One of the strongest legal weaponsavailable to audit firms sued byshareholders or creditors followingrevelations of corporate fraud is

the defense of in pari delicto. This legaldoctrine, over two centuries old, is ground-ed in the policy that a court should notintercede between two wrongdoers.Consider the following scenarios. Theseare taken from actual court cases, wherethe issue was whether an audit firm thatwas allegedly negligent in failing to detectfraud, or to detect it soon enough, or assist-ed the client in the fraud should be ableto bar a plaintiff from recovery becausethe corporation was at least equally at faultin the wrongdoing:■ The chief executive officer (CEO) ofa large U.S. commodities broker alleged-ly orchestrated a fraud to hide hundredsof millions of dollars of the company’suncollectible debt. Within two months ofan initial public offering, the company dis-closes the fraud and seeks Chapter 11bankruptcy protection. The trusteeacknowledges that company insiders mas-terminded the fraud, but files claims forfraud, breach of fiduciary duty, and mal-practice against several parties, includingits accounting firms. ■ The CEO and an inner circle of seniorofficers of a giant insurance companyallegedly orchestrated a variety of fraudu-lent acts, making the company look moreprofitable than it really was. After thefinancial deception is discovered, the stockprice plummets and shareholder valuedeclines by more than $3 billion.Shareholders file a lawsuit against the auditfirm to recover their losses, claiming thatthe firm was negligent in failing to detectthe fraud.

■ The CEO of a nonprofit corporationengaged in a strategy of aggressive acquisi-tions. When the strategy failed, high-levelofficers allegedly misstated the finances.Ultimately, the board discovers the dire

financial situation and files for bankruptcyprotection. A committee of unsecured cred-itors alleges that the auditor colluded withthe corporation’s officers to fraudulently mis-state the corporation’s finances and files

Shielding the Auditor from Corporate Fraud Liability

M A N A G E M E N T

a c c o u n t a n t ’ s l i a b i l i t y

APRIL 2012 / THE CPA JOURNAL58

By Sandra S. Benson

Recent Decisions and Rationale for the in Pari Delicto Defense

suit against the audit firm for breach ofcontract, professional negligence, and aidingand abetting a breach of fiduciary duty.■ A bank engaged in a risky mortgagesecuritization strategy. The failure rate wasexcessive, and some management membersand others made bogus entries. An audit firmis called in after bank regulators discoverbookkeeping discrepancies. A clean auditopinion is issued when the bank is actuallygrossly insolvent. A few months later, thebank is closed and the Federal DepositInsurance Corporation (FDIC) files suit andobtains a judgment against the firm for morethan $23 million for the postaudit losses.

The in pari delicto doctrine is raised inall of these cases. This doctrine is of seri-ous importance to the profession, because,without the defense, an audit firm mightpotentially be held liable for the entire dropin market capitalization of its public com-pany audit clients. According to a U.S.Treasury report, the average public com-pany common stock capitalization in2007 was $3.842 billion, and the expo-sure to an excessive judgment “is unrelat-ed to the scope of any audit error or mis-conduct, and dramatically dwarfs auditfees” (U.S. Treasury Advisory Committeeon the Auditing Profession, Final Report,p. VII:27, October 6, 2008). The litigationconcern is not limited to firms that auditpublic companies. One indictment or largejudgment against a firm could possiblydestroy the entire firm, even if it is lateroverturned (U.S. Chamber of Commerce,“Auditing: A Profession at Risk,” January2006). Audit firms may feel pressured tosettle claims with little merit due to theselitigation risks.

The in pari delicto doctrine, togetherwith agency law, allows the fraudulentactions of corporate management to beimputed to the corporation if the acts ofthe corporate agents were not totallyadverse to the company and benefited thecorporation in some way. In the context ofauditing cases, this means that the corpo-ration cannot seek a remedy against theaudit firm even if the audit firm negligentlyfailed to detect the fraud. When the doc-trine is recognized by the court, the firmmay be dismissed from the lawsuit in theearly pleading stage. This defense may alsoextend to bar a third-party plaintiff, suchas a shareholder or bankruptcy trustee, whosues on behalf of the corporation. In its

pure form, the defense even applies if theauditor colluded in the fraud, as long as theplaintiff was at least equally at fault. Thepolicy justifications for this defense in theaudit context have been debated in thecourts in recent years.

