Calif. court says no to importing NY standard for auditor suits

October 20, 2011

A year ago, the New York Court of Appeals gave a big, shiny gift to accounting firms facing fraud claims. Both the Delaware Chancery Court and the U.S. Court of Appeals for the Second Circuit had asked New York’s high court to clarify its application of the common-law doctrine of in pari delicto, which basically holds that wrongdoers can’t demand compensation from their partners-in-crime. Trustees for two companies shattered by internal fraud had sued their auditors, claiming that the auditors failed to detect, and maybe even helped cover up, the wrongdoing by corporate insiders. But the Court of Appeals, in its October 2010 ruling in Kirschner v. KPMG, said that if the corporation benefited in any way from the insider’s fraud, in pari delicto shields the auditors.

“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,” the New York court wrote, the doctrine applies.

Lawyers from Boies, Schiller & Flexner relied heavily on New York’s Kirschner ruling in their Aug. 31 motion to dismiss claims against the boutique auditor Rothstein, Kass & Company. It’s easy to see why: The case against RKC seems to fit exactly the scenario the Court of Appeals described.

Two veteran hedge fund execs, Peter McConnon and Timothy Lyons, retained RKC to vet a trader named James Crombie, their partner in a newly-formed fund called Paron. According to Paron’s amended complaint in San Francisco superior court, investors wanted a green light from the auditor before they’d sink money into Paron. RKC gave Paron its okay in November 2010. You can guess what happened next: It turned out that Crombie had falsified his trading records.

The National Futures Association launched an audit of Paron in March 2011, which prompted McConnon and Lyons to conduct their own check on Crombie. According to Paron’s complaint against RKC, they found discrepancies in the documents he’d given them. They reported their findings to the NFA and Paron’s clients. Soon thereafter, the fund shut down. McConnon and Lyons claimed in their suit to have suffered tens of millions of dollars in losses, as well as damage to their reputations.

Boies Schiller argued, however, that Paron, McConnon, and Lyons had all benefited from Crombie’s deception, at least in the short term. So under the Kirschner in pari delicto analysis, they couldn’t blame RKC.

“Because Crombie’s fraud is properly imputed to Paron, Paron cannot sue RKC for failing to stop it from defrauding investors,” the auditor asserted. “It is in pari delicto with RKC and cannot recover.” (The auditor’s lawyers also disputed Paron’s account of its engagement, asserting that it wasn’t hired to verify Crombie’s trading records.)

Paron’s lawyers at Braun Hagey & Borden countered that the New York standard has never been adopted by a California court. “Under California law, in pari delicto is never applied to innocent parties,” Braun Hagey partner J. Noah Hagey wrote in Paron’s response to RKC. “A [motion to dismiss] only may be sustained if the complaint alleges that every decision maker in the company was involved in the misconduct.” McConnon and Lyons, Paron argued, were the victims of Crombie’s fraud, not beneficiaries of it. Crombie’s actions cannot be imputed to Paron and its principals.

Judge Harold Kahn of San Francisco Superior Court agreed with Paron. After a hearing Wednesday he entered an order denying RKC’s motion to dismiss (which is called a demurrer in California). Kahn hasn’t written an opinion explaining his ruling, but he clearly accepted Paron’s interpretation of in pari delicto, since his ruling reinstates claims that had been dismissed by the previous judge on Paron’s case.

Paron and its Braun Hagey team still have a long way to go; RKC claims it was never supposed to check the trading records that turned out to be falsified. And California corporations hoping to sue their auditors can’t count on a ruling by one trial judge to protect their claims. But this ruling is at least a small chink in auditors’ in pari delicto armor.

Paron counsel Hagey and a Boies Schiller spokesperson declined comment.

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