Safety in Numbers
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Safety in Numbers

by Thomas Brom

April 2013

Until recently, God appeared to have a special providence for fools, drunks, the United States of America - and the accounting profession. Accountants' liability - at least since Arthur Andersen's collapse in 2002 - was an oxymoron, subject mostly to a late afternoon panel at corporate governance seminars.

Until recently. In November, the Federal Deposit Insurance Corporation filed its first suit against the auditors of a failed bank - in Alabama - since hundreds of regional banks evaporated during the financial crisis. Then in January the SEC filed administrative proceedings against two KPMG auditors in Nebraska for failing to adequately challenge management's characterizations of nonperforming loans.

OK, not exactly big game - and KPMG itself wasn't even named in the administrative charges. But Cornerstone Research reports this year it has observed "an increase in both securities class action filings involving accounting allegations and filings involving financial statement restatements."

Despite enormous barriers to recovery, the plaintiffs bar seems emboldened. In November, Hewlett-Packard announced a write-down of $8.8 billion on its $11.1 billion acquisition of the UK software firm Autonomy, completed with great fanfare in 2011. Despite having employed a small army of financial advisors and six law firms to vet the deal, HP chief executive Meg Whitman blamed the auditors - in this case, UK Deloitte and KPMG - for "accounting improprieties, misrepresentations and disclosure failures." To date, Hewlett-Packard has taken no legal action against the auditors.

But the company's shareholders have. Within weeks of the announcement, groups of plaintiffs had filed three class actions and seven derivative suits against HP and its directors, alleging violations of the Securities Exchange Act, breach of fiduciary duty, and abuse of control. Plaintiffs in the derivative actions brought claims against KPMG - hired by HP to review UK Deloitte's audit of Autonomy's books - for aiding and abetting fraud and for negligence. (In re Hewlett-Packard Co. S'holder Derivative Litig., No. C-12-6003 (consolidation order filed Feb. 21, 2013).)

Significantly, plaintiffs in the class actions did not sue the auditors. UK Deloitte, per the Supreme Court's Morrison ruling (130 S.Ct. 2869 (2010)), is beyond the reach of U.S. securities laws. KPMG appears well-protected by provisions of the Private Securities Litigation Reform Act of 1995, which require plaintiffs to plead facts sufficient to establish a "strong inference" of fraud. With regard to accountants' liability, the Ninth Circuit requires plaintiffs to plead and prove "that the accounting practices were so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts." (In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994).)

In a recent law review article, University of Texas, Austin, business professors Dain C. Donelson and Robert A. Prentice note that "auditors are rarely named as defendants in securities class actions, even when their clients are accused of accounting fraud." They cite Cornerstone Research findings that between 2006 and 2010, auditors were named in securities class actions at an annual rate of only 1 percent to 6 percent, even though 26 percent to 57 percent of those cases alleged accounting violations. (See 63 CASE W. RES. L. REV. 441, 456 (2012).)

But derivative actions, filed by shareholders on behalf of a corporation for harm suffered by all shareholders, avoid the difficulties of pleading under the securities laws. And defendants may include third parties - such as accountants and lawyers - who may have participated as agents of the company to aid and abet or perpetrate fraud.

Even when wrongdoing can be proved, however, plaintiffs face the powerful defense of in pari delicto ("in equal fault"), an equitable doctrine that prevents one participant in fraud from seeking redress against another participant. As The CPA Journal noted last year, "the doctrine is of serious importance to the profession, because without the defense, an audit firm might potentially be held liable for the entire drop in market capitalization of its public company audit clients."

In the corporate context, the defense depends first on the agency law principle that the actions or knowledge of an officer may be imputed to the legal entity. Should a fraud benefit the company in some way, then a third party - such as a negligent or complicit auditor - may be dismissed from litigation at the pleading stage. The doctrines of imputation and in pari delicto work together.

The defense differs from state to state, and it includes a crucial adverse interest exception if a corporate agent pursues a fraud solely for private gain. A New York appellate court recently bolstered the auditors' defenses, ruling that to come within the adverse interest exception, an agent must have "totally abandoned the principal's interests and be acting entirely for his own or another's purposes." Accepting the main points of an industry amicus brief, the court asked, "[W]hy should the interests of innocent stakeholders of corporate fraudsters trump those of innocent stakeholders of the outside professionals who are the defendants in these cases? The costs of litigation and any settlements or judgments would have to be borne, in the first instance, by the defendants' blameless stakeholders; in the second instance, by the public." (Kirschner v. KPMG LLP, 15 N.Y. 3d 446, 475 (2010).)

Subsequently, courts in New Jersey and Pennsylvania set less restrictive standards for imputation and for the in pari delicto defense.

California's standard is now at issue in a 2011 case brought by principals in a San Francisco hedge fund who allege that their accounting firm never uncovered the fabricated trading activity of one of their own partners. The principal shareholders filed claims in Delaware against the former partner for fraud, and in California against the auditor for negligent misrepresentation, malpractice, fraud, and breach of contract. (Paron Capital Mgmt. LLC v. Rothstein, Kass & Co. LLP, No. CGC-11-510203 (S.F. Super. Ct. filed April 14, 2011).)

Attorneys for the auditor Rothstein Kass filed a cross-complaint against the plaintiffs last July, arguing that all the partners had participated in wrongdoing. The defendants then filed a demurrer, which relied heavily on New York's Kirschner ruling. "In pari delicto is alive and well in California," says Farley J. Neuman, defense counsel and a principal at San Francisco's Goodman Neuman Hamilton.

In their opposition brief, attorneys for Paron Capital maintained that imputing the fraudulent actions of a corporate insider to the entire company "would bar recovery by innocent victims in every case - even if, as here, the accountant was complicit in the insider misrepresentation." Attorney Noah Hagey, principal in San Francisco's BraunHagey & Borden, contended that under California law, claims against third parties are barred only if every controlling officer and director is guilty of fraud.

Rejecting the New York standard, Judge Richard A. Kramer overruled the demurrer and reinstated claims that had previously been dismissed on in pari delicto grounds. The case is currently in discovery; in December, Judge Kramer issued a protective order and procedure for advising the jury that workbooks and a BlackBerry used by the defendant's principal accountant had disappeared.

"The accounting firms are trying to sell Kirschner in other states," Hagey says in an interview. "But it's an outlier opinion. In pari delicto is a dead loser in our case."

The defendants, however, aren't so sure. Though no trial date is scheduled, Rothstein Kass has brought in Quinn Emanuel Urquhart & Sullivan. One of that firm's star litigators - Kathleen M. Sullivan - argued the Kirschner appeal in 2011. God's special providence for accountants has manifested itself in stranger ways.

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