Opinion
CV-S-02-0537-PMP (LRL), BK-S-00-10533-LBR, ADV-02-1023-LBR.
April 1, 2005
ORDER
Presently before the Court is KPMG LLP's Motion for Summary Judgment (Imputation, In Pari Delicto, and Causation-Damages) (Doc. ##691, 692), filed on July 20, 2004. Defendant KPMG LLP ("KPMG") also filed Sealed Exhibits and Errata Exhibits supporting the Motion (Doc. ##693, 735, 736, 777). Plaintiff Anthony H.N. Schnelling filed the Trustee's Response to KPMG LLP's Motion for Summary Judgment (Imputation, In Pari Delicto, and Causation-Damages) and supporting exhibits (Doc. ##704, 705, 706) on August 13, 2004. KPMG filed its Reply (Doc. #734) on September 13, 2004.
I. BACKGROUND
AgriBioTech, Inc. ("AgriBioTech" or "ABT") was founded in 1983. (Third Am. Compl. (Doc. #328) ¶ 51.) ABT was a developer, producer, marketer, and distributor of forage and turfgrass seed. (KPMG LLP's Mot. for Summ. J. (Imputation, In Pari Delicto, and Causation-Damages) (Doc. #691), Ex. 6 at 2.) ABT developed a three-stage business strategy to capitalize on the fragmented seed industry by acquiring companies in the industry, realizing efficiencies from integrating these companies, and developing higher value proprietary seed varieties. (Id.) Between 1995 and 1999, ABT acquired thirty-four companies, and increased revenues from $26 million to $370 million. (Id. at 4.) As of 1998, AgriBioTech was the largest forage and turfgrass seed producer in the United States. (Third Am. Compl. ¶ 1.)
For ease of reference, KPMG's exhibits to its Motion for Summary Judgment and its sealed and errata exhibits will be cited as "KPMG's Ex. ___." The Trustee's exhibits in its Response and two volumes of exhibits will be cited as "Trustee's Ex. ___."
To record ABT's acquisitions in its financial statements, ABT used a recording method the parties refer to as "effective date" accounting. (Trustee's Ex. 17 at 38; Trustee's Ex. 2 at KPMG000042895, KPMG000042947). Rather than record the acquired company's earnings on the date of closing, ABT used effective date accounting to report the acquired company's earnings as its own upon the date ABT took effective control of the purchased company. (KPMG's Ex. 6 at F8.) ABT used this method with KPMG's knowledge and concurrence, based on an opinion by the Accounting Principles Board ("APB"), APB-16. (Id.; Trustee's Ex. 17 at 38-42.) Paragraph 93 of APB-16 states:
The Board believes that the date of acquisition of a company should ordinarily be the date assets are received and other assets are given or securities are issued. However, the parties may for convenience, designate as the effective date the end of an accounting period between the dates a business combination is initiated and consummated. The designated date should ordinarily be the date of acquisition for accounting purposes if a written agreement provides that effective control of the acquired company is transferred to the acquiring corporation on that date without restrictions except those required to protect the stockholders or other owners of the acquired company — for example, restrictions on significant changes in the operations, permission to pay dividends equal to those regularly paid before the effective date, and the like. Designating an effective date other than the date assets or securities are transferred requires adjusting the cost of an acquired company and net income otherwise reported to compensate for recognizing income before consideration is transferred. The cost of an acquired company and net income should therefore be reduced by imputed interest at an appropriate current rate on assets given, liabilities incurred, or preferred stock distributed as of the transfer date to acquire the company.
(Trustee's Ex. 8 at 247.) APB-16 was part of generally accepted accounting principles ("GAAP") during the relevant time period. (Trustee's Ex. 17 at 43-44.)
KPMG's own Business Combinations Manual, although not part of GAAP, contained guidance for KPMG auditors on when using effective date accounting was appropriate:
To use a date prior to the acquisition date . . . the following conditions should be met:
(a) The parties reach a firm purchase agreement that includes specifying the date of acquisition other than the closing date.
(b) Effective control of the acquired enterprise, including the risks and rewards of ownership, transfers to the acquiring enterprise as of the designated effective date.
(c) The time period between the designated effective date and the closing date is relatively short (say, less than 30 days), except if the delay is caused by obtaining required regulatory approval.
(d) The designated effective date and the closing date fall in the same accounting period (i.e., same interim and annual accounting period).
(Trustee's Ex. 11 at KPMG000053456.)
There is some evidence that ABT timed its acquisitions and the reported time of the effective date at least in part to maximize reported earnings from the companies it purchased. (Trustee's Ex. 35 at 3.) ABT disclosed its use of effective date accounting in its financial statements. (Trustee's Ex. 1 at KPMG000043058, Trustee's Ex. 2 at KPMG000042947, Trustee's Ex. 3 at Item 7, page 27.)
In early 1998, ABT filed a registration statement with the Securities and Exchange Commission ("SEC") to raise equity and debt funding. (Trustee's Ex. 5 at 250-53.) The SEC initiated a review and issued comments on the registration statement. (Id.; KPMG's Ex. 17.) Among the SEC's comments was a concern about the propriety of ABT's use of effective date accounting. (Id.)
After the SEC initiated its review, ABT Chief Financial Officer Henry Ingalls ("Ingalls") informed ABT Vice President of Acquisitions and Operations Kathleen Gillespie ("Gillespie") that ABT had to show the SEC that ABT was managing the acquired companies. (Trustee's Ex. 35 at 3.) He asked her document things she did at each acquired entity to justify the effective dates used. (Id.) In response to this request, Gillespie told Ingalls that ABT "did not have control at all." (Id.) According to Gillespie, Ingalls responded, "Yeah, I know, and ABT could lose them all." (Id.)
