Motion to Amend §§ 5.03 and 5.04 (Chapter 5),
Restatement of the Law of Agency:
Imputation of Notice of Fact to Principal; Exceptions
Tentative Draft No. 3 (March 18, 2002)
Sponsored By
Gerald K. Smith
Lewis and Roca LLP
Phoenix, Arizona
I. INTRODUCTION
Section 5.04 ("An agent who acts adversely to a principal") creates an exception to the general rule regarding imputation of an agent’s knowledge to the principal. As drafted, § 5.04 would limit those exceptions to situations in which the agent is determined to have "acted adversely" to the principal; such a determination to be made solely on whether the agent had any subjective motivation whatsoever to "benefit" the principal.
This narrow definition and exception are insufficient to address the more complex issues involving a third-party professional, such as an auditor, which is seeking to defeat a claim brought against it by the corporation, on the grounds that the knowledge of the corrupt corporate insider with which the auditor allegedly colluded, should be "imputed" to the corporation itself.
Application of the narrowly-defined "subjective intent" test of the current Draft would make it far too easy for third parties, such as auditors, to escape their just liability to the corporation. "Illustration 3" of the current Draft is a prime example of this. Illustration 3 would have the knowledge of the corrupt corporate insider imputed to the corporation, so as to defeat the corporation’s claim against its auditor for negligence and professional malpractice, simply because the corrupt corporate insider "believed" that the corporation would "benefit if its shares sell at a higher price as opposed to a lower price." Not only does this set the bar so low as to virtually gut the adverse intent exception, but given the narrow and rigid language of the present Draft, imputation would still be the order of the day, regardless of whether the CEO in Illustration 3 was also taking advantage of the situation to actively loot, steal, and dissipate the corporation’s assets, or drive the corporation deeper into insolvency, all with the aid and assistance of the corporation’s auditors. This is because, under the current Draft, once any subjective intent to "benefit" the corporation is found, the case is (quite literally) closed.
This is neither good policy, nor a reflection of the current state of the law with respect to corporate imputation, as reflected in the seminal case of Schacht v. Brown, 711 F.2d 1343 (7th Cir.) cert. denied, 464 U.S. 1002 (1983), in which the Seventh Circuit discussed and explained its reasoning in Cenco, Inc. v. Seidman and Seidman, 686 F.2d 449 (7th Cir. 1982). The Proposed Amendment, which explicitly follows the Schacht/Cenco analysis, would bring the Restatement into line with current doctrine, and mitigate against not only the unjust enrichment which results from a dismissal of the corporation’s claims against otherwise culpable auditors and other professionals, but also the corresponding inequity to the innocent corporate entity, and its likewise innocent shareholders and creditors.
II. THE PROPOSED AMENDMENT TO DRAFT §§ 5.03 AND 5.04
For the convenience of the reader, a "red-lined" version of §§ 5.03 and 5.04, as modified by this Proposed Amendment, reads as follows:
[Proposed Amendment to § 5.04]
§ 5.04 An Agent Who Acts Adversely to a Principal IMPUTATION OF AN
AGENT’S KNOWLEDGE TO THE PRINCIPAL; EXCEPTIONS
1. Notice is not imputed to a principal of a fact that an agent knows or has reason to know if ANY OF THE FOLLOWING APPLY
(a) the agent acts adversely to the principal without the principal’s knowledge, unless
(i) the agent deals with a third party who does not know or have reason to know that the agent acts adversely to the principal and who reasonably believes the agent to be authorized so to deal; or
(ii) before the principal has changed position, the principal knowingly retains a benefit from action taken by the agent that the principal would not otherwise have received, OR
(b) THE TOTALITY OF THE CIRCUMSTANCES WOULD OTHERWISE RENDER IT INEQUITABLE TO IMPUTE SUCH NOTICE.
2. For purposes of this Chapter, an agent acts adversely to a principal if the agent acts without any REASONABLE intention of benefiting the principal by the action taken, TAKING INTO CONSIDERATION THE EXTERNAL MANIFESTATIONS OF THE AGENT’S ACTIONS, AS WELL AS THE EFFECT OF THOSE ACTIONS ON THE WELFARE OF THE PRINCIPAL.
[The following new language to be included in the Comments with respect to Subsection (1)(b)]
When the totality of the circumstances renders imputation inequitable. As stated in subsection (1)(b), there may be circumstances which render the imputation of notice to the principal inequitable, as when the principal has in fact been injured by the agent’s misconduct, and a recovery by the principal would properly compensate the victims, and deter future wrongdoing. The context often involves the principal seeking recovery against a third party (e.g., accountant or lawyer) who is alleged to have colluded with the agent against the principal.
