Counsel for Merrimack College

A college whose financial aid director committed fraud could sue its auditor under the doctrine of in pari delicto, the Massachusetts Supreme Judicial Court has ruled, finding that because the employee was not a member of senior management, her conduct could not be imputed to the school.

After the financial aid director’s misdeeds were discovered, the college sued its auditor for failing to detect the fraud. Superior Court Judge Kenneth W. Salinger granted the defendant auditor summary judgment, relying on traditional principles of agency law.

In the 2006 case Baena v. KPMG, the 1st U.S. Circuit Court of Appeals held that the in pari delicto doctrine barred a trustee, acting on behalf of a bankrupt corporation, from recovering from the corporation’s former accountants for their failure to prevent the fraudulent conduct of the corporation’s senior managers. The 1st Circuit noted that it was not the court’s “job to make new law for Massachusetts.”

In taking a different approach under similar circumstances, SJC Chief Justice Ralph D. Gants found that, “indeed, that job is ours.”

Writing on what he called “essentially a clean slate of Massachusetts law,” Gants said traditional rules of imputation under Massachusetts common law are not without their limits. The rules are inapplicable “where the aim is to assign blame rather than risk,” he added.

When deciding whether punitive damages are warranted against an employer for an employee’s misconduct, a key factor is whether members of senior management participated or acquiesced in the misconduct, Gants said.

“To support an award of punitive damages, a jury must find the employer itself to be morally blameworthy, and that requires a finding that a member of the employer’s senior management was morally blameworthy,” Gants wrote.

For similar reasons, Gants said, under common law, a principal acting through an agent cannot be barred from recovery under the doctrine of in pari delicto “unless the principal is found to be morally blameworthy, and conduct by an agent that is sufficient to hold a principal vicariously liable to third parties will not always be sufficient, on its own, to support that finding.”

Though the employee here had substantial responsibilities, she was not among those primarily responsible for the management of the college, Gants said.

The college’s senior management may have been negligent in retaining the financial aid director or supervising her, which could limit the college’s recovery under the comparative negligence statute, the SJC found. But that conduct did not rise to the level that would bar recovery entirely under the doctrine of in pari delicto.

The 33-page decision is Merrimack College v. KPMG LLP.

One lesson: Define scope of engagement

The attorney for appellant Merrimack College, Elizabeth N. Mulvey of Boston, called the decision a “common-sense result,” given that the case involves a professional services organization contracted specifically to discover the type of mistake that had gone undetected.

“It does not seem unfair to hold [the auditor] responsible for not doing what it promised to do,” she said.

Because the court resisted creating a carve-out specifically for auditors, the guidelines the SJC outlined will have broad application, according to Mulvey.

But she said she did not think the SJC opened the proverbial floodgates. Rather, it created rules that sensibly apply to those, like a president or treasurer, who are most able to loot a company by the nature of their positions.

Ian D. Roffman of Boston, counsel for the appellee auditor, did not respond to requests for comment before deadline.

Boston and Framingham attorney Jon S. Barooshian, who regularly represents accountants, said the decision offers a cautionary tale for the accounting industry. His advice for accountants: Be more careful about the scope of audits and who the “players” are.

Though the SJC declined to create an auditor exception to the doctrine of in pari delicto, that is something the Legislature could still do, Barooshian said.

He further noted that the decision does not take the college off the hook for its own negligence, which could ultimately reduce a jury’s award.

As to whether the SJC adequately defined “senior management,” Barooshian said that may be more clear in larger organizations, which have a “C-suite,” and less so in smaller organizations, where employees’ roles may shift from day to day and organizational lines get blurred.

Boston attorney Edward S. Cheng said he was struck by the pains the SJC took to make clear that the BLS judge had not made some kind of legal error but rather that the SJC was making new law.

The court’s justification for the rule it announced is that there always has been a separate test for imputing liability as opposed to assigning blame, and the “punitive part” has always been limited, Cheng said.

“As a practitioner, I’m not thrilled with two tests when one would suffice,” he said.