On June 11, 1998, ABT responded to the SEC's comments, and indicated ABT obtained effective control of the acquired entities as of the effective date in the letters of intent. (KPMG's Ex. 19.) On July 7, 1998, the SEC responded that at least with respect to ABT's acquisition of Olsen Fennell Seeds, Inc., the letter of intent did "not contain provisions for the transfer of effective control" to ABT. (KPMG's Ex. 20 at 3.) The SEC directed ABT to revise its financial statements to reflect a different acquisition date for Olsen Fennell Seeds, Inc. (Id.)
In July 1998, ABT had a meeting with the SEC to discuss the effective date accounting issue. (KPMG's Ex. 24 at 72.) Although ABT Chief Executive Officer Johnny Thomas ("Thomas") originally was slated to attend, a death in the family required his presence out of state. (Trustee's Ex. 6 at 21-22; Trustee's Ex. 35 at 4.) Consequently, Gillespie took his place at the meeting with the SEC. (Trustee's Ex. 6 at 21-22.)
The morning of the meeting, Gillespie met with Elliot Lutzker of Snow Becker Krauss, ABT's outside attorneys, and Terry Iannaconi of KPMG. (Trustee's Ex. 6 at 25-29.) At that meeting, Gillespie asked whether she should convince the SEC that ABT had effective control. (Trustee's Ex. 35 at 4.) She was told that she should, although it is unclear whether Lutzker or Iannaconi advised Gillespie on this point. (Trustee's Ex. 37 at 10.) Gillespie responded: "[S]o you don't want me to tell them we put together a bunch of letters so we could get profits up front, right? You basically want me to convince them that we did have control?" (Trustee's Ex. 35 at 4; Trustee's Ex. 37 at 10.)
Gillespie, Lutzker, and Iannaconi met with the SEC later that day. (KPMG's Ex. 24 at 127-28.) At the meeting, Lutzker offered ABT's legal position that the letters of intent were binding agreements reflecting a meeting of the minds between ABT and the purchased companies that ABT would assume effective control as of the effective date. (KPMG's Ex. 24 at 129-32; Trustee's Ex. 6 at 35-37.) Iannaconi supported ABT's position from an accounting standpoint, arguing on ABT's behalf that its activities fell within APB-16 paragraph 93. (KPMG's Ex. 24 at 133-34; Trustee's Ex. 6 at 37-38.) Gillespie told the SEC that ABT did have control as of the dates reflected in the letters of intent, and that the acquired companies could not make major decisions without ABT's approval. (Trustee's Ex. 6 at 39-42.) Gillespie later indicated that she had "stretched" or "flowered up" the truth at the SEC meeting. (Trustee's Ex. 35 at 4.)
After the meeting and further correspondence, the SEC stated it was concerned about ABT's use of effective date accounting because it was unclear whether the letter of intent ABT entered into with other companies actually gave ABT control on the reported date. (KPMG's Ex. 25 at 2.) The SEC also was concerned that "ABT's recognition of acquisitions was not consistent with its auditor's own published guidance regarding the use of an effective date earlier than the consummation date." (Id.) The SEC noted that the market and ABT had emphasized aggregate revenues and revenue growth during the reporting period, and thus "any premature recognition of revenues may have materially affected investment decisions with respect to ABT's securities." (Id.)
Despite these concerns, the SEC concluded it was "not in a position at this time to verify [ABT's] representations or test [its] legal conclusions." (Id.) The SEC did not decline the registration statement or require ABT to restate its financial information, provided ABT made certain disclosures, including the "effect on reported results of using a business acquisition date earlier than its consummation." (Id.) ABT did as requested, putting the required information in a press release and in its 10-K annual report for the fiscal year ending June 30, 1998. (KPMG's Ex. 28 at 2; Trustee's Ex. 3 at 27, 34-36.) ABT also announced it no longer would use effective date accounting. (KPMG's Ex. 28 at 2; Trustee's Ex. 3 at 27.)
Throughout 1998 and 1999, ABT was experiencing operational and financial pressures brought on by its rapid acquisition of numerous companies requiring extensive funding, and its initial focus on acquisition rather than on integrating the new companies into a single, efficient whole. (Trustee's Ex. 24 at 1-3; Trustee's Ex. 23 at 124, 205; KPMG's Ex. 6 at 17, 21-22; KPMG's Ex. 15 at 6; Trustee's Ex. 5 at 237-38; Trustee's Ex. 31 at 177-78.) Despite ABT's continuous liquidity crunch, its inefficiencies in integrating acquired companies, and its difficulties with the SEC and effective date accounting, KPMG issued unqualified audit reports on ABT's financial statements throughout 1998 and 1999. (Trustee's Exs. 3, 4.) KPMG did not advise ABT to restate its financial statements regarding the misuse of effective date accounting, and did not qualify its opinion of ABT's financial statements based on ABT's use of effective date accounting. (Id.) KPMG also never issued a going concern opinion to reflect doubt about ABT's status as a going concern. (Id.)
