In Pari Delicto Not a Bar to a Bankruptcy Trustee's Recovery

This bar on a trustee's recovery arises directly from the relationship between the in pari delicto defense and federal bankruptcy law. Upon appointment, the trustee steps into the debtor's shoes and, in doing so, succeeds only to the rights in property that the debtor enjoyed upon commencement of the case. See Parks v. Ditmar (In re Ditmar), 618 F.3d 1199, 1212 (10th Cir. 2010).

Under the Code, the debtor's bankruptcy estate is comprised of all of the debtor's legal or equitable interests in property as of the petition date, and includes prepetition causes of action that the debtor could have asserted but for the bankruptcy filing. See Hopkins v. Foothill Mt., Inc. (In re Hopkins), 346 B.R. 294, 303 (Bankr. E.D.N.Y. 2006); see also 11 U.S.C. ' 541(a)(1). However, the Code does not shield the trustee from those defenses that would have defeated a debtor's prepetition claim, as noted by the legislative history of Code section 541, stating:

Though this paragraph will include … claims by the debtor against others, it is not intended to expand the debtor's rights against others more than they exist at the commencement of the case. For example, if the debtor has a claim that is barred … then the trustee would not be able to pursue that claim, because he too would be barred. He could take no greater rights than the debtor himself had.

Senate Report, 95'989, 1978 U.S.C.C.A.N. 5787, 5868.

As the trustee does not obtain rights or interests greater than those of the pre-petition debtor, if a defendant could have defeated a pre-petition claim by the debtor with the in pari delicto defense, then so too could that defendant defeat the same claim asserted by the trustee. “If a claim of [the debtor] would have been subject to the defense of in pari delicto at the commencement of the bankruptcy, then the same claim, when asserted by the trustee, is subject to the same affirmative defense.” Official Committee of Unsecured Creditors of PSA, Inc. v. Edwards, 437 F.3d 1145, 1152 (11th Cir. 2006).

Equitable Receivers

Unlike the circumstances a bankruptcy trustee faces in certain actions against third parties, the in pari delicto defense is virtually ineffective against a court-appointed equitable receiver. Judge Richard A. Posner's 1995 decision in Scholes v. Lehmann, 56 F.3d 750 (7th 1995), and its “evil zombie rule,” is cited for originating the view that a court-appointed receiver is not subject to the in pari delcito defense. See Grassmueck v. Am. Shorthorn Ass'n, 365 F.Supp.2d 1042, 1048 (D.Neb. 2005).

In Scholes, Michael Douglas (Douglas) created a web of corporations and limited partnerships, the express purposes of which were to trade commodities in an effort to yield a high return for limited partners/investors. Scholes, 56 F.3d at 752. In reality, however, this conglomerate was created to carry out the fraudulent process more aptly described as a Ponzi Scheme, whereby limited-partner interests would be liquidated in order to pay the promised return. Id. After the scheme was discovered and Douglas was sentenced to federal prison, the Securities and Exchange Commission (SEC) requested the appointment of a receiver over the remaining corporations. Id.

The United States District Court for the Northern District of Illinois granted the SEC's request, and the receiver immediately began the task of recovering funds lost in the fraud. Id. at 752-53. Of note, the receiver commenced certain actions under the Illinois Fraudulent Conveyance Act against three individuals and five religious corporations, all of whom the district court found liable for receiving fraudulent transfers. Id. at 753.

On appeal to the Seventh Circuit, Judge Posner stated that, under in pari delicto, as long as Douglas was in control of the corporations, they would not be heard to seek restitution from transferee's on account of the fraud. Id. at 754. However, once the receiver was appointed, “the corporations were no more Douglas's evil zombies. Freed from his spell they became entitled to the return of the moneys ' .” Id.

Judge Posner continued by stating that “the defense of in pari delicto loses its sting when the person who is in pari delicto is eliminated.” Id. Once the receiver was put into place, the taint of the prior bad acts was eliminated, thus allowing the receiver to carry forward unobstructed by the in pari delicto defense.

