In late October, the New York Court of Appeals issued an important decision that clarified New York’s law of agency and the in pari delicto doctrine. [See Kirschner v. KPMG LLP, Nos. 151, 152, 2010 N.Y. LEXIS 2959 (Oct. 21, 2010).] In these times, when companies are under growing scrutiny and when accusations of corporate malfeasance are abundant, the decision should be of particular interest to in-house counsel.

In-house counsel may be familiar with the traditional agency-law principle that provides, in the words of the Kirschner Court, that “the acts of agents, and the knowledge they acquire while acting within the scope of their authority are presumptively imputed to their principals.” Counsel may have also encountered the in pari delicto doctrine, which provides that “courts will not intercede to resolve a dispute between two wrongdoers.” Agency law and the in pari delicto doctrine frequently intersect in circumstances where a business has been harmed by its own agents’ misconduct, and the business then sues a third party that allegedly participated, or was complicit, in that misconduct. Here’s a classic scenario: A company’s managers engage in fraud to conceal the company’s financial troubles, the fraud is subsequently revealed, the company suffers as a result, and the company then sues the accounting firm that failed to detect and/or report the accounting fraud. If the managers’ acts are imputed to the company, the in pari delicto doctrine bars the suit; the company cannot recover from the accounting firm, even if that firm’s actions exacerbated the company’s losses.

This scenario was, in fact, featured in the Kirschner case. The question presented was whether the acts of certain agents should be imputed to their employers under New York law. More precisely, the Kirschner Court considered the scope of the so-called “adverse interest exception” to the ordinary rule of imputation. That exception provides that when an agent has “totally abandoned” the interests of his principal, and when he is acting entirely for his own or another’s purposes, then his knowledge and conduct will not be imputed to his principal. If the adverse interest exception applied–if the plaintiffs’ agents were acting in their own interests such that their misconduct could not be imputed to plaintiffs–then the defendants would not be able to successfully invoke the in pari delicto doctrine. If the exception did not apply, then the defendants would prevail.

The Court of Appeals held that the exception did not apply, and in doing so, resolved some confusion that had arisen from previous federal-court decisions that had attempted to articulate New York law. Here are a few highlights from the decision:

  • A corporation is responsible for the acts of its authorized agents even if particular acts themselves were unauthorized. “When corporate officers carry out the everyday activities central to any company’s operation and well-being–such as issuing financial statements, accessing capital markets, handling customer accounts, moving assets between corporate entities, and entering into contracts–their conduct falls within the scope of their corporate authority.”
  • Imputation is based on the presumption that an agent, acting within the scope of its authority, discloses all relevant information to its principal. This presumption cannot be countered by evidence that there was in fact no disclosure. The presumption, in other words, “does not depend on a case-by-case assessment of whether that is likely to happen. Instead, it is a legal presumption that governs in every case, except where the corporation is actually the agent’s intended victim.”
  • The adverse interest exception will not apply if the principal enjoyed a short-term benefit, rather than immediate harm, from the agent’s actions. Clarifying an earlier 2nd Circuit decision, the Court held that the exception does not turn on the intent or motives of the insiders. Thus, it is irrelevant that insiders acted with their “personal profit in mind” or that they acted “for their own interests.” “This rule avoids ambiguity where there is a benefit to both the insider and the corporation, and reserves this most narrow of exceptions for those cases–outright theft or looting or embezzlement–where the insiders’ misconduct benefits only himself or a third party….The crucial distinction is between conduct that defrauds the corporation and conduct that defrauds others for the corporation’s benefit. . . . [W]hen insiders defraud third parties for the corporation, the adverse interest exception is not pertinent.”

As these snippets reveal, the Court of Appeals envisions a very narrow exception to the ordinary rule of imputation. That should come as partly unwelcome -and partly welcome – news to inside counsel. On the one hand, it is now clear that businesses are at significant risk of being held accountable for their employees’ misconduct, even if that misconduct was unsanctioned. This means not only that businesses are more vulnerable to the in pari delicto doctrine in suits that they bring, but also–and perhaps more distressingly–that businesses face a greater risk of liability in suits brought against them for harm arising from their employees’ acts. In-house counsel will therefore have to ensure that their organizations are as vigilant as possible in monitoring employees’ behavior and reacting to potential signs of misconduct.

In-house counsel should find some measure of comfort, however, in their companies’ (somewhat) decreased exposure to lawsuits brought by clients, service providers, joint venturers, and other entities that inside counsel’s employers do business with. A narrow adverse-interest exception yields a more robust in pari delicto doctrine, and companies can thus feel more secure that they will not have to endure the injustice of being sued by a company for harm that arises from that company’s own agents.

Read Matthew Ingber’s previous column.