In a Matter of First Impression, the Supreme Judicial Court Narrows the In Pari Delicto Defense

Emily Renshaw_102x126Jason Frank_102x126by Emily E. Renshaw and Jason D. Frank

Case Focus

In Merrimack College v. KPMG LLP, 480 Mass. 614 (2018), the Supreme Judicial Court limited the equitable doctrine of in pari delicto, which bars a plaintiff who has participated in wrongdoing from recovering damages for related losses. Vacating an order granting summary judgment for the auditor defendant, KPMG, the SJC held for the first time that, under the in pari delicto doctrine, only the conduct of “senior management,” those who are “primarily responsible for managing” a plaintiff entity, may be imputed to that entity. Merrimack could have broad implications for professional services providers and will likely lead to the further development of in pari delicto jurisprudence in Massachusetts.

The In Pari Delicto Doctrine

In pari delicto, Latin for “in equal fault,” is an equitable doctrine that courts historically have used to assign blame. In Massachusetts, the doctrine has generally operated to bar a plaintiff who engaged in intentional wrongdoing from recovering from a defendant who was an accomplice or co-conspirator. (Where a plaintiff and defendant are merely negligent, the Massachusetts comparative negligence statute, M.G.L. c. 231, § 85, applies.) The practical import of the in pari delicto doctrine is that the law “‘will not recognize a right of action’ based on inequitable conduct.” Merrimack Coll. v. KPMG LLP, 34 Mass. L. Rptr. 220, at 2 (Mass. Super. Ct. May 15, 2017).

Facts and Procedural History

Merrimack College incurred more than $6 million in losses as a result of a fraudulent scheme by its former Financial Aid Director, Christine Mordach. Unbeknownst to students who had received grants and scholarships, Mordach replaced some grants and scholarships with federal Perkins loans, which she approved without the students’ knowledge or consent.  As a result, Mordach was able to make her budget appear more balanced (reducing projected scholarship expense and ultimately increasing tuition revenue).  The unsuspecting students were saddled with debt they did not need (they were supposed to receive grants or scholarships) and had neither requested nor agreed to repay. Mordach pleaded guilty to federal charges, was sentenced to prison, and ordered to pay approximately $1.5 million in restitution.

Merrimack sought to recover its losses from its independent auditor, KPMG, bringing suit for breach of contract, negligence, negligent misrepresentation, professional malpractice, and violation of M.G.L. c. 93A, and contending that KPMG failed to detect Mordach’s fraud. KPMG moved for summary judgment, arguing, in part, that Merrimack’s claims were barred by the in pari delicto doctrine.  Merrimack contended that it should not be held liable for the misdeeds of a low-level employee.

The Trial Court Decision: In Pari Delicto Bars Recovery

The trial court granted summary judgment in favor of KPMG.  Relying on traditional principles of agency law, the court concluded that Mordach’s conduct was properly imputed to Merrimack. It deemed her to be a “relatively high-level staffer,” noting that, as Financial Aid Director, Mordach had overseen the award and distribution of almost $150 million in financial aid and had signed numerous annual management representation letters to KPMG. Merrimack Coll. v. KPMG LLP, 34 Mass. L. Rptr. 220, at 5. Furthermore, the court explained that in Massachusetts there is no “low-level employee” exception to the law holding employers vicariously liable for employee conduct. Id. at 4.

The trial court also concluded that Mordach’s fraud was “far more serious” than KPMG’s alleged negligence in failing to uncover it, thus further barring Merrimack’s recovery under the in pari delicto doctrine. Id. at 7.

Following the majority of courts, the court declined to recognize a blanket “auditor exception” to the doctrine, noting that such an exception would be inconsistent with Massachusetts law (which in the analogous context of legal malpractice, bars clients who engage in wrongdoing from suing their attorneys for joining in the wrongdoing. See Choquette v. Isacoff, 65 Mass. App. Ct. 1, 7-8 (2005)). Merrimack appealed from the grant of summary judgment, and the SJC accepted direct appellate review.

