Cenco Inc. v. Seidman & Seidman
1982 U.S. App. LEXIS 20664, 686 F.2d 449 (1982)
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Rule of Law:
When a corporation's top management perpetrates a fraud for the benefit of the corporation, the fraud is imputed to the corporation and may be raised as a defense by the corporation's independent auditor in a subsequent lawsuit by the corporation for professional malpractice or breach of contract.
Facts:
- Between 1970 and 1975, top managerial employees of Cenco Incorporated, including its chairman and president, engaged in a massive fraud.
- The fraud involved artificially inflating the value of Cenco's inventories.
- Cenco used the inflated value of its stock to acquire other companies, to borrow money at more favorable rates, and to receive inflated payments from its insurers for lost inventory.
- The managers' fraud was intended to aggrandize Cenco, not to steal from it.
- Seidman & Seidman served as Cenco's independent auditor throughout the fraud period and failed to discover or report the wrongdoing.
- The fraud was eventually discovered and reported to the Securities and Exchange Commission by a newly hired financial officer at Cenco.
- While most of Cenco's board of directors was not involved in the fraud, there was evidence they were negligent in their oversight duties.
Procedural Posture:
- Purchasers of Cenco stock filed a class action lawsuit in federal district court against Cenco, its corrupt managers, and its auditor, Seidman & Seidman.
- Cenco, under new management, filed a cross-claim against its co-defendant Seidman & Seidman for breach of contract, professional malpractice, and fraud.
- Seidman & Seidman filed its own cross-claim against Cenco, alleging it was a victim of Cenco's fraud.
- Prior to the trial on the cross-claims, the class action was settled, with Seidman paying $3.5 million to the class plaintiffs.
- At the close of evidence in the trial on the cross-claims, the district court judge granted a directed verdict in favor of Cenco, dismissing Seidman's cross-claim.
- The judge also granted a directed verdict in favor of Seidman on Cenco's counts of aiding and abetting and conspiracy.
- The jury returned a verdict in favor of Seidman on Cenco's remaining counts of breach of contract, professional malpractice, and fraud.
- Cenco appealed the jury verdict and the directed verdicts to the U.S. Court of Appeals for the Seventh Circuit. Seidman cross-appealed the dismissal of its cross-claim.
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Issue:
Does the fraudulent conduct of a corporation's top managers, committed for the corporation's benefit, bar the corporation from recovering damages from its independent auditor for the auditor's failure to detect the fraud?
Opinions:
Majority - Posner
Yes. A corporation is barred from recovering damages from its auditor for failing to detect a fraud perpetrated by its own top management for the corporation's benefit. The court's reasoning is based on the underlying objectives of tort law: compensation and deterrence. From a compensation standpoint, allowing Cenco to recover would perversely benefit the very stockholders who are the principals of the fraudulent agents (the managers) and who were either beneficiaries of the fraud or negligent in their oversight through the board of directors. From a deterrence standpoint, allowing the corporation to shift the entire cost of the fraud to its auditor would reduce the incentive for shareholders and their delegates on the board to hire honest managers and monitor their behavior effectively. Because the fraud was widespread at the highest levels of Cenco and intended to benefit the company, the managers' wrongdoing is imputed to Cenco itself, giving Seidman a valid defense.
Analysis:
This decision establishes an important limitation on the liability of auditors by allowing them to impute the wrongdoing of a client corporation's top management back to the corporation itself, a concept often referred to as the 'Cenco defense' or 'in pari delicto.' The key distinction is whether the fraud was committed 'for' or 'against' the company. This ruling places a greater burden on corporate governance structures, like the board of directors, to actively monitor management, as the corporation cannot simply shift the cost of its own internal, high-level corruption onto its external auditors. It has significantly influenced subsequent cases involving auditor liability in the context of corporate fraud.