Arguments in favor of the in pari delic-to defense for the auditing professioninclude, among others, that auditors shouldbe permitted to use it just as other individ-uals and professionals have done in com-mon law cases for over two centuries. If thedefense is not allowed, a client can shift itsprimary responsibility to prevent fraud to anoutside auditor, resulting in more expansiveaudits, higher audit fees, and the exclusionof services for high-risk clients in need ofquality auditors. Arguments opposing theuse of this defense include the notions thatinnocent victims of harm should be com-pensated and that legal liability deterswrongful conduct and motivates higher qual-ity audits. This, in turn, may instill confi-dence in investors as to the quality ofaudits—or, conversely, the lack of the abil-ity to sue may weaken investor confi-dence. This view might also stem from per-ceptions of auditors as “deep pocket”insurers with the duty to detect even thesmallest fraud (see Exhibit 1).

A 2010 New York Court of Appealsopinion addressed the scope and viabilityof the in pari delicto doctrine in cases stem-ming from the American InternationalGroup Inc. (AIG) and Refco frauds. Areview of the New York court’s opinionand its underlying policy rationale fol-lows below, as well as a comparison of theimplications of this decision to cases fromNew Jersey and Pennsylvania. Next, theremay be a potential surge of litigation apply-ing the in pari delicto defense to auditorsin cases that might develop from the fail-ure of over 380 banks in the last threeyears. Finally, continued advocacy of theimplications of litigation and the scope ofthe in pari delicto defense for the profes-sion is recommended.

A Potent Legal ShieldOn January 3, 2011, the Supreme Court of

Delaware affirmed the dismissal of the mal-practice and breach of contract claims againstPricewaterhouseCoopers in Teachers’Retirement System of Louisiana et al. v.PricewaterhouseCoopers LLP, 2011 WL13545. A few months earlier, on November

18, 2010, the U.S. Court of Appeals for theSecond Circuit affirmed the district court’sdismissal of a suit brought by the trustee ofa bankrupt corporation’s litigation trust againstKPMG (Kirschner v. KPMG LLP, 626 F.3d673 [2d Cir., 2010]). Both of these dismissalsagainst audit firms rested on an important rul-ing by the New York Court of Appeals thatclarified the scope of the in pari delictodoctrine under New York law (Kirschner v.KPMG LLP, 15 N.Y.3d 446, 938 N.E.2d 941[N.Y., 2010]). These cases and the subsequentrulings from the New York Court of Appealsare discussed below.

The AIG fraud. The Teachers’Retirement System of Louisiana and the Cityof New Orleans Retirement System filedshareholder derivative suits in Delaware torecover funds to make AIG whole, claimingAIG’s senior officers had orchestrated a vari-ety of fraudulent acts to make the corpora-tion appear more prosperous than it reallywas, resulting in the issuance of materiallymisleading financial statements. The mis-conduct was allegedly at the direction andunder the control of the chairman of the cor-poration’s board of directors, its CEO, andhis inner circle of senior officers. The largestalleged act of deception involved a fraudu-lent $500 million reinsurance transaction thathad no substance. Other activities allegedlyincluded avoiding taxes by falsely claimingthat workers’ compensation policies wereother types of insurance. After the financialmaneuverings were discovered, shareholderequity declined by $3.5 billion.

The plaintiffs did not allege fraud byits audit firm or that the firm conspired withAIG to commit accounting fraud. Theplaintiffs did, however, claim that the auditwas performed negligently, which resultedin failure to detect or report the fraud per-petrated by AIG’s senior officers. Thelower court (Court of Chancery inDelaware) held that the acts of the seniorofficers were imputed to the corporation.Thus, the corporation was in equal fault,and the audit firm’s defense of in pari delic-to stood, barring the derivative claims. Theplaintiffs appealed to the DelawareSupreme Court, which decided that a res-olution depended on significant andunsettled questions of New York law.The Delaware court then followed a spe-cial procedure to “certify” the question inMarch 2010 for resolution by the NewYork Court of Appeals.

