BAENA v. KPMG LLP AND KLYNVELD PEAT MARWICK GOERDELER

389 F.Supp.2d 112 (2005) | Cited 2 times | D. Massachusetts | September 27, 2005

MEMORANDUM AND ORDER

I. INTRODUCTION

This case arises out of an alleged fraudulent scheme at Lernout& Hauspie N.V. ("L&H"), a saga which has spawned a series ofactions both against and on behalf of the bankrupt company. Inthis iteration, Plaintiff Scott L. Baena, Trustee of the L&HLitigation Trust, has filed an action against Defendants KPMG LLP("KPMG US") and Klynveld Peat Marwick Goerdeler Bedrijfsrevisoren("KPMG Belgium"), L&H's long-time auditors.1 Thecomplaint alleges that Defendants assisted L&H's management in itselaborate scheme of accounting fraud by certifying audits andissuing opinion letters, which, in part, facilitated theincurrence of $340 million of additional debt due to the Belgianlender that L&H would never be able to repay. The complaintasserts that Defendants' conduct gives rise to claims forviolations of Mass. Gen. Laws ch. 93A, aiding and abetting breachof fiduciary duty, and accounting malpractice. Moving to dismiss,Defendants argue, among other things, that the Trustee lacksstanding, and that the action is barred by the doctrine of inpari delicto.2 The Trustee responds that it has acognizable injury under the theory of "deepening insolvency."After hearing, the motion to dismiss is ALLOWED.

II. FACTUAL BACKGROUND3 The complaint alleges the following facts (many of whichDefendants dispute).

L&H, a Belgian speech recognition company, has its UnitedStates headquarters in Burlington, Massachusetts. From 1995 to2000, L&H reported over a 100% rise in revenue and had a stockprice of over $70 per share. L&H suffered a catastrophic fallfollowing the August 2000 revelation that this success was theresult of "a systematic and elaborate program of misstatement andoverstatement of Company revenue." (¶¶ 3-6.) Various members ofL&H's management, whom the complaint refers to as the "BreachingManagers," engaged in significant activity to falsely inflaterevenue and earnings, including barter transactions, transactionswithout contracts, and sham transactions with fictitious parties.(¶¶ 22-23.)

As L&H's auditors, the KPMG Defendants had "continuous andunfettered access" to L&H's financial information and providedextensive consulting services to L&H. (¶¶ 47, 50.) On numerousoccasions, despite internal e-mails from auditors expressingreservations about L&H's transactions, Defendants allowed L&H torecord the revenue in its financial statements. (¶¶ 51-60, 66.) In addition, Defendants knew that L&H's internal accountingdepartment was "functionally inadequate," but still issuedunqualified audit opinions regarding L&H's financial statements.(¶¶ 61-62.) KPMG performed its audit functions primarily out ofits Boston office. (¶ 97.)

The conduct which gives rise to the asserted $340 million ofdamages in this case arises from L&H's March 2000 acquisitions ofDictaphone Corp. ("Dictaphone") and Dragon Systems, Inc.("Dragon"). (¶ 68.) Despite their knowledge of questionablepractices at L&H, Defendants issued an opinion letter certifyingL&H's balance sheets and statements of operations for fiscalyears 1998 and 1999. (¶ 69.) Without these certifications, "L&Hwould not have been able to complete the acquisitions ofDictaphone and Dragon." (¶ 71, 94.) Furthermore, if Defendantshad exposed the Breaching Managers' activities to L&H'sindependent directors, they would have "prevented thedissemination of the false financial information" that wasintegral to the Dictaphone and Dragon acquisitions. (¶ 112.) Inorder to finance these acquisitions, L&H incurred $340 million innew debt. (¶ 73.) Unfortunately, because the company's financialstatements were based on an ongoing scheme to falsify revenue,L&H could not possibly have satisfied these new obligations. (¶77.)

Soon after the acquisitions of Dictaphone and Dragon, L&H entered a downward spiral thanks to a series of Wall StreetJournal articles revealing the company's widespreadoverstatement and fabrication of revenue. (¶ 78.) Thearticles, which appeared in August and September 2000, triggered both SECand internal Audit Committee investigations. (¶ 80.) Thesedevelopments sent the corporation into a "free fall," with thestock price eventually falling below one dollar per share byDecember 15, 2000. (¶ 84.)