On January 25, 2000, ABT and three of its subsidiaries commenced jointly administered Chapter 11 cases by filing voluntary petitions under Chapter 11 of the United States Bankruptcy Code. (Third Am. Compl. ¶ 12.) The Debtors created a Creditors' Trust pursuant to the First Amended Joint Plan of Reorganization ("Reorganization Plan" or "Plan"), which United States Bankruptcy Judge Linda B. Riegle confirmed. (Id.; Trustee's Resp. to KPMG LLP's Mot. for Summ. J. on All Claims Purportedly Brought by Trustee on Behalf of Non-Debtor Third Parties, Ex. B.)
Plaintiff Anthony H.N. Schnelling ("Trustee"), as Trustee of the AgriBioTech Creditors' Trust, brought this lawsuit against certain former ABT professionals based on the rights assigned to him pursuant to the Plan. (First Am. Compl. (Doc. #438) ¶¶ 1, 7.) The Trustee asserts against KPMG claims for professional negligence (count 8), participation in breach of fiduciary duty (count 9), actual and constructive fraud (count 16), and aiding and abetting actual and constructive fraud (count 18). (Third Am. Compl. ¶¶ 351-387, 393-97, 403-09.)
KPMG asserts that because ABT's officers knew they were engaged in effective date accounting fraud, that knowledge is imputed to ABT. Because ABT knew of the fraud through the imputed knowledge of its officers, ABT could not have justifiably relied on KPMG's audit work. Additionally, KPMG argues that because ABT through its officers was involved in the alleged fraud, ABT was in pari delicto with KPMG and cannot recover for injuries arising out of its own wrongdoing. KPMG argues that under the Bankruptcy Code, the Trustee takes no greater rights than the debtor, and thus these defenses are as good against the Trustee as they would have been against ABT. Finally, KPMG argues it is entitled to summary judgment because the Trustee has failed to provide sufficient evidence to raise a genuine issue of material fact as to causation and damages.
The Trustee responds that it is an innocent successor to ABT and thus these equitable doctrines should not apply against the Trustee. According to the Trustee, once the officers engaged in the wrongdoing were removed, the reason for applying the equitable doctrines disappeared, and it would be inequitable to use equitable defenses at the expense of innocent creditor-victims to protect KPMG from its own misconduct. The Trustee also argues that its expert's testimony and report raise genuine issues of material fact as to causation and damages.
II. LEGAL STANDARDS
Summary judgment is appropriate if "the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any" demonstrate "there is no genuine issue as to any material fact and . . . the moving party is entitled to a judgment as a matter of law." Fed.R.Civ.P. 56(c). The substantive law defines which facts are material. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986). All justifiable inferences must be viewed in the light most favorable to the non-moving party. County of Tuolumne v. Sonora Cmty. Hosp., 236 F.3d 1148, 1154 (9th Cir. 2001).
The party moving for summary judgment bears the initial burden of showing the absence of a genuine issue of material fact.Fairbank v. Wunderman Cato Johnson, 212 F.3d 528, 531 (9th Cir. 2000). The burden then shifts to the non-moving party to go beyond the pleadings and set forth specific facts demonstrating there is a genuine issue for trial. Id.; Far Out Prods., Inc. v. Oskar, 247 F.3d 986, 997 (9th Cir. 2001).
III. DISCUSSION
Under Nevada law, the knowledge of an officer or agent is imputed to the corporation when the agent obtains the knowledge "while acting in the course of his employment and within the scope of his authority." Strohecker v. Mut. Bldg. Loan Ass'n of Las Vegas, 34 P.2d 1076, 1077 (Nev. 1934) (quotation omitted); see also Bates v. Cottonwood Cove Corp., 441 P.2d 622, 624 (Nev. 1968). Nevada also recognizes the equitable doctrine of in pari delicto. Shimrak v. Garcia-Mendoza, 912 P.2d 822, 826 (Nev. 1996). In pari delicto, literally meaning "of equal fault," historically "has been used to protect the integrity of the court where it was called upon to decide between two wrongdoers." Berner v. Lazzaro, 730 F.2d 1319, 1321 (9th Cir. 1984). Essentially, the in pari delicto doctrine prohibits a plaintiff who has participated in wrongdoing from recovering when he suffers injury as a result of the wrongdoing. First Beverages, Inc. of Las Vegas v. Royal Crown Cola Co., 612 F.2d 1164, 1172 (9th Cir. 1980).
Because Nevada law recognizes the equitable principles of imputation and in pari delicto, two questions arise. First, do state law equitable defenses apply against an innocent bankruptcy trustee to the same degree as those defenses would apply to the debtor? If so, do the defenses factually apply to bar the Trustee from recovering in this case?
A. Equitable Defenses Against a Bankruptcy Trustee
The commencement of a bankruptcy proceeding creates an estate, and the bankruptcy trustee is required to marshal all of the estate's property for the estate's benefit. 11 U.S.C. §§ 541(a), 704. Pursuant to 11 U.S.C. § 541(a), property of the bankruptcy estate includes "all legal or equitable interests of the debtor in property as of the commencement of the case." Id. § 541(a)(1). This includes causes of action. H.R. Rep. 95-595, 95th Cong., 1st Sess. 367-68 (1977); S. Rep. 95-989, 95th Cong., 2d Sess. 82-83 (1978). A bankruptcy trustee stands in the debtor's shoes and "take[s] no greater rights than the debtor himself had." H.R. Rep. 95-595, 95th Cong., 1st Sess. 367-68 (1977); S. Rep. 95-989, 95th Cong., 2d Sess. 82-83 (1978); see also Bank of Marin v. England, 385 U.S. 99, 101 (1966) ("The trustee succeeds only to such rights as the bankrupt possessed; and the trustee is subject to all claims and defenses which might have been asserted against the bankrupt but for the filing of the petition.").
