In Seitz v. Marcum LLP, 2024 N.Y. Slip Op. 51141(U) (Sup. Ct., N.Y. County Aug. 30, 2024) (here), Justice Robert R. Reed of the New York County Commercial Division addressed the doctrine of in pari delicto,[1] which “bars a party that has been injured as a result of its own intentional wrongdoing from recovering for those injuries from another party whose equal or lesser fault contributed to the loss.”[2] The doctrine is available to a defendant as an affirmative defense that can be raised in any type of action.[3]
Seitz arose from defendant’s allegedly negligent services as auditor and accountant for now-bankrupt entities City Line Behavioral Healthcare, LLC, formerly known as Liberation Behavioral Health, LLC (“LBH”), and its subsidiary, Life of Purpose-Pennsylvania, LLC, formerly known as Liberation Way, LLC (“Liberation Way”) (collectively, the “Liberation companies”). Plaintiff, as trustee of the bankruptcy estates of the Liberation companies, asserted four claims against defendant for accounting malpractice, breach of fiduciary duty, breach of contract, and unjust enrichment. Defendant moved to dismiss the complaint pursuant to CPLR 3211 (a) (5) and (a) (7). As discussed below, Justice Reed granted the motion and dismissed the complaint.
Background
The Liberation companies operated three facilities in Pennsylvania that provided treatment for drug and alcohol addiction. Liberation Way was a single-member limited liability company owned and controlled by LBH, which was, in turn, managed by a five-person board of directors.
From 2015, the year of its founding, the CEO, CFO, and COO and President of LBH allegedly began engaging in fraudulent schemes including: “(i) fraudulently billing patients and insurance companies for treatments that were not provided, not medically necessary or were substandard; (ii) paying for patients to fraudulently obtain high-end insurance policies and fraudulently billing the insurance companies under those policies; (iii) generating kickbacks by sending thousands of medically unnecessary urine tests from the Company’s patients to co-conspiring labs in Florida; (iv) housing clients at sober-living homes associated with the Company without an inpatient license; and (v) failing to comply with [the Pennsylvania Department of Drug and Alcohol Program’s] regulations and licensing requirements.”[4]
In addition, the Liberation companies allegedly “manipulated [their] financial statements, including by overstating [their] revenue collection figures.”[5]
In or about May 2016, the Liberation companies engaged defendant, Marcum LLP, to perform accounting and auditing services for them.
In 2016, Independent Blue Cross (“IBC”), an insurance company that insured many of the Liberation companies’ patients, began conducting an audit of the Liberation companies’ claims and billing practices. Through the audit, IBC discovered the alleged fraud and other misconduct that the Liberation companies committed between July 2015 and late 2017.
IBC’s audit was known to the Liberation companies’ officers, directors, and critical advisors, and legal counsel to the Liberation companies disclosed the audit to defendant by no later than March 31, 2017.
In December 2016, non-party Fulcrum Equity Partners, Inc. (“Fulcrum”) offered to purchase the Liberation companies and entered into a period of negotiation and due diligence.
Under the proposed transaction, certain members of LBH would sell their membership units in LBH to LBH Holdings, LLC (“LBH Holdings”), a company newly created to become the parent company for LBH, and its subsidiary, LBH Holdco Corp. (“LBH Holdco”), pursuant to a Unit Purchase and Contribution Agreement (“Purchase Agreement”), in exchange for millions of dollars and membership units in LBH Holdings.
In the Purchase Agreement, the selling members of LBH represented “that the [Liberation companies] and its staff had always followed all applicable laws, that they had not engaged in activity in violation of Pennsylvania law governing rehabilitation facilities, and that they maintained all required records.”[6] These representations and warranties induced LBH Holdings and LBH Holdco to enter into the Purchase Agreement. As a result of the transaction, LBH became a wholly owned subsidiary of LBH Holdings.
In connection with this proposed transaction, defendant performed accounting services for the Liberation companies, including valuation, due diligence, and opening balance sheet corrections. However, in its April 2017 audit report and accounting work, defendant allegedly never investigated or considered the implications of the IBC audit.
Fulcrum and non-party Vocap Partners ultimately acquired the Liberation companies on December 11, 2017, contributing $12 million in cash and $29.6 million in funds loaned from Oxford Finance LLC (“Oxford”) and another bank, to purchase 70% of LBH Holdings. The $29.6 million loan was secured primarily by LBH’s assets. The selling members of LBH maintained a 30% stake in LBH Holdings.