L&H filed for Chapter 11 bankruptcy protection on November 29,2000, in the United States Bankruptcy Court for the District ofDelaware, and soon thereafter it became evident that thecorporation could not be reorganized. On March 13, 2001, theUnited States Trustee appointed an official Committee ofUnsecured Creditors. The Plan of Liquidation vests authority tomaintain and prosecute claims with a litigation trustee appointedby the Committee of Unsecured Creditors, which on April 2, 2004appointed plaintiff Baena as litigation trustee. On May 30, 2003,the Bankruptcy Court confirmed L&H's proposed Plan of Liquidationof the Company under Chapter 11, which became effective April 2,2004. (¶¶ 88-89).

The Litigation Trustee seeks to recover damages from Defendants"including, but not limited to, the incurrence of $340 million ofdebts that L&H could not possibly repay." (¶ 96.)

III. DISCUSSION A. Motion to Dismiss Standard

For purposes of this motion, the Court takes as true "thewell-pleaded facts as they appear in the complaint, extending[the] plaintiff every reasonable inference in his favor." Coynev. City of Somerville, 972 F.2d 440, 442-43 (1st Cir. 1992)(citing Correa-Martinez v. Arrillaga-Belendez, 903 F.2d 49, 51(1st Cir. 1990)). A complaint should not be dismissed underFed.R.Civ.P. 12(b)(6) unless "`it appears beyond doubt that theplaintiff can prove no set of facts in support of his claim whichwould entitle him to relief.'" Roeder v. Alpha Indus., Inc.,814 F.2d 22, 25 (1st Cir. 1987) (quoting Conley v. Gibson,355 U.S. 41, 45-46 (1957)).

B. Standing

Defendants vigorously contest the Trustee's standing underArticle III of the Constitution, arguing the corporation sufferedno distinct injury from that of the creditors. Secondly,Defendants argue that the Trustee's claim is barred by thedoctrine of in pari delicto.

To have standing, "[a] plaintiff must allege personal injuryfairly traceable to the defendant's allegedly unlawful conductand likely to be redressed by the requested relief." Raines v.Byrd, 521 U.S. 811, 818 (1997) (quoting Allen v. Wright,468 U.S. 737, 751 (1984)). "The injury alleged must be, for example,distinct and palpable, and not abstract or conjectural or hypothetical. The injury must be fairly traceable to thechallenged action, and relief from the injury must be likely tofollow from a favorable decision." Allen, 468 U.S. at 751(internal citations omitted).

Therefore, in order for the Trustee to have standing, he mustallege injuries to L&H itself, and not injuries to third parties,such as L&H's creditors who currently will not be repaid. In reRare Coin Galleries of Am., Inc., 862 F.2d 896, 901 (1st Cir.1988) ("The trustee steps into the shoes of the debtor for thepurposes of asserting or maintaining the debtor's causes ofaction, which become property of the estate."). "It is wellsettled that a bankruptcy trustee has no standing generally tosue third parties on behalf of the estate's creditors, but mayonly assert claims held by the bankrupt corporation itself."Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, 118-20(2d Cir. 1991) (citing Caplin v. Marine Midland Grace TrustCo., 406 U.S. 416, 434 (1972) ("A claim against a third partyfor defrauding a corporation with the cooperation of managementaccrues to creditors, not to the guilty corporation.")).

To satisfy this requirement of demonstrating an injury to thedebtor corporation, the Trustee advances a nascent theory ofinjury known as "deepening insolvency." The term refers to"fraudulent prolongation of a corporation's life beyondinsolvency." See Schacht v. Brown, 711 F.2d 1343, 1350 (7thCir. 1983). The Trustee argues that L&H, the debtor, suffered adistinct injury by incurring $340 million of additional debt,saddling the company with a burden so large that it could notpossibly recover, forcing it, first to enter bankruptcy, andsubsequently, to liquidate. Plaintiffs' theory is based on thecontention that Defendants' conduct in certifying inaccuratefinancial statements allowed L&H to prolong its artificialsolvency and to receive more credit, which, under thecircumstances, was a detriment rather than a benefit.