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The Refco fraud. About three monthsearlier, in December 2009, the U.S. Courtof Appeals for the Second Circuit hadcertified a similar question involving thescope of the in pari delicto doctrine to theNew York Court of Appeals. TheKirschner matter involved Refco, previ-ously a provider of brokerage and clear-ing services in the derivatives, currency,and futures markets. In August 2005, Refcodisclosed that its president and CEO hadorchestrated a series of loans that hidhundreds of millions of dollars of the com-pany’s uncollectible debt. Refco filed forChapter 11 bankruptcy protection. Thebankruptcy trustee, Kirschner, filedclaims for fraud, breach of fiduciary duty,and malpractice against many parties,including several Refco senior managersand other owners, as well as Refco’s lawfirm, accounting firms, and several cus-tomers. The parties moved to dismiss theclaims. The trustee acknowledged that theRefco insiders masterminded Refco’s fraud.

The parties agreed that the Second Circuit’sdecision in Shearson Lehman Hutton Inc.v. Wagoner (944 F.2d 114, 118 [2d Cir.1991]) applied. Wagoner held that a trusteedoes not have legal standing to sue (theability to initiate a lawsuit) when the actsof the corporate wrongdoers are imputedto the corporation. Thus, the issuedepended on whether, under New Yorklaw, the acts of the Refco corporate insid-ers could be imputed to Refco. The lowercourt held that the acts could be imputedto Refco and dismissed the suit againstthe auditors. Upon dismissal, the plaintiffappealed to the Second Circuit, which, inturn, certified questions to the New YorkCourt of Appeals.

The N.Y. Court Ruling The New York Court of Appeals reviewed

the certified questions from both lawsuits andissued an opinion on October 21, 2010, thatwas of major significance to accounting firms.The court had essentially been asked by the

plaintiffs to reinterpret and broaden NewYork law to make remedies available to cred-itors or shareholders of a corporation whosemanagement was engaged in financial fraudand whose auditors, investment bankers,lawyers, financial advisors, or other advisorseither allegedly assisted with the fraud ordid not detect the fraud (Kirschner, 2010).The AICPA and the NYSSCPA jointlyfiled a brief of amici curiae (friends of thecourt) discussing the implications if the courteviscerated the defense of in pari delicto inclaims by or on behalf of companies whosesenior managers engaged in fraud. The amicibrief argued that eliminating the doctrinewould expand auditor liability disproportion-ately to the auditor’s ability to detect and pre-vent fraud (p. 1). The brief also argued thatbecause litigation is so expensive, a firmmight have to settle claims with little merit,resulting in higher audit fees. This couldalso take away a key incentive for compa-nies to police their own managers (p. 24).Furthermore, accountants may be more selec-

For several decades, the accounting profession and scholars have discussed a gap between what society expects of audi-

tors and what auditors can reasonably be expected to achieve in audits. The accounting profession has worked diligently to

educate the public and to set clearer performance standards to narrow this gap. Two earlier studies that indicated the exis-

tence of an expectation gap in the U.S. legal system may still apply in some instances today.

EXHIBIT 1Perceptions of Judges and Jurors

Surveys of 100 auditors at a CPE seminar and 100

prospective jurors at a municipal county courthouse in a

study by Kimberly E. Frank, D. Jordan Lowe, and

James K. Smith revealed that jurors—

■ perceived the auditor’s role as public watchdog,

■ expected the auditor to search for the smallest fraud,

■ held auditors more responsible for financial statements

than the auditors themselves, and

■ moderately agreed with the auditor in the role of the insurer.

Source: “The Expectation Gap: Perceptual Differences

Between Auditors, Jurors, and Students,”

Managerial Auditing Journal, vol. 16, no. 3, 2001, pp. 145–149

A study by D. Jordan Lowe surveying 71 state and federal

judges and 78 auditors showed a divergence in perceptions

between judges and auditors in the following ways:

■ Judges were not clear whether management or auditors

were primarily responsible for the financial statements.

■ Judges moderately agreed with the assertions that the

auditors’ role is as a public watchdog, to the extent that they

should search for even the smallest fraud.

Source: “The Expectation Gap in the Legal System:

Perception Differences Between Auditors and Judges,”

Journal of Applied Business Research, vol. 10, no. 3, 1994,

pp. 39–44

APRIL 2012 / THE CPA JOURNAL 61

tive about clients, affecting the clients in great-est need of quality auditors (p. 27). The amicibrief argued the following three mainpoints:■ The defense should be based solelyon the conduct of the wrongdoing insid-ers and not on the state of mind of the audi-tor-defendants.■ The exception to the doctrine, based onadverse interest of the insiders, should applyonly when the agent has “totally abandoned”the interests of the corporation.■ The doctrine should not be replaced bycomparative negligence.