The Trustee contends that although ABT was engaged in the effective date accounting fraud, the wrongdoing ABT officers have been removed, and therefore equitable defenses such as imputation and in pari delicto should not apply against the Trustee who represents the innocent creditors. The Trustee rests its argument primarily upon a case in the United States Court of Appeals for the Ninth Circuit, F.D.I.C. v. O'Melveny Myers, 969 F.2d 744 (9th Cir. 1992).
In O'Melveny, the Federal Deposit Insurance Corporation ("FDIC") took over as receiver for an insolvent bank whose principals had been involved in fraud. F.D.I.C. v. O'Melveny Myers, 969 F.2d at 746-47. As receiver, the FDIC sued the bank's outside attorneys for professional negligence, negligent misrepresentation, and breach of fiduciary duty based on the law firm's alleged participation in preparing misleading documents designed to induce outside investment in real estate deals. Id. The law firm argued that the wrongdoing of the bank's officers should be imputed to the bank, that the FDIC stood in the bank's shoes, and therefore the FDIC could not recover against the law firm. Id. at 747.
The Ninth Circuit concluded that federal, not state, law governed the application of defenses against the FDIC. Id. at 751. Analyzing the issue under a federal rule of decision, the Ninth Circuit ruled that equitable defenses good against the bank should not apply to the FDIC as its receiver:
A receiver, 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. . . .
Also significant is the fact that the receiver becomes the bank's successor as part of an intricate regulatory scheme designed to protect the interests of third parties who also were not privy to the bank's inequitable conduct. That scheme would be frustrated by imputing the bank's inequitable conduct to the receiver, thereby diminishing the value of the asset pool held by the receiver and limiting the receiver's discretion in disposing of the assets.Id. at 751-52. The Court clarified that equitable defenses sometimes may be asserted against the FDIC acting as a receiver, but the bank's inequitable conduct in this case should not be imputed to the FDIC. Id. at 752; see also Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995) (holding that receiver is not barred by in pari delicto because once wrongdoers were removed, the reason for application of the rule no longer applied).
Every other Circuit to analyze this issue in the bankruptcy context has reached the contrary conclusion, however. See In re Bennett Funding Group, Inc., 336 F.3d 94 (2d Cir. 2003);Official Comm. of Unsecured Creditors v. R.F. Lafferty Co., Inc., 267 F.3d 340 (3d Cir. 2001); In re Dublin Secs., Inc., 133 F.3d 377 (6th Cir. 1997); In re Hedged-Investments Assocs., Inc., 84 F.3d 1281 (10th Cir. 1996). The United States Courts of Appeals for the Third and Tenth Circuits distinguishedO'Melveny and Scholes on the basis that those cases involved receivers while a bankruptcy trustee derives its powers from the Bankruptcy Code. Lafferty, 267 F.3d at 358; In re Hedged-Investments Assocs., Inc., 84 F.3d at 1284-85. According to these Circuits, § 541(a)'s language defining estate property as the debtor's interests "as of the commencement of the case" limits the estate's rights as no stronger than when actually held by the debtor. Lafferty, 267 F.3d at 356-58; In re Hedged-Investments Assocs., Inc., 84 F.3d at 1285. The Third and Tenth Circuits cite legislative history to note congressional intent that the trustee stand in the debtor's shoes and "take no greater rights than the debtor himself had." Lafferty, 267 F.3d at 356 (citing H.R. Rep. 95-595, 95th Cong., 1st Sess. 367-68 (1977)); In re Hedged-Investments Assocs., Inc., 84 F.3d at 1285 (same). Although acknowledging the Trustee's position may be the better policy, the Tenth Circuit concluded deference to Congress' intent was required. In re Hedged-Investments Assocs., Inc., 84 F.3d at 1285-86. Additionally, the United States Courts of Appeals for the Second and Sixth Circuits also have applied imputation and in pari delicto doctrines to bankruptcy trustees. See In re Bennett Funding Group, Inc., 336 F.3d 94, 100 (2d Cir. 2003); In re Dublin Secs., Inc., 133 F.3d 377 (6th Cir. 1997).
The Second Circuit's application of imputation to a trustee has developed through that Circuit's use of imputation rules to determine whether a trustee has standing to pursue claims against third parties. See Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114 (2d Cir. 1991). The Second Circuit thus has made imputation a federalized test for standing. Standing is a separate question from the application of state law equitable defenses on the merits, however. As this Court held in its prior Order, the Trustee has standing to pursue the causes of action in the Third Amended Complaint because those claims belonged to ABT at the commencement of bankruptcy proceedings. (Order dated Dec. 8, 2004 (Doc. #775) at 3-12.)
The distinguishing factor between the Ninth Circuit's decision in O'Melveny and the other Circuits' opinions with respect to bankruptcy trustees lies in the differing rules of decision governing the application of defenses against the FDIC as a receiver versus a bankruptcy trustee. The Ninth Circuit's original opinion inO'Melveny was reversed by the United States Supreme Court on the ground that the Ninth Circuit had used a federal rule of decision to decide whether defenses apply against the FDIC as a receiver. O'Melveny Myers v. F.D.I.C., 512 U.S. 79, 83-89 (1994). The Supreme Court stated that federal law generally does not supplant state law on imputation of knowledge to corporate agents because "[t]here is no federal general common law." Id. at 83 (quotation omitted). The Court then addressed whether federal law displaced state law on the more narrow question of whether imputation ought to apply to FDIC as a receiver. Id. at 85.