As this is a diversity case, the question is whether thealleged theory of injury — deepening insolvency — is cognizableunder state law, in this case Massachusetts.4 Althoughneither Massachusetts, nor the First Circuit has examined closelythe validity of "deepening insolvency" as a cause of action, othercourts have struggled with the theory. See Kittay v. AtlanticBank of N.Y. (In re Global Serv. Group LLC), 316 B.R. 451,457-59 (Bankr. S.D.N.Y. 2004) (collecting cases both acceptingand rejecting the notion of deepening insolvency as anindependent cause of action or a measure of damages for breach offiduciary duty). See Official Comm. of Unsecured Creditors v.R.F. Lafferty & Co., 267 F.3d 340, 349 (3d Cir. 2001) (holding"if faced with issue, the Pennsylvania Supreme Court woulddetermine that `deepening insolvency' may give rise to acognizable injury"); Bloor v. Dansker (In re Investors FundingCorp. of New York Sec. Litig.), 523 F. Supp. 533, 541 (S.D.N.Y.1980) (finding that increased debt encouraged by auditors'negligent conduct was detrimental to the corporation). Cf.Branch v. Ernst & Young, 311 F. Supp. 2d 179, 182 (D. Mass.2004) (mentioning in passing what the appropriate measure wouldbe for the value of a company in a deepening insolvency case).

The Court need not, however, decide whether the deepeninginsolvency theory is cognizable under Massachusetts law becausePlaintiff's claims are barred by the doctrine of in paridelicto, which "provides that a plaintiff may not assert a claimagainst a defendant if the plaintiff bears fault for the claim."Id. at 354.

The doctrine of in pari delicto has been recognized by courts in the First Circuit. Fleming v. Lind-Waldock & Co.,922 F.2d 20, 28 (1st Cir. 1990) (stating "in the context of onewrongdoer suing a co-conspirator, these [traditional equitable]standards similarly suggest that parties generally in paridelicto should be left where they are found."). See MerrillLynch v. Nickless (In re Advanced RISC Corp.), 324 B.R. 10, 14(D. Mass. 2005).

While some courts assess the doctrine of in pari delicto asan equitable defense, the Second Circuit and courts in the FirstCircuit have viewed it as a standing issue. See Breeden v.Kirkpatrick & Lockhart LLP (In re The Bennett Funding Group,Inc.), 336 F.3d 94, 99-100, 102 (2d Cir. 2003) (finding that ifthe in pari delicto doctrine applies to the corporation, thenthe Trustee does not have standing to sue). This Court assessedthe in pari delicto doctrine as a standing issue in a recent casearising from the alleged L&H accounting fraud. See Nisselsonv. Lernout, No. 03-10843-PBS, slip op. at 7 (D. Mass. Aug. 9,2004) (holding that the litigation trustee for the new companyemerging from the bankruptcy proceeding of L&H had no standing tosue for damages which were sustained by shareholders and wasbarred by the doctrine of in pari delicto). See alsoErricola v. Gaudette (In re Gaudette), 241 B.R. 491, 500(Bankr. D.N.H. 1999) (finding that the Trustee lacked standing tosue numerous defendants on grounds that the debtor corporationwas a co-conspirator in the fraud); Goldin v. Primavera Familienstifung, TAG Assocs., Ltd.(In re Granite Partners), 194 B.R. 318, 328 (Bankr. S.D.N.Y.1996) ("If in pari delicto applies, the trustee cannot sue thethird parties for injury that the corporation suffered inconnection with the fraudulent scheme."). But see Lafferty,267 F.3d at 346 ("An analysis of standing does not include ananalysis of equitable defenses, such as in pari delicto.").

The parties agree that the Trustee may only bring causes ofaction which the debtor corporation possessed at the time of thebankruptcy. See Lafferty, 267 F.3d at 356 (rejecting theargument that post-petition events allowed the trustee to bringclaims the corporation would not have possessed at the time ofbankruptcy); In re Mediators, Inc., 105 F.3d 822, 825-26 (2dCir. 1997) ("The Bankruptcy Code places a trustee in the shoes ofthe bankrupt corporation and affords the trustee standing toassert any claims that the corporation could have institutedprior to filing its petition for bankruptcy."); In re AdvancedRISC, 324 B.R. at 16 (holding that "the in pari delictodoctrine bars a claim by a bankruptcy trustee where the debtorwould have been so barred before the bankruptcy petition wasfiled"). Therefore, if the in pari delicto doctrine would havebarred L&H from bringing a claim against Defendants, then theTrustee is barred as well. See Wagoner, 944 F.2d at 118(holding that "when a bankrupt corporation has joined with athird party in defrauding its creditors, the trustee cannot recover against the third party forthe damage to the creditors.").