How Effective Is the Defense?

In the long wake of Scholes, the question arises as to how effective the in pari delicto defense is against a bankruptcy trustee that is appointed after a court-appointed receiver places an entity into bankruptcy. As noted, the trustee has historically been subject to the defense when pursuing actions against third parties based on the debtor's own bad acts. But if the bad actor has been removed prior to the bankruptcy, into whose shoes does the trustee step and to what extent is the trustee hampered by the in pari delicto defense?

The answer to this question also lies in the fundamental relationship between in pari delicto and the federal bankruptcy laws that define the constraints under which the trustee must operate. As we have found, the bankruptcy estate is created immediately upon petition, and includes all causes of action that could have been asserted against third parties at that very moment.

When the fraudulent debtor holds the reins just prior to the petition, the limitations on the trustee's powers are clear and in pari delicto prevails. However, if the court-appointed receiver is the party placing an entity under the protections of Title 11 of the United States Code, then the trustee must necessarily be free from the prohibitive effects of the defense. If not for the commencement of the bankruptcy case, Scholes dictates that the receiver is free to pursue causes of action that otherwise would be unavailable. Therefore, property of the debtor's estate includes this freedom to pursue such otherwise prohibited causes of actions, as they exist upon commencement of the case.

Though case law analyzing the interplay between receivership, in pari delicto, and federal bankruptcy law is scant, what does exist supports the assertion that the trustee inherits the receiver's rights to pursue these formerly proscribed causes of action.

The United States Bankruptcy Court for the Southern District of Florida, in analyzing and applying Scholes, has noted that “it would make no sense to say that suddenly imputation and in pari delicto were 'back' when [a] Receiver caused [a debtor] to file for bankruptcy.” Mukamal v. BDO Seidman, LLP (In re E.S. Bankest, L.C.), Bankr. No. 04-17602-BKC-AJC, Adv. No. 06-1220-BKC-AJC-A, 2010 WL 2926203, at *8 (Bankr. S.D. Fla. July 23, 2010).

As a result of the receiver's appointment, and its subsequent entry of a debtor into bankruptcy, the in pari delicto defense will be denied when asserted against the bankruptcy trustee. Id. The Bankruptcy Court for the Northern District of Illinois, bound by Scholes, noted that when a receiver is appointed to oversee a corporation once controlled by a wrongdoer, the defenses to which the corporation was once subject are altered upon the wrongdoer's removal from control. Edgewater Medical Center v. Rogan (In re Edgewater Medical Center), 332 B.R. 166, 177 (Bankr. N.D. Ill. 2005). As the receiver and custodian who placed the debtor in Edgewater into bankruptcy were not subject to the in pari delicto defense, the bankruptcy trustee was also free from its constraints. Id.

Other Rulings

The United States Bankruptcy Court for the Eastern District of Louisiana indirectly voiced support for Scholes when it refused to extend its reasoning to a debtor in possession. Sexson v. Orthodontic Centers of Illinois, Inc. (In re OCA, Inc.), Bankr. No. 06-10179, Adv. No. 06-1126, 2008 WL 978524, at *4-5 (Bankr. E.D.La. April 8, 2008). Finally, the United States Bankruptcy Court for the Western District of Pennsylvania concluded that because a debtor's fraud cannot be imputed to a receiver appointed shortly before an involuntary bankruptcy filing, the in pari delicto defense does not apply to the bankruptcy trustee. Kirschner v. Wachovia Capital Markets, LLC (In re Le-Nature's, Inc.), No. 08-15818, 2009 WL 3571331, at 5-6 (Sept. 16, 2009 Bankr. W.D.Pa. 2009).