On this question, the Supreme Court concluded the federal statute allowing the FDIC to step in as receiver "places the FDIC in the shoes of the insolvent [bank], to work out its claims under state law, except where some provision in the extensive [statutory] framework provides otherwise." Id. at 86. In reaching this conclusion, the Court pointed out that matters left un addressed in a comprehensive statutory and regulatory scheme presumably are left to resolution by state law, but an explicit federal statutory provision or a comprehensive and detailed federal statutory regulation could displace state law and create a federal rule of decision. Id. at 85.
The Supreme Court thus remanded to the Ninth Circuit to determine whether California state law would apply the equitable defense against the FDIC. Id. at 89. On remand, the Ninth Circuit concluded California likewise would not apply equitable defenses against a bank's receiver where it would be inequitable to do so. F.D.I.C. v. O'Melveny Myers, 61 F.3d 17, 19 (9th Cir. 1995) ("While a party may itself be denied a right or defense on account of its misdeeds, there is little reason to impose the same punishment on a trustee, receiver or similar innocent entity that steps into the party's shoes pursuant to court order or operation of law."). In doing so, the Ninth Circuit reaffirmed its earlier language that "[a] receiver, like a bankruptcy trustee and unlike a normal successor in interest, does not voluntarily step into the shoes of the bank" and thus to apply the equitable defenses against the receiver would frustrate the intricate regulatory scheme designed to protect innocent third parties. Id. The Court also reiterated that it was ruling only that the bank's inequitable conduct is not imputed to FDIC, not that equitable defenses never can be asserted against FDIC as a receiver. Id.
Pursuant to the Supreme Court's decision in O'Melveny, the Court must determine whether it is a state or federal rule of decision governing the application of a state law's general imputation rules to a bankruptcy trustee. Under O'Melveny, explicit federal statutory provisions may displace state law. O'Melveny, 512 U.S. at 85. As the four Circuits that have examined the issue have concluded. 11 U.S.C. § 541(a) displaces state law for determining the force of state law defenses against a bankruptcy trustee. Pursuant to § 541(a), the bankruptcy estate includes "all legal or equitable interests of the debtor in property as of the commencement of the case." Both the Senate and House of Representatives reports on this language indicate that Congress intended the trustee to "take no greater rights than the debtor himself had." H.R. Rep. 95-595, 95th Cong., 1st Sess. 367-68 (1977); S. Rep. 95-989, 95th Cong., 2d Sess. 82-83 (1978). Accordingly, an equitable defense is as good against a bankruptcy trustee as it would have been against the debtor as of the commencement of the bankruptcy case.
Only a few scattered bankruptcy courts have considered whether the relevant state law would apply equitable defenses against a bankruptcy trustee to the same degree as against the debtor. See In re Jack Greenberg, Inc., 240 B.R. 486, 501-06 (Bankr. E.D. Pa. 1999) (holding that Pennsylvania would leave it to court's discretion whether equitable defenses should apply against bankruptcy trustee when it would produce an inequitable result); Welt v. Sirmans, 3 F. Supp. 2d 1396, 1402-03 (S.D. Fla. 1997) (holding that Florida 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). In re Jack Greenberg retains little authority, however, because the Third Circuit in Lafferty rejected the bankruptcy trustee's argument, in which it cited that case for support, that Pennsylvania would allow courts to reject the in pari delicto defense against a bankruptcy trustee when its invocation would produce an inequitable result.Lafferty, 267 F.3d at 355-57.
This is consistent with this Court's prior Order denying KPMG's motion to dismiss on the same grounds. In that Order, the Court denied KPMG's motion because Nevada's in pari delicto doctrine required a fact specific inquiry into KPMG's relationship with ABT, and the Court declined to dismiss without further discovery on the matter. (Order dated July 31, 2002 (Doc. #234) at 4.)
The Ninth Circuit's O'Melveny decision is not at odds with this conclusion. O'Melveny involved a receiver, not a bankruptcy trustee. Therefore, although the Ninth Circuit likened a receiver to a bankruptcy trustee, its references to a bankruptcy trustee were dicta. The Ninth Circuit had no occasion to consider whether § 541(a)'s language altered the equation. Although the statutory language for appointing a receiver states that the FDIC succeeds to all the insured depository institution's rights, titles, powers, and privileges, it does not contain the limiting phrase "as of the commencement of the case," which both the House and Senate reports state was intended to grant the trustee no greater rights than those held by the debtor.
As the Tenth Circuit recognized, the Trustee's position arguably is the better policy. See In re Hedged-Investments Assocs., Inc., 84 F.3d at 1285-86. The reasons for applying the equitable defenses in this case no longer exist, with the effect that an equitable defense may allow a wrongdoer to escape at the expense of innocent creditors. Under the above-stated rule, this result would hold even if Nevada explicitly stated that its law would not apply in pari delicto or imputation against a bankruptcy trustee. Nevertheless, Congress has expressed its intent and fashioned an explicit statutory rule which this Court is bound to apply. If a policy change is to occur, it must come from Congress. Accordingly, the Court holds that the Trustee is subject to the imputation and in pari delicto doctrines to the same effect and degree as the debtor ABT would have been as of the commencement of the bankruptcy proceedings.
