In Pari Delicto: The Seventh Circuit Gives New Life to Evil Zombies

That seemingly simple legal rule was at the heart of Peterson.

Background

The story of Peterson begins in the early 2000s with the now-notorious Tom Petters. Once a prominent businessman in Minneapolis, MN, who “could talk your wallet right out of your pocket,” Petters perpetrated a $3.65 billion Ponzi scheme that earned him 50 years in federal prison. David Phelps and Jon Tevlin, The Tom Petters Fraud Case, Part 1: The Collapse of the Petters Empire, Star Tribune, Oct. 26, 2008, www.startribune.com/business/33287804.html. Under Petters' scheme, investors were told that their money would be used to purchase electronic goods that were then sold for profit to large retailers such as Sam's Club and Costco. See United States v. Petters, 663 F.3d 375, 379 (8th Cir. 2011), cert. denied, 132 S. Ct. 2417 (2012). In September 2008, Petters' scam collapsed when one of his confederates confessed to government authorities.

Investigators eventually discovered that there were no underlying goods, and the purchase orders and invoices that purported to relate to goods purchased by retailers like Costco were fabricated. See Id.; Peterson v. McGladrey & Pullen, LLP, No. 10 C 274, 2010 WL 4435543, at *1 (N.D. Ill. Nov. 3, 2010), vacated and remanded, 676 F.3d 594 (7th Cir. 2012). The government branded Petters' fraud as “staggering and unprecedented in size and impact on victims and the community.” United States v. Petters, No. 08 CR 364, Docket No. 388 at p. 1 (Mar. 8, 2010).

Meanwhile, several investment funds that were instrumentalities of Petters' fraud filed cases under Chapter 7 of the Bankruptcy Code, 11 U.S.C. ' 101 et seq., and Ronald R. Peterson was appointed trustee of one group of feeder funds known as Lancelot Investors Fund, L.P., et al. (the “Lancelot Funds”). Peterson soon filed a civil action against the Lancelot Funds' outside auditors, McGladrey & Pullen LLP and related entities (“McGladrey”), on behalf of the Lancelot Funds' bankruptcy estates, alleging that McGladrey negligently conducted the Lancelot Funds' audits by failing to detect Petters' Ponzi scheme, thereby causing the Lancelot Funds to lose over $1.5 billion. McGladrey moved to dismiss Peterson's complaint, arguing that in pari delicto barred recovery by the bankruptcy estates because of allegations Peterson had made in a separate lawsuit against the Lancelot Funds' former manager, Gregory Bell (“Bell”), also on behalf of the Lancelot Funds' bankruptcy estates. In his action against Bell, Peterson attempted to recover the same losses he sought from McGladrey on the theory that Bell negligently managed the Lancelot Funds by failing to verify the legitimacy of Petters' business activities. McGladrey argued that Peterson's allegations of wrongdoing by Bell ' an agent of the Lancelot Funds of which Peterson was trustee ' mandated the conclusion that Peterson, as the representative of the Lancelot Funds' bankruptcy estates, was at least at equal fault for his claimed injury and thus his recovery was barred by in pari delicto. See Peterson, 2010 WL 4435543, at *1-2.

