Corporate Governance

The failures of corporations such as MCI Worldcom and Enron have made headlines in recent years.  In cases such as these, where there has been evidence of the company’s officers’ or directors’ misconduct, questions have arisen as to whether professionals engaged by the company to verify the accuracy of its books and records may still be held accountable for their negligence.  Traditionally, an officer’s or director’s wrongdoing has been imputed to the company itself to prevent the company from suing third parties for misconduct initially caused by the company’s officers or directors.  The case law that has developed over recent years, however, appeared to indicate that this traditional “imputation rule” might not be applied against a trustee or receiver for the company, or when the company has been “looted,” or when the interests of the officers or directors who acted fraudulently are adverse to the interests of the company itself.  Just when clear exceptions to the rule seemed to becoming well-defined, however, a bankruptcy court in Florida seems to have swept at least one of the exceptions under the rug.  This article briefly summarizes the evolution of the exceptions to the imputation rule in Florida and other jurisdictions, as well as the possible retreat from at least one of those exceptions.

            An Introduction to the Imputation Rule

            In the seminal case of Cenco, Inc., v. Seidman & Seidman,[1] Judge Posner addressed the application of a rule by which a corporation’s officers’ wrongful acts may be imputed to the corporation itself.  This doctrine, which was based upon the principle of in pari delicto (“in equal fault”), came to be known as the imputation rule.

            In predicting how the Illinois courts might decide the case, Judge Posner looked at the “victim” of the accounting firm’s laxity: the corporation.  Because a corporation is a legal fiction, however, Judge Posner reasoned that the “people who will receive the benefits of any judgment” are really the corporation’s stockholders, some of whom were the corrupt officers themselves.[2]  As a result, Judge Posner recognized that “[o]nce the real beneficiaries of any judgment in favor of Cenco are identified, it is apparent that such a judgment would be perverse from the standpoint of compensating the victims of the wrongdoing.”[3]  In other words, the very corrupt officers who perpetrated the fraud would benefit pro rata, as stockholders themselves, from a judgment in favor of the corporation.  As a result, Judge Posner held that the corporation’s officers’ fraudulent acts should be imputed to the corporation.

            Like many other rules, exceptions to the imputation rule developed over time.  The three primary exceptions to the imputation doctrine that have been adopted by the courts are the adverse interest exception, the looting exception and the trustee (or receiver) exception.  According to the case law that developed subsequent to the Cenco decision, acts justifying the application of any of these principles may preclude the wrongdoing officer’s or director’s acts from being imputed to the company.  Thus, even where these officers and directors may have contributed to the downfall of the company, professionals retained by the company may not be able to shield themselves from their own negligence. 

            The Adverse Interest Exception

            Approximately a year after the Cenco decision, the Seventh Circuit issued another opinion involving the imputation rule.  In Schact v. Brown[4] the court found Cenco to be inapplicable.  Unlike Cenco, the Schact court found that there was a “far reaching scheme in which, as a consequence of the illegal activities of [the corporation’s] directors and the outside defendants, [the corporation] was, inter alia, fraudulently continued in business past its point of insolvency and systematically looted of its most profitable and least risky business and more than $3,000,000 of income – all actions which aggravated [the corporation’s] insolvency.”[5]  As such, “[i]n no way can these results be described as beneficial to [the corporation].”[6]  The Seventh Circuit rejected the defendants’ argument that the corporation benefitted pro tanto.  To the contrary, the court noted that “the fact that [the corporation’s] existence may have been artificially prolonged pales in comparison with the real damage allegedly inflicted by the diminution of its assets and income.”[7]  In that case, the prolonged artificial insolvency benefitted only the corporation’s managers, not the corporation itself.

