Supreme Court Clarifies Contours of In Pari Delicto Doctrine
The Delaware Supreme Court, in a recent order affirming the opinion of the Delaware Court of Chancery, provided clear guidance about when third-party corporate advisers may raise the in pari delicto defense as a shield to claims brought by or on behalf of the corporation, in Stewart v. Johnson Lambert & Co., Del. Supr. No. 204, 2015, Order (Nov. 2, 2015). Specifically, when the corporation's fiduciaries have themselves engaged in the wrongdoing for which the third-party advisers have been joined, the adviser will face liability for knowing participation in a breach of fiduciary duty; the adviser, however, will not risk liability to the wrongdoing corporation for professional liability claims based on contract or negligence. At a time when auditors and financial advisers are increasingly targeted in corporate litigation, the Delaware Supreme Court's rejection of a professional adviser exception to the in pari delicto doctrine provides important guidance for corporations and their professional advisers to manage their respective risks.
The in pari delicto doctrine prevents a party from recovering damages if its losses are substantially caused by activities forbidden by law. The doctrine is rooted in two important policy goals: (1) deterring wrongful conduct by refusing wrongdoers any legal or equitable relief, and (2) protecting the judicial system from having to use its resources to provide an accounting among wrongdoers. Because it is an equitable doctrine, various exceptions to the rule have developed to ensure that its implementation promotes equitable results. Perhaps foremost among the exceptions is the fiduciary exception that permits a corporation and its stockholders to assert claims for their benefit against a wrongdoing officer or director whose breach of fiduciary duty has harmed or threatens to harm the corporation. Without this exception, a corporation would be barred from recovery because entities act through agents and managers and the agents' wrongful conduct and knowledge is imputed to the corporation, making the corporation itself therefore a wrongdoer.
In the Stewart case, the Delaware insurance commissioner as the receiver of an insolvent affiliated group of insurance companies sued an individual who was the former CEO and sole stockholder for engaging in pervasive fraud and failing to adequately capitalize the insurers. The receiver also sued a member of the insurer's board of directors who was also employed by the insurer's captive manager, the third-party captive manager itself and the insurer's auditors. The receiver accused these three of aiding and abetting the CEO's breach of fiduciary duty by understanding the insurer was not adequately accounting for its assets and for knowingly turning a blind eye to the unacceptable state of affairs for several years. The receiver also claimed alternatively that the captive manager and the auditor breached their duty of care as professional advisers to the insurers and were responsible in tort and contract for the resulting damages.
The Court of Chancery dismissed the professional negligence and contract claims based on the in pari delicto bar, but it did not dismiss the aiding and abetting claims. In so ruling, the Chancery Court took into account various policy factors, including the need to hold professional advisers accountable for serious wrongdoing (if they knowingly participated in a breach of fiduciary duty), while avoiding a litigation-intensive approach that would expose professional advisers to "more than an optimal threat of liability in situations where their clients had engaged in unlawful behavior." In affirming the court below, the Supreme Court said, "The balance the Court of Chancery struck between the need for accountability of professional advisers and the costs of exposing professional advisers to potentially excessive risks is a sensible one, and reflects the one chosen by sister states, such as New York, whose laws are often involved in situations involving Delaware corporations."
The affirming order signed by Chief Justice Leo E. Strine Jr. on behalf of the Supreme Court puts to rest previous uncertainty about how Delaware might treat an in pari delicto defense raised by auditors. (See, e.g., In re American International Group Consolidated Derivative Litigation, 965 A.2d 763 (Del. Ch. 2009) (AIG I); and In re American International Group Consolidated Derivative Litigation, 976 A.2d 872 (Del. Ch. 2009), aff'd 11 A.3d 228 (Del. 2011) (AIG II).) In AIG I, then-Vice Chancellor Strine upheld an in pari delicto defense raised by PricewaterhouseCoopers to claims of professional liability, under an application of New York law. In dictum, however, Strine said if Delaware law applied, he would be "chary" about following the New York approach and questioned the rationale of New York's in pari delicto doctrine as it applies to corporate auditors like PwC.
Later, in AIG II, Vice Chancellor Strine applied Delaware law to dismiss claims against three third-party insurers that allegedly conspired with AIG to accomplish the fraudulent transactions in question. He concluded that Delaware's in pari delicto defense applied to bar AIG from stating claims against any of the three co-conspirators. Given the similarity and frequent overlap of aiding and abetting and civil conspiracy claims in OptimisCorp v. Waite, Del. Ch., C.A. No. 8773, 2015, Parsons V.C. (Aug. 26, 2015), and given the skepticism earlier expressed in AIG I about Delaware's application of in pari delicto to claims against auditors, the precise contours of the in pari delicto defense in corporate litigation have remained uncertain.
The Supreme Court's decision in Stewart affirming the "well-reasoned" Court of Chancery decision below clarifies the doctrine and the circumstances under which professional advisers may face liability for the corporation's own wrongdoing. In short, a professional adviser that is shown to have knowingly participated in a fiduciary's breach of duty will face liability and not be shielded by the in pari delicto defense. But an adviser will obtain the benefit of the defense and will not be required to defend against claims by a wrongdoing corporation for professional liability based on negligence or contract.