The Peterson Argument

Peterson's principal legal argument ' advanced unsuccessfully before the district court and the court of appeals ' was that in pari delicto does not apply to trustees in bankruptcy acting on behalf of a bankruptcy estate. See Peterson, 2010 WL 4435543, at *2; Peterson, 676 F.3d at 597-98. As the district judge recognized, however, Peterson faced a mountain of contra authority. His argument that bankruptcy trustees are not ' or should not ' be subject to in pari delicto had already been rejected by the Courts of Appeals for the First, Second, Third, Sixth, Eighth, Tenth and Eleventh Circuits. See, e.g., Mosier v. Callister, Nebeker & McCullough, 546 F.3d 1271, 1276 (10th Cir. 2008); Nisselson v. Lernout, 469 F.3d 143, 153 (1st Cir. 2006); Official Comm. of Unsecured Creditors of PSA, Inc. v. Edwards, 437 F.3d 1145, 1152 (11th Cir. 2006); Grassmueck v. Am. Shorthorn Ass'n, 402 F.3d 833, 841-42 (8th Cir. 2005); Official Comm. of Unsecured Creditors of Color Tile, Inc. v. Coopers & Lybrand, LLP, 322 F.3d 147, 152 (2d Cir. 2003); Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340, 357 (3d Cir. 2001); Terlecky v. Hurd (In re Dublin Secs., Inc.), 133 F.3d 377, 380-81 (6th Cir. 1997). Perhaps not surprisingly, the district court agreed with McGladrey that Peterson's status as a federal bankruptcy trustee did not, ipso facto, relieve him of the in pari delicto defense. See Peterson, 2010 WL 4435543, at *3. The court proceeded to reject Peterson's other arguments and dismissed his complaint. See Id. at *3-4.

On appeal, Peterson urged the Seventh Circuit to hold that, because “public policy” favors greater recoveries for the estates in bankruptcy, in pari delicto should be categorically inapplicable to federal bankruptcy trustees. See Peterson, 676 F.3d at 598. Peterson had an important case on his side (or so he thought) ' the Seventh Circuit's earlier decision in Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995), which also arose out of a Ponzi scheme. In Scholes, an individual named Michael Douglas masterminded a $30 million Ponzi scheme whereby he used several corporations to peddle certain investments to the public that promised a return on investment of 10% to 20% per month. Because Douglas used the proceeds of the investments to pay the promised return, the fraud collapsed after two years. Like Petters, Douglas's fraud made him an involuntary guest of Uncle Sam for several years.

The Securities and Exchange Commission (“SEC”) filed a securities enforcement action against Douglas and his corporations, and persuaded the district court to appoint a receiver for all of them. The receiver, Steven S. Scholes, filed multiple fraudulent conveyance actions to recover additional money to return to the scheme's victims. In that litigation, some of the defendants argued that, because the principal fault rested with Douglas, the receiver should not be allowed to profit from Douglas's wrongdoing by recovering property that he had transferred to stymie his creditors. (Those defendants apparently did not characterize this defense as in pari delicto.) The court, through then-Chief Judge Richard A. Posner, agreed with the defendants that it would have been inequitable to allow Douglas to recover that property when he was still in control of his corporations, but the landscape had fundamentally changed once the receiver was installed. Judge Posner used some rather memorable language to make the point:

The appointment of the receiver removed the wrongdoer from the scene. The corporations were no more Douglas's evil zombies. Freed from his spell they became entitled to the return of the moneys ' for the benefit not of Douglas but of innocent investors ' that Douglas had made the corporations divert to unauthorized purposes ' Put differently, the defense of in pari delicto loses its sting when the person who is in pari delicto is eliminated.

Scholes, 56 F.3d at 754.

That analysis, Peterson argued, meant that McGladrey's in pari delicto defense lost its “sting” once Peterson took over as trustee and Petters was removed from the scene such that the Lancelot Funds were no longer his “evil zombies.” See Peterson, 676 F.3d at 599.

The Seventh Circuit's View

The Seventh Circuit disagreed. As an initial matter, the court reined in Scholes, clarifying it was “dictum” for the court to have stated that “the defense of in pari delicto loses its sting when the person who is in pari delicto is eliminated.” Peterson, 676 F.3d at 599. This was because the Scholes defendants did not assert the in pari delicto defense. But more fundamentally, Chief Judge Easterbrook, speaking for the court, viewed Peterson's argument as inconsistent with the seminal case of Butner v. United States, 440 U.S. 48 (1979). In Butner, the Supreme Court held that state law generally defines the “property” that enters the bankruptcy estate (unless the Bankruptcy Code overrides state law), and rejected the suggestion that “such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.” Butner, 440 U.S. at 55. Under Butner, then, the issues for the court were: 1) does applicable state law make claims like Peterson's subject to the in pari delicto defense? and 2), if it does, then does the Bankruptcy Code override that law? See Peterson, 676 F.3d at 598-99.