The New York Court of Appeals wasapparently persuaded by the position of thedefendants and their amici brief and agreedwith all three points. The court explainedthat the doctrine of in pari delicto has beenpart of the common law for over twocenturies and requires courts not to inter-cede to resolve a dispute between twowrongdoers. The court asserted that thisdoctrine serves the following importantpublic policy purposes: ■ It deters illegality by denying relief toan admitted wrongdoer.■ It avoids involving the courts in disputes between wrongdoers (Kirschner, p. 950).

Adverse interest exception. Agency prin-ciples are involved because a corporationacts through its officers and employees, andthe acts of agents within the scope oftheir authority are presumed to be imput-ed to their principals. This includes actionsthat are unauthorized, actions where theagent shows poor judgment, or evenactions where the agent commits fraud(Kirschner, pp. 950–951). Actions withinthe scope of the agent’s authority includeeveryday activities central to the compa-ny’s operations, such as issuing financialstatements, moving assets between corpo-rate entities, and entering into contracts.

But there is an exception to imputing theacts of an agent to the company. The court,quoting from an earlier case, explained thisadverse interest exception: “To come within the exception, the agent must havetotally abandoned his principal's interests andbe acting entirely for his own or another’spurposes” (Kirschner, p. 952). This narrowexception can be applied to cases where theinsider’s misconduct benefits only himselfor a third party and is committed againstthe corporation, such as embezzlement or

outright theft. Conduct that defrauds othersfor the benefit of the corporation would notfall within this exception, even if the fraudis ultimately revealed and later harms thecorporation. Although the trustee inKirschner tried to claim that bankruptcy clas-sifies as a harm that should trigger theadverse interest exception, the court said thiswas not relevant (p. 953).

The plaintiffs wanted the New York Courtof Appeals to broaden the exception as amatter of public policy to “recompense theinnocent and make outside professionals(especially accountants) responsible for theirnegligence and misconduct in cases of cor-porate fraud” (Kirschner, p. 954). Theyclaimed this would benefit blameless unse-cured creditors (as in the case of Refco)and shareholders (as in the case of AIG) atthe expense of defendants who allegedlyassisted the fraud or were negligent; how-ever, the court did not find the argumentcompelling and said the equities were notquite that clear. The court asked:

In particular, why should the interests ofinnocent stakeholders of corporate fraud-sters trump those of innocent stakehold-ers of the outside professionals who arethe defendants in these cases? The costsof litigation and any settlements or judg-ments would have to be borne, in the firstinstance, by the defendants’ blamelessstakeholders; in the second instance, bythe public. … In a sense, plaintiffs’ pro-posals may be viewed as creating a dou-ble standard whereby the innocent stake-holders of the corporation’s outside pro-fessionals are held responsible for the sinsof their errant agents while the innocentstakeholders of the corporation itself arenot charged with knowledge of theirwrongdoing agents. And, of course, thecorporation’s agents would almost invari-ably play the dominant role in the fraudand therefore would be more culpablethan the outside professional’s agents whoallegedly aided and abetted the insiders ordid not detect the fraud at all or soonenough. The owners and creditors ofKPMG and PwC may be said to be atleast as “innocent” as Refco's unsecuredcreditors and AIG’s stockholders.(Kirschner, p. 958). Thus, the New York Court of Appeals

refused to broaden the adverse interest excep-tion, keeping the in pari delicto doctrinestrong and viable in the context of auditing

cases. The court also refused to adopt thetrustee Kirschner’s suggestion to utilize com-parative fault rather than allow the in paridelicto defense to be a total bar to recovery,as New Jersey has done. Following this opin-ion, on November 18, 2010, the U.S. Courtof Appeals for the Second Circuit affirmedthe district court’s dismissal of the trustee’ssuit against KPMG and others. Likewise, theDelaware Supreme Court affirmed the dis-missal of the claims against Pricewater-houseCoopers on January 3, 2011. (TheDelaware court also refused to applyDelaware law, which the plaintiffs believedwould have provided a different result.)

