The In Pari Delicto Defense For Auditors in Professional Negligence Cases: The Imputation of Managers’ Unlawful Acts To A Client Corporation

• In Event: SESSION 7C: Ethics, Auditing, and the Law

Abstract

In a company’s lawsuit alleging that its auditor was negligent in failing to detect a manager’s fraud, the auditor may be able to use an in pari delicto defense if the manager’s fraud is imputable to the company. Since a bankruptcy trustee or a receiver steps into the shoes of the bankrupt company it represents, a similar defense (the Wagoner Rule) may also be applicable if a trustee or a receiver files a negligence lawsuit against the company’s auditor. However, in pari delicto is inapplicable when: (1) the wrongful acts of the manager are so adverse to the corporate client that the manager is deemed to have totally abandoned the corporation for its, or a third party’s, sole benefit (unless the manager is also the sole shareholder, or the company has incurred a short-term benefit because of the fraud); (2) the corporate client had at least one innocent manager or shareholder who could have prevented or stopped the fraud if he had known about it; (3) the auditor does not deal with the corporate client in good faith and engages in unlawful conduct; or (4) the plaintiffs are totally-innocent shareholders (but in this case, the in pari delicto defense is still applicable with respect to culpable shareholders). The State of New York has been on the cutting edge in the evolution of the in pari delicto defense, and this defense is strongest there. Other states recognizing the defense include New Jersey; Pennsylvania; and (in dicta) Delaware (only if the company has engaged in actual wrongdoing).

Author

• Stephen Blythe, Abu Dhabi University