Illinois Law

Peterson's attempt to slay the defendants' in pari delicto defense failed because the court answered those questions “yes” and “no,” respectively. Illinois law, which applied to Peterson's claims, makes a client's suit against its auditor subject to the in pari delicto defense. See Peterson, 676 F.3d at 596 (citing First Nat'l Bank of Sullivan v. Brumleve & Dabbs, 183 Ill. App. 3d 987 (4th Dist. 1989), and other cases). Because Peterson could not identify any provision of the Bankruptcy Code that overrode such principles of state law, the court concluded that “[p]ublic policy” is not a ground on which the federal judiciary may create such a limit ' not unless the Supreme Court first overrules Butner ' and similar decisions.” Peterson, 676 F.3d at 598. As a result, the court held that “a person sued by a trustee in bankruptcy may assert the defense of in pari delicto, if the jurisdiction whose law creates the claim permits such a defense outside of bankruptcy.” Id. at 598-99. To the extent that Scholes suggested otherwise, the court cautioned that “Scholes should not be generalized beyond the law of fraudulent conveyances and preferential transfers.” Id. at 599.

Even though the Seventh Circuit rejected Peterson's principal legal argument, the court vacated the order dismissing his complaint. What Bell actually knew about Petters' scheme was a critical component of McGladrey's in pari delicto argument; but because the court decided that “the state of Bell's knowledge [could not] be determined at the complaint stage of this litigation,” it remanded the lawsuit to the district court for further proceedings. Peterson, 676 F.3d at 600.

Conclusion

In sum, the Seventh Circuit has joined the majority of other circuits in espousing the trustee-unfriendly position that bankruptcy trustees asserting claims based on the wrongdoing of the defendant cannot claim that they are the “innocent successors” of their debtors' former management. Cf. Nisselson, 469 F.3d at 153 (“there is no 'innocent successor' exception available to a bankruptcy trustee in a case in which the defendant successfully could have mounted an in pari delicto defense against the debtor.”). The familiar rule of Butner forces a bankruptcy trustee ' like any other litigant ' to grapple with the in pari delicto issues that were created when the debtor was merely an “evil zombie” doing the ex-insiders' bidding. But the extent to which trustees must deal with in pari delicto depends upon applicable state law, which may differ from state to state and from issue to issue. Thus, the specter of whether a bankruptcy estate will succumb to the legacy of “evil zombies” in post-petition litigation is an issue of which any potential litigant should always be aware.

Brian L. Shaw and Terence G. Banich are members of Shaw Gussis Fishman Glantz Wolfson & Towbin LLC, a boutique law firm in Chicago made up of 25 lawyers who focus their practices on business bankruptcy and insolvency, litigation and commercial real estate.

In April 3, 2012, the United States Court of Appeals for the Seventh Circuit decided Peterson v. McGladrey & Pullen, LLP , 676 F.3d 594 (7th Cir. 2012), which held that bankruptcy trustees are not immune from the litigation defense known as “ in pari delicto ” ' the argument that if opposing parties in a lawsuit are equally in the wrong, then neither has a colorable claim against the other. See Schlueter v. Latek, — F.3d —, No. 11-3679, 2012 WL 2044362, at *4 (7th Cir. June 6, 2012). In so deciding, the Seventh Circuit brought itself into alignment with several other courts of appeals and severely limited the applicability of Scholes v. Lehmann , 56 F.3d 750 (7th Cir. 1995), perhaps the court's most cited decision addressing in pari delicto (and independently notable for its use of the term “evil zombies”). As the authors discuss in this article, Peterson is a critically important decision to bankruptcy lawyers, particularly those who prosecute and defend causes of action brought by bankruptcy estates and their representatives.

