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Litigating Insider Misconduct

Few aspects of the practice of law are as challenging, frustrating and exhilarating as investigating and litigating cases of insider fraud. Enough ethical, tactical and evidentiary issues are subsumed in each case to dizzy even the seasoned practitioner.

The key consideration in handling these cases is litigation strategy. While there are many aspects of these cases that set them apart, they are all impacted and shaped by counsel's strategy in uncovering and litigating the fraud. In highlighting some of the major issues that these cases present, this article will raise more questions than it answers. The answers lie only in the unique circumstances of each case and in the strategies that counsel employs.

The "Paper" Client and the "Paper" Witness
Even institutional clients are usually personified by a human being on whom lawyers can rely to learn the basic facts of the case, the identity of witnesses to be interviewed and the perceived outlines of the wrong to be redressed. When dealing with insider fraud, there may be no one, save the "alleged" defrauders, who has any real comprehension of what may have occurred.

Funds may be missing, assets may suddenly prove worthless but typically it is not at all clear how or why this has happened. The sophisticated, modern embezzler usually covers his or her tracks in a maze of transactions and entities that confound easy analysis. One can only find out what actually happened by extensive (and sometimes tedious) analysis of documents and financial records. There often is no one to ask to clarify the multitude of transactions and paper trail. Obfuscation is an important technique in creating the fraud in the first place.

Assuming an attorney can find his or her way through the maze and conclude that a fraud has been perpetrated, the "paper" case leads to some anomalous discovery disputes and trial issues. From the defense perspective, the lawyers demand that answers to interrogatories or that party deponents explain the basis of the claims. "Someone tell me the facts that support the various assertions," the lawyer says. "You have accused my client of fraud and I want to know why."

In response, plaintiff's counsel calmly and coyly observes that no one knows anything other than what they have learned from advice of counsel and that, of course, is privileged or work product. "At best, the discovery requests call for expert opinion, and I don't have to provide you with expert reports until fact discovery is closed," they claim.

But the defense may have the last laugh. The plaintiff may get away with keeping the adversary at bay in discovery, but counsel can't be coy at trial. How does the plaintiff make a paper case come alive at trial? Without a flesh and blood witness, how does counsel convince a jury that the maze of transactions and blizzard of documents constitutes "clear and convincing" proof of a fraud? Should the plaintiff rely on expert witnesses alone? Risk calling hostile witnesses as on cross? The defendant, on the other hand, may remind the trier of fact that no expert can opine on a defendant's state of mind and that the alleged fraud is nothing more than a sophisticated business strategy that failed.

Whose Knowledge Is It, Anyway?
How does a corporation or other "fictional" entity know? How does it rely? How is it deceived? These questions, which are invariably crucial to fraud litigation, can be surprisingly difficult to answer when dealing with insider fraud, for corporate knowledge and corporate state of mind can only be imputed from the knowledge and state of mind of the people who play various corporate roles. One recent case turned almost exclusively on imputation of knowledge -- to whom would the defrauders' knowledge would be imputed?

Corporation A decided to sell its XYZ subsidiary to XYZ Acquisition Corporation, an entity formed by a group of outside investors and inside managers. Some months after the deal closed, a federal investigation uncovered that some of the inside managers had been engaged in fraudulent billing practices for years and that much of XYZ subsidiary's historical earnings were illegitimate or overstated. XYZ Acquisition sued Corporation A claiming it had been defrauded. But, since the only people with actual knowledge of the misconduct prior to the closing were the inside managers, who actually "knew" about the billing practices? Should the knowledge of the inside managers be imputed to Corporation A or to XYZ Acquisition Corp.?

More often, the question of imputed knowledge arises when the defrauded corporation seeks redress from third parties such as accounting firms that failed to uncover the fraud during audits, or law firms that unwittingly handled transactions that were part of the fraud. As a rule, if the insider fraud was completely adverse to the corporation, the embezzler's knowledge of his own misconduct will not be imputed to his corporation. But what if the fraud has mixed consequences, such as the billing fraud described above? If the corporation benefitted from the fraudulent billing practices, is the knowledge of the fraud imputed to it? If it is imputed, how can a claim be asserted against a third party for not telling the corporation what it already knew?