Cheng added that he struggled with the court deciding that the financial aid director was not a member of senior management, when she had considerable power, including the authority to bind the college to contracts.

In the wake of the ruling, he said, an attorney should be careful about defining the scope of his engagement when conducting an investigation or overall review of an entity client. In certain circumstances, including in an engagement letter a “carve out” that says the lawyer will not be looking behind the numbers or documents it receives to discover intentional wrongdoing may make sense, he said.

As to whether the SJC adequately defined “senior management,” attorney Jon S. Barooshian said that may be more clear in larger organizations, which have a “C-suite,” and less so in smaller organizations, where employees’ roles may shift from day to day and organizational lines get blurred.

Books balanced artificially

From 1998 to 2004, Merrimack College hired the multi-national accounting firm KPMG LLP as its independent auditor. Among KPMG’s duties was to conduct annual audits of Merrimack’s financial statements. It also conducted audits related to the college’s receipt of substantial federal funds in the form of student financial aid.

KPMG’s audits included Merrimack’s financial aid office, which administers various grant and loan programs, including the federal Perkins loan program.

KPMG had on several occasions noted issues with the financial aid office, including delayed reconciliations and other ledger discrepancies, along with a lack of formal policies and procedures relating to the disbursement of grants and loans.

Though KPMG reported the issues to Merrimack’s management, it also ultimately gave Merrimack’s financial statements a clean bill of health and issued an opinion that Merrimack was in material compliance with federal program requirements.

What KPMG failed to discover was that Merrimack’s financial aid director, Christine Mordach, was engaged in a scheme in which she regularly replaced grants and scholarships that previously had been awarded to students with Perkins loans, often without the students’ knowledge or consent. In some cases, she created false paperwork with false names and Social Security numbers.

Mordach’s actions made the financial aid office’s budget appear more balanced, but they also put students on the hook for debt they had neither requested nor even knew they had.

After Mordach’s fraud was detected in 2011, an investigation by an independent forensic accounting team found more than 1,200 invalid or potentially uncollectible loans stemming from Mordach’s activities.

In 2014, Mordach pleaded guilty to federal mail and wire fraud charges, was sentenced to prison, and ordered to pay more than $1.5 million in restitution to former Merrimack students.

Between writing off the fraudulent loans, repaying students who had made payments on them, and conducting its investigation, Merrimack reported having lost more than $6 million. It sought to recover some of the losses by suing KPMG in Superior Court, alleging professional malpractice, breach of contract, negligence, negligent misrepresentation, and violation of G.L.c. 93A.

KPMG moved for summary judgment on four grounds, ultimately succeeding with its argument based in the equitable doctrine of in pari delicto.

Judge Salinger also declined to create a blanket “auditor exception” to the doctrine of in pari delicto, explaining he was following the lead of the majority of courts that had considered the issue.

Merrimack appealed Salinger’s decision, and the SJC granted its application for direct appellate review.

The case now has been remanded to Superior Court, where the defendant’s other three grounds for summary judgment will be considered.

About that ‘auditor exception’

Like Salinger, the SJC declined to carve out an exception to the in pari delicto doctrine specific to auditors as a matter of public policy. Not only was such an exception unnecessary to its decision, but the Legislature in 2001 had enacted G.L.c. 112, §87A 3/4, the court noted.

Under the Legislature’s scheme, if the case gets all the way through trial, a jury or judge will be asked to apportion the fault attributable to each of the parties.

Under the statute, if a plaintiff suffered damages of $1 million, and 70 percent of those damages is attributed to the plaintiff’s own conduct while 30 percent is attributable to the negligence of the auditor, the firm shall not be required to pay more than $300,000.

“By enacting this statute, the Legislature appears to have replaced the common-law doctrine of in pari delicto in cases where an accounting firm is sued for its failure to detect fraud by a client’s employee, with a statutory allocation of damages akin to, but different from, comparative negligence,” Gants wrote.

Neither the parties nor Salinger had cited G.L.c. 112, §87A 3/4, but Gants noted that there “may be relevant conduct that occurred after its effective date and that may be governed by it.”