In such a scenario, if the plaintiff/principal is a trustee, receiver or similar innocent entity that has stepped into the principal’s shoes pursuant to a court order or operation of law, it will generally not be equitable to impose imputation, insofar as such entities are normally appointed to protect innocent parties, such as creditors of the corporation, who were not privy to the alleged misconduct of either the corporate agent or the third party with whom the agent colluded. However, if the principal itself is found by the trier of fact to have been nothing more than an "engine of fraud" with no legitimate business purpose, or if the plaintiff is unable to allege even one high ranking decision maker, officer, or board member of the principal who was unaware of the wrongdoing, then it may well be equitable, under those circumstances, to impute the knowledge and wrongful conduct of the agent to the principal, thus defeating its action against the third party.
[The following new language to replace Illustration 3]
A, the chief executive officer of P Corporation, intending to artificially prolong the existence of P Corporation past the point of its insolvency, fraudulently misrepresents its financial condition to T, P Corporation’s auditor. One or more of the top level decision makers or board members of P Corporation, which is otherwise a legitimate, bona fide enterprise, is unaware of A’s misrepresentations. T subsequently certifies materially inaccurate financial statements for P Corporation. As a result of these misrepresentations, loans are secured and additional stock is issued, allowing P Corporation to continue in operation, and allowing A to continue in his well-compensated position and avoid civil and/or criminal charges being brought against him, while burdening P Corporation with additional debt and creditor claims which it cannot satisfy. P Corporation is not charged with notice of A’s misrepresentations to T.
[The following new language to be included in the Comments regarding intent to "act adversely"]
Intent to "act adversely" will be seldom admitted by the agent, and such an adverse intent may be found even though denied by the agent itself.
[Proposed Amendment to § 5.03 (for purposes of conformance)]
§ 5.03 Imputation of Notice of Fact to Principal
Notice of a fact that an agent knows or has reason to know is imputed to a principal if knowledge of the fact is material to the agent’s duties to the principal and to the principal’s legal relations with third parties. Notice is not so imputed
if the agent acts adversely to the principalUNDER THE CIRCUMSTANCES as stated in § 5.04 or IF THE AGENT is subject to a duty not to disclose the fact to the principal.III. THE PROPOSED AMENDMENT TO § 5.04 WITH RESPECT TO "WHEN THE TOTALITY OF THE CIRCUMSTANCES RENDERS IMPUTATION INEQUITABLE"
The Proposed Amendment retains the historical exception to the rule of imputation with respect to an agent "acting adversely" to the principal; however, this doctrine is not flexible enough to deal with the complex public policy and equitable issues involved in the attempted use of imputation by third-party defendants to defeat the modern corporation’s claims against them.
This is due in no small part to the fact that in the context of a modern, publicly-held corporation, the principal is not the corrupt CEO, or corrupt member of the Board of Directors, but rather the corporation itself, as represented by the entire Board of Directors, who themselves sit as representatives of thousands of shareholders who have no knowledge of and no complicity in the wrongdoing of that CEO or board member. Accordingly, the law of imputation which has developed with respect to an attempt by a third party to defeat a corporation’s claim, has not focused on a judicial psychoanalysis of the corrupt corporate insider in order to determine his or her "subjective intent"; rather, as set forth in the seminal cases of Schacht and Cenco, supra, the analysis of whether imputation is proper in these situations takes quite a different turn.
Instead of focusing on the intent of the corporate insiders, Schacht employs the following analysis, and addresses the following considerations:
·
As a threshold matter, have the managers of the corporation turned the company "into an engine of theft against outsiders?" 711 F.2d at 1347 1·
Has the corporate insiders’ misconduct "clearly benefited the corporation," thereby making the case "ripe for an analysis of whether the directors’ knowledge of the fraud should be imputed to the benefited corporation"? 711 F.2d at 1347. (In the absence of such a benefit to the corporation, Schacht held that the "Cenco analysis, which seeks to determine the propriety of imputing to the corporation the directors’ knowledge of fraud," was not "even trigger[ed]." Id. at 1348.)·
Assuming that the "engine of theft" and "benefit to the corporation" thresholds have been met, will "a judgment in favor of the plaintiff corporation . . . properly compensate the victims of the wrongdoing, and . . . deter future wrongdoing"? 711 F.2d at 1348.