Whether L&H could have brought this claim depends on whetherthe conduct of the Breaching Managers is imputed to thecorporation, thus barring the claim by both L&H and the Trustee.The question of imputation is governed by state law, in this caseMassachusetts. See In re Bennett Funding, 336 F.3d at 100("State law determines whether a right to sue belongs to thedebtor in a bankruptcy proceeding."); In re Advanced RISCCorp., 324 B.R. at 14 ("State law determines the circumstancesunder which the misconduct of corporate actors may be imputed tothe corporation.").

The Supreme Judicial Court of Massachusetts has set forth thefollowing governing rule on imputation: The general rule is that the knowledge of an officer of the corporation obtained while acting outside the scope of his official duties, in relation to a manner in which he acted for himself and not for the corporation, is not, merely because of his office, to be imputed to the corporation. However, knowledge of officers and directors having substantial control of all activities of a corporation is imputed to the corporation. When all corporate power is exercised by a few who perform misdeeds, knowledge of those misdeeds must be imputed to the corporation.Demoulas v. Demoulas, 428 Mass. 555, 584-85, 703 N.E.2d 1149,1170 (Mass. 1998) (internal citations omitted).

In this case, Defendants argue that because the BreachingManagers controlled L&H and perpetrated the fraud which gives rise to this action, Defendants should not be liable. TheComplaint itself catalogues a laundry list of fraudulentactivities that inflated L&H's earnings and "caused" thecorporation to incur the $340 million of debt. (Compl. ¶¶ 22-43.)In prior securities litigation against the Breaching Managers,the Senior Officers of L&H, this Court detailed the factsalleged. In re Lernout & Hauspie Sec. Litig.,208 F. Supp. 2d 74, 85, 90-91 (D. Mass. 2002) ("Lernout, Hauspie, Bastiaens, andWillaert each exercised control over the decision-makingprocesses of L&H.").

The Plaintiffs do not contest that the Breaching Managersexercised substantial control over L&H's corporate activities.Instead, Plaintiffs argue that the Breaching Managers' actionsshould fall under the "adverse interest" exception to the inpari delicto doctrine. The "adverse interest" exception statesthat "a principal is not affected by the knowledge of an agent ina transaction in which the agent secretly is acting adversely tothe principal and entirely for his own or another's purposes."Sunrise Props. v. Bacon, Wilson, Ratner, Cohen, Salvage, Fialky& Fitzgerald, P.C., 425 Mass. 63, 66-67, 679 N.E.2d 540, 543(Mass. 1997). But, under Massachusetts law, when a senior officerof a corporation who is an agent of the corporation and "who wasacting within the scope of his employment when he learned ofcircumstances that might give rise to a claim against both him and [the corporation] . . . under ordinary agency principles,"his knowledge is imputed to the corporation. Id. at 67.

Plaintiffs argue that the Breaching Managers acted adversely tothe corporation because their schemes resulted in the corporationincurring detrimental debt. Plaintiffs also argue that theadverse interest exception applies to the Breaching Managers'conduct because it was concealed from L&H's audit committee andindependent directors who could have prevented the malfeasancehad they known of it. However, Plaintiffs do not argue that theBreaching Managers acted to loot the corporation, but rather to"falsely and artificially inflate? L&H's revenues and earnings."(Compl. ¶ 22.) Courts have been loath to apply the adverseinterest exception in the context of fraud to increase the valueof the corporation. See In re Bennett Funding,336 F.3d at 100-01 (finding that in pari delicto applied to a case wheremanagers were engaged in fraud to boost value of thecorporation); Cenco, Inc. v. Seidman & Seidman, 686 F.2d 449,454 (7th Cir. 1982) (finding that far-reaching fraud bymanagement designed to increase stock price and earnings could beimputed to the corporation and that responsibility should not beshifted to the auditor). Furthermore, the case does not resembleparadigmatic cases that have applied the adverse interestexception because agents were engaged in a fraud solely for theirown benefit. See Union Old Lowell Nat'l Bank v. Paine, 318 Mass. 313, 324, 61 N.E.2d 666, 672 (Mass. 1945) (applying adverseinterest exception when a bank employee secretly investedcustomers' bonds in a speculative scheme without the knowledge ofthe bank).

Plaintiffs argue that any actions by L&H management whichcontributed to the artificial prolongation of L&H's existence andthe incurrence of debts it could not repay must be adverse to theinterests of the company. See Schacht, 711 F.2d at 1348.