The SJC Decision

The SJC vacated the grant of summary judgment. Observing that he was writing on “essentially a clean slate of Massachusetts law,” Chief Justice Gants based his ruling on the purposes of the in pari delicto doctrine and principles of imputation. 480 Mass. at 626. In pari delicto, the court explained, is an equitable doctrine “focused squarely on the moral blame of the parties.” Id. at 621-22. The rules of imputation, on the other hand, are designed to allocate fairly risks between principals and innocent third parties. Id. at 621. Traditional rules of imputation under Massachusetts common law, the court noted, “are not without their limits,” and are inapplicable where the aim is to assign blame rather than allocate risk. Id. at 626-27. For example, when determining whether punitive damages—which require “a moral judgment” of the defendant’s conduct—are warranted against an employer for an employee’s misconduct, the court departs from traditional imputation rules. Id. at 627-28. In that circumstance, the court explained, the key factor is whether “members of senior management” are morally blameworthy by participating or acquiescing in the misconduct; “[t]he misconduct of lower-level employees—even those at the supervisory level—is insufficient to warrant punitive damages.” Id. at 628.

For similar reasons, the SJC held that under Massachusetts common law, a corporate entity’s “moral responsibility” can be measured only by the conduct of “senior management—that is, the officers primarily responsible for managing the corporation, the directors, and the controlling shareholders, if any.” Id. In Merrimack, the court ruled for the first time that, under the doctrine of in pari delicto, only the intentional misconduct of “senior management” may be imputed to the plaintiff and, “only then, will a court need to consider whether application of the doctrine would comport with public policy.” Id.

On this matter of first impression, while leaving open to interpretation the term “senior management,” the SJC observed that Mordach was not a member of senior management whose conduct could be imputed to Merrimack under the doctrine of in pari delicto. Although Mordach had substantial responsibilities as Financial Aid Director, she was “not among the select few who were primarily responsible for the management of the college[.]” Id. at 629.

The SJC declined to carve out as a matter of public policy an auditor exception to the in pari delicto doctrine, which the Court opined was unnecessary to its decision. The Court further raised a question about the intersection between the in pari delicto doctrine and another statute, M.G.L. c. 112, § 87A3/4, which provides for the apportionment of losses in cases involving an accounting firm in which a claim or defense of fraud is raised against the plaintiff or another party. The Court declined, however, to interpret the statute, noting that on remand the trial court may do so and consider its proper application. Id. at 632.

The Court made clear that its decision was narrowly confined to the question of imputation in the application of the in pari delicto defense. Thus, there seems to be no change in Massachusetts law with respect to the imputation of conduct by non-senior management for purposes of Massachusetts’s other comparative fault statutes or common law.

Implications

Merrimack could have broad implications for professional services providers, and the issues identified in the decision likely will lead to the further development of in pari delicto jurisprudence in Massachusetts. Notably, the SJC did not provide analytical tools to determine precisely what constitutes “senior management” for purposes of the in pari delicto doctrine. For example, applying Merrimack, will courts impute to a plaintiff corporation the conduct of a corporate controller who manages a 100-person finance department, and engages in a multi-million-dollar accounting fraud scheme? Merrimack may also result in strategic behavior by buyers and providers of professional services, as they seek to allocate and minimize risk, and such behavior may increase costs of service providers in Massachusetts. Following Merrimack, it is even more critical than ever for service providers to carefully define the scope of their corporate engagements, particularly in the context of audits and investigations.

Emily E. Renshaw is a partner at Morgan, Lewis & Bockius LLP in Boston.  Emily focuses her practice on securities litigation and complex business matters. She represents a diverse client base in an array of matters including shareholder and consumer class actions, derivative actions, governmental, regulatory, and internal investigations, and all forms of contractual disputes and business torts. She represents clients before state and federal courts at the trial and appellate levels and in regulatory proceedings before federal and state securities agencies.

Jason D. Frank is a partner at Morgan, Lewis & Bockius LLP in Boston. For the last two decades, Jason has represented clients in shareholder class actions, derivative suits, SEC proceedings, internal investigations, and a broad array of complex business litigation, including auditor malpractice. He has litigated in trial and appellate courts throughout the United States, appearing before courts in virtually every federal circuit.



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