A similar problem arises in the context of causation. If the misbehaving insiders dominate the top levels of a closely held corporation, what difference would it have made if third parties had discovered the misconduct? Who relied on the negligent audits or sloppy due diligence? Surely not the defrauders.

Adverse Domination
The two year statute of limitations for fraud or fiduciary duty claims is not a very long one when dealing with insider fraud. It is rare that these complex schemes are discovered quickly, particularly when they are carried out by top level management. In addition, the schemes have usually been ongoing for years. One approach to overcome this problem is to assert a RICO claim and gain the benefit of its four-year limitations period, but the peg of insider fraud will not always fit into a RICO hole. Another approach is to rely on the doctrine of adverse domination. This doctrine, yet to be accepted or rejected by the Supreme Court of Pennsylvania, holds that the statute of limitations cannot begin to run against a corporation during the time it is dominated by the wrongdoers. Conceptually appealing, the doctrine can be confusing in its application. How "adverse" must the domination be? If a corporation has one independent director on its board, is the tolling doctrine unavailable? What if there are a number of independent directors, but not a majority of the board?

If the unsettled state of the law was not enough, the unwary plaintiff, anxious to avoid a statute of limitations defense, may unwittingly damage his case in his zeal to prove adverse domination. By proving that the corporation was truly adversely dominated, you may also prove a third party's causation defense. Nothing an outsider did could have possibly made a difference.

Suing the people who retained you
It is smart practice to warn the directors or officers of a client's corporation that they may well be dragged into any fraud related litigation, not merely as witnesses, but as actual defendants. If all of the officers and directors were around during the time the fraud was perpetrated, it then is a good idea to go further and suggest that they appoint new outside directors to act as trustees ad litem. This advice is not always warmly received, but it is better to face this awkward reality early in the game.

At a minimum, plaintiff's counsel must anticipate that if third parties are sued, they, in turn, may join the innocent officers and directors claiming that the innocent insiders were negligent themselves in not preventing the fraud. At worst, an investigation may lead defense counsel to question the innocence of the client's corporate representatives and, if the corporation has purchased substantial D&O coverage, this "pocket" may be the deepest and most accessible source of recovery. The defrauders rarely have the embezzled assets by the time the scheme is uncovered. The classic PBI ethics seminar hypothetical, which fantasizes all sorts of unsuspected conflicts in representing a corporate client, is all too real when defense counsel is charged with investigating possible insider fraud.

From the defense perspective, the joinder of insiders may prove to be a trap. It may be quite difficult to prove that the merely negligent insiders should have discovered or prevented the fraud without proving much of the plaintiff's case. While it may be easy to plead "in the alternative" it is almost impossible to try a case in the alternative. Increasingly, sophisticated defense counsel resists the temptation to join additional defendants.

The problem of settlement
No defendant wants to settle a case without obtaining certainty that his or her exposure is at an end. However, once outside the relatively straightforward world of joint tort feasors, the issue of "contribution protection" can prove daunting. The indemnification of the settling defendant can be particularly problematic if the plaintiff has articulated vicarious liability theories, aider and abettor claims, or conspiracy counts. While such theories can be singularly effective and powerful tools that expand the exposure of "second tier" defendants, they may provide "third tier" defendants with the basis for a claim of common law indemnification.

If a plaintiff has given a settling second tier defendant complete contribution protection, he or she may have substantially undermined the value of the case against the third tier defendants. The reason for this reduction in value is that if the third tier defendants succeed in their common law indemnification claims against the "protected" second tier defendants, the value of any plaintiff's verdict against them will be reduced to zero by virtue of the protection the plaintiff gave the settling second tier defendant. There are times when it is easier to negotiate the dollar value of a settlement than to negotiate the degree of contribution protection which would be given in exchange for the money.

There are no "answers," only strategic considerations that vary from case to case. How counsel deals with one problem will inevitably impact his or her ability to deal with the next. In the end, it is the need to envision these inter-relationships which makes this area so challenging. The importance of devising and implementing an over all litigation strategy which takes a bird's eye view of the situation while managing the intricacy of all of the interwoven relationships truly distinguishes this area of practice.

Antoinette R. Stone, a shareholder with the Philadelphia office of Buchanan Ingersoll, chairs the firm's Corporate Investigations Group.

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