Conclusion

Code section 541 defines what property comprises a debtor's bankruptcy estate upon the filing of a petition. This property includes causes of action that could have been asserted upon commencement if not for the entry into bankruptcy. However, a bankruptcy trustee succeeds not only to the debtor's property, but to the defenses that would have barred pre-petition recovery against certain parties.

When it is the debtor that files the petition, the trustee inherits the results of the in pari delicto defense and may not assert causes of action that would have stymied the debtor's pre-petition recovery in the same action. However, a court-appointed equitable receiver inherits no such burden, and may freely pursue claims that would have otherwise been barred by in pari delicto. When the receiver files a bankruptcy petition on behalf of the entity under its charge, the trustee succeeds to the receiver's rights with regard to causes of action rather than those of the bad actor who has utilized the entity as its “evil zombie.”

Thus, when receivership eliminates in pari delicto, it remains eliminated upon the appointment of a bankruptcy trustee who may pursue recovery against third parties regardless of the pre-petition bad acts carried out by the debtor.

Travis Powers'is a member of the Bankruptcy & Insolvency practice group at Fafinski Mark & Johnson, P.A. in Minneapolis, MN. He is also a 2010 graduate of the LL.M. in Bankruptcy Program from the St. John's University School of Law. Powers may be reached at [email protected].

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The doctrine of in pari delicto stands for the proposition that when parties litigate based on mutual fault, the defending party's position is superior. See Pinter v. Dahl , 486 U.S. 622, 632 (1988); see also Mosier v. Caliter, Nebeker & McCullough , 546 F.3d 1271, 1275 (10th Cir. 2008). The doctrine, rooted in the common law, prevents a wrongdoer from profiting from its own bad acts and promotes judicial efficiency by ensuring “that courts [do] not lend their good offices to mediating disputes among wrongdoers ' .” Mosier, 546 F.3d at 1275.

Bankruptcy trustees are particularly susceptible to this affirmative defense when pursuing certain claims against third parties, as the debtor's own culpability may bar recovery. This is especially relevant in cases of fraud where a trustee pursues an action against a third party that colluded with the debtor or its agents, resulting in pre-petition harm to the debtor. See, e.g., Grassmueck v. American Shorthorn Ass'n , 402 F.3d 833, 837-41 (8th Cir. 2005). Courts have equally found that in pari delicto bars a trustee's recovery against certain professionals whose negligence contributed to the debtor's fraudulent conduct. See Luzinski v. Peabody & Arnold, LLP (In re Gosman), 382 B.R. 826, 838 (S.D. Fla. 2007). However, courts generally have refused to apply the in pari delicto defense to a bankruptcy trustee seeking to avoid certain fraudulent transfers under section 548 of the United States Bankruptcy Code (Code) despite the debtor's pre-petition bad acts. See, e.g., Kapila v. Bennet) In re Pearlman, 472 B.R. 115, 122 (Bankr. M.D. Fla. 2012).

In Pari Delicto and Federal Bankruptcy Law

This bar on a trustee's recovery arises directly from the relationship between the in pari delicto defense and federal bankruptcy law. Upon appointment, the trustee steps into the debtor's shoes and, in doing so, succeeds only to the rights in property that the debtor enjoyed upon commencement of the case. See Parks v. Ditmar (In re Ditmar), 618 F.3d 1199, 1212 (10th Cir. 2010).

Under the Code, the debtor's bankruptcy estate is comprised of all of the debtor's legal or equitable interests in property as of the petition date, and includes prepetition causes of action that the debtor could have asserted but for the bankruptcy filing. See Hopkins v. Foothill Mt., Inc. (In re Hopkins), 346 B.R. 294, 303 (Bankr. E.D.N.Y. 2006); see also 11 U.S.C. ' 541(a)(1). However, the Code does not shield the trustee from those defenses that would have defeated a debtor's prepetition claim, as noted by the legislative history of Code section 541, stating:

Though this paragraph will include … claims by the debtor against others, it is not intended to expand the debtor's rights against others more than they exist at the commencement of the case. For example, if the debtor has a claim that is barred … then the trustee would not be able to pursue that claim, because he too would be barred. He could take no greater rights than the debtor himself had.