B. Applying the Defenses
1. Imputation
Under Nevada law, the knowledge of an officer or agent is imputed to the corporation when the agent obtains the knowledge "while acting in the course of his employment and within the scope of his authority, and the corporation is charged with such knowledge even though the officer or agent does not in fact communicate his knowledge to the corporation." Strohecker v. Mut. Bldg. Loan Ass'n of Las Vegas, 34 P.2d 1076, 1077 (Nev. 1934); see also Bates v. Cottonwood Cove Corp., 441 P.2d 622, 624 (Nev. 1968). This is so because a corporation can acquire knowledge or receive notice only through its officers and agents.Strohecker, 34 P.2d at 1077. An officer or director's knowledge will not be imputed to the corporation when the agent is acting on his own behalf and not on behalf of the corporation.Keyworth v. Nev. Packard Mines Co., 186 P. 1110, 1113 (Nev. 1920). This "adverse interest" exception is itself subject to an exception where the agent is the sole representative of the principal corporation. 3 Fletcher Cyclopedia of Private Corp. § 789.
By the Trustee's own allegations and offered evidence, several ABT officers were aware of the improper use of effective date accounting, and such knowledge was obtained during the course of their employment and within the scope of their authority. According to notes of an interview with Gillespie, ABT's Chief Financial Officer Ingalls knew ABT did not have effective control of the companies they were purchasing, yet he told Gillespie to prepare documentation for the SEC suggesting they did have control. (Trustee's Ex. 17 at 61-62; Trustee's Ex. 35 at 3-4.) Ingalls worked for KPMG prior to joining ABT and had advised ABT on using effective date accounting. (Trustee's Ex. 17 at 16-20, 34-44, 48-55.) Ingalls thus would have been familiar with APB-16 paragraph 93's requirements, and would have known that ABT's lack of control meant that ABT had misstated its financial statements.
Additionally, ABT's Vice President of Acquisitions and Operations Kathleen Gillespie knew she did not have effective control by the date reported in ABT's financial statements. (Trustee's Ex. 35 at 4.) Gillespie later admitted she stretched or flowered up the truth before the SEC to convince the SEC that ABT had control. (Id.) Gillespie also indicated that ABT's CEO Thomas knew about ABT's lack of effective control, an allegation echoed by the Trustee's Complaint. (Trustee's Ex. 35 at 4; Third Am. Compl. ¶ 210.)
The Trustee argues that Thomas, Ingalls, and Gillespie were acting on their own interests because their actions inflated ABT's value and stock price, and several ABT officers sold their ABT stock. The Trustee thus contends their knowledge should not be imputed to ABT under the adverse interest exception. KPMG responds that ABT officers actually engaged in very little trading of ABT's stock, selling only when forced to by margin calls and even holding on to much of their stock all the way through ABT's bankruptcy.
Nevada has not indicated whether an officer or agent's interest must be completely adverse to its principal to invoke the adverse interest exception. Other jurisdictions would require an agent to completely abandon the principal's interests and act entirely for his own purposes. See In re Bennett Funding Group, Inc., 336 F.3d at 100 (indicating adverse interest exception applies only when the agent has "totally abandoned" the principal's interests); In re Crazy Eddie Secs. Litig., 802 F. Supp. 804, 817 (E.D.N.Y. 1992) (stating that when the agent acts both for himself and for the principal, the agent's knowledge is imputed to the principal even if the agent's primary interest is inimical to the principal). According to Fletcher's Cyclopedia of the Law of Private Corporations, the agent's relations to the subject matter must be "so adverse as practically to destroy the relation of agency." 3 Fletcher Cyclopedia of Private Corp. § 789. The Ninth Circuit, in evaluating an Idaho case, adopted the Restatement (Second) of Agency's formulation of the rule that "[t]he mere fact that the agent's primary interests are not coincident with those of the principal does not prevent the latter from being affected by the knowledge of the agent if the agent is acting for the principal's interests." Funk v. Tifft, 515 F.2d 23, 26 n. 4 (9th Cir. 1975) (citing Restatement (Second) of Agency. § 282 comment c illustration 4 at 613 (1958)). Based on these authorities, the Court concludes Nevada would adopt a similar rule.
No evidence shows any of the officers looted ABT, embezzled from the corporation, or converted corporate assets to personal use. The Trustee suggests the officers acted in their own interests to inflate ABT's stock price, and then opportunistically sold their shares. In February 1999, Thomas sold over 900,000 shares at approximately $5 a share. (Trustee's Ex. 5 at 385-89; Trustee's Ex. 50.) In November 1998, Gillespie sold 80,000 options to her partner who sold them for Gillespie on the market. (Trustee's Ex. 35 at 5.) Ingalls purchased ABT stock for himself and his children and exercised stock options, but he and his children held all of these shares until after ABT's bankruptcy, except for some shares Ingalls sold at a loss in 1999. (KPMG's Ex. 26 at 25-34.)
This evidence does not raise a genuine issue of material fact that ABT officers were acting adversely to ABT or acting solely in their own interests. The only shares Ingalls sold before ABT's bankruptcy he sold at a loss, and thus no evidence supports a conclusion he was attempting to artificially increase ABT stock prices only for his own benefit to cash in on the inflated price. This corresponded with ABT's unofficial policy that officers and directors should not sell their ABT stock. (KPMG's Ex. 37 at 80-83.) Ingalls' knowledge therefore should be imputed to ABT.
Although Gillespie made sales in November 1998, she had wanted to exercise options earlier in the year when she thought ABT's price was artificially high but she did not do so at Thomas' direction. (Trustee's Ex. 35 at 5.) Her decision to forego sales at a time she thought ABT's stock price was artificially high suggests she was not acting solely for her own interests. Additionally, when Gillespie finally did sell, Thomas asked her to space out her sales a few thousand shares at a time so ABT's stock price would not be affected negatively. (Id.)
