On Petition for Certification of Question of Law from the United States Court of Appeals for the Third Circuit.
The opinion of the court was delivered by: Mr. Justice SAYLOR*fn1
CASTILLE, C.J., SAYLOR, EAKIN, BAER, TODD, McCAFFERY, ORIE MELVIN, JJ.
SUBMITTED: November 10, 2008
This case presents issues of Pennsylvania law on certification from the United States Court of Appeals for the Third Circuit, with the questions of first impression centering on the availability of an imputation-based in pari delicto defense in an auditor-liability scenario.
The background is set forth in the Third Circuit's certification petition. See Official Comm. of Unsecured Creditors of AHERF v. PriceWaterhouseCoopers, LLP, [hereinafter AHERF Creditors' Comm. v. PwC], No. 07-1397, slip op., 2008 WL 3895559, at *1 (3d Cir. July 1, 2008). Briefly, Allegheny Health, Education, and Research Foundation ("AHERF"), presently a debtor in liquidation under the United States Bankruptcy Code, is a Pennsylvania nonprofit corporation which operated hospitals, medical schools, and physicians' practices. From the late-1980s through the mid-1990s, AHERF management aggressively pursued acquisitions in furtherance of an integrated-delivery-system business model. Ultimately, this plan failed, precipitating the bankruptcy filing. Subsequently, a committee of creditors with authority conferred by federal bankruptcy law (the "Committee") commenced various causes of action against officers, insiders, and PriceWaterhouseCoopers, LLP ("PwC"), as successor to AHERF's auditor, Coopers and Lybrand ("C&L").*fn2
The present action entails claims against PwC for C&L's alleged collusion with high-level AHERF officers, including its chief executive and financial officers, to fraudulently misstate AHERF's finances between 1996 and 1997. For example, the Committee contends that management overstated net income by more than $150 million and net unrestricted assets by more than $240 million in 1997.*fn3 According to the Committee, the objective was to create the impression that management strategy was effective, thus concealing the corporation's deepening insolvency and facilitating management's continuation of a ruinous business strategy while thwarting essential, remedial intervention by the board of trustees. See Committee Brief at 14 ("Had Coopers performed its audits in compliance with GAAS, AHERF's trustees and its creditors could and would have intervened and put a halt to a growth strategy that could not be afforded.").*fn4 The claims were predicated on theories, asserted under Pennsylvania law, of breach of contract, professional negligence, and aiding and abetting a breach of fiduciary duty. The Committee sought damages equal to the "full extent of [AHERF's] insolvency," or over one-billion dollars.
PwC moved for summary judgment. The core factual basis for its defense was the participation of AHERF officers in the asserted fraud, since they provided C&L with false financial statements in the first instance. According to PwC's theory, such fraud is properly imputed to the officers' principal, AHERF. PwC then asserted that, regardless of whether or not C&L's own agents knew that the financial statements were false, where the culpability of the plaintiff (the Committee, standing in AHERF's shoes) is at least as great as that of the defendant (PwC, standing in C&L's shoes), the action is barred by in pari delicto potior est condition defendentis (meaning in a case of equal or mutual fault the position of the defending party is the stronger one). See generally Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 306-07, 105 S.Ct. 2622, 2626-27 (1985) (discussing the in pari delicto defense).
The district court found such theory to be a valid application of Pennsylvania law and awarded summary judgment. In so ruling, the court relied in the first instance on a general rule, deriving from agency-law principles, that fraudulent conduct of a corporate officer is imputed to the corporation if committed in the course of the officer's employment and for the benefit of the corporation. See AHERF Creditors' Comm. v. PwC, No. 2:00cv684, slip op. at 14 (W.D. Pa. Jan. 17, 2007) (citing Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 358-59 (3d Cir. 2001)). See generally Gordon v. Continental Casualty Co., 319 Pa. 555, 565, 181 A. 574, 577-78 (1935) ("A corporation shall be held responsible for the knowledge which is possessed by those whom it appoints to represent it. From the nature of its constitution it can have no other knowledge than that of its officers, and, in dealing with such officers, as with the corporation itself, third parties have a right to consider that what they know it knows." (citation omitted)). The court reasoned that the preparation and presentation of financial statements, albeit false ones, to an auditor was within the course of the employment of AHERF's senior management. Further, it determined that the corporation benefitted, at least in the short term, from the fraudulent conduct of its officers. See AHERF Creditors' Comm. v. PwC, No. 2:00cv684, slip op. at 20 ("Clearly, if during the periods relevant to the misstated financial statements, AHERF made acquisitions of other hospitals, physician practices and/or educational facilities, then over the immediate short term AHERF did indeed benefit. The benefits to AHERF include an increase of its assets and the addition of income streams.").
