Insolvencies Created By Bad Actors

The in Pari Delicto Defense

Under common law, 'a plaintiff who has participated in a wrongdoing may not recover damages resulting from wrongdoing.' Black's Law Dictionary (7^th ed. 1999). 'In pari delicto is both an affirmative defense and an equitable defense. Broadly speaking, the defense prohibits plaintiffs from recovering damages resulting from their own wrongdoing.' '[t]he doctrine is grounded on twin premises. The first is that 'courts should not lend their good offices to mediating disputes among wrongdoers.' The second is that 'denying judicial relief to an admitted wrongdoer is an effective means of deterring illegality.” See Nisselson, 469 F.3d 143, 151, (1^st Cir. 2006), citing Baterman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 306 (1985).

Exceptions to the in Pari Delicto Defense

Despite the general principles enunciated above, there are instances in which the in pari delicto defense does not apply. Two circumstances prevent a defendant from raising such a defense to liability for the defendant's alleged wrongdoing: 1) when the defendant is an insider of the injured corporation; and 2) if the defendant-agent's actions are adverse to the interests of the principal. The exceptions are pragmatic, designed to prevent wrongdoers from insulating themselves from liability in circumstances in which they owe a fiduciary duty to another or act on behalf of another.

Corporate insiders such as officers and directors cannot assert the in pari delicto defense against claims against them for breach of fiduciary duty. In pari delicto is not a defense to 'aiding and abetting claims against corporate insiders for looting the company.' See In re Parmalat, 383 F. Supp.2d, 587, 599 (S.D.N.Y. 2005). Absent this exception, neither a corporation nor the successor trustee could sue the corporation's insiders to hold them accountable for their wrongdoing. In re Amcaset Indus- trial Corporation, 2007 Bankr. LEXIS 692 (S.D. Ohio 2007).

Under the adverse interest exception to the in pari delicto defense, the wrongful acts of an agent are not imputed to the agent's principal when the agent's actions are adverse to the principal's interests. Wight v. BankAmerica Corp., 219 F.3d 79, 87 (2d Cir. 2000). This exception is only applicable when the agent is acting entirely adverse to the principal, and the principal is in no way benefiting from the agent's actions. Official Committee of Unsecured Creditors v. Lafferty, 267 F.3d 340, 359 (3^rd Cir. 2001); in accord, Official Committee of Unsecured Creditors of Allegheny Health, Education and Research Foundation v. Pricewaterhouse Coopers, LLP, 2007 U.S. Dist. LEXIS 3331, *20-32 (W.D. Pa. 2007); In re Scott Acquisition Corp., 2007 Bankr. LEXIS 643 (Bankr. D. Del. 2007); Moratzka v. Morris, et al., (In re Senior Cottages of America LLC), 482 F.3d 997 (8^th Cir. 2007); In re Greater Southeast Community Hospital Corp, I v. Tuft, 353 B.R. 324, 366-68 (Bankr. D.Dist.Col. 2006). If the agent's wrongdoing provides some benefit to the principal, the adverse interest exception does not apply. Baena v. KPMG LLP, 453 F. 3d at 7-8; Beck v. Deloitte & Touche, 144 F.3d 732, 736 (11^th Cir. 1998).

Not only must the agent act adverse and without benefit to the principal, the agent also cannot be the principal's sole representative. If an agent is the sole representative of the principal, then the agent's actions are imputed to the principal notwithstanding the agent's adverse interest. See Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340,359 (3^rd Cir. 2001); Official Committee of Unsecured Creditors of Allegheny Health, Education and Research Foundation v. Pricewaterhouse Coopers, LLP, 2007 U.S. Dist. LEXIS 3331, *20-32 (W.D. Pa. 2007). For example, a board of directors acting unanimously qualifies as a sole actor for purposes of the sole actor exception. See Official Comm. of Unsecured Creditors of Color Tile, Inc. v. Coopers Lybrand, LLC, 322 F. 3d 147, 165-66 (2d Cir. 2003). In such situations, a principal will be deemed equally guilty as its sole agent and cannot raise an in pari delicto defense no matter how self-interested any of the directors may have been when they voted unanimously to take a fraudulent action.

