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Court: when accountants fail to detect fraud, in pari delicto no longer applies

By enacting M.G.L.c. 112, §87A 3/4, the Massachusetts Legislature intended to preempt the common-law doctrine of in pari delicto as it applies to the negligent conduct of accountants and auditors in failing to detect fraud, the state Supreme Judicial Court ruled July 9.

In Chelsea Housing Authority v. McLaughlin, et al., the court ruled that, where a plaintiff sues an accountant for negligently failing to detect the fraudulent conduct of the plaintiff, the plaintiff may recover damages from the accountant, but only for the percentage of fault attributed to the accountant (as compared to the fault of all others whose fraudulent conduct contributed to causing the plaintiff’s damages).

The Chelsea Housing Authority case involved the alleged negligent failure of the Housing Authority’s former accountants, John Marotto and Martin J. Scafidi, P.C., to detect the fraudulent conduct of its former executive director, Michael E. McLaughlin, and former finance director, Vitus Shum.

Among other malfeasance, McLaughlin sought and obtained board approval for salary increases vastly higher than those permitted by the regulatory limits imposed by the Department of Housing and Community Development.

McLaughlin then concealed his salary by discontinuing the submission of his employment agreements to DHCD and preparing and filing budget reports with deliberately falsified salary figures that fell within state regulatory guidelines.

At McLaughlin’s direction, the Housing Authority also “misallocated and misused” federal funds.

To reach its decision, the SJC carefully examined the language of that statute in the context of its legislative history. The statute sought to alleviate the unfair burden joint and several liability was placing on accountants who did work for failed companies, including the state’s largest health maintenance organization, Harvard Pilgrim Health Care, which was placed into receivership early in 2000 after suffering dramatic financial losses.

An initial version of the bill was rejected by then-Gov. Paul Cellucci, who recognized that the proposed legislation did not enact proportional liability for accountants but instead protected accountants from any liability unless their negligence was the sole cause of the client firm’s losses.

Cellucci proposed a bill that provided for proportional liability for accountants in all civil cases, but — for reasons that the SJC said were unclear — the amended House bill that ultimately became law limited the application of proportional liability for accountants to cases in which a defense or claim of fraud is raised against the plaintiff or any other party, person or entity, and one or more of them is found to have acted fraudulently. The SJC suggested that revelations about the accounting practices of the Enron Corporation may have played a role.

That final version of the statute “cannot coexist in harmony with the common-law doctrine of in pari delicto,” the court concluded.

With its decision, the court answered a question that it had left open with its decision last year in the case Merrimack College v. KPMG LLP.

In Merrimack College, the SJC held that, where the plaintiff is a corporation, it is barred under the in pari delicto doctrine from recovering damages for the negligence of its accounting firm in failing to detect the corporation’s fraudulent conduct only if the fraud was committed by someone in its “senior management.” The employee who committed the fraud in that case, a financial aid director, did not qualify as “senior management,” the court concluded.

But the parties in Merrimack College had not raised the issue of the effect of M.G.L.c. 112, §87A 3/4.

The 29-page decision is Chelsea Housing Authority v. McLaughlin, et al., Lawyers Weekly No. 10-113-19. The full text of the ruling can be found here.

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