuit decided Baena v. KPMG, Case No. 05-2868, affirming the district court’s holding that the in pari delicto defense barred a trustee from bringing an action against an accounting firm that failed to notify the Debtor’s corporate directors of accounting irregularities because the wrongful actions of the corporate officers were imputed to the Debtor as a whole.
From 1998 to 2000, the Debtor, a Belgium company, reported high revenue and profits. As a result, in early 2000, the Debtor acquired two U.S. companies, taking on $340 million in new debt. Based on investigations into soaring revenues, an audit conducted in late 2000 determined that revenues for the past two and a half years had been overstated by over a quarter of a billion dollars. The Debtor’s top officers and directors were aware of the false financial statements, which were inflated using accounting devices such as booking revenue in a lump sum rather than being amortized across several years and recording revenue from contracts the Debtor had not executed. The Debtor filed bankruptcy shortly after the fraud was discovered.
As part of the approved plan of liquidation, a litigation trustee was appointed to prosecute claims on behalf of the Debtor, which included an action against the Debtor’s former accountants, KPMG, for allowing patently improper accounting practices and not alerting independent directors of serious problems, which then allowed the Debtor to proceed with its two acquisitions. The trustee brought a claim against the KPMG for unfair or deceptive trade practices under Massachusetts law.
KPMG moved to dismiss the complaint arguing, inter alia, that the trustee’s claim was barred by the doctrine of in pari delicto because the fraud was one primarily committed by the Debtor’s management in misstating earnings. In pari delicto is a doctrine commonly asserted in tort actions to prevent wrongdoers from recovering against an accomplice. The trustee asserted that the claim was not barred by this doctrine because 1) there were applicable exceptions to in pari delicto, and 2) the application of in pari delicto undermined federal law and policy.
The First Circuit noted that, under Massachusetts law, the Debtor’s management would not be allowed to sue KPMG for assisting in the wrongdoing under the doctrine of in pari delicto. Accordingly, if management’s actions were imputed to the Debtor, then it too would be barred from recovery. The trustee admitted that the chairman of the board, CEO and managing directors were knowing parties to the false financial statements. However, the trustee argued that management’s actions should not be imputed to the debtor based on the adverse interest and innocent decision-maker exceptions to the in pari delicto doctrine.
The adverse interest exception states that imputation may be avoided where the manager’s wrongdoing is done primarily for personal benefit of the officer and is adverse to the company (e.g. officer looting of the company). The court held that this exception did not apply because the trustee did not allege any facts suggesting that the Debtor’s managers were acting out of self-interest. The court also rejected the trustee’s argument that the "innocent decision-maker" limitation barred imputation to the Debtor. The court acknowledged the rulings of trial courts in the Second Circuit that do not impute bad acts to the company when the independent directors of the company, if alerted, could have stopped the fraud. However, the First Circuit held that this exception was not applicable in Baena because Massachusetts authorities had not adopted such an exception.
The trustee also argued that in pari delicto should not be applied because such an application runs counter to reforms in federal securities law, which impose an independent federal responsibility on accounting firms to alert a company’s audit committee and independent directors to wrongdoing by management. The First Circuit found this argument unpersuasive. First, the trustee did not bringing a claim under federal law. Second, the court noted that federal law does not require Massachusetts to abolish or modify a state law defense, such as in pari delicto, to a state cause of action. Last, the trustee made no argument that relevant Massachusetts law was preempted by federal law.
The court noted that Massachusetts could adopt a policy regarding the duties of accounting firms, similar to that espoused in federal law, and proceed to limit the use of in pari delicto in cases such as in Baena. However, no authorities were cited suggesting that Massachusetts intended to adopt such a policy. The court finally commented that, as an equitable doctrine, one may argue that in pari delicto should not be applied where prior management of a debtor was at fault but the claim is asserted on behalf of creditors and shareholder. Again, because no Massachusetts law was cited in support of this argument, the court rejected such an argument, holding that any change in existing law should come from Massachusetts authorities.
In sum, because the wrongful actions of the Debtor’s management were imputed to the Debtor as a whole, the doctrine of in pari delicto barred the trustee’s action against the accounting firm. The First Circuit affirmed the district court’s dismissal of the case.
Written by: Theresa Wardle