Application of the in pari delicto defense and its exceptions requires a fact intensive inquiry into the circumstances and actors involved in the proceedings. The actors may include debtors, bankruptcy trustees, official committees, plan administrators and receivers. The effectiveness of the defense differs. While the defense is available to defendants to be asserted in actions commenced by debtors, bankruptcy trustees, official committees, and plan administrators in actions to recover property of the estate, it may not be effective in avoidance actions brought by those players under other provisions of the Bankruptcy Code. In matters involving receivers, however, an in pari delicto defense generally is barred no matter what action is brought.

In Pari Delicto Defense and Debtors, Trustees, Committees and Plan Administrators

Six U.S. Circuit Courts of Appeal have concluded that the in pari delicto defense bars a trustee from asserting causes of action that the debtor would not have been able to assert because of the in pari delicto defense. Courts so ruling are the First, Second, Third, Eighth, Tenth and Eleventh Circuits. See Baena v. KPMG, LLP, 453 F.3d 1 (1^st Cir. 2006); Official Comm. of Unsecured Creditors of Color Tile Inc. v. Coopers & Lybrand LLP, 322 F.3d 147 (2^nd Cir. 2003); Official Comm. of Unsecured Creditors v. Lafferty & Co., 267 F.3d 340 (3^rd Cir. 2001); In re Dublin Securities Inc., 133 F.3d 377 (6^th Cir. 1997); Grassmueck v. The Am. Shorthorn Assoc., 402 F.3d 833 (8^th Cir. 2005); Sender v. Buchanan, 84 F.3d 1281 (10^th Cir. 1996); and Official Comm. of Unsecured Creditors of PSA Inc. v. Edwards, et al., 437 F.3d 1145 (11^th Cir. 2006), cert. denied, 127 S.Ct. 45 (2006).

Each of these Courts of Appeal has relied on ' 541(a) of the Bankruptcy Code, which provides that the debtor's estate includes 'all legal or equitable interest of the debtor in property as of the commencement of the case.' 11 U.S.C. ' 541(a).

In Lafferty, the Third Circuit held that the in pari delicto defense barred the Official Committee of Unsecured Creditors from prosecuting actions that the trustee would have been barred from prosecuting. The court concluded that the in pari delicto defense must be evaluated without regard to whether the committee is an innocent purchaser. Lafferty, 267 F.3d 357; in accord, Official Committee of Unsecured Creditors of Allegheny Health, Education and Research Foundation v. Pricewaterhouse Coopers, LLP, 2007 U.S. Dist. LEXIS 3331, *20-32 (W.D. Pa. 2007). See also Global Crossing Estate Representatives v. Winnick, 2006 U.S. Dist. LEXIS 53785 (S.D.N.Y. 2006) and Trenwick American Litigation Trust v. Ernst & Young, et al., 906 A.2d 168 (Del. Ch., 2006)(the 'Estate Representative' and 'Litigation Trust' were respectively treated the same as the debtor for purposes of the application of the in pari delicto defense); In re Parmalat Securities Litigation: Bondi v. Bank of America, et al., 383 F. Supp. 2d 587 (S.D. N.Y. 2005)(the 'Extraordinary Administrator' appointed in the Italian reorganization proceeding was 'roughly equivalent to that of a Chapter 11 bankruptcy trustee in the United States,' and applied the in pari delicto defense to preclude its claims for fraud and negligent misrepresentation). The common ground in all of these bankruptcy actions is that the plaintiff is not bringing claims on behalf of innocent targets of the fraud ' but rather on behalf of a complicit party.

The Pari Delicto Defense and Avoidance Actions

Courts that have enforced the in pari delicto defense in bankruptcy cases brought on behalf of the debtor do so by relying on the plain language of ' 541 of the Bankruptcy Code, which bars consideration of events that occur after the commencement of the bankruptcy. Therefore, the prebankruptcy actions of the debtor, its principals and agents, are imputed to the bankruptcy trustee.

