When a trustee uses avoiding power to recover fraudulent transfers under Section 548 or state law, there is no in pari delicto defense, according to Bankruptcy Judge Scott C. Clarkson of Santa Ana, Calif.

In his March 27 opinion, Judge Clarkson explained that in pari delicto did not apply because the trustee was not suing on behalf of the debtor. Rather, the trustee was “assert[ing] [the defense] for the benefit of [the] Debtor’s creditors, whose rights [the] Trustee enforces.”

If the debtor in possession had been suing under Section 544, Judge Clarkson said there also would have been no in pari delicto defense because “the debtor-in-possession would also be stepping into the shoes of the unsecured creditors.”    

The Criminal Enterprise

The chapter 11 debtor was a law firm where management was soon replaced by a chapter 11 trustee. In the third paragraph of his opinion, Judge Clarkson said he had “previously found that [the] Debtor, since its pre-petition inception (and through the time of the appointment of the Chapter 11 Trustee), was, in this Court’s opinion, operating a significant criminal enterprise.”

Judge Clarkson described the debtor as “a law firm that allegedly provided consumer debt resolution services on a nationwide basis, with client files numbering in the several tens of thousands, if not more.” To land clients, the debtor used marketing agents who brought in clients in return for “a percentage of monthly payments collected from the clients.” 

Judge Clarkson said it was an “unethical and most likely illegal enterprise.” Among other things, he said that retainers paid by clients were not held in trust until earned but “were most likely looted by the principal or principals controlling [the] Debtor pre-petition and post-petition, before the appointment of the Chapter 11 Trustee.”

The trustee sued one of the marketing agents to recover fraudulent transfers of about $620,000 plus preferences of some $420,000. The defendant raised an in pari delicto defense. 

The Illegal ‘Capping’ Agreement

The trustee responded by saying that the marketing arrangement was an illegal “capping agreement” barred under California law that “conferred no reasonably equivalent value to Debtor.” Specifically, Judge Clarkson said that the arrangement violated California Business and Professional Code § 6154(a), which states that “[a]ny contract for professional services secured by any attorney at law or law firm in this state through the services of a runner or capper is void.”

A “capper” is defined in the statute as someone “acting for consideration . . . as an agent for an attorney . . . in the solicitation or procurement of business for the attorney at law or law firm as provided in this article.” Judge Clarkson said that the defendant fit “squarely” into the definition of a “capper.”

Judge Clarkson said that the debtor “engaged in actually fraudulent transfers by engaging in illegal activity with Defendant . . . in furtherance of Debtor’s criminal enterprise.”

Analyzing the undisputed facts, Judge Clarkson concluded that the trustee had shown the elements of both fraudulent transfers and preferences. He was left to decide whether the defendant could raise the in pari delicto defense, because the debtor was the primary motivator in the illegal activity.

The Scope of In Pari Delicto

Citing the Ninth Circuit, Judge Clarkson said that the “in pari delicto doctrine bars recovery by a plaintiff who bears ‘at least substantially equal responsibility for his injury,’ and also has been applied to bar recovery ‘where the plaintiff has participated in some of the same sort of wrongdoing as the defendant.’”

The trustee countered by saying that he was not on behalf of the debtor but on behalf of creditors under the trustee’s powers given by Sections 544 and 548, alongside similar California law.

Judge Clarkson said it’s “generally” true that a trustee stands in the shoes of the debtor, making in pari delicto available when the defense could be raised against the debtor. “In this adversary proceeding, however,” he said, the “Trustee is not standing in the shoes of Debtor but rather the unsecured creditors, making the in pari delicto defense inapplicable.”

Judge Clarkson explained that a trustee has two sources for mounting avoidance actions. Under Section 541(a)(1), the trustee succeeds to the debtor’s interests. On the other hand, a trustee may sue under Section 544 by asserting the rights of creditors. He cited a handful of cases for the proposition “that the doctrine of in pari delicto is inapplicable for claims brought under § 544” because the trustee “is not attempting to bring a claim for the benefit of a debtor but in favor of unsecured creditors.”

Just like “in pari delicto is not applicable as a defense to Trustee’s claims under § 548,” Judge Clarkson said “it is likewise not applicable to Trustee’s claims under” California fraudulent transfer law.

Judge Clarkson held that “the in pari delcito defense is not available to Defendant” because “a defendant cannot raise the in pari delicto defense against a trustee when the causes of action asserted rely on avoidance powers.”

Dispensing with other defenses raised by the defendant, Judge Clarkson granted summary judgment to the trustee on the preference and fraudulent transfer claims.

Observations

A creature of common law predating the U.S. constitution, in pari delicto came into vogue under the former Bankruptcy Act given the understanding that a bankruptcy trustee steps into the shoes of the debtor.

The same concept does not exist under the Bankruptcy Code. Rather, the Code creates an estate under Section 541 that the trustee administers under Section 704. There are no transfers of estate property to the trustee. The bankruptcy trustee no longer steps into the debtor’s shoes.

The in pari delicto defense does not infect federal receivers, because a receiver represents creditors, not the debtor. As Judge Clarkson has held, it’s about time that federal courts came to realize that bankruptcy trustees are in the same position as receivers and that in pari delicto should not apply to trustees any more than it applies to federal receivers.

There is a choice-of-law question, however. If a trustee is suing under Section 548, it would seem to this writer that a federal court would be in a position to decide whether in pari delicto exists as a matter of federal law. In some circuits, though, reconsideration of in pari delicto might require presentation to a circuit court sitting en banc.

What if the trustee is suing under state law and state law promotes in pari delicto? Is a federal court sitting in bankruptcy entitled to declare that in pari delicto does not apply to trustees suing under state law? What if state courts have held that in pari delicto applies to bankruptcy trustees? Must a federal court certify a question to the state supreme court?