            The Seventh Circuit accentuated its reasoning with the following statement:

More colloquially put, if the defendant’s position were accepted, the possession of such “friends” as [the corporation] had would certainly obviate the need for enemies.  We do not believe such a pyrrhic “benefit” to [the corporation] is sufficient to even trigger the Cenco analysis which seeks to determine the propriety of imputing to the corporation the directors’ knowledge of fraud.[8] 

The Schact court refused to impute the illegal activities of the company’s directors to the corporation itself as a plaintiff.  The Court’s rationale was bolstered by the conclusion that any recovery in Schact would inure to the company’s estate and not to the wrongdoing directors.   The Court believed that where there are allegations of a far reaching scheme to continue a corporation in business past its point of insolvency and to systematically loot it, it cannot be said that such conduct benefitted the corporation.[9]

            In 1992, Florida’s Third District Court of Appeal adopted the imputation rule in Seidman & Seidman v. Gee.[10]  In a scheme to keep a license and continue operating the subject company, Universal, in the insurance business, a corporate officer represented that Universal was backed by a $10 million certificate of deposit. Using false financial statements reflecting the $10 million CD, Universal obtained a license required to operate in the Cayman Islands and solicited customers internationally.  In analyzing whether the officer’s conduct should be imputed to the corporation, the court relied on Cenco and Schacht.  The Gee Court noted in Cenco the “rationale was that the corporation is precluded from recovering on a claim for fraud where the corporation actually benefitted from the fraud.” [11]  The Gee court then distinguished the Schacht decision because the “illegal activities of the managing directors in Schacht inflicted real damage on the corporation by diminishing its assets and income, a result that was not beneficial to the corporation.”[12]  The Third District recognized that the corporate officer’s fraudulent act was committed for the benefit of the corporation because the corporation was only able to operate the business based on the false $10 million CD.[13]  Because the officer’s wrongful acts were not adverse to the corporation’s interests, there was no exception to the general rule and the wrongful acts were imputed to the corporation itself. 

            The Looting Exception

            Closely related to the adverse interest exception is the looting exception. Several  courts have refused to impute the corporation’s officers’ or directors’ wrongdoing to the corporation where there is evidence that the company’s assets were “looted.”[14]

            For example, in Tew v. Chase Manhattan Bank, N.A.,[15] the court refused to impute the misconduct to the corporation because the officers and directors “ran [the corporation] into the ground and robbed the corporate entity for their own aggrandizement.”  Similarly, in Golden Door Jewelry Creations, Inc. v. Lloyds Underwriters Non-Marine Assoc.,[16] the court “rejected the invitation to impute [the] illegal acts to the insureds” because the wrongdoer “did not act in furtherance of the insured's interests when they stole company property and subsequently filed a fraudulent claim for the loss.”[17]   Like the adverse interest exception, therefore, the looting exception is based upon the premise that the corporation could not have benefitted by the scheme that ultimately caused its downfall.

            The Receiver or Trustee Exception

            In Scholes v. Lehman,[18] Judge Posner, the author of the Cenco decision, revisited the principle of in pari delicto.   In Scholes, the wrongdoing officer, Douglas, formulated a Ponzi scheme, created three corporations and caused them to create limited partnerships in which the corporations would be the general partners and would sell limited partnership interests to the investing public. The money raised from the sale of the limited partnership interests was used to pay the promised return, which gave the scheme credibility.  Ultimately, the scheme crashed, but Douglas managed to raise $30 million. 

            The issue in Scholes was whether a court-appointed receiver for the companies had standing to bring the lawsuit. In ruling that the receiver did have standing, Judge Posner concluded that a receiver enjoys special rights because the “appointment of the receiver removed the wrongdoer from the scene.”[19]  “Put differently, the defense of in pari delicto loses its sting when the person who is in pari delicto is eliminated.”[20] 

            The defendants in Scholes argued that the corporations should be bound by Douglas’s wrongdoing because the corporations were complicit in Douglas’s fraud.  Judge Posner, however, rejected the argument because Douglas had been ousted from control of, and beneficial interest in, the corporations. Judge Posner noted:

[t]he corporations were no more Douglas's evil zombies. Freed from his spell they became entitled to the return of the monies--for the benefit not of Douglas but of innocent investors--that Douglas had made the corporations divert to unauthorized purposes. That the return would benefit the limited partners is just to say that anything that helps a corporation helps those who have claims against its assets. The important thing is that the limited partners were not complicit in Douglas's fraud; they were its victims.[21] 