Several courts have found no such limitation in the avoidance provisions of the Bankruptcy Code. These courts have concluded that they may take the appointment of the trustee into account in evaluating the fraudulent conveyance claim, and thereby not impute the debtor's conduct to the trustee. In re: The Personal and Business Insurance Agency, 334 F.3d 239, 245 (3d Cir. 2003); in accord, In re Student Finance Corporation v. Pepper Hamilton, 335 B.R. 539, 554 (D. Del. 2005). However, the Tenth Circuit has rejected this argument in Sender v. Buchanan (In re Hedged Investments Assocs.), 84 F.3d 1281, 1285 (10^th Cir. 1996); Sender v. Mann, 423 F.Supp.2d 1155 (D.Colo. 2006).

In Pari Delicto Defense and Receivers

The U.S. Court of Appeals for the Seventh Circuit addressed the ability of a receiver to pursue fraudulent transfer claims in Scholes v. Lehmann, 56 F.3d 750 (7^th Cir. 1995), cert. denied sub. nom. African Enterprise Inc. v. Scholes, 516 U.S. 1028 (1995). In Scholes, the receiver of three corporations that were instruments of a Ponzi scheme sought to recover fraudulent transfers from the 'investors' who had received distributions on account of their investments.

Permitting the actions to proceed, the Seventh Circuit found that the corporations with the receiver in charge, were 'freed from the spell of the evil zombie [the principal], and became entitled to the return of the moneys ' for the benefit not of the [principal] but of innocent investors ' that the [principal] had made the corporations divert to the unauthorized persons.' Scholes, 56 F.3d 754. The court found that the 'defense of in pari delicto loses its sting when the persons who is in pari delicto is eliminated.' Id.

The Seventh Circuit was persuaded by the 'public policy' of 'getting the money back into the pockets of its rightful owners.' Id. See also, Liberte Capital Group, 419 F. Supp.2d 992 (N.D. Ohio, 2006) (receiver, operating under a broad order, and not the individual claimant, was authorized to pursue arbitration claims against the respective brokerage firms for acts of their representatives); Marion v. TDI, Inc., 2004 U.S. Dist. LEXIS 9754, *9 (E.D. Pa. 2004)(receiver authorized to pursue violations of securities laws for the benefit of investors).

Courts that have held similarly include DeNune v. Consolidated Capital of North America, Inc., 288 F. Supp.2d 844 (N.D. Ohio, 2003) (a subsidiary's receiver's suit against the parent and its officers was allowed to proceed despite the claim that the doctrine of in pari delicto barred the suit); F.D.I.C. v. O'Melveny & Myers, 61 F.3d 17 19 (9^th Cir. 1995) (receiver becomes the bank's successor as part of an intricate regulatory scheme designed to protect the interests of third parties who also were not privy to the bank's inequitable conduct); in accord, Quilling v. Cristell, 2006 U.S. Dist. LEXIS 8480 (W.D. N.C. 2006). However, a 'liquidator' appointed in a Bahamian proceeding, who was not acting independently of the debtor, did not 'lose its sting.' Waldock v. M.J. Select Global, Ltd., 2005 U.S. Dist. LEXIS 26790 at *40 (N.D. Ill. 2005).

Conclusion: Look Before You Leap

Those faced with the task of seeking recovery from an insolvent
company on behalf of an innocent victim should attempt to determine the likely scope and application of the in pari delicto defense 'before requesting or supporting the filing of a bankruptcy petition or seeking the appointment of a receiver. The actors and circumstances involved in the case must be thoroughly considered to determine the potential impact the in pari delicto defense may have upon recovery.

Given the strictures and intricacies of this defense, innocent investors often may be best advised to institute their own direct actions against the bad actors to achieve the highest recovery from the bad actors involved.

Amy M. Tonti is a member of the Commercial Restructuring & Bankruptcy Group at Reed Smith in New York. A member of this newsletter's Board of Editors, she practices in the areas of bankruptcy, corporate restructuring, insolvency, and creditors' and debtors' rights. She may be reached at [email protected].

While the market is swimming with innovative and highly leveraged financial transactions, and many parties are enjoying sizeable gains, some of those involved in these enterprises ultimately will become insolvent. A fraction of these insolvencies will result from fraudulent investment schemes perpetrated by multiple parties acting in concert for their mutual benefit. Innocent victims, including creditors and investors, will bear the financial brunt of the insolvencies, and will be eager to recover from all parties that participated in the fraud.

