New York’s highest court just gave a big gift to accountants, lawyers, and any other outside professional in a position to detect fraud at one of their corporate clients: The court ruled that shareholders still can’t sue them for failing to detect the fraud.
New York has a long-standing judicial doctrine that says one wrongdoer — for example, the company that committed fraud — cannot sue another wrongdoer — for example, the accountants or lawyers whose lax attention (if not willful blindness) enabled it.
Or, as the N.Y. Court of Appeals put it in its decision: “[C]ourts will not intercede to resolve a dispute between two wrongdoers.” For the purposes of this doctrine, shareholders are wrongdoers, as they are believed to know everything the corporate executives do. The only exception is if an executive is acting purely in his own interest, against the company’s interest — and no, committing massive accounting fraud didn’t count, and now it continues not to count. Only actions like embezzlement do.
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This doctrine is common in the U.S., but the recent instances of spectacular frauds that have brought companies down in flames has caused courts to reexamine it. In New Jersey and Pennsylvania, top courts have recently changed their interpretations of the doctrine to allow such suits in corporate fraud cases. The mega-corporate implosions of Refco and American International Group gave the New York court the opportunity to similarly revise its doctrine. But it emphatically chose not to.
The effect of this ruling goes far beyond New York’s borders, as New York law can be controlling in corporate cases elsewhere. For example, the AIG case — which involved pre-financial meltdown accounting fraud that cost the company some $5 billion in lost equity and fines, and forced the company to restate years of financial statements — was brought in Delaware, but New York law applied. Under the New York doctrine, the Delaware trial court dismissed the suit. On appeal, the Delaware Supreme Court asked the New York high court to see if the doctrine still applied — perhaps hoping the court would rule that it no longer did.
The New York court rejected the idea that allowing these suits would force accountants and lawyers to look more closely at their clients, noting that the securities law claims were still available, and indeed accountant and underwriter defendants had agreed to multimillion dollar settlements in those types of suit in both the AIG and Refco situations. It also noted that any unfairness in holding AIG or Refco’s shareholders liable for the executives’ fraud would be mirrored by holding the accountants’ shareholders liable for the individual accountants’ negligence in missing the client’s fraud.
Although the court didn’t explicitly take note of it, another path to holding outside professionals accountable — admittedly, not a path available to shareholders — is criminal law. In the Refco’s outside counsel, a law firm partner, was convicted of participating in Refco’s fraud. He’s serving seven years.
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