After the Fulcrum transaction, Fulcrum selected new officers and directors to control and direct the Liberation companies, including a new CEO.
In January 2018, defendant began its 2017 audit and accounting services for the Liberation companies. During the audit, defendant allegedly learned of a material overstatement of net accounts receivable that it had missed in its 2016 audit and accounting services for the Fulcrum transaction. In addition, in reviewing the companies’ legal bills, defendant allegedly became aware of a series of governmental investigations that placed them in jeopardy, such as an order from the Pennsylvania State Department of Drug and Alcohol Programs (“DDAP”) to cease patient intake at multiple locations due to problems discovered during its inspections, an investigation by the Pennsylvania Office of the Attorney General, and an order from the federal Drug Enforcement Agency regarding violations of federal regulations governing Narcotics Treatment Programs. Defendant also allegedly learned that the Liberation companies were in default of their Credit Agreement with Oxford, according to a notice of default received on July 6, 2018.
When defendant issued its 2017 audit report on August 8, 2018, it allegedly conducted no investigation into the government subpoenas or letter inquiries and never revisited findings from the IBC audit or Oxford’s notice of default. Likewise, when defendant began its audit and accounting service for 2018 in January 2019, it allegedly did not investigate or address any of these issues.
On March 25, 2019, the Pennsylvania Office of the Attorney General announced criminal charges against LBH and its former officers and directors. At or about that time, defendant informed LBH’s new CEO that the Liberation companies should no longer rely on its audited financial statements. Defendant continued to perform audit and accounting services, including in connection with the Attorney General’s investigation, until the Liberation companies declared bankruptcy on April 17, 2019. Defendant did not issue an audit report for 2018.
The Liberation companies declared bankruptcy on or about April 17, 2019. Plaintiff was appointed the trustee of the bankruptcy estates of the Liberation companies.
On April 16, 2021, plaintiff commenced the action by filing a summons with notice. Plaintiff filed a complaint on May 20, 2021, asserting four causes of action for accounting malpractice, breach of fiduciary duty, breach of contract, and unjust enrichment with respect to defendant’s audit and accounting services from 2016 to 2019.
On June 18, 2021, defendant filed a motion to dismiss the complaint. Plaintiff opposed the motion.
The Motion Court’s Ruling
In its motion, defendant principally argued that the complaint should be dismissed under the in pari delicto doctrine.
Relying on the Court of Appeals’ decision in Kirschner v. KPMG LLP, Justice Reed held that the doctrine barred plaintiff’s claims.
The motion court found that plaintiff, as the trustee of the bankruptcy estates of the Liberation companies, stood in the shoes of the Liberation companies and had no greater rights than they would have if they had not filed for bankruptcy.[7] This was significant since plaintiff alleged that LBH’s officers themselves engaged in fraud and other malfeasance, and those acts had to be imputed to LBH. Therefore, said the motion court, “defendant sufficiently demonstrate[d] that, as a party in pari delicto, plaintiff [was] barred from bringing its claims stemming from the wrongful acts of the Liberation companies’ directors and officers.”[8]
In granting defendants’ motion, the motion court rejected plaintiff’s argument that issues of fact prevented the court from applying the in pari delicto doctrine to the complaint.[9] Noting that the Court of Appeals specifically held that “in pari delicto may be resolved on the pleadings … in an appropriate case,” the motion court found that plaintiff did “not point to any factual dispute that would preclude dismissal on the basis of th[e] doctrine.”[10] In fact, noted the motion court, the doctrine’s “applicability [was] apparent on the face of [plaintiff’s] pleadings.”[11]
As explained by defendant, to which the motion court agreed, “‘[t]here is not a single allegation in the Complaint which suggests that Marcum’s auditing services were negligent in any way other than in failing to detect the Company’s own fraud. And there is no allegation that the Company’s financial statements were inaccurate in any way other than as a result of the Company’s fraud.’”[12]
The motion court also rejected plaintiff’s argument that the “adverse interest” exception to the in pari delicto doctrine should apply, such that the wrongful actions of the company’s officers would not be imputed to LBH.