These innocent victims are likely to weigh recovery options, including the alternatives of either filing a bankruptcy petition (whether voluntary or involuntary) or seeking the appointment of a receiver to obtain recovery on their behalf. Before such actions are taken, careful consideration should be given as to whether the defense of 'in pari delicto' will preclude the ability of the bankruptcy estate or the receiver from pursuing such recovery.

Application of the in pari delicto defense can bar recovery for claims asserted by an insolvent corporation on behalf of its estate. The defense, however, does not apply in all circumstances, and it does not apply to all actors involved in a proceeding to recover property lost in a fraudulent scheme.

The in Pari Delicto Defense

Under common law, 'a plaintiff who has participated in a wrongdoing may not recover damages resulting from wrongdoing.' Black's Law Dictionary (7^th ed. 1999). 'In pari delicto is both an affirmative defense and an equitable defense. Broadly speaking, the defense prohibits plaintiffs from recovering damages resulting from their own wrongdoing.' '[t]he doctrine is grounded on twin premises. The first is that 'courts should not lend their good offices to mediating disputes among wrongdoers.' The second is that 'denying judicial relief to an admitted wrongdoer is an effective means of deterring illegality.” See Nisselson , 469 F.3d 143, 151, (1 st Cir. 2006), citing Baterman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 306 (1985).

Exceptions to the in Pari Delicto Defense

Despite the general principles enunciated above, there are instances in which the in pari delicto defense does not apply. Two circumstances prevent a defendant from raising such a defense to liability for the defendant's alleged wrongdoing: 1) when the defendant is an insider of the injured corporation; and 2) if the defendant-agent's actions are adverse to the interests of the principal. The exceptions are pragmatic, designed to prevent wrongdoers from insulating themselves from liability in circumstances in which they owe a fiduciary duty to another or act on behalf of another.

Corporate insiders such as officers and directors cannot assert the in pari delicto defense against claims against them for breach of fiduciary duty. In pari delicto is not a defense to 'aiding and abetting claims against corporate insiders for looting the company.' See In re Parmalat, 383 F. Supp.2d, 587, 599 (S.D.N.Y. 2005). Absent this exception, neither a corporation nor the successor trustee could sue the corporation's insiders to hold them accountable for their wrongdoing. In re Amcaset Indus- trial Corporation, 2007 Bankr. LEXIS 692 (S.D. Ohio 2007).

Under the adverse interest exception to the in pari delicto defense, the wrongful acts of an agent are not imputed to the agent's principal when the agent's actions are adverse to the principal's interests. Wight v. BankAmerica Corp., 219 F.3d 79, 87 (2d Cir. 2000). This exception is only applicable when the agent is acting entirely adverse to the principal, and the principal is in no way benefiting from the agent's actions. Official Committee of Unsecured Creditors v. Lafferty, 267 F.3d 340, 359 (3 rd Cir. 2001); in accord , Official Committee of Unsecured Creditors of Allegheny Health, Education and Research Foundation v. Pricewaterhouse Coopers, LLP, 2007 U.S. Dist. LEXIS 3331, *20-32 (W.D. Pa. 2007); In re Scott Acquisition Corp., 2007 Bankr. LEXIS 643 (Bankr. D. Del. 2007); Moratzka v. Morris, et al., (In re Senior Cottages of America LLC), 482 F.3d 997 (8^th Cir. 2007); In re Greater Southeast Community Hospital Corp, I v. Tuft, 353 B.R. 324, 366-68 (Bankr. D.Dist.Col. 2006). If the agent's wrongdoing provides some benefit to the principal, the adverse interest exception does not apply. Baena v. KPMG LLP, 453 F. 3d at 7-8; Beck v. Deloitte & Touche, 144 F.3d 732, 736 (11 th Cir. 1998).

Not only must the agent act adverse and without benefit to the principal, the agent also cannot be the principal's sole representative. If an agent is the sole representative of the principal, then the agent's actions are imputed to the principal notwithstanding the agent's adverse interest. See Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340,359 (3 rd Cir. 2001); Official Committee of Unsecured Creditors of Allegheny Health, Education and Research Foundation v. Pricewaterhouse Coopers, LLP, 2007 U.S. Dist. LEXIS 3331, *20-32 (W.D. Pa. 2007). For example, a board of directors acting unanimously qualifies as a sole actor for purposes of the sole actor exception. See Official Comm. of Unsecured Creditors of Color Tile, Inc. v. Coopers Lybrand, LLC, 322 F. 3d 147, 165-66 (2d Cir. 2003). In such situations, a principal will be deemed equally guilty as its sole agent and cannot raise an in pari delicto defense no matter how self-interested any of the directors may have been when they voted unanimously to take a fraudulent action.