In response to the Committee's argument that the officers' interests were in fact adverse to the corporation, thus triggering an "adverse-interest exception" to the general rule of imputation, the district court reasoned that such exception applies only if the corporation "received no benefit" from the officers' improper conduct. AHERF Creditors' Comm. v. PwC, No. 2:00cv684, slip op. at 16 (citing In re Phar-Mor, Inc. Securities Litig., 900 F. Supp. 784, 786 (W.D. Pa. 1995) ("A corporation is not imputed with 'knowledge of an agent in a transaction in which the agent secretly is acting adversely to the [corporation] and entirely for his own or another's purposes'" (citation and emphasis omitted))). Referencing a decision of a federal intermediate appellate court, the district court also determined that short-term benefit to the corporation associated with the acquisition of hospitals, physician practices and/or educational facilities accrued to the corporation, thereby preventing the application of the adverse-interest exception to imputation. See id. at 18-19 (citing Baena v. KMPG LLP, 453 F.3d 1, 7-8 (1st Cir. 2006) ("A fraud by top management to overstate earnings, and so facilitate stock sales or acquisitions, is not in the long-term interest of the company; but, like price-fixing, it profits the company in the first instance and the company is still civilly and criminally liable...[; n]or does it matter that the implicated managers also may have seen benefits to themselves -- that alone does not make their interests adverse.")).
The district court also was not persuaded by the Committee's attempt to invoke an "innocent decision-maker" exception to imputation on the ground that, if members of AHERF's board of trustees had been made aware of the corporation's actual financial condition, they could have taken corrective measures. The court reasoned that such a limitation deviates from traditional agency doctrine and Pennsylvania agency law. See AHERF Creditors' Comm. v. PwC, No. 2:00cv684, slip op. at 23 (citing, inter alia, Am. Soc'y of Mech. Eng'rs, Inc. v. Hydrolevel Corp., 456 U.S. 556, 570-74, 102 S.Ct. 1935, 1944-47 (1982)). In this regard, and in summary, the court stated:
Despite the averments of the Committee regarding the decade long business strategy consisting of ill-conceived, ill-advised mergers and acquisitions, and despite the intentional accounting misstatements by AHERF management, the Committee lays AHERF's entire bankruptcy at the feet of its outside auditors. The very harm allegedly suffered at the hands of PwC, however, presupposes the Board approved business strategy, as well as the imputable wrongdoing of AHERF's management. The Court, therefore, finds no equitable bar to either the imputation of the misdeeds of AHERF management to AHERF or to the application of the doctrine of in pari delicto.
Id. at 24. An appeal to the Third Circuit followed, in which context the federal intermediate appellate court lodged the present certification request.
In its certification petition, the Third Circuit framed the issues by explaining that AHERF's chief financial officer is alleged to have knowingly falsified corporate finances, assisted by agents of C&L who issued a "clean" audit statement despite their own knowledge of the fraud, thus deceiving AHERF's board of trustees to the ultimate detriment of the non-profit corporation. See AHERF Creditors' Comm. v. PwC, No. 07-1397, slip op., 2008 WL 3895559, at *2. The court then posed the question of whether imputation should apply, followed by an inquiry into the viability of PwC's in pari delicto defense under Pennsylvania state law. See id. at *3, *6.