Senate Report, 95'989, 1978 U.S.C.C.A.N. 5787, 5868.

As the trustee does not obtain rights or interests greater than those of the pre-petition debtor, if a defendant could have defeated a pre-petition claim by the debtor with the in pari delicto defense, then so too could that defendant defeat the same claim asserted by the trustee. “If a claim of [the debtor] would have been subject to the defense of in pari delicto at the commencement of the bankruptcy, then the same claim, when asserted by the trustee, is subject to the same affirmative defense.” Official Committee of Unsecured Creditors of PSA, Inc. v. Edwards , 437 F.3d 1145, 1152 (11th Cir. 2006).

Equitable Receivers

Unlike the circumstances a bankruptcy trustee faces in certain actions against third parties, the in pari delicto defense is virtually ineffective against a court-appointed equitable receiver. Judge Richard A. Posner's 1995 decision in Scholes v. Lehmann , 56 F.3d 750 (7th 1995), and its “evil zombie rule,” is cited for originating the view that a court-appointed receiver is not subject to the in pari delcito defense. See Grassmueck v. Am. Shorthorn Ass'n , 365 F.Supp.2d 1042, 1048 (D.Neb. 2005).

In Scholes, Michael Douglas (Douglas) created a web of corporations and limited partnerships, the express purposes of which were to trade commodities in an effort to yield a high return for limited partners/investors. Scholes, 56 F.3d at 752. In reality, however, this conglomerate was created to carry out the fraudulent process more aptly described as a Ponzi Scheme, whereby limited-partner interests would be liquidated in order to pay the promised return. Id. After the scheme was discovered and Douglas was sentenced to federal prison, the Securities and Exchange Commission (SEC) requested the appointment of a receiver over the remaining corporations. Id.

The United States District Court for the Northern District of Illinois granted the SEC's request, and the receiver immediately began the task of recovering funds lost in the fraud. Id. at 752-53. Of note, the receiver commenced certain actions under the Illinois Fraudulent Conveyance Act against three individuals and five religious corporations, all of whom the district court found liable for receiving fraudulent transfers. Id. at 753.

On appeal to the Seventh Circuit, Judge Posner stated that, under in pari delicto, as long as Douglas was in control of the corporations, they would not be heard to seek restitution from transferee's on account of the fraud. Id. at 754. However, once the receiver was appointed, “the corporations were no more Douglas's evil zombies. Freed from his spell they became entitled to the return of the moneys ' .” Id.

Judge Posner continued by stating that “the defense of in pari delicto loses its sting when the person who is in pari delicto is eliminated.” Id. Once the receiver was put into place, the taint of the prior bad acts was eliminated, thus allowing the receiver to carry forward unobstructed by the in pari delicto defense.

How Effective Is the Defense?

In the long wake of Scholes, the question arises as to how effective the in pari delicto defense is against a bankruptcy trustee that is appointed after a court-appointed receiver places an entity into bankruptcy. As noted, the trustee has historically been subject to the defense when pursuing actions against third parties based on the debtor's own bad acts. But if the bad actor has been removed prior to the bankruptcy, into whose shoes does the trustee step and to what extent is the trustee hampered by the in pari delicto defense?

The answer to this question also lies in the fundamental relationship between in pari delicto and the federal bankruptcy laws that define the constraints under which the trustee must operate. As we have found, the bankruptcy estate is created immediately upon petition, and includes all causes of action that could have been asserted against third parties at that very moment.

When the fraudulent debtor holds the reins just prior to the petition, the limitations on the trustee's powers are clear and in pari delicto prevails. However, if the court-appointed receiver is the party placing an entity under the protections of Title 11 of the United States Code, then the trustee must necessarily be free from the prohibitive effects of the defense. If not for the commencement of the bankruptcy case, Scholes dictates that the receiver is free to pursue causes of action that otherwise would be unavailable. Therefore, property of the debtor's estate includes this freedom to pursue such otherwise prohibited causes of actions, as they exist upon commencement of the case.