Application of the in pari delicto defense and its exceptions requires a fact intensive inquiry into the circumstances and actors involved in the proceedings. The actors may include debtors, bankruptcy trustees, official committees, plan administrators and receivers. The effectiveness of the defense differs. While the defense is available to defendants to be asserted in actions commenced by debtors, bankruptcy trustees, official committees, and plan administrators in actions to recover property of the estate, it may not be effective in avoidance actions brought by those players under other provisions of the Bankruptcy Code. In matters involving receivers, however, an in pari delicto defense generally is barred no matter what action is brought.

In Pari Delicto Defense and Debtors, Trustees, Committees and Plan Administrators

Six U.S. Circuit Courts of Appeal have concluded that the in pari delicto defense bars a trustee from asserting causes of action that the debtor would not have been able to assert because of the in pari delicto defense. Courts so ruling are the First, Second, Third, Eighth, Tenth and Eleventh Circuits. See Baena v. KPMG, LLP, 453 F.3d 1 (1 st Cir. 2006); Official Comm. of Unsecured Creditors of Color Tile Inc. v. Coopers & Lybrand LLP, 322 F.3d 147 (2 nd Cir. 2003 ); Official Comm. of Unsecured Creditors v. Lafferty & Co., 267 F.3d 340 (3 rd Cir. 2001); In re Dublin Securities Inc., 133 F.3d 377 (6^th Cir. 1997); Grassmueck v. The Am. Shorthorn Assoc., 402 F.3d 833 (8 th Cir. 2005); Sender v. Buchanan, 84 F.3d 1281 (10 th Cir. 1996); and Official Comm. of Unsecured Creditors of PSA Inc. v. Edwards, et al., 437 F.3d 1145 (11 th Cir. 2006), cert. denied , 127 S.Ct. 45 (2006).

Each of these Courts of Appeal has relied on ' 541(a) of the Bankruptcy Code, which provides that the debtor's estate includes 'all legal or equitable interest of the debtor in property as of the commencement of the case.' 11 U.S.C. ' 541(a).

In Lafferty, the Third Circuit held that the in pari delicto defense barred the Official Committee of Unsecured Creditors from prosecuting actions that the trustee would have been barred from prosecuting. The court concluded that the in pari delicto defense must be evaluated without regard to whether the committee is an innocent purchaser. Lafferty, 267 F.3d 357; in accord, Official Committee of Unsecured Creditors of Allegheny Health, Education and Research Foundation v. Pricewaterhouse Coopers, LLP, 2007 U.S. Dist. LEXIS 3331, *20-32 (W.D. Pa. 2007). See also Global Crossing Estate Representatives v. Winnick, 2006 U.S. Dist. LEXIS 53785 (S.D.N.Y. 2006) and Trenwick American Litigation Trust v. Ernst & Young, et al., 906 A.2d 168 (Del. Ch., 2006)(the 'Estate Representative' and 'Litigation Trust' were respectively treated the same as the debtor for purposes of the application of the in pari delicto defense); In re Parmalat Securities Litigation: Bondi v. Bank of America, et al., 383 F. Supp. 2d 587 (S.D. N.Y. 2005)(the 'Extraordinary Administrator' appointed in the Italian reorganization proceeding was 'roughly equivalent to that of a Chapter 11 bankruptcy trustee in the United States,' and applied the in pari delicto defense to preclude its claims for fraud and negligent misrepresentation). The common ground in all of these bankruptcy actions is that the plaintiff is not bringing claims on behalf of innocent targets of the fraud ' but rather on behalf of a complicit party.

The Pari Delicto Defense and Avoidance Actions

Courts that have enforced the in pari delicto defense in bankruptcy cases brought on behalf of the debtor do so by relying on the plain language of ' 541 of the Bankruptcy Code, which bars consideration of events that occur after the commencement of the bankruptcy. Therefore, the prebankruptcy actions of the debtor, its principals and agents, are imputed to the bankruptcy trustee.