'In Pari Delicto'

While Peterson arose from a factually complex and multifaceted Ponzi scheme, the concept of in pari delicto has much more straightforward roots in the English common law. In 1725, the English Court of Exchequer decided Everet v. Williams, better known as The Highwayman's Case, in which a highwayman (i.e., a robber) sued a fellow robber for an accounting of the illegal profits of their criminal activity. Not surprisingly, the English chancellor took a dim view of being asked to settle a dispute between highwaymen regarding the division of what they stole and dismissed the plaintiff's complaint as “both scandalous and impertinent.” (Practitioner's note: the court also issued an arrest warrant for the plaintiff's lawyers to answer charges of contempt of court for filing the case.) In addition to losing the litigation, both highwaymen were later hanged. See Everet v. Williams (Ex. 1725), reported in The Highwayman's Case, 35 L.Q. Rev. 197 (1893) (reproduced at www.hosteny.com/funcases/highwayman.html). The Highwayman's Case, then, is the common-law genesis for the modern principle that “if awarding relief to the plaintiff would reward wrongdoing ' courts will not adjudicate their dispute.” Schlueter, 2012 WL 2044362, at *4.

That seemingly simple legal rule was at the heart of Peterson.

Background

The story of Peterson begins in the early 2000s with the now-notorious Tom Petters. Once a prominent businessman in Minneapolis, MN, who “could talk your wallet right out of your pocket,” Petters perpetrated a $3.65 billion Ponzi scheme that earned him 50 years in federal prison. David Phelps and Jon Tevlin, The Tom Petters Fraud Case, Part 1: The Collapse of the Petters Empire, Star Tribune, Oct. 26, 2008, www.startribune.com/business/33287804.html. Under Petters' scheme, investors were told that their money would be used to purchase electronic goods that were then sold for profit to large retailers such as Sam's Club and Costco. See United States v. Petters , 663 F.3d 375, 379 (8th Cir. 2011), cert. denied, 132 S. Ct. 2417 (2012). In September 2008, Petters' scam collapsed when one of his confederates confessed to government authorities.

Investigators eventually discovered that there were no underlying goods, and the purchase orders and invoices that purported to relate to goods purchased by retailers like Costco were fabricated. See Id.; Peterson v. McGladrey & Pullen, LLP , No. 10 C 274, 2010 WL 4435543, at *1 (N.D. Ill. Nov. 3, 2010), vacated and remanded, 676 F.3d 594 (7th Cir. 2012). The government branded Petters' fraud as “staggering and unprecedented in size and impact on victims and the community.” United States v. Petters , No. 08 CR 364, Docket No. 388 at p. 1 (Mar. 8, 2010).

Meanwhile, several investment funds that were instrumentalities of Petters' fraud filed cases under Chapter 7 of the Bankruptcy Code, 11 U.S.C. ' 101 et seq., and Ronald R. Peterson was appointed trustee of one group of feeder funds known as Lancelot Investors Fund, L.P., et al. (the “Lancelot Funds”). Peterson soon filed a civil action against the Lancelot Funds' outside auditors, McGladrey & Pullen LLP and related entities (“McGladrey”), on behalf of the Lancelot Funds' bankruptcy estates, alleging that McGladrey negligently conducted the Lancelot Funds' audits by failing to detect Petters' Ponzi scheme, thereby causing the Lancelot Funds to lose over $1.5 billion. McGladrey moved to dismiss Peterson's complaint, arguing that in pari delicto barred recovery by the bankruptcy estates because of allegations Peterson had made in a separate lawsuit against the Lancelot Funds' former manager, Gregory Bell (“Bell”), also on behalf of the Lancelot Funds' bankruptcy estates. In his action against Bell, Peterson attempted to recover the same losses he sought from McGladrey on the theory that Bell negligently managed the Lancelot Funds by failing to verify the legitimacy of Petters' business activities. McGladrey argued that Peterson's allegations of wrongdoing by Bell ' an agent of the Lancelot Funds of which Peterson was trustee ' mandated the conclusion that Peterson, as the representative of the Lancelot Funds' bankruptcy estates, was at least at equal fault for his claimed injury and thus his recovery was barred by in pari delicto. See Peterson, 2010 WL 4435543, at *1-2.