            Judge Posner’s analysis turned on the fact that the control of the corporations which were created and initially controlled by Douglas was assumed by a receiver whose objective was to maximize the value of the corporations for the benefit of their investors and creditors.  “We cannot see an objection to the receiver's bringing suit to recover corporate assets unlawfully dissipated by Douglas. We cannot see any legal objection and we particularly cannot see any practical objection.”[22]     Consistent with the Seventh Circuit’s decisions, in Welt v. Sirmans[23]  the Southern District of Florida refused to impute the misconduct of an officer or director to a trustee in bankruptcy. Welt was appointed as the trustee in bankruptcy for the corporate debtor, Cascade.  Welt filed suit on behalf of Cascade and its subsidiaries against Cascade's directors, Cascade's legal counsel and individual partners of the law firm.[24]

            In deciding Welt, Judge Nesbitt tracked the development of the imputation rule from the Seventh Circuit and the Florida law.  Based on the analysis of Cenco and Schact, Judge Nesbitt ruled that any recovery by the trustee would serve to properly compensate the victims of the wrongdoing and deter future wrongdoing.[25]  Judge Nesbitt noted that the “Schact court essentially distinguished Cenco because a liquidator brought the action, as opposed to the corporation itself.”[26]  Judge Nesbitt concluded:

if the issue as framed by this Court would be squarely presented to a Florida state court the court would permit a trustee to bring a claim for damages stemming from a third party’s negligent failure to discover a fraud perpetrated by such corporation’s officers and directors.[27] 

            Judge Nesbitt also noted that other courts have concluded the fraud that is imputed to the corporation should not be imputed to the corporation’s trustee or receiver:

While recognizing the general rule that a receiver, like a bankruptcy trustee, occupies no better position than that which was occupied by the party for whom he acts, the Court found that defenses based on the party's unclean hands or inequitable conduct do not generally apply against a party's receiver.[28] 

            Banco Latino, Int’l. v. Lopez[29] is another decision in which a court applying Florida law acknowledged the trustee exception to the imputation rule.  In Banco Latino, Judge Highsmith noted, “Judge Nesbitt ruled in Welt that the imputation rule did not apply in a case brought to vindicate the rights of a defunct corporation by a bankruptcy trustee, for the benefit of the defunct corporation’s creditors.”[30]  Thus, for similar reasons that form the foundation for the adverse interest and looting exceptions, the imputation rule has been found not to apply when a trustee or receiver pursues the claims in the place of a corporation.

            A Retreat From an Exception

            Just when it seemed  the exceptions to the imputation rule were becoming well-defined, a Florida bankruptcy court retreated from the trustee exception to the imputation doctrine.   In In re: Meridian Asset Management, Inc.,[31]  Meridian was a financial services company offering brokerage and investment advice and falsely promised to invest and oversee the investment of monies, funds, and credits belonging to and in the care of numerous clients.  Instead of investing the funds, Meridian’s principal officer embezzled the investors’ funds.  The Securities Investor Protection Corporation (“SIPC”) was appointed as trustee to liquidate Meridian and the case was moved to bankruptcy court.  SIPC brought suit in two capacities: (1) as trustee of Meridian, standing in the shoes of Meridian and (2) on behalf of defrauded investors.[32]  One of the defendants filed a Motion to Dismiss SIPC’s complaint, arguing that SIPC lacked standing to bring its claims. 

            With respect to whether SIPC had standing as trustee of Meridian, Judge Killian thoroughly analyzed the development of the imputation doctrine, including the Schacht, Gee and Welt decisions.  Judge Killian rejected the Welt holding, reasoning that if the “proposition is advanced that a trustee stands in larger shoes because he represents creditors and shareholders, and a director’s fraud should not be imputed to the trustee,” then “we end up violating a basic rule of bankruptcy: that a trustee in bankruptcy cannot assert claims on behalf of creditors of the estate.”[33]  Judge Killian found the Welt court’s decision to allow the trustee to assert claims that did not belong to the estate, but instead to the estate’s creditors, was not supported by prevailing case law and he therefore refused to apply the receiver/trustee exception to the imputation rule.  