Several courts have found no such limitation in the avoidance provisions of the Bankruptcy Code. These courts have concluded that they may take the appointment of the trustee into account in evaluating the fraudulent conveyance claim, and thereby not impute the debtor's conduct to the trustee. In re: The Personal and Business Insurance Agency, 334 F.3d 239, 245 (3d Cir. 2003); in accord , In re Student Finance Corporation v. Pepper Hamilton, 335 B.R. 539, 554 (D. Del. 2005). However, the Tenth Circuit has rejected this argument in Sender v. Buchanan (In re Hedged Investments Assocs.), 84 F.3d 1281, 1285 (10^th Cir. 1996); Sender v. Mann, 423 F.Supp.2d 1155 (D.Colo. 2006).

In Pari Delicto Defense and Receivers

The U.S. Court of Appeals for the Seventh Circuit addressed the ability of a receiver to pursue fraudulent transfer claims in Scholes v. Lehmann, 56 F.3d 750 (7 th Cir. 1995), cert. denied sub. nom. African Enterprise Inc. v. Scholes, 516 U.S. 1028 (1995). In Scholes, the receiver of three corporations that were instruments of a Ponzi scheme sought to recover fraudulent transfers from the 'investors' who had received distributions on account of their investments.

Permitting the actions to proceed, the Seventh Circuit found that the corporations with the receiver in charge, were 'freed from the spell of the evil zombie [the principal], and became entitled to the return of the moneys ' for the benefit not of the [principal] but of innocent investors ' that the [principal] had made the corporations divert to the unauthorized persons.' Scholes, 56 F.3d 754. The court found that the 'defense of in pari delicto loses its sting when the persons who is in pari delicto is eliminated.' Id.

The Seventh Circuit was persuaded by the 'public policy' of 'getting the money back into the pockets of its rightful owners.' Id. See also, Liberte Capital Group, 419 F. Supp.2d 992 (N.D. Ohio, 2006) (receiver, operating under a broad order, and not the individual claimant, was authorized to pursue arbitration claims against the respective brokerage firms for acts of their representatives); Marion v. TDI, Inc., 2004 U.S. Dist. LEXIS 9754, *9 (E.D. Pa. 2004)(receiver authorized to pursue violations of securities laws for the benefit of investors).

Courts that have held similarly include DeNune v. Consolidated Capital of North America, Inc., 288 F. Supp.2d 844 (N.D. Ohio, 2003) (a subsidiary's receiver's suit against the parent and its officers was allowed to proceed despite the claim that the doctrine of in pari delicto barred the suit); F.D.I.C. v. O'Melveny & Myers, 61 F.3d 17 19 (9 th Cir. 1995) (receiver becomes the bank's successor as part of an intricate regulatory scheme designed to protect the interests of third parties who also were not privy to the bank's inequitable conduct); in accord, Quilling v. Cristell, 2006 U.S. Dist. LEXIS 8480 (W.D. N.C. 2006). However, a 'liquidator' appointed in a Bahamian proceeding, who was not acting independently of the debtor, did not 'lose its sting.' Waldock v. M.J. Select Global, Ltd., 2005 U.S. Dist. LEXIS 26790 at *40 (N.D. Ill. 2005).

Conclusion: Look Before You Leap

Those faced with the task of seeking recovery from an insolvent
company on behalf of an innocent victim should attempt to determine the likely scope and application of the in pari delicto defense 'before requesting or supporting the filing of a bankruptcy petition or seeking the appointment of a receiver. The actors and circumstances involved in the case must be thoroughly considered to determine the potential impact the in pari delicto defense may have upon recovery.

Given the strictures and intricacies of this defense, innocent investors often may be best advised to institute their own direct actions against the bad actors to achieve the highest recovery from the bad actors involved.

Amy M. Tonti is a member of the Commercial Restructuring & Bankruptcy Group at Reed Smith in New York. A member of this newsletter's Board of Editors, she practices in the areas of bankruptcy, corporate restructuring, insolvency, and creditors' and debtors' rights. She may be reached at [email protected].