However, recognition of the theory of deepening insolvency neednot eviscerate the long-standing doctrine of in pari delicto,which prevents the corporation from recovering damages due to afraud of its own making. See Lafferty, 267 F.3d at 359-60(finding that in pari delicto bars a claim of deepeninginsolvency when those who controlled the corporation perpetratedthe underlying fraud). Even when all reasonable inferences aredrawn in favor of plaintiff, the adverse interest exception,styled in Massachusetts as action taken "entirely for [theagent's] own or another's purposes," is inapplicable. There is noallegation in the complaint that the Breaching Managers engagedin the fraud exclusively to further their own purposes, butrather to boost L&H's revenues and value.

Plaintiffs argue that because the corporation is publiclytraded it should be exempted from the in pari delicto doctrine.True, the Defendants' duties under the Securities Exchange Act required them to inform the L&H audit committee of any possibleillegal acts, and they failed to do so. See15 U.S.C. § 78j1-(b)(1)(B) (2000); SEC v. Solucorp. Indus. Ltd.,197 F. Supp. 2d 4, 10 (S.D.N.Y. 2002). However, this federal statutoryduty, enforceable by the SEC, does not purport to give thecorporation a cause of action under state law when its insidemanagers were complicit in the fraud.

Plaintiffs insist that because the Breaching Managers' fund wasallegedly concealed from L&H's audit committee and itsindependent directors, the fraud should not be imputed to thecorporation. They argue that there has never been a case wherein pari delicto has been applied in the context of publiclytraded corporation with outside directors and an outside auditcommittee. They find support for that argument in In reAgribiotech, No. 02-0537, 2005 U.S. Dist. LEXIS 6466, at *39-42(D. Nev. Apr. 1, 2005), which barred a bankrupt corporation'scomplaint against an accounting firm because the trustee failedto submit evidence of outside directors who were both unaware ofthe fraud and capable of stopping it had they been aware. Thisdicta suggests, plaintiffs argue, that a public corporationshould be disaggregated, and that the doctrine of in paridelicto should be inappplicable when the inside directors areinvolved in the fraud but the audit committee and independentoutside directors are not. The In re Agribiotech courtexplicitly did not reach the question of whether the doctrine of in paridelicto would apply if independent directors existed who couldhave stopped the fraud. Id. at *40.

Furthermore, that independent directors existed does notobviate that the Breaching Managers controlled the corporation,perpetrated the fraud, and, in the words of the complaint,"caused" the $340 million of additional debt to be incurred. Assuch, the corporation cannot sustain a claim against Defendantsarising out of its own misdeeds. See In re Bennett Funding,336 F.3d at 101 (applying doctrine of in pari delicto eventhough corporation had independent directors because the managersperpetrated the fraud and controlled the corporation'sactivities); Lafferty, 267 F.3d at 360 (applying the doctrineof in pari delicto, noting that "the possible existence of anyinnocent independent directors does not alter the fact that the[managers] controlled and dominated the Debtors."). Furthermore,this Court recently applied the doctrine of in pari delicto toa publicly traded corporation in connection with the L&H fraud.See Nisselson, No. 03-10843-PBS, slip op. at 9 (applying thedoctrine of in pari delicto against a publicly tradedsubsidiary of L&H).

Plaintiffs cite a non-precedential Massachusetts Superior Courtcase for the contention that even if knowledge of the fraud isimputed to the corporation, claims under Chapter 93A, of accounting fraud, and professional malpractice against Defendantsmay still be sustained. See Young v. Deloitte & Touche, LLP,18 Mass.L.Rptr. 287, at *31 (Mass. Super. 2004) ("To this Court,the rub is that, despite NutraMax's imputed knowledge of what itsOfficers may have been doing . . . Deloitte nevertheless providedunqualified audits for each of the four fiscal years from 1995 to1998."). However, that case did not address the doctrine of inpari delicto. Rather, the court rejected the argument that therewere insufficient allegations of causation and reliance. Id.

In sum, the complaint alleges that because the Defendantsfailed to expose the fraud by those controlling the Plaintiffcorporation, and the fraud succeeded, the Defendants should bearresponsibility for the Breaching Managers' fraud. Such a resultis inconsistent with the doctrine of in pari delicto.5

ORDER

The Court ALLOWS the motion to dismiss. (Docket Nos. 38 &41).

Back to top