            Although the Meridian court did not address either the adverse interest or looting exceptions to the imputation doctrine, Meridian represents a retreat from a developed exception to the imputation rule.  The enduring viability of all of  the exceptions therefore remains in question.

            The Exceptions to the Imputation Rule Have Led to Viable Claims Against Professionals Despite the Company’s Officers’ or Directors’ Fraudulent Conduct.    

            To date, the exceptions to the imputation rule have enabled corporations’ trustees or receivers to bring causes of action against professionals, such as accounting or auditing firms, without being hindered by the companies’ officers’ or directors’ fraudulent conduct.  Likewise, where there has been evidence supporting application of the looting or adverse interest exceptions, several courts have ruled that the professionals will not be permitted to escape liability for their own misconduct.[34]

Under these circumstances, most courts reason that the rationale for imputing the wrongful acts to the corporation do not apply and the wrongdoing acts may not be imputed to the corporation or its receiver or trustee.  As a result, even in cases where the corporations’ officers’ or directors’ misconduct may have contributed to the corporation’s downfall, the corporation or its trustee or receiver may maintain claims against the corporation’s professionals for their misfeasance or malfeasance, and those professionals should therefore exercise due care in performing their services.

            Conclusion.

            Although the Meridian decision may signal the beginning of the end of the exceptions to the imputation rule, accounting firms, law firms and other professionals should be careful to comply with their legal obligations to the fullest extent without regard to whether its corporate client is suffering, or has already suffered, damages as a result of its own officers’ or directors’ misconduct.  For the time being at least, the exceptions to the imputation rule are alive and kicking.                

[1].  Cenco, Inc. v. Seidman & Seidman, 686 F.2d 449 (7th Cir. 1982).

[2].  Id. at 455.

[3].  Id.

[4].  Schact v. Brown, 711 F.2d 1343 (7th Cir. 1983).

[5].  Id.  at 1347-48.

[6].  Id.

[7].  Id. at 1348.

[8].  Id.

[9].  Smith v. Arthur Andersen, LLP, 175 F. Supp. 2d 1180 (D.C. Ariz. 2001) (citing In re Stat-Tech Securities Litigation, 905 F. Supp. 1416 (D.C. Colo. 1995)).

[10].  Seidman & Seidman v. Gee, 625 So. 2d 1 (Fla. 3d DCA 1992).

[11].  Id. at 4. 

[12].  Id. at 7; see also Tew v. Chase Manhattan Bank, N.A., 728 F. Supp. 1551, 1560-61 (S.D. Fla. 1990) (applying adverse interest exception under Florida law and finding the Cenco analysis unavailing); In Re: Stat-Tech Securities Litigation, 905 F. Supp. 1416 (D. Colo. 1995) (applying adverse interest exception under Colorado law).

[13].  In Gee, the liquidator failed to argue at either the trial or appellate level that the imputation of fraud doctrine did not apply to a liquidator for the corporation. The Department of Insurance subsequently filed an amicus brief on appeal raising the issue that the imputation rule does not apply to a liquidator.  The court refused to consider the argument because it had not been raised by the parties, but rather had been raised in an amicus brief.  The “trustee exception,” however was destined to gain more prominence in subsequent opinions.

[14].  In fact, an officers’ or director’s wrongful acts may not even have to rise to the level of looting or embezzlement in order to prevent application of the imputation rule, so long as the corporation does not receive a benefit from the misconduct (as the adverse interest exception would then apply).  See, e.g.,  Beck v. Deloitte & Touche, 144 F.3d 732 (11th Cir. 1998) (“A directors’ wrongful actions toward his corporation do not have to rise to the level of corporate “looting” (as in Tew) or embezzlement (as in Golden Door) in order to be adverse and thereby prevent imputation, as long as the corporation receives no benefit from the director’s misbehavior.”).