The Peterson Argument

Peterson's principal legal argument ' advanced unsuccessfully before the district court and the court of appeals ' was that in pari delicto does not apply to trustees in bankruptcy acting on behalf of a bankruptcy estate. See Peterson, 2010 WL 4435543, at *2; Peterson, 676 F.3d at 597-98. As the district judge recognized, however, Peterson faced a mountain of contra authority. His argument that bankruptcy trustees are not ' or should not ' be subject to in pari delicto had already been rejected by the Courts of Appeals for the First, Second, Third, Sixth, Eighth, Tenth and Eleventh Circuits. See, e.g., Mosier v. Callister, Nebeker & McCullough , 546 F.3d 1271, 1276 (10th Cir. 2008); Nisselson v. Lernout , 469 F.3d 143, 153 (1st Cir. 2006); Official Comm. of Unsecured Creditors of PSA, Inc. v. Edwards , 437 F.3d 1145, 1152 (11th Cir. 2006); Grassmueck v. Am. Shorthorn Ass'n , 402 F.3d 833, 841-42 (8th Cir. 2005); Official Comm. of Unsecured Creditors of Color Tile, Inc. v. Coopers & Lybrand, LLP , 322 F.3d 147, 152 (2d Cir. 2003); Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., Inc. , 267 F.3d 340, 357 (3d Cir. 2001); Terlecky v. Hurd (In re Dublin Secs., Inc.), 133 F.3d 377, 380-81 (6th Cir. 1997). Perhaps not surprisingly, the district court agreed with McGladrey that Peterson's status as a federal bankruptcy trustee did not, ipso facto, relieve him of the in pari delicto defense. See Peterson, 2010 WL 4435543, at *3. The court proceeded to reject Peterson's other arguments and dismissed his complaint. See Id. at *3-4.

On appeal, Peterson urged the Seventh Circuit to hold that, because “public policy” favors greater recoveries for the estates in bankruptcy, in pari delicto should be categorically inapplicable to federal bankruptcy trustees. See Peterson, 676 F.3d at 598. Peterson had an important case on his side (or so he thought) ' the Seventh Circuit's earlier decision in Scholes v. Lehmann , 56 F.3d 750 (7th Cir. 1995), which also arose out of a Ponzi scheme. In Scholes, an individual named Michael Douglas masterminded a $30 million Ponzi scheme whereby he used several corporations to peddle certain investments to the public that promised a return on investment of 10% to 20% per month. Because Douglas used the proceeds of the investments to pay the promised return, the fraud collapsed after two years. Like Petters, Douglas's fraud made him an involuntary guest of Uncle Sam for several years.

The Securities and Exchange Commission (“SEC”) filed a securities enforcement action against Douglas and his corporations, and persuaded the district court to appoint a receiver for all of them. The receiver, Steven S. Scholes, filed multiple fraudulent conveyance actions to recover additional money to return to the scheme's victims. In that litigation, some of the defendants argued that, because the principal fault rested with Douglas, the receiver should not be allowed to profit from Douglas's wrongdoing by recovering property that he had transferred to stymie his creditors. (Those defendants apparently did not characterize this defense as in pari delicto.) The court, through then-Chief Judge Richard A. Posner, agreed with the defendants that it would have been inequitable to allow Douglas to recover that property when he was still in control of his corporations, but the landscape had fundamentally changed once the receiver was installed. Judge Posner used some rather memorable language to make the point:

The appointment of the receiver removed the wrongdoer from the scene. The corporations were no more Douglas's evil zombies. Freed from his spell they became entitled to the return of the moneys ' for the benefit not of Douglas but of innocent investors ' that Douglas had made the corporations divert to unauthorized purposes ' Put differently, the defense of in pari delicto loses its sting when the person who is in pari delicto is eliminated.