As for Thomas, he made sales when ABT's stock price was relatively low, and sold then because he was forced to meet margin calls. (Trustee's Ex. 5 at 340, 385-89.) In July 1997 he agreed to reduce his salary. (KPMG's Ex. 5 at 46.) His wife invested $3 million in ABT stock in November 1998. (KPMG's Ex. 18 at 362.) Even after Thomas resigned from the Board of Directors in 1999, he agreed to consult for the company compensated primarily with stock options that would not vest until 2000 and 2001. (KPMG's Ex. 54 at 1.) Consequently, even if Gillespie and Thomas were acting partly in their own interests to cash in on ABT's value, these sales do not raise a genuine issue of material fact that Gillespie and Thomas were acting solely for their own purposes such that their knowledge should not be imputed to ABT.
Finally, the Trustee argues that where a corporation has innocent directors not participating in or aware of the fraud, the knowledge of the wrongdoing officers should not be imputed to the corporation. KPMG responds that the Trustee has not consistently identified the so-called innocent directors, and in any event, the Trustee has presented no evidence the innocent directors could or would have stopped the fraud.
The "innocent decision-maker" doctrine has developed in the Second Circuit as an exception to that Circuit's framework of imputation rules to determine whether a trustee has standing. For example, in Wechsler v. Squadron, Ellenoff, Plesent Sheinfeld, L.L.P., 212 B.R. 34, 36 (S.D.N.Y. 1997), the district court adopted the rule that fraud by corporate agents cannot be imputed to the corporation unless all relevant shareholders and/or decision-makers are involved in the fraud. The Wechsler court found, however, that the trustee had not alleged any such innocent decision-makers. Id. Similarly, in In re CBI Holding Co., Inc., 247 B.R. 341, 364-65 (Bankr. S.D.N.Y. 2000), the court reiterated the rule that the trustee had to show at least one decision-maker in management or among its stockholders who was innocent of the fraud and could have stopped it. The evidence in that case showed that the debtor's forty-eight percent shareholder was innocent of the fraud, and one of its representatives on the debtor's board of directors testified that had he known of the fraud, he would have taken steps to stop it.Id. at 365. Accordingly, the court held that the wrongdoing on the part of the debtor's management was not imputable to the debtor. Id. In In re Bennett Funding Group, Inc., 336 F.3d at 101, the Second Circuit declined to adopt or reject this rule, holding instead that even if the rule applied the trustee had failed to demonstrate an innocent director who could have acted to stop the fraud. The Second Circuit found the "so-called independent" directors were "impotent to actually do anything," and that a "would-a, could-a, should-a test" is insufficient to defeat imputation. Id.
The Court finds it unnecessary to decide if Nevada would adopt the "one innocent decision-maker" rule as part of its state imputation law because even if Nevada followed the rule, the Trustee has failed to present evidence that the innocent directors could or would have done anything to stop the fraud. The Trustee has not consistently identified the innocent directors. In one set of answers to interrogatories, the Trustee identified the innocent directors as Byron Ford ("Ford"), James Hopkins ("Hopkins"), and Harrison Bains. (KPMG's Ex. 45 at 4.) In its Response to the pending Motion for Summary Judgment, the Trustee contends it has presented evidence of innocent directors with the depositions of Hopkins, Kent Schulze ("Schulze"), and Richard Budd ("Budd"). (Trustee's Resp. to KPMG LLP's Mot. Summ. J. (Imputation, In Pari Delicto, Causation-Damages) at 20 n. 75.) The Trustee also notes that it never sued Ford. (Id.)
Although the Trustee has identified these individuals as innocent officers or directors, the Trustee has offered no evidence to support that conclusion. The Trustee does not offer any affidavit or deposition testimony from any of these officers or directors that had they known ABT was misstating its financial information through effective date accounting fraud, they could or would have taken steps to stop it.
Although the Trustee points to the depositions of Hopkins, Schulze, and Budd as evidence of innocent directors, the Trustee does not provide a single page citation in these depositions that would support the Trustee's position. The Court will not scan the record to find a triable issue of fact on the Trustee's behalf.Keenan v. Allan, 91 F.3d 1275; 1279 (9th Cir. 1996) (noting that it is not the district court's task "to scour the record in search of a genuine issue of triable fact"); see also Orr v. Bank of Am., NT SA, 285 F.3d 764, 774-75 (9th Cir. 2002) (holding that "when a party relies on deposition testimony in a summary judgment motion without citing to page and line numbers, the trial court may in its discretion exclude the evidence"). At the summary judgment stage, the Trustee must "identify with reasonable particularity the evidence that precludes summary judgment." Keenan, 91 F.3d at 1279 (quotation omitted).
Additionally, the Court notes that in prior pleadings, the Trustee contended Budd was aware of the fraud. (KPMG's Ex. 16 at 6.) Further, the Trustee has asserted in other pleadings that Hopkins was unqualified to understand financial information and was negligent in performing his director duties. (KPMG's Ex. 7 at 56-57.) At the summary judgment stage, the Trustee's mere allegation unsupported by any record evidence that there were innocent officers and directors is insufficient to raise a genuine issue of material fact that these officers could or would have stopped the fraud such that the wrongdoing officers' knowledge should not be imputed to ABT. Because several ABT officers were aware of the alleged effective date accounting fraud, that knowledge is imputed to ABT, and by operation of § 541(a) to the Trustee.