[15].  Tew v. Chase Manhattan Bank, N.A., 728 F. Supp. 1551, 1553 (S.D. Fla. 1990).

[16].   Golden Door Jewelry Creations, Inc. v. Lloyds Underwriters Non-Marine Assoc., 117 F.3d 1328, 1338-39 (11th Cir. 1998).

[17].  Cf. Cenco, Inc. v. Seidman & Seidman, 686 F.2d 449 (7th. Cir. 1982)(imputing the fraud to the company because “those involved in the fraud were not stealing from the company, as in the usual corporate fraud case, but were instead aggrandizing the company)”; Seidman & Seidman v. Gee, 625 So. 2d 1 (Fla. 3d DCA 1992) (imputing the fraud to the company because there was no evidence of looting and because the purpose of the misconduct was to allow the company to obtain a license to continue operating).

[18].  Scholes v. Lehman, 56 F.3d 750 (7th Cir. 1995), cert. denied, 516 U.S. 1028 (1995).

[19].  Id. at 754.

[20].  Id.

[21].  Id.

[22].  Id. at 755; see also FDIC v. O’Melveny & Myers, 61 F. 3d 17 (9th Cir. 1995) (where the court refused to impute a bank’s officers’ wrongdoing to a receiver because a “[R]eceiver, like a bankruptcy Trustee and unlike a normal successor in interest, does not voluntarily step into the

shoes of the bank; it is thrust into those shoes.  It was neither a party to the original inequitable conduct nor is it in a position to take action prior to assuming the bank’s assets to cure any associated defects or force the bank to pay for incurable defects.  This places the Receiver in stark contrast to the normal successor in interest who voluntarily purchases a bank or its assets and can adjust the purchase price for the diminished value of the bank’s assets due to their associated equitable defense.  In such cases, the bank receives less consideration for its assets because of its inequitable conduct, thus bearing the cost of its own wrong.”).

[23].  Welt v. Sirmans, 3 F. Supp. 2d 1396 (S.D. Fla. 1997).

[24].  Id. at 1400.

[25].  Id. at 1402. 

[26].  Id.

[27].  Id. 

[28].  Id. citing Waslow v. Thornton (In re Greenberg), 212 B.R. 76, 91 (Bankr. E.D. Pa. 1997) (citing F.D.I.C. v. O’Melveny & Myers, 61 F.3d 17, 19 (9th Cir. 1995)); see also Scholes , 56 F.3d at 754; Gordon v. Basroon (In re Plaza Mortgage and Fin. Corp.), 187 B.R. 37 (Bankr. N.D. Ga. 1995).

[29].  Banco Latino Int’l v. Lopez, 95 F. Supp. 2d 1327 (S.D. Fla. 2000).

[30].  In Banco Latino, however, the action was not brought by a Trustee, and therefore the Trustee exception did not apply.  Judge Highsmith proceeded to the issue of whether the adverse interest exception applied.  Id. at 1336 n.12.

[31].  In re: Meridien Asset Management, Inc. (Securities Investor Protection Corp. v. Capital City Bank), 296 B.R. 243 (Bankr. N.D. Fla. 2003).

[32].  While the court found that SIPC had standing to in the second capacity, on its own behalf, the court dismissed the complaint for failure to state a claim.  Id. at 267.

[33].  Id. at 256.

[34].  Smith v. Arthur Anderson, 175 F. Supp 2d 1180 (D. Ariz. 2001) (under Arizona law the adverse interest exception, trustee exception and looting exception all preclude imputation of officers’ or directors’ wrongful acts to the corporation and do not effect ability of Trustee to pursue claims against the corporation’s auditors who distorted or concealed the corporation’s true financial condition); In Re: Jack Greenberg, Inc., 212 B.R. 76 (Bankr. E.D. Pa. 1997) (adverse interest and trustee exception did not affect trustee’s or debtor’s claims against accounting firm alleging misfeasance and malfeasance even where officer of company acted fraudulently).