1 This "engine of theft" rationale applies in situations where the corporation had, from the outset, no legitimate business purpose. See, e.g., Grove v. Sutcliffe, 916 S.W.2d 825 (Mo. App. 1995) (involving a classic "Ponzi" scheme). This line of reasoning also finds application in instances where all of the company’s shareholders and decision makers are involved in and aware of the wrongful conduct. However, this doctrine does not apply "if plaintiff can sufficiently allege an innocent member of [the company’s] management . . ." who was unaware of the misconduct of the company’s officers, and who would have taken appropriate remedial action, had they been so aware. Wechsler v. Squadron, Ellenoff, Pleasant & Sheinfeld, LLP, 212 B.R. 34, 36 n.1 (S.D.N.Y. 1997).
Thus, in neither of what are generally considered to be the two leading cases on imputation—Schacht and Cenco—does the court follow the black and white "agent’s subjective intent" approach, as set forth in the Draft, which focuses entirely on whether the trier of fact can be persuaded that the corporate insider had the requisite "one percent of subjective motivation" to benefit the corporation. Rather, the analysis in these cases, and in the vast majority of cases which followed them, runs along well-considered lines of public policy and equity. In other words, given the totality of the circumstances, would the public, including the innocent shareholders and creditors of the corporation, be better served by allowing the corporation to bring suit against these third parties, or was the corporation nothing but an "engine of theft" or "Ponzi scheme," or so thoroughly dominated by corrupt directors and officers, that it would indeed be inequitable and poor public policy to allow such an entity to bring claims against its proverbial partners in crime? Provision for such considerations and such analysis desperately needs to be included in the language of § 5.04. Presently, there is none.
Accordingly, the Proposed Amendment to § 5.04 would include a new subsection (1)(b), which states that notice would not be imputed when "the totality of the circumstances would otherwise render it inequitable to impute such notice." This is precisely where the case law, following and consistent with Schacht and Cenco, has taken us with respect to the issue of corporate imputation. The language of the proposed Comment with respect to this new subsection simply tracks the Schacht/Cenco analysis, and highlights the relevant issues of whether the corporation has a legitimate purpose and function, whether it has been injured in fact, and whether recovery by the principal would properly compensate the victims, and deter future wrongdoing.
The language of the proposed Comment also includes language stating that it will "generally not be equitable" to impose imputation upon a "trustee, receiver or similar innocent entity that has stepped into the principal’s shoes pursuant to a court order or operation of law. . ." Although the present Draft acknowledges that "some courts . . . proceed under the assumption that a trustee or receiver stands in larger shoes than those of the failed entity itself and do not impute fraud to a trustee or receiver that would have been imputed to the entity itself," the Draft abstains from taking a position on the issue, claiming that "this question is beyond the scope of agency doctrine." (See p. 125)
We disagree. The question is an important one, well within the scope of agency, and should be addressed. Recognizing the unique position of receivers and trustees vis-à-vis the corporation itself, many courts, including Schacht, supra, 2 have refused to impute the knowledge of corporate insiders to receivers and trustees which might otherwise be imputed to the corporation, insofar as receivers and bankruptcy trustees are outsiders who had no involvement in any wrongdoing whatsoever. See, e.g., 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.") See also, Scholes v. Lehmann, 56 F.3d 750 (7th Cir.), cert. denied, 516 U.S. 1028 (1995); Waslow v. Thornton (In re Greenberg), 212 B.R. 76 (Bankr. E.D. Pa. 1997); Gordon v. Basroon (In re Plaza Mortgage & Fin. Corp.), 187 B.R. 37 (Bankr. N.D. Ga. 1995); and Comeau v. Rupp, 810 F. Supp. 1127 (D. Kan. 1992).
IV. THE PROPOSED AMENDMENT TO § 5.04 WITH RESPECT TO THE DEFINITION OF "ADVERSE ACTION"
The addition of the word "reasonable" prior to "intention," in the Proposed Amendment, is to provide some parameter to the otherwise wholly subjective "intention" claimed by or asserted on behalf of the agent. Without such a modifier, a principal could lose its ability to sue a third party solely because the trier of fact is able to be convinced that the agent acted with any degree of intention to benefit the principal, regardless of whether that intent was totally irrational, or indeed delusional. The limiting term "reasonable" properly frames the issue in terms of whether, at a minimum, a reasonable person, given the set of facts as presented, could have formed the claimed or asserted intention.
