Let's Play The In Pari Delicto Blame Game! Can an Auditor Use Fraud it Missed as a Shield from L

Typewriter Fraud Detection Amicus Announcements

Photo Credit: Fraud Detection by Nick Youngson CC BY-SA 3.0 ImageCreator

Auditors are people too. They make mistakes and when they do, they can be sued and held liable for them. Sometimes.

But what if a company sues its independent auditor for failing to find a company employee's fraud in its annual audits?

Should an auditor escape liability if agency law holds the company responsible for its employee's fraud?

Most courts say yes.

The Supreme Judicial Court will answer this question in Massachusetts this year in

Merrimack v. KPMG. The Court's focus is on whether it should create an "auditor exception" to the in pari delicto defense. Or at least that is the issue it solicited amicus briefs on.

What is in pari delicto?

The in pari delicto doctrine bars a plaintiff who participated in wrongdoing from recovering damages or any loss resulting from the wrongdoing. Choquette v. Isacoff, 65 Mass. App. Ct. 1, 3 (2005). It reflects an equitable and policy judgment that courts should "not lend aid to parties who base their cause of action on their own immoral or illegal acts." Id. at 4. The doctrine does not create an absolute bar to recovery. If both parties engaged in misconduct, the "less guilty" party may be able to recover damages or obtain equitable relief. Id. (quoting Council v. Cohen, 303 Mass. 348, 354 (1939), and Berman v. Coakley, 243 Mass. 348, 350 (1923)).

“In pari delicto” translates to "in equal fault.” It comes from a long-standing equitable maxim, “in pari delicto potior est conditio defendentis,” that can be translated as “[i]n a case of equal or mutual fault, the position of the [defending party] is the better one.” Baena v. KPMG LLP, 453 F.3d 1, n.5 (1st Cir. 2006) (quoting Black’s Law Dictionary).

What's Happening with Merrimack College v. KMPG, LLC?

The facts.

Merrimack's financial aid director awarded fake federal Perkins loans to non-existent and dead students and to existing students who had never applied, all allegedly to give the college access to more federal money and to make it appear as if the school had a balanced financial aid budget (and allegedly to save her own job).

After Merrimack discovered the fraud and the financial aid director pleaded guilty to federal criminal charges of wire and mail fraud, Merrimack sued KPMG. Merrimack alleged that KPMG noticed discrepancies in the school’s Perkins loan records during its annual audits but did not follow up on them and failed to discover the fraud.

What's happened so far?

KPMG invoked the in pari delicto doctrine in its motion for summary judgment. It argued that agency law attributed the financial aid director’s fraud to Merrimack and that Merrimack was, therefore, more at fault than KPMG and should not be entitled to recover damages from KPMG for negligence.

The trial court (Salinger, J.) agreed.

First, the court held that Merrimack was legally responsible for the financial aid director's fraud because she committed it squarely within the scope of her employment and intended, at least in some part, to benefit the college.

Second, the Court held that the “intentional misconduct by Merrimack's agent in authorizing fraudulent Perkins loans [was] far more serious than KPMG's failure to ferret out that fraud when auditing Merrimack's finances.” As a result, the court concluded that Merrimack's claims against KPMG were therefore barred by the in pari delicto doctrine.

The trial court expressly refused to recognize an “auditor exception” to the in pari delicto doctrine on public policy grounds because, it held, the “proposal would ‘creat[e] a double standard whereby the innocent stakeholders' of the outside auditor 'are held responsible for the sins of their errant agents while the innocent stakeholders of' the entity injured by its employee's fraud 'are not charged with knowledge of their wrongdoing agents.’” (quoting Kirschner v. KPMG, LLP, 938 N.E.2d 941, 958 (N.Y. 2010) (applying New York law)). The court explained that Merrimack had not shown a “compelling public policy justification for letting entities that were injured by the deliberate fraud of their employees sidestep the in pari delicto doctrine and shift responsibility to an independent auditor that negligently failed to discover the fraud.” The court also noted that only one state - New Jersey - had recognized an auditor exception and that other states had considered and rejected such an exception.

Merrimack appealed.

The appeal is now fully briefed. In addition to the parties' briefs, the American Institute for Certified Public Accountants (AICPA) and the Massachusetts Society of Certified Public Accountants filed an amicus brief in January in support of KPMG.

The brief argues that the Court should not recognize an auditor exception because, among other reasons: (1) management, not the auditor, is responsible for preventing and detecting fraud; (2) to recognize an exception would allow the company to shift the cost of its own employee's wrongdoing entirely to the auditor and reduce the company's incentive to hire honest employees and to monitor their behavior; and (3) auditors already have plenty of incentives to do their jobs right.

Amicus Announcement.

Last month, the SJC invited amicus briefs in the case on the question of whether it should recognize an "auditor exception" to the in pari delicto doctrine to allow a client to assert a claim for negligence against an independent auditor that fails to detect fraud or misconduct by the client's employee in connection with annual audits. So far, no new amicus briefs have been filed.

What's Next?

According to the SJC docket, the Court plans to hold oral argument in May, but has not yet set a specific date.


*Note: an earlier battle in the case stemmed from KPMG's efforts to invoke an arbitration agreement in an engagement letter that post-dated the audit work at issue in this case. The Appeals Court affirmed the trial court's refusal to order arbitration on the grounds that nothing in the later engagement letter indicated that its terms were intended to be retroactive. The SJC denied FAR.

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