Implications for the ProfessionThis lawsuit represents a big victory

for firms whose claims are or will begoverned by New York law because theNew York Court of Appeals refused tobroaden the “adverse interest” exception tothe in pari delicto defense. If the courthad broadened the exception, as argued bythe plaintiffs, then the misconduct of a cor-poration’s officers would not be imputedto the corporation, and any advisors whowere professionally negligent in failing todiscover the fraud could be held liable. Theway the New York Court of Appealsframed the question was advantageous tothe outside advisor: “why should the inter-ests of innocent stakeholders of corporatefraudsters trump those of innocent stake-holders of the outside professionals whoare the defendants in these cases?”(Kirschner, p. 958).

But other states and courts interpretingfederal laws have developed differing inter-pretations of the in pari delicto defense.Courts in New Jersey and Pennsylvaniain the Third Circuit have considered thestate of mind of the defendant-auditor.For example, the Pennsylvania SupremeCourt considered a case involving a failedacquisition strategy of a nonprofit health-care services company. The company’sCEO had engaged in a program ofaggressive acquisitions in order to build an“integrated delivery system” of physicianpractices, medical schools, and hospitals,but the strategy failed. A group of high-level officers allegedly misstated the cor-poration’s finances in figures provided totheir independent audit firm in order toconceal the dire financial situation. Thecommittee of unsecured creditors alleged

APRIL 2012 / THE CPA JOURNAL62

that the auditor colluded with the officers.The board claimed that they did not inter-vene to stop the CEO from continuedacquisitions, based on the issuance of“clean” audit opinions. Following the fil-ing of a Chapter 11 bankruptcy petition,the audit firm was sued for breach of con-

tract, professional negligence, and aidingand abetting a breach of fiduciary duty. Inruling on the issue of the in pari delictodefense, the court asserted that a negli-gent auditor could assert the defense, butnot an auditor who secretly colluded withthe principal.

The New Jersey Supreme Court wentfurther in crafting an exception that pre-vents auditors from utilizing the defenseagainst innocent shareholders. The auditormay now only raise the defense in NewJersey against shareholders who wereengaged in the fraud, should have been

Case Potential Implications for the Audit Profession

New Jersey: NCP Litigation Trust v. ■ The New Jersey Supreme Court singled out auditors when it crafted an auditor- KPMG LLP, 187 N.J. 353 (2006) exception, barring the auditor from asserting the in pari delicto defense, regardless of

whether the auditor was negligent or in collusion with the client.■ The audit firm cannot shield its liability by asserting the in pari delicto defenseagainst innocent shareholders. ■ An auditor may assert the defense against those shareholders who engage in thefraud, should have been aware of it, or who owned large blocks of stock and thereforehad some ability to oversee the company’s operations. ■ The relative fault will be sorted out as matters of comparative negligence, resultingin more expensive litigation. This could result in the need for more expanded audits,higher audit fees, or a “megaclaim.” ■ The Third Circuit later followed this case ruling when applying the auditor-exception(Thabault v. Chait, 541 F.3d 512 [3d Cir. 2008]).■ The impact could potentially be increased litigation expenses and settlement ofclaims that have little merit.

Pennsylvania: Official Committee of ■ Imputation is not available for an auditor who did not deal materially in good faith Unsecured Creditors of Allegheny with the client-principal. Thus, if the auditor secretly colludes with officers to misstate Health, Education and Research the financial statements, the firm cannot get the benefit of the in pari delicto defense.Foundation v. Pricewaterhouse- ■ The auditor can assert the defense in the case of negligence but the adverse Coopers, LLP, 605 Pa. 269 (2010) interest exception will be broadly applied (meaning the auditor will not get the

advantage of this defense if the corporation’s agent’s acts are not imputed to the corporation).■ Thus, the auditor’s state of mind becomes a factor in applying this defense. ■ A savvy plaintiff can allege that the accountant did not act in good faith and theauditor will not get the claim dismissed at the early pleading stage. This can result inmore expensive and prolonged litigation and pressure to settle.

New York: Kirschner v. KPMG LLP, ■ Auditors, even collusive ones, can successfully assert the defense of in pari delicto15 N.Y.3d 446, 938 N.E.2d 941 (2010) at the pleading stage to be dismissed from a suit, as long as the insiders’ acts had

some benefit to the company (i.e., the insiders did not totally abandon the company’sinterests and acted within the course of their employment). ■ The court stated that the presumption of imputation “reflects the recognition thatprincipals, rather than third parties, are best-suited to police their chosen agents andto make sure they do not take actions that ultimately do more harm than good”(Kirschner, p. 953). ■ While the culpable auditor may assert a shield, the court was not convinced thatexpanding remedies to plaintiffs would produce any meaningful additional deterrents toprofessional misconduct. The profession already faces deterrents through regulatoryrequirements and various legal claims.