With respect to the proposed addition of the words, "taking into account the facts and circumstances of the agent’s action, as well as the effect of those actions on the welfare of the principal," we note that these important considerations are presently found in the Comments to the existing Restatement (Comment a to § 235 states that the "external manifestations" of the servant’s mind are important as evidence of his intent, and that ordinarily "it is only from the manifestations of the servant and the circumstances that . . . his intent can be determined"), as well as in the Comments to the present Draft, which state (at p. 123) that "whether the principal benefited through the agent’s action may be relevant to establishing the motive with which the agent acted.") (This latter principle is strongly evident in the increasingly large volume of cases discussing, with approval, the "deepening insolvency" doctrine, as discussed, infra.) In light of the importance which the Draft places on ascertaining the agent’s subjective motivation, these critical factors deserve to be included in the body of § 5.04 itself, rather than in the Comments.
V. THE PROPOSED DELETION OF ILLUSTRATION 3
As set forth above, Illustration 3 contains none of the information, and addresses none of the considerations embodied in the Schacht/Cenco test, regarding the propriety of imputing the knowledge of a corrupt corporate insider to the corporation itself, so as to defeat the corporation’s claim against a third party.
Indeed, Illustration 3 in which the imputation to the corporation hinges entirely on the CEO’s subjective belief that the corporation "will benefit if its shares sell at a higher price as opposed to a lower price" has the potential of virtually eliminating the adverse interest exception to the rule of imputation, especially with respect to auditors, which are the named "third parties" in the Illustration. It clearly would not prove difficult for the auditors’ attorney (after obtaining a jury instruction, based on § 5.04, that the CEO’s knowledge is imputed to the corporation if the jury finds that he or she had any subjective intent whatsoever to benefit the corporation), to convince the jury of the CEO’s subjective belief that the corporation would benefit "if its shares sell at a higher price as opposed to a lower price." ("Ladies and Gentlemen of the jury, of course Mr. A believed that the corporation would benefit if its shares sold at a higher price; do you really think he believed that the corporation would benefit if its shares sold at a lower price"?)
Moreover, Illustration 3 could be read to suggest that the auditor had a right to rely on the financial representation of the CEO, notwithstanding that it is the auditor’s very duty and function to investigate and test the corporation’s financial representations, and bring any suspected irregularities to the attention of management and/or the audit committee. 3
Thus, the choice of auditors to fill the role of the "third party" in Illustration 3 raises a whole host of collateral issues, which assuredly was not the intent of the Illustration. Nonetheless, the auditing profession will jump on this Illustration as sure as night follows day, and parade it in front of the jury and the judge in letters big enough to be read a mile away.
In summary, Illustration 3 is not consistent with existing case law,4 and has tremendous potential for abuse by the auditing profession. It is imperative that it be deleted.
The two other cases cited in the Reporter’s Notes (at p. 133 of the Draft) as ostensibly supporting Illustration 3, similarly do no such thing. In Mid-Continent Paper Converters, Inc. v. Brady, Ware & Schoenfeld, Inc., 715 N.E.2d 906 (Ind. App. 1989), the court expressly narrowed its decision "to the facts of this case," which included, inter alia, that the corporate officers’ fraud "did benefit the company," (as opposed to "was intended to benefit the company). The court also found "irrelevant" the fact that Mid-Continent’s sole shareholder was unaware of and did not participate in the fraud (id. at 910, n.4) despite the admonition in Schacht that a "prerequisite" to the Cenco imputation analysis was a situation in which "fraud permeates the top management of the company," thereby "turning the company into an engine of theft . . . ." Cenco, 686 F.2d at 454; see also Schacht, 711 F.2d at 1347.
The third case cited in the Reporter’s Notes as supportive of Illustration 3 isSeidman & Seidman v. Gee, 625 So. 2d 1 (Fla. App. 1992), a case which according to the Reporter’s own Notes (at page 130 of the Draft) presents an “alternative test” to imputation, requiring that the corporate officer not only “intended to [but] did benefit the corporation.” Again, there is no indication in Illustration 3 that the corporation was in fact benefited by the CEO’s intentional misconduct.
VI. THE PROPOSED REPLACEMENT FOR ILLUSTRATION 3
The proposed "replacement" Illustration in the Proposed Amendment again follows a Schach/Cenco analysis, and further highlights the important concept of "deepening insolvency," a doctrine which got jump-started in Schacht, where the court rejected out of hand the argument that the artificial prolongation of a corporation’s life does not harm the corporation, stating:
[T]he prolonged artificial insolvency of Reserve benefited only Reserve’s managers and the other alleged conspirators, not the corporation * * * We do not believe that such a Pyrrhic ‘benefit’ to Reserve is sufficient to even trigger the Cenco analysis, which seeks to determine the propriety of imputing to the corporation the directors’ knowledge of fraud.
