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.