The Trustee asserts against KPMG claims for professional negligence (count 8), fraud (count 16), and aiding and abetting fraud (count 18). One element of a professional negligence claim is that the negligence proximately caused the client's damages.Semenza v. Nevada Med. Liability Ins. Co., 765 P.2d 184, 185 (Nev. 1988). An element of a fraud claim is that the plaintiff justifiably relied on the misrepresentation resulting in damages.Bulbman, Inc. v. Nevada Bell, 825 P.2d 588, 592 (Nev. 1992). Because ABT knew of and participated in the fraud, it could not have justifiably relied on KPMG's audits to uncover a fraud of which it already was aware. Cenco Inc. v. Seidman Seidman, 686 F.2d 449, 454 (7th Cir. 1982) ("[A] participant in a fraud cannot also be a victim entitled to recover damages, for he cannot have relied on the truth of the fraudulent representations, and such reliance is an essential element in a case of fraud."); PNC Bank, Kentucky, Inc. v. Housing Mortg. Corp., 899 F. Supp. 1399, 1406 (W.D. Pa. 1994) (noting that where principals and officers were engaged in fraud, they knew the audit reports were not accurate, and hence did not rely on them). Additionally, "[i]f nobody relied upon the audit, then the audit could not have been a `substantial factor in bringing about the injury.'" F.D.I.C. v. Ernst Young, 967 F.2d 166, 170 (5th Cir. 1992). Accordingly, the Court will grant KPMG's motion for summary judgment as to counts 8, 16 and 18.
2. In Pari Delicto
Nevada recognizes the defense of in pari delicto, but has cautioned courts applying Nevada law not to be "so enamored with the latin phrase `in pari delicto' that they blindly extend the rule to every case where illegality appears somewhere in the transaction." Shimrak v. Garcia-Mendoza, 912 P.2d 822, 826 (Nev. 1996). The Nevada Supreme Court has outlined when use of the rule is appropriate:
The fundamental purpose of the rule must always be kept in mind, and the realities of the situation must be considered. Where, by applying the rule, [1] the public cannot be protected because the transaction has been completed, [2] where no serious moral turpitude is involved, [3] where the defendant is the one guilty of the greatest moral fault and [4] where to apply the rule will be to permit the defendant to be unjustly enriched at the expense of the plaintiff, the rule should not be applied.Id. (citing Magill v. Lewis, 333 P.2d 717, 719 (1958)).
As this Court noted in its prior Order, the transaction between KPMG and ABT has been completed; therefore, the public cannot be protected. (Order dated July 31, 2002 (Doc. #234) at 4.) Under the second factor, the Trustee has alleged and offered evidence that both ABT officers and KPMG were involved in conduct which could be construed as "serious moral turpitude." According to the Trustee, KPMG and ABT insiders were involved in a fraud upon the investing public and lied to the SEC to cover it up.
"Moral turpitude" is defined as "an act of baseness vileness, or depravity in the private and social duties which a man owes to his fellowmen or to society in general contrary to the accepted rule of right and duty between man and man." State ex rel. Conklin v. Buckingham, 84 P.2d 49, 50-51 (Nev. 1938).
With respect to the third factor, however, the Trustee cannot show that KPMG is the one guilty of the greatest moral fault. The Court has little doubt that had ABT sued KPMG for damages arising out of the fraud the moment before commencing bankruptcy proceedings, Nevada would waste little time in denying relief. ABT's theory essentially is that because KPMG did not stop ABT from defrauding its own investors and creditors. KPMG owes damages to ABT. Although policy favors holding watchdogs like auditors to a heightened standard, the Court concludes Nevada courts would not allow ABT to recover from KPMG for the fraud ABT initiated and perpetrated on others. ABT, as originator of the fraud, is at least as guilty as its aider and abetter. See In re Dublin Secs., Inc., 133 F.3d at 380 (stating that where the debtors perpetrated a fraud on their investors, such purposeful conduct made the debtors at least as culpable as the attorneys who knew or should have known of the fraud but failed to apprise the businesses of those illegalities); cf. Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 313 (1985) (stating that in insider trading context, the Court could not say that "a person whose liability is solely derivative can be said to be as culpable as one whose breach of duty gave rise to that liability in the first place").
U.S. v. Arthur Young Co., 465 U.S. 805, 817-18 (1984) (noting that independent certified public accountants assume public watchdog function when certifying a company's public financial documents and therefore have responsibility to the public).
Because the defense of in pari delicto applies against the Trustee with equal force as it would apply against ABT itself as of the commencement of bankruptcy proceedings, the Trustee is barred from recovering from KPMG. The Court therefore will grant KPMG's motion for summary judgment on counts 8, 9, 16, and 18.
Because the Court will grant KPMG's motion on the basis of imputation and in pari delicto, the Court need not consider KPMG's causation and damages arguments. Additionally, all other pending motions in the action as between KPMG and the Trustee will be denied as moot.
III. CONCLUSION
IT IS THEREFORE ORDERED that KPMG LLP's Motion for Summary Judgment (Imputation, In Pari Delicto, and Causation-Damages) (Doc. #691) is hereby GRANTED. All claims against Defendant KPMG LLP in the Third Amended Complaint are hereby dismissed with prejudice.
IT IS FURTHER ORDERED that KPMG LLP's Motion to Strike Portions of the Declaration of D. Paul Regan, CPA, CFE (Doc. #740) is hereby DENIED as moot.
IT IS FURTHER ORDERED that KPMG LLP's Motion to Preclude Anthony Schnelling From Testifying as an Expert Witness (Doc. #745) is hereby DENIED as moot.