Bankruptcy trustees are subject to the in pari delicto defense, but, curiously, receivers are not. The defense puts bankruptcy trustees at a disadvantage when it comes to pursuing fraudulent transfers effected by the debtor before bankruptcy.

The imposition of the in pari delicto defense stems from the outdated notion that a bankruptcy trustee steps into the shoes of the debtor and is therefore subject to defenses that could be raised against a debtor if the debtor were to pursue a fraudulent transfer outside of bankruptcy. The defense disembowels a trustee who is precluded from recovering fraudulent transfers that damaged creditors.

The in pari delicto defense was a creature of common law originally applicable in altogether different circumstances. If judges and courts dreamed up the defense, this writer believes that courts have the ability to eradicate the defense when it comes to bankruptcy trustees.

When a bankruptcy trustee succeeds a receiver, the existence of the receivership before bankruptcy does not “cleanse” the estate of the in pari delicto defense, the Eighth Circuit said, bound by the circuit’s own precedent.

The Thomas Petters Ponzi Scheme

Thomas Petters conducted a Ponzi scheme that blew up in 2008 about the same time as Bernie Madoff’s. Petters is serving a 50-year