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September 13, 2010 6:19 PM

A Landmark Day for Auditor Liability?

Posted by Zach Lowe

The question seems pretty simple: If executives at a public company commit fraud that later comes back to cost the company, can its shareholders go after the company's auditors for missing the fraud in the first place? 

Stuart Grant, a plaintiffs lawyer and name partner of Grant & Eisenhofer, says the answer has too often been no, with courts denying shareholders the right to pursue malpractice claims against auditors in public fraud cases. Grant will have a chance to make a dent in that precedent Tuesday in New York's Court of Appeals, where he will ask for permission to sue the accounting firm PricewaterhouseCoopers on behalf of various institutional shareholders of AIG, according to Grant and court records. Courts in Delaware have so far denied shareholders' request to sue PwC, but the accounting firm, which has used Cravath, Swaine & Moore throughout the case, isn't taking any chances. It has retained King & Spalding's Paul Clement, a former U.S. solicitor general, to argue the case Tuesday at New York's highest state court. 

Grant and the shareholders claim that PwC did a bad job auditing AIG in the early 2000s, when various higher-ups, including ex-CEO Maurice Greenberg, allegedly engaged in various sham transactions designed to prop up AIG's bottom line. Authorities eventually caught the fraud, and the insurance giant had to restate years of financial statements that "eventually reduced stockholder equity by $3.5 billion," plaintiffs claim. The company has paid more than $1.5 billion in additional fines, plaintiffs say. Pricewaterhouse missed the fraud, and shareholders argue they should be allowed to sue PwC for malpractice. 

But they have not been allowed to do. Why? Because of a legal doctrine known as "in pari delicto," which translates loosely to "of equal fault." The doctrine generally bars one coconspirator in a fraud from suing another coconspirator, since they were all part of the same bad scheme, court records show. Courts in Delaware have ruled that the doctrine bars the AIG shareholders from suing PwC, since the allegedly poor auditing was so closely linked to Greenberg's fraud. The shareholders, standing in for AIG itself, cannot go after a second participant in the same accounting scam, the courts have ruled. 

Grant disagrees with that ruling and says courts have gotten lazy in lumping auditors together with those who commit fraud at public companies, effectively shielding auditors from malpractice suits. "It's a lack of intellectual discipline," Grant says. In Grant's view, PwC's bad auditing is entirely separate from Greenberg's fraud. Greenberg didn't tell the PwC auditors he was engaging in sham transactions, Grant says; in fact, Greenberg and his codefendants intentionally hid those facts from PwC. It was PwC's cause to catch them. "The two of them were not in any way coconspirators," Grant says of PwC and the Greenberg group. "Does Pricewaterhouse really get to say, Hey, Maurice Greenberg committed fraud, never mind that we screwed up?"

Delaware's Chancery Court indeed ruled that way when it first considered how New York law would govern the case, court records show. The Chancery Court dismissed the suit. Grant appealed to Delaware's Supreme Court, and that court decided to do something Grant says it has never done before: It asked New York's Court of Appeals for advice on whether the shareholders have a claim under New York law against PwC. 

The New York court will hear arguments Tuesday. If the shareholders win, they will get to argue their case from scratch in Delaware, Grant says. (Clement declined to comment and Thomas Rafferty of Cravath did not respond to a call seeking comment. A representative for PwC said the company would not make any public statement ahead of Tuesday's hearing.)

Grant has a backup argument ready to go as well. The Delaware dismissal of the shareholder suit under the doctrine of "in pari delicto" is premised on the idea that AIG's shareholders, Greenberg, and the corporation AIG are all basically the same legal entity. If top officials committed fraud, the company (with some exceptions) is also said to have committed that same fraud. And as a participant in that fraud, it can't sue third parties who helped the fraud along. 

In Grant's view, reading the law that way is unfair to AIG and its shareholders. The fraud in question was committed by Greenberg and a very small number of high-level officials, he says. Much of AIG's board had no idea it was going on, Grant says. Shareholders certainly didn't. To lump all of those entities together as "AIG" and bar them from suing PwC and other such parties isn't right, Grant says. "You can't use the law like this to protect PwC at the expense of the good guys." 

We'll see Tuesday if New York is kinder to Grant's arguments than was Delaware.

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Fraud is an act that is so often skilfully concealed. This may be by an individual or a group of individuals.
The fundamental question should be whether an external auditor performed all reasonable steps to gain reasonable comfort that the financial statements were free of material mistatements.

There are many examples where fraud has been committed even under some of the most robust systems of internal controls.

True the auditor may do a bad job but the company's internal control unit should also be put to task to explain how a fraud can continue under its daily watch

One may think there is a prima facie inconsistency between "in pari dilecto" applied to public company auditors, and the independent, "public watchdog" status ascribed to them in, e.g., US v Arthur Young.

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