Subject to Inquiry: White Collar, Congressional, SEC, Energy Enforcement & Other Government Inquiries

On October 21^st, New York’s highest court held that New York law does not permit suits against third parties who allegedly assist or fail to detect corporate wrongdoing.  The court’s holding was in response to certified questions from two different cases: Kirschner v. KPMG, 590 F.3d 186 (2009) and Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP, 998 A.2d 280 (2010).  Examples of third parties protected by this ruling include accountants, auditors, and attorneys.

Judge Susan Phillips Read wrote the opinion for the 4-3 majority and noted that the court was “not convinced that altering [its] precedent to expand remedies for these or similarly situated plaintiffs would produce a meaningful additional deterrent to professional misconduct or malpractice.”  Judge Read confirmed that that “the principles of in pari delicto and imputation, … which are imbedded in New York law, remain sound.” 

The in pari delicto defense allows a defendant in a lawsuit to claim that the plaintiff is at least equally at fault.  If the defense is successful, the plaintiff’s claim must be dismissed.  For the defense to be successful, the court must hold the corporation responsible for its employees’ actions by imputing the illegal actions of the corporation’s senior officers to the corporation.

This ruling is another victory in the ongoing fight against third party liability.  This issue keeps popping up across the country in courts and in Congress.  The ruling answers Delaware’s question to New York from earlier this summer.  And the decision comes only three months after the Texas Supreme Court made a similar ruling in denying third party claims against Grant Thornton.  On the other hand, the Pennsylvania Supreme Court limited the availability of in pari delicto earlier this year.

It will be important to pay close attention as more and more courts weigh in on this evolving issue and as Congress considers whether to create a private right of action for third party wrongdoing.

In Grant Thornton LLP v. Prospect High Income Fund, ML CBO IV (Cayman), Ltd., et al., No. 06-0975, 2010 Tex. LEXIS 478 (Tex. Jul. 2, 2010), the Texas Supreme Court rejected multiple third party claims against auditor Grant Thornton.

The claims in this case revolved around audit reports issued by Grant Thornton regarding Epic Resorts, LLC’s (“Epic”) compliance with a bond indenture agreement.  Despite allegedly discovering direct evidence to the contrary, Grant Thornton issued reports in 1999 and 2000 confirming that Epic was in compliance with an escrow requirement in the indenture agreement.  On June 15, 2001, Epic defaulted on the bonds in question by missing a scheduled interest payment and the plaintiffs, three hedge funds, forced Epic into bankruptcy.

The court divided the claims against Grant Thornton into two categories: (1) claims brought by purchasers of securities, who indicated that they would not have purchased the securities but for Grant Thornton’s alleged misrepresentations; and (2) claims brought by holders of securities, who stated that the audit reports induced them not to sell the bonds.

Third Party Claims Against Auditors Brought by Purchasers of Securities

With regard to purchaser claims, the court followed the American Law Institute’s Restatement (Second) of Torts § 522 in holding that auditors’ liability is limited to “situations in which the [auditor] is aware of the nonclient and intends the nonclient to rely on the information.”  The court determined that a hedge fund that purchased bonds after Grant Thornton issued its 1999 audit report was not part of the limited group under § 522 for whose benefit and guidance Grant Thornton intended to supply the information and was thus not within Grant Thornton’s scope of liability.

Third Party Claims Against Auditors Brought by Holders of Securities

In considering the holder claims, the court decided a matter of first impression for Texas: are third party holder claims against auditors cognizable under Texas law?  The court held that a plaintiff must show a “direct communication” between the plaintiff and the auditor in order to bring a successful third party holder claim against an auditor.  The plaintiffs in this case did not have direct communications with Grant Thornton, so the court held that the claims failed as a matter of Texas law.

With the onslaught of litigation brought by the market crash, plaintiffs are reaching out more and more to third parties who interacted with failed companies.  Auditor liability in particular has been in the headlines with some frequency recently.  It will be very important going forward for auditors to pay close attention as states continue to redefine the scope of auditor liability.  For now though, in the state of Texas, auditors can breathe a little easier, knowing that ordinary investors will find it much more difficult to successfully bring third party suits against them.

Mark W. Kinghorn contributed to this post.

On June 23rd, Florida’s Third District Court of Appeal overturned the largest jury verdict in history against a U.S. accounting firm and ordered a new trial.

Banco Espirito Santo sued BDO Seidman in 2004 over $170 million in losses that allegedly resulted from BDO’s negligence in failing to find fraud during its audits of E.S. Bankest, a company that Espirito Santo backed.

The jury issued its unprecedented award in 2007, which consisted of $170 million to compensate for Espirito Santo’s losses and a whopping $351 million in punitive damages. 

During the trial, BDO warned that losing just $170 million would force the company to layoff employees and endanger the company’s standing.  Being forced to pay three times that amount could cripple the company beyond the point of no return.

The appellate court overturned the exceptional jury award primarily because it found that the trial court erred in deciding to trifurcate the trial, which allowed the trial to be presented in three phases.  This unusual three-part trial allowed the jury to find BDO grossly negligent without considering the conduct of other actors. 

In its opinion, the appellate court wrote, “The cart cannot lead the horse” and “The jurors should have been allowed to consider all of the evidence...” as they decided on BDO’s conduct.  The court concluded, “We have carefully considered every substantive and procedural authority that might be applied to preserve at least some of the jury’s findings.  In this case, however, no such balm is found.”

Steven Thomas, lead counsel for Banco Espirito Santo said, “The evidence of BDO Seidman’s failures of even the most basic auditing procedures is so overwhelming that we expect a new jury will reach the same conclusion as the original jury.”

BDO CEO Jack Weisbaum said, “We are very pleased that the Appeals court has reversed the lower court verdict.  We have consistently stated that we were confident that the jury’s erroneous verdict in this case would be reversed on appeal.”

A new trial date has not yet been scheduled.