Schacht, 711 F.2d at 1348 (1983) (emphasis added). Elaborating on the public policy considerations embodied in its finding, the court succinctly stated:
Acceptance of a rule which would bar a corporation from recovering damages due to the hiding of information concerning its insolvency would create perverse incentives for wrongdoing officers and directors to conceal the true financial condition of a corporation from the corporate body as long as possible.
711 F.2d at 1350. (Emphasis added.)
Since Schacht, the deepening insolvency doctrine—that is, refusing to impute to the corporation the corporate insiders’ misconduct in concealing and furthering the corporation’s insolvency—has been followed in innumerable cases and jurisdictions from coast to coast,5 leading the Third Circuit to recently state, "[G]rowing acceptance of the deepening insolvency theory confirms its soundness." Official Comm. Of Unsecured Creditors v. R. F. Lafferty Company, Inc., 267 F.3d 340, 350 (3rd Cir. 2001). These deepening insolvency cases clearly reflect the existing case law of corporate imputation, which focuses, in large part, on whether the corporate insiders’ actions benefited or harmed the corporation. (Again, Schacht refers to this as a "threshold inquiry.")
5
Cases following this reasoning include Battenfeld of America Holding Company, Inc. v. Baird, Kurtz & Dobson, 60 F. Supp.2d 1189 (D. Kan. 1989); In Re Latin Inv. Corp., 168 B. R. 1 (Bankr. D. D. C. 1993); Comeau v. Rupp, 810 F. Supp. 1127 (D. Kan. 1992); Holland v. Arthur Andersen & Co., 469 N.E.2d 419 (Ill. App. 1984); In Re American Reserve Corp., 70 B.R. 729 (N.D. Ill. 1987); In re Stat-Tech Sec. Lit., 905 F. Supp. 1416, 1422 (D. Colo. 1995); In re Huff, 109 B.R. 506 (Bankr. S.D. Fla. 1989); Tew v. Chase Manhattan Bank, 728 F. Supp. 1551 (S.D. Fla. 1990); Askanase v. Fatjo, 828 F. Supp 465 (S.D. Tex. 1993); Southmark Corp. v. Cagan, 999 F.2d 216 (7th Cir. 1993); Hannover Corp. of America v. Beckner, 211 B.R. 849 (M.D. La. 1997); Allard v. Arthur Andersen & Co., 924 F. Supp. 488, 494 (S.D.N.Y. 1996); In re Gouiran Holdings, Inc., 165 B.R. 104, 107 (E.D.N.Y. 1994); Herbert H. Post & Co. v. Sidney Bitterman, Inc., 639 N.Y.S.2d 329 (N.Y. App. Div. 1996); and Corcoran v. Frank B. Hall & Co., 545 N.Y.S.2d 278 (N.Y. App. Div. 1989).VII. THE PROPOSED AMENDMENT’S ADDITIONAL COMMENT REGARDING PROOF OF THE AGENT'S INTENT
The Proposed Amendment would include in the Comments regarding the proof of the agent’s intent, the following language:
Intent to "act adversely" will be seldom admitted by the agent, and such an adverse intent may be found even though denied by the agent itself.
Such language is necessary to make clear that the bald assertion of the agent (who may well be loyal to the third-party defendants and their imputation defense) is by no means determinative on the issue of his intent. See State Highway Department v. Civil Service Comm., 173 A.2d 28 (N.J. 1961); Franklin Investment Co. v. Homburg, 252 A.2d 95 (D.C. 1969); Lassmann v. Commissioner of Internal Revenue, 327 F.2d 990 (8th Cir. 1964).
VIII. THE PROPOSED AMENDMENT TO § 5.03
For purposes of conformance only, the Proposed Amendment would modify § 5.03 as follows:
Notice of a fact that an agent knows or has reason to know is imputed to a principal if knowledge of the fact is material to the agent’s duties to the principal and to the principal’s legal relations with third parties. Notice is not so imputed
if the agent acts adversely to the principalUNDER THE CIRCUMSTANCES as stated in § 5.04 or IF THE AGENT is subject to a duty not to disclose the fact to the principal.IX. CONCLUSION
The above-referenced Amendments to the existing Draft of §§ 5.04 and 5.03 are necessary to bring the Restatement in line with the current case law regarding corporate imputation, and to avoid the Restatement becoming the ultimate safe haven for auditors and other third-party professionals who collude with corporate insiders to benefit themselves at the expense of the corporation.