EXHIBIT 2A Comparison of In Pari Delicto Cases

(New Jersey, Pennsylvania, and New York)

APRIL 2012 / THE CPA JOURNAL 63

aware of it, or who owned large blocks ofstock providing some ability to oversee thecompany’s operations. Exhibit 2 shows a comparison between New Jersey, NewYork, and Pennsylvania law and the result-ing implications for the audit profession.

In Pari Delicto and Failed BanksMany courts will consider whether equi-

table reasons exist that weigh againstallowing the in pari delicto defense as abar to recovery. Courts might find impor-tant policy considerations that they equi-tably believe should prevent the defense.One such instance might occur in thecontext of a Federal Deposit InsuranceCorporation (FDIC) receiver who filesclaims of malpractice on behalf of afailed bank.

In the last three years, 389 banks havefailed (FDIC, “Bank Failures in Brief,” for2009, 2010, and 2011 [through December16, 2011], www.fdic.gov). When a bankfails, the FDIC steps in as receiver, withall the rights and powers of the failed insti-tution (Elizabeth V. Tanis and Drew D.Dropkin, “Asserting Imputation-BasedDefenses in Actions Brought by the FDICas Receiver for a Failed DepositoryInstitution,” Accountants’ Liability:Litigation and Issues in the Wake of theFinancial Crisis, ALI-ABA, 2011). Thisincludes the right to file malpractice claimsagainst the former auditor. The FDIC’s teamof investigators and attorneys examinespotential professional liability claims forevery failed institution. Following the sav-ings and loan (S&L) crisis of the 1980s, theFDIC was able to recover approximately$1.15 billion from accounting malpracticeactions (Tanis and Dropkin 2011).

The Keystone case. In a West Virginiacase arising from a failed mortgage secu-ritization strategy, the FDIC, as receiverfor the First National Bank of Keystone,sued an audit firm for professional mal-practice, alleging negligence in the per-formance of its audit (Grant Thornton LLPv. Federal Deposit Insurance Corp., 2011WL 2420264 [C.A.4.W.Va., 2011]). In1992, Keystone began an investment strat-egy involving the securitization of high-risk mortgage loans, pooling these loansinto groups and selling interests in the poolthrough underwriters to investors. Thepooled loans were serviced by third-partyloan services, such as Advanta. Keystone

retained residuals, receiving payments onlyafter all other investors and expenseswere paid. The residuals were shown onKeystone’s books as an asset, and this assetrepresented a significant portion ofKeystone’s book value. By 1998, Keystonehad securitized over 120,000 loans with atotal value in excess of $2.6 billion.

But the failure rate was excessive.Keystone’s valuation of the residuals wasgreater than their market value. Somemembers of management and othersmade bogus entries, falsifying Keystone’sbooks, in order to conceal the failure of thesecuritizations from directors, sharehold-ers, depositors, and regulators. The Officeof the Comptroller of the Currency(OCC) noted the irregular bank records andbegan an investigation. The OCC requiredKeystone to hire a nationally recognizedindependent accounting firm to audit thebank’s mortgage banking operations, spec-ifying that the firm needed to determinethe appropriateness of the bank’s account-ing for purchased loans and all securitiza-tions. Keystone then hired Grant Thornton,which characterized the audit as maximumrisk. The auditor made a crucial error, how-ever, when she failed to obtain written con-firmation of a purported oral representationfrom Advanta.

The auditor called Advanta and claimedthat the Advanta representative confirmedon the phone that she had located a pool ofmortgages owned by Keystone. The Advantarepresentative sent an e-mail just minuteslater stating the loans were not owned byKeystone, but by another banking entity.Unfortunately, the auditor chose to rely onthe oral statement even though it conflictedwith the written evidence. Because the $236 million mortgage portfolio was aboutone-quarter of the bank’s claimed assets, thiswas significant. The audit firm issued a cleanaudit opinion on April 16, 1999, but thefinancial statements overstated Keystone’sassets by $515 million—in reality, this meantthe bank was grossly insolvent. The OCCdiscovered the discrepancies in August, andit closed the bank on September 1, 1999.Had the audit firm discovered the fraud inApril, the bank would have been closed byApril 21, 1999, according to the court opin-ion. The losses incurred by the bank fromtwo days after the issuance of the audit reportuntil the time the bank was closed inSeptember amounted to over $23 million.