Though case law analyzing the interplay between receivership, in pari delicto, and federal bankruptcy law is scant, what does exist supports the assertion that the trustee inherits the receiver's rights to pursue these formerly proscribed causes of action.

The United States Bankruptcy Court for the Southern District of Florida, in analyzing and applying Scholes, has noted that “it would make no sense to say that suddenly imputation and in pari delicto were 'back' when [a] Receiver caused [a debtor] to file for bankruptcy.” Mukamal v. BDO Seidman, LLP (In re E.S. Bankest, L.C.), Bankr. No. 04-17602-BKC-AJC, Adv. No. 06-1220-BKC-AJC-A, 2010 WL 2926203, at *8 (Bankr. S.D. Fla. July 23, 2010).

As a result of the receiver's appointment, and its subsequent entry of a debtor into bankruptcy, the in pari delicto defense will be denied when asserted against the bankruptcy trustee. Id. The Bankruptcy Court for the Northern District of Illinois, bound by Scholes, noted that when a receiver is appointed to oversee a corporation once controlled by a wrongdoer, the defenses to which the corporation was once subject are altered upon the wrongdoer's removal from control. Edgewater Medical Center v. Rogan (In re Edgewater Medical Center), 332 B.R. 166, 177 (Bankr. N.D. Ill. 2005). As the receiver and custodian who placed the debtor in Edgewater into bankruptcy were not subject to the in pari delicto defense, the bankruptcy trustee was also free from its constraints. Id.

Other Rulings

The United States Bankruptcy Court for the Eastern District of Louisiana indirectly voiced support for Scholes when it refused to extend its reasoning to a debtor in possession. Sexson v. Orthodontic Centers of Illinois, Inc. (In re OCA, Inc.), Bankr. No. 06-10179, Adv. No. 06-1126, 2008 WL 978524, at *4-5 (Bankr. E.D.La. April 8, 2008). Finally, the United States Bankruptcy Court for the Western District of Pennsylvania concluded that because a debtor's fraud cannot be imputed to a receiver appointed shortly before an involuntary bankruptcy filing, the in pari delicto defense does not apply to the bankruptcy trustee. Kirschner v. Wachovia Capital Markets, LLC (In re Le-Nature's, Inc.), No. 08-15818, 2009 WL 3571331, at 5-6 (Sept. 16, 2009 Bankr. W.D.Pa. 2009).

Conclusion

Code section 541 defines what property comprises a debtor's bankruptcy estate upon the filing of a petition. This property includes causes of action that could have been asserted upon commencement if not for the entry into bankruptcy. However, a bankruptcy trustee succeeds not only to the debtor's property, but to the defenses that would have barred pre-petition recovery against certain parties.

When it is the debtor that files the petition, the trustee inherits the results of the in pari delicto defense and may not assert causes of action that would have stymied the debtor's pre-petition recovery in the same action. However, a court-appointed equitable receiver inherits no such burden, and may freely pursue claims that would have otherwise been barred by in pari delicto. When the receiver files a bankruptcy petition on behalf of the entity under its charge, the trustee succeeds to the receiver's rights with regard to causes of action rather than those of the bad actor who has utilized the entity as its “evil zombie.”

Thus, when receivership eliminates in pari delicto, it remains eliminated upon the appointment of a bankruptcy trustee who may pursue recovery against third parties regardless of the pre-petition bad acts carried out by the debtor.

Travis Powers'is a member of the Bankruptcy & Insolvency practice group at Fafinski Mark & Johnson, P.A. in Minneapolis, MN. He is also a 2010 graduate of the LL.M. in Bankruptcy Program from the St. John's University School of Law. Powers may be reached at [email protected].

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