Under the adverse interest exception, which is narrowly applied, “management misconduct will not be imputed to the corporation if the officer acted entirely in his own interest and adversely to the interest of the corporation.”[13] To avail oneself of the exception, a plaintiff must show that “the agent … totally abandoned his principal’s interests and [acted] entirely for his own or another’s purposes.”[14] “It cannot be invoked merely because he has a conflict of interest or because he is not acting primarily for his principal.”[15]
Justice Reed held that the adverse exception did not apply because plaintiff failed to allege that the LBH “officers and directors ‘totally abandoned [their] principal’s interests and … act[ed] entirely for [their] own or another’s purposes.’”[16] Examining the Fulcrum transaction, which formed the basis of plaintiff’s argument, Justice Reed found that “[t]he transaction would have benefited the companies through the infusion of $12 million from Fulcrum and Vocap and $29.6 million in loans from Oxford. That the loan was secured by LBH’s assets alone [did] not render the transaction in ‘adverse interest’ to the Liberation companies.”[17] “Indeed,” said the motion court, “the transaction may, at least before discovery of the officers’ fraudulent acts, have permitted them to ‘survive,’ ‘attract investors and customers and raise funds for corporate purposes’ for the time being.”[18]
In conclusion, Justice Reed, quoting from the Court of Appeals’ decision in Kirschner, held that “the complaint must be dismissed in its entirety under the doctrine of in pari delicto”:[19]
However, as the Court of Appeals also observed in Kirschner, “[a] fraud that by its nature will benefit the corporation is not ‘adverse’ to the corporation’s interests, even if it was actually motivated by the agent’s desire for personal gain” (Kirschner at 467). “So long as the corporate wrongdoer’s fraudulent conduct enables the business to survive—to attract investors and customers and raise funds for corporate purposes—this test is not met” (id. at 468). Moreover, “any harm from the discovery of the fraud—rather than from the fraud itself—does not bear on whether the adverse interest exception applies. The disclosure of corporate fraud nearly always injures the corporation” (id. at 469). In addition, pertinent to this case, “the mere fact that a corporation is forced to file for bankruptcy does not determine whether its agents’ conduct was, at the time it was committed, adverse to the company” (id. at 468).[20]
Takeaway
The in pari delicto doctrine serves two salutary purposes. First, the doctrine deters illegal activity by denying judicial relief to an admitted wrongdoer. Second, it conserves judicial resources because it avoids entangling courts in disputes between wrongdoers.[21] Notwithstanding, the doctrine will not bar an action when an agent totally abandons his/her principal’s interests and acts entirely for his/her own purposes or those of another (i.e., the agent’s acts are “totally” adverse to the principal).[22]
In Seitz, plaintiff was unable to persuade the motion court that the officers and directors of the Liberation companies acted solely for their benefit. As such, the motion court was compelled to dismiss the complaint.
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Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.
This article is for informational purposes and is not intended to be and should not be taken as legal advice.
[1] This Blog previously examined the in pari delicto doctrine here.
[2] Rosenbach v Diversified Grp., Inc., 85 A.D.3d 569, 570 (1st Dept. 2011).
[3] Kirschner v. KPMG LLP, 15 N.Y.3d 446 (2010) (malpractice); Donovan v. Rothman, 302 A.D.2d 238 (1st Dept. 2003) (breach of contract), Gitlin v. Chirinkin, 121 A.D.3d 939 (2d Dept. 2014) (breach of contract, breach of fiduciary duty, unjust enrichment).
[4] Slip Op. at *1 (quoting the complaint).
[5] Id. (quoting the complaint).
[6] Id. (quoting the complaint).
[7] Id. (citing Mediators, Inc. v. Manney (In re Mediators, Inc.), 105 F.3d 822, 826 (2d Cir 1997)).
[8] Id.
[9] See Stokoe v. Marcum & Kleigman LLP, 135 A.D.3d 645, 645 (1st Dept. 2016). Justice Reed distinguished Stokoe by noting that in Stokoe the defendants had failed to show fraudulent activity by the plaintiffs’ agent, whereas in the case before him, “plaintiff himself … pleaded the officers’ fraudulent activity.” Slip Op. at *2.
[10] Slip Op. at *2 (citing Kirschner, 15 N.Y.3d at 459, n.3).
[11] Id.
[12] Id. (quoting defendant’s reply memorandum).
[13] Symbol Tech., Inc. v. Deloitte & Touche, LLP, 69 A.D.3d 191, 197 (2d Dept. 2009).
[14] Kirschner, 15 N.Y.3d at 466.
[15] Id.
[16] Slip Op. at *3 (quoting Kirschner, N.Y.3d at 466).
[17] Id.
[18] Id. (quoting Kirschner, 15 N.Y.3d at 468).
[19] Id. at *3-*4.
[20] Id. at *3.
[21] Kirschner, 15 N.Y.3d at 464.
[22] Id. at 466.