Grant Thornton did not challenge thedistrict court’s finding that it was negligentin the conduct of its audit, but insteadargued that its negligence was not the prox-imate (legal) cause of Keystone’s losses.The audit firm had wanted to raise thedefense that the bank’s management wasan intervening and superseding cause ofpostaudit losses in the lower court becausesome of the bank’s management tookactions to impede the audit, such asrewording the confirmation letters so thatloans owned by another bank would alsobe included. The appellate court did not

find that the management’s actions inattempting to continue the fraud were anintervening and superseding cause, becausethe continued fraudulent conduct by thebank’s management was not unforeseeable.The audit firm’s expert conceded that itwas foreseeable from the standpoint of areasonably prudent auditor that the failureto discover fraud would result in the con-tinuation of the fraud (Grant Thornton, p.4). The firm also unsuccessfully contend-ed that this finding of proximate causewould make them the insurer; however, thecourt reasoned this was a unique situationwhere the audit firm was called in specif-ically after irregularities were discoveredand the lower court had reasonably limit-

The decision in Grant Thornton

also shows that, under some

interpretations, the in pari delicto

defense may not be allowed if

regulators have stepped in to collect

assets for the failed institution.

APRIL 2012 / THE CPA JOURNAL64

ed the audit firm’s damages to the periodfollowing issuance of its audit report.

In addition, Grant Thornton argued thatit should have been allowed to offer claimsor defenses, including comparative or con-tributory negligence and the in pari delic-to doctrine. Because the FDIC was col-lecting on assets of a failed institution, theGrant Thornton case inferred that theduty of the FDIC should be to the publicand not the former officers and directorsof the failed institution; thus, the U.S. Courtof Appeals for the Fourth Circuit inter-preted West Virginia law to hold that thedoctrine would not apply. The FourthCircuit held that the audit firm was liablefor the postaudit losses.

Insights. An audit firm can be liable forthe losses resulting from the failure to dis-cover the continuing fraud by bank man-agement under West Virginia law after reg-ulators have insisted on an audit. Accordingto the outcome of this case, a reasonably pru-dent auditor should have foreseen that abank’s management would continue to per-petrate the fraud. Relying on an oral confir-mation that contradicts a written confirma-tion is a crucial error. Furthermore, if a firmundertakes an audit after regulatory bank offi-cials noticed irregularities in the reports anddemanded an audit, under West Virginia lawit is at risk for continuing losses if the auditis negligently performed.

The decision in Grant Thornton alsoshows that, under some interpretations, thein pari delicto defense may not beallowed if regulators have stepped in to col-lect assets for the failed institution. Thisstems from O’Melveny & Myers v. FDIC(512 U.S. 79), a 1994 Supreme Court deci-sion ruling that state law determineswhether the knowledge of the institution’sofficers or employees can be imputed tothe institution and then to the FDIC. Thevast majority of states have not yetaddressed this issue, however, and thisunsettled area of law might become a bat-tle area “if and when the FDIC filesaccounting malpractice actions arising outof the bank and thrift failures of the GreatRecession” (Tanis and Dropkin 2011).

Looking to the Future The in pari delicto doctrine acts as a

powerful legal shield for an audit firmwhen state or federal law allows its use.Depending on the jurisdiction, an audit firm

The 2011 Fourth Circuit decision, citing West Virginia law and the facts of theKeystone Bank case, made the following determinations:

■ A reasonably prudent auditor should foresee that the bank’s management will continue to perpetrate the fraud.

■ Relying on an oral confirmation that contradicts a written confirmation is a crucial error.

■ A firm that undertakes an audit after regulatory bank officials have noticedirregularities in the reports and demands an audit is at risk for continuing losses.

■ The in pari delicto, comparative negligence, and contributory defenses will not be allowed if the regulators have stepped in to collect assets for the failedinstitution because the FDIC is collecting for the public.