Scholes, 56 F.3d at 754.

That analysis, Peterson argued, meant that McGladrey's in pari delicto defense lost its “sting” once Peterson took over as trustee and Petters was removed from the scene such that the Lancelot Funds were no longer his “evil zombies.” See Peterson, 676 F.3d at 599.

The Seventh Circuit's View

The Seventh Circuit disagreed. As an initial matter, the court reined in Scholes, clarifying it was “dictum” for the court to have stated that “the defense of in pari delicto loses its sting when the person who is in pari delicto is eliminated.” Peterson, 676 F.3d at 599. This was because the Scholes defendants did not assert the in pari delicto defense. But more fundamentally, Chief Judge Easterbrook, speaking for the court, viewed Peterson's argument as inconsistent with the seminal case of Butner v. United States , 440 U.S. 48 (1979). In Butner, the Supreme Court held that state law generally defines the “property” that enters the bankruptcy estate (unless the Bankruptcy Code overrides state law), and rejected the suggestion that “such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.” Butner, 440 U.S. at 55. Under Butner, then, the issues for the court were: 1) does applicable state law make claims like Peterson's subject to the in pari delicto defense? and 2), if it does, then does the Bankruptcy Code override that law? See Peterson, 676 F.3d at 598-99.

Illinois Law

Peterson's attempt to slay the defendants' in pari delicto defense failed because the court answered those questions “yes” and “no,” respectively. Illinois law, which applied to Peterson's claims, makes a client's suit against its auditor subject to the in pari delicto defense. See Peterson , 676 F.3d at 596 (citing First Nat'l Bank of Sullivan v. Brumleve & Dabbs , 183 Ill. App. 3d 987 (4th Dist. 1989), and other cases). Because Peterson could not identify any provision of the Bankruptcy Code that overrode such principles of state law, the court concluded that “[p]ublic policy” is not a ground on which the federal judiciary may create such a limit ' not unless the Supreme Court first overrules Butner ' and similar decisions.” Peterson, 676 F.3d at 598. As a result, the court held that “a person sued by a trustee in bankruptcy may assert the defense of in pari delicto, if the jurisdiction whose law creates the claim permits such a defense outside of bankruptcy.” Id. at 598-99. To the extent that Scholes suggested otherwise, the court cautioned that “Scholes should not be generalized beyond the law of fraudulent conveyances and preferential transfers.” Id. at 599.

Even though the Seventh Circuit rejected Peterson's principal legal argument, the court vacated the order dismissing his complaint. What Bell actually knew about Petters' scheme was a critical component of McGladrey's in pari delicto argument; but because the court decided that “the state of Bell's knowledge [could not] be determined at the complaint stage of this litigation,” it remanded the lawsuit to the district court for further proceedings. Peterson, 676 F.3d at 600.

Conclusion

In sum, the Seventh Circuit has joined the majority of other circuits in espousing the trustee-unfriendly position that bankruptcy trustees asserting claims based on the wrongdoing of the defendant cannot claim that they are the “innocent successors” of their debtors' former management. Cf. Nisselson, 469 F.3d at 153 (“there is no 'innocent successor' exception available to a bankruptcy trustee in a case in which the defendant successfully could have mounted an in pari delicto defense against the debtor.”). The familiar rule of Butner forces a bankruptcy trustee ' like any other litigant ' to grapple with the in pari delicto issues that were created when the debtor was merely an “evil zombie” doing the ex-insiders' bidding. But the extent to which trustees must deal with in pari delicto depends upon applicable state law, which may differ from state to state and from issue to issue. Thus, the specter of whether a bankruptcy estate will succumb to the legacy of “evil zombies” in post-petition litigation is an issue of which any potential litigant should always be aware.

Brian L. Shaw and Terence G. Banich are members of Shaw Gussis Fishman Glantz Wolfson & Towbin LLC, a boutique law firm in Chicago made up of 25 lawyers who focus their practices on business bankruptcy and insolvency, litigation and commercial real estate.