The Adverse Interest Exception – Imputation of a Control Person’s Knowledge to the Corporation

For an agent’s knowledge to be imputed to his principal, the agent’s conduct, even if fraudulent, must in some way benefit the employer. Imputation of a control person’s knowledge becomes critical in fraud cases where the insider’s knowledge will defeat the corporation’s claim, for example against an auditor. If an insider, such as the CFO, embezzles funds from his employer, a critical issue in the employer’s claim against the auditor is imputation and its exceptions. This also is a huge issue in receiver “claw back” cases.  Where the agent is acting against the interests of the principal, the knowledge of an agent cannot be imputed to the principal. See Franklin Credit Mgmt. Corp. v. Hanney, 2011 UT App 213, ¶ 36, 262 P.3d 406, cert. granted, 272 P.3d 168 (Utah 2012).

In the context of an auditor malpractice case, the New York Court of Appeals in Kirschner v. KPMG LLP, 15 N.Y.3d 446, 938 N.E.2d 941 (N.Y. 2010), illustrates the adverse interest exception:

The rationale for the adverse interest exception illustrates its narrow scope. As already discussed, the presumption that an agent will communicate all material information to the principal operates except in the narrow circumstance where the corporation is actually the victim of a scheme undertaken by the agent to benefit himself or a third party personally, which is therefore entirely opposed (i.e., “adverse”) to the corporation’s own interests (see Center [v. Hampton Affiliates, Inc.], 66 N.Y.2d at 784, 497 N.Y.S.2d 898, 488 N.E.2d 828). Where the agent is perpetrating a fraud that will benefit his principal, this rationale does not make sense.

Id. at 519, 938 N.E.2d at 952 (emphasis added). In the Kirschner case, the fraud the corporate insiders perpetrated “hid hundreds of millions of dollars of the company’s uncollectible debt from the public and regulators. These maneuvers created a falsely positive picture of Refco’s financial condition.” Id. at 512, 938 N.E.2d at 945. That fraudulent conduct benefited the company – by allowing its continued existence – resulting in the insiders’ fraudulent conduct to be imputed to the company because the adverse interest exception did not apply. In the instant case, Haycock’s fraudulent conduct harmed Arrowhead, as did his cover up of his embezzlement.

Securities Investor Protection Corp. v. Bernard L. Madoff Inv. Securities LLC, 476 B.R. 715 (S.D.N.Y. 2012), relies upon the Kirschner case. In the Bernie Madoff case, imputation was not allowed where the purported agent of the investors was involved in a Ponzi scheme designed to defraud them.

However, “when an agent is engaged in a scheme to defraud his principal, either for his own benefit or that of a third person, the presumption that knowledge held by the agent was disclosed to the principal fails because he cannot be presumed to have disclosed that which would expose and defeat his fraudulent purpose.” Ctr. v. Hampton Affiliates, 66 N.Y.2d 782, 784, 497 N.Y.S.2d 898, 488 N.E.2d 828 (1985), cited with approval in Kirschner, 15 N.Y.3d at 466, 912 N.Y.S.2d 508, 938 N.E.2d 941. Thus, because the Trustee’s allegations describe in detail how Madoff Securities “engaged in a scheme to defraud” these defendants, the Trustee cannot impute Madoff Securities’ bad faith to them.

Id. at 724 fn. 9. Utah follows the adverse interest exception. Jensen v. IHC Hospitals, Inc., 944 P.2d 327, 334 fn. 4 (Utah 1997); Latses v. Nick Floor, Inc., 99 Utah 214, 104 P.2d 619, 623 (Utah 1940)(There is no imputation of knowledge from the agent to the principal, “[w]here the agent’s relations to the subject-matter are so adverse as to practically destroy the relation of agency. . . .”); Western Securities Co. v. Silver King Consol. Mining Co. of Utah, 57 Utah 88, 192 P. 664 (Utah 1920)(“in case a director, officer, or agent of a corporation transacts business in which he is adversely interested, his knowledge respecting the particular transaction (except under special conditions to which reference will be made later) is not imputable to the corporation, and hence it is not liable for his acts.”) No one would expect an insider to disclose his embezzlement to his employer, which would result in his criminal prosecution.

Fraud cases are won or lost based upon whether an insider’s knowledge is imputed to the corporate plaintiff. Knowing how and when this exception applies is critical to the successful prosecution of civil fraud cases.