Source: Grant Thornton, LLP v. Federal Deposit Insurance Corp., 2011 WL 2420264(C.A.4.W.Va., 2011)

EXHIBIT 3The 2011 Fourth Circuit Decision

In Pari Delicto Defense for the JPMorgan Defendants On November 1, 2011, the U.S. District Court for the Southern District of New Yorkissued an opinion that ruled that the trustee for the liquidation of Bernard L.Madoff Investment Securities (BMIS), Irving Picard, could not pursue common lawclaims for aiding and abetting fraud and breach of fiduciary duty againstJPMorgan defendants on behalf of Madoff’s failed investment firm. Picard allegedthat the JPMorgan defendants, as the primary banker of Madoff and BMIS, knew or should have known, or consciously avoided discovering, that BMIS wasmisappropriating customer funds and sought damages of approximately $19 billionunder various claims. The court said the doctrine of in pari delicto would precludethe trustee from recovering against the defendants because Madoff’s wrongdoingwould be imputed to BMIS.

StandingThe District Court for the Southern District of New York held that the trustee didnot have “standing” to bring the claims that properly belong to BMIS customers.Under the Second Circuit’s rule, known as the Wagoner rule, standing is a thresh-old issue in order for a plaintiff to bring a suit in federal court. The trustee hasappealed the district court’s decision to the Second Circuit, arguing that thetrustee should not be tainted by Madoff’s wrongdoing.

ImpactWhat impact could a reversal on appeal have on auditor liability? While this case does not involve an accounting firm, a reversal in the trustee’s favor couldconceivably widen the door to a Securities Investor Protection Act (SIPA)trustee’s ability to file suit against outside advisors on behalf of claims that belongto the debtor’s customers.

EXHIBIT 4More Fallout from the Madoff Scheme: A Case to Watch

APRIL 2012 / THE CPA JOURNAL 65

may be able to assert the defense and bedismissed at the early pleading stage of thelawsuit. Arguments in favor of this defensein this context are that an audit firm shouldnot be uniquely disabled from using thisdefense; however, exceptions to the legaldefense create ambiguity and can possi-bly intensify the number of claims filed.Taking a case to trial with uncertain legaloutcomes is risky because of the possibil-ity of a huge judgment that could destroythe firm.

While the likelihood of such an effectcan be debated, the systemic risks arisingfrom litigation involving rogue corporateofficers could conceivably affect thelong-term insurability and stability of theauditing profession. Market losses sufferedby a large company that becomes insolventoften greatly exceed the total capital of itsauditing firm. A suit for damages in theamount of the loss could devastate an auditfirm. According to the U.S. TreasuryAdvisory Committee on the Auditing

Profession’s final report, “No audit firmis too big to fail,” and the loss of one ofthe larger firms would have repercussionsthroughout the global capital markets(October 6, 2008, p. II:5). Firms are alreadyat risk for large judgments through a vari-ety of civil and criminal legal claims. Inaddition, the Sarbanes-Oxley Act of 2002(SOX) imposed more stringent regulatoryrequirements. Thus, the deterrent effect ofallowing shareholders, receivers, andtrustees to sue in the corporate fraud con-text may only be minimal. As theKirschner court noted, “any former part-ner at Arthur Andersen LLP … couldattest, an outside professional (and espe-cially an auditor) whose corporate clientexperiences a rapid or disastrous decline infortune precipitated by insider fraud doesnot skate away unscathed” (p. 953). Injurisdictions where the issue is unsettled,persuasive advocacy of the implications onthe audit profession will remain importantif the defense is not allowed or is narrowed.

Finally, a November 2011 decision in acase stemming from the Madoff Ponzischeme raised the issue of a SecuritiesInvestor Protection Act (SIPA) trustee’sstanding to sue on behalf of creditor claimsagainst third parties (Picard v. JPMorganChase & Co, 2011 WL 5170434 [S.D.N.Y.2011]). In its ruling, the U.S. District Courtfor the Southern District of New York main-tained that the in pari delicto defenseasserted by the JPMorgan defendants didapply in this instance (Exhibit 4). This is acase to watch during 2012 for an appeal anda ruling from the Second Circuit Court ofAppeals, which will help assess the impacton the scope of the trustee’s standing andthe interplay with the in pari delictodefense for outside advisors. ❑

Sandra S. Benson, JD, is an assistant pro-fessor in the department of accounting atMiddle Tennessee State University,Murfreesboro, Tenn.