Regarding imputation, the court observed that the question is presented in a factual context in which the party invoking imputation (PwC, as successor to C&L) is not an innocent third party; rather, C&L agents purportedly conspired with AHERF officers in bringing about the alleged harm to the client-corporation. It noted that the scenario raises novel questions concerning the degree to which imputation may be utilized as a shield benefitting wrongdoers. The Third Circuit found this variation particularly significant, since the rationale supporting imputation is grounded, at least in part, on the protection of innocent third parties who do business with agents of the principal. See id. at *4 (citing Aiello v. Ed Saxe Real Estate, Inc., 508 Pa. 553, 559, 499 A.2d 282, 285 (1985)). While seemingly the court's own precedent favored PwC's position, see Lafferty, 267 F.3d at 360 (applying imputation in favor of parties alleged to have participated in wrongdoing), the court recognized that some other jurisdictions had taken a more restrictive view of imputation-based defenses, finding their broad application in the corporate auditing setting to be incompatible with the interests of justice. See AHERF Creditors' Comm. v. PwC, No. 07-1397, 2008 WL 3895559, at *4 (citing NCP Litig. Trust v. KPMG, LLP, 901 A.2d 871, 882 (N.J. 2006) (explaining that "the rationale for imputation in a simple principal-agent relationship begins to break down in the context of a corporate audit where the allocation of risk and liability among principals, agents, and third parties becomes more complicated.")); cf. In re Jack Greenberg, Inc., 212 B.R. 76, 90 (Bankr. E.D. Pa. 1997) (recognizing that the "framework for an accountant liability case does not fit squarely into the well developed agency law concerning imputation").
The Third Circuit concluded that resolution of the many competing concerns flowing from the extension, or refusal to extend, a broad imputation rule to the auditor liability setting requires a policy judgment best left to this Court, particularly in light of the magnitude and importance of the question to the Commonwealth. Therefore, the court asked that we set out the "appropriate test under Pennsylvania law for deciding whether imputation is appropriate when the party invoking that doctrine is not conceded to be an innocent third party but an alleged co-conspirator in the agent's fraud." AHERF Creditors' Comm. v. PwC, No. 07-1397, 2008 WL 3895559, at *4
On the broader question of the availability of an in pari delicto defense in Pennsylvania in the first instance, the Third Circuit characterized in pari delicto as "an ill-defined group of doctrines" and "a murky area of the law." Id. at *5. The court recognized the general unavailability of the defense for corporate directors alleged to have breached their fiduciary duties, and, concomitantly, questioned the degree to which it should be available to benefit those who have aided and abetted this sort of conduct. See id. It concluded:
Given the questions surrounding the Lafferty holding, the need for clarification of the in pari delicto doctrine under Pennsylvania law, and the presence of the aiding and abetting cause of action, we believe that the best course is to request that the Pennsylvania Supreme Court clarify the contours of in pari delicto under Pennsylvania law.
The Third Circuit's explanation was followed by the framing of two discrete legal issues as follows:
1. What is the proper test under Pennsylvania law for determining whether an agent's fraud should be imputed to the principal when it is an allegedly non-innocent third-party that seeks to invoke the law of imputation in order to shield itself from liability?
2. Does the doctrine of in pari delicto prevent a corporation from recovering against its accountants for a breach of contract, professional negligence, or aiding and abetting a breach of fiduciary duty, if those accountants conspired with officers of the corporation to misstate the corporation's finances to the corporation's ultimate detriment.
Id. at *6. We accepted certification of these questions per our operating procedures. See Supreme Court Internal Operating Procedures §10.*fn5
In its brief, the Committee couches in pari delicto as an equitable affirmative defense which should not be applied to produce an inequitable result. In particular, the Committee derives support from Universal Builders, Inc. v. Moon Motor Lodge, Inc., 430 Pa. 550, 555, 244 A.2d 10, 14 (1968) (holding that a bankruptcy trustee was not subject to the equitable "unclean hands" defense against a party that allegedly defaulted on a contract where, among other considerations, denying recovery for the estate would "result in the enrichment of [the breaching party] at the expense of the innocent creditors of the bankrupt [plaintiff]"). The Committee posits that no equities could be served by invoking in pari delicto to favor an auditor who conspires or colludes with corporate officers to misstate the corporation's financial statements.
In terms of the general, agency-law based rule of imputation, the Committee advocates implementation of exceptions to avoid shielding a wrongdoing auditor from liability to a company harmed by the auditor's malpractice. In support of such exceptions, and in line with the Third Circuit's comments, the Committee stresses the grounding of imputation doctrine in the protection of innocents. See Committee Brief at 22 ("[N]o innocents will be protected when a wrongdoing auditor seeks to impute to a financially devastated corporation the bad acts of the very corporate financial managers that the auditing firm was paid to monitor."). Additionally, the Committee highlights the Third Restatement of Agency and, in particular, the following comment:
A principal may retain a service provider on terms or for tasks that make imputation of agents' knowledge irrelevant to subsequent claims that the principal may assert against the service provider. For example, a principal may retain a service provider to assess the accuracy of its financial reporting or the adequacy of its internal financial controls or other internal processes, such as its processes for reporting and investigating complaints of harassment in the workplace. If the service provider fails to detect or report deficiencies, the principal's claim against the service provider should not be defeated by imputing to the principal its agents' knowledge of deficiencies in the process under scrutiny.
Restatement (Third) of Agency §5.03 cmt. b (2006); accord id. at §5.04 cmt. b ("[I]mputation protects innocent third parties but not those who know or have reason to know that an agent is not likely to transmit material information to the principal.").
As to the particular exceptions, the Committee first advances the adverse-interest exception based on its proffer that the misdeeds of AHERF's officers were motivated by their interest in preserving their positions and personally profiting from their extended tenure. Accord Phar-Mor, 900 F. Supp. at 786-87; Buckley v. Deloitte & Touche USA LLP, No. 06-3291, 2007 WL 1491403, at *5-7 (S.D.N.Y. May 22, 2007). Responding to the district court's position that any benefit to the corporation is sufficient to negate the adverse-interest exception, the Committee suggests such understanding resulted from a misreading of this Court's decision in Todd v. Skelly, 384 Pa. 423, 120 A.2d 906 (1956). See id. at 429, 120 A.2d at 909 ("Where an agent acts in his own interest which is antagonistic to that of the principal, or commits a fraud for his own benefit in a matter which is beyond the scope of his actual or apparent authority or employment, the principal who has received no benefit therefrom will not be liable for the agent's tortious act." (emphasis added)). According to the Committee, the district court errantly converted a simple, fact-specific comment from Todd into an overarching legal rule, which was never intended by this Court. Furthermore, the Committee criticizes the district court's finding of a benefit in the perpetuation, through alleged fraudulent collusion, of a harmful business strategy fostering deepening insolvency. Accord Thabault v. Chait, 541 F.3d 512, 529 (3d Cir. 2008) ("Given that [the chief executive officer's] conduct allowed [the insurance company] to continue past the point of insolvency, his actions cannot be deemed to have benefited the corporation."); Schacht v. Brown, 711 F.2d 1343, 1348 (7th Cir. 1983) ("We do not believe that such a Pyrrhic 'benefit'" to the corporation "is sufficient to even trigger the... analysis which seeks to determine the propriety of imputing to the corporation the directors' knowledge of fraud."). At the very least, the Committee asserts, the matter is fact-based and, therefore, unsuited for resolution at the summary judgment stage.*fn6
The Committee distinguishes the primary authority relied upon by the district court, Baena, inter alia, on the ground that it involved a for-profit corporation with stockholders; whereas, AHERF, as a nonprofit corporation, had no trading stock the price of which could be manipulated and which could then be traded for assets. Thus, the Committee maintains, the Baena court's finding of such benefit to the corporation deriving from similar misconduct on the part of corporate officers and auditors does not pertain here. Moreover, according to the Committee, because many of AHERF's acquisitions were of money-losing enterprises -- and the relevant ones were made in reliance on misstated financial statements -- such acquisitions caused AHERF only additional financial loss. See, e.g., Committee Reply Brief at 11 n.5 ("Indeed, the tens of millions of dollars in cash laid out, debt assumed, and operating losses incurred as a result of these same acquisitions did nothing but help push the company into bankruptcy and form, in significant part, the basis of the Committee's damage measures." (citing JA3211-32212, JA3223-3254)).
In any event, the Committee contends, the litmus for adverse interest lies in the subjective motivation of the agent-actor, not incidental or unintended benefit resulting from the action. See Committee Brief at 12-13 (citing Reich v. Compton, 57 F.3d 270, 279 (3d Cir. 1995) (reflecting a similar position in the context of an alleged party-in-interest transaction under the federal Employee Retirement Income Security Act)). The Committee also maintains that there is no requirement for the agent-actor to have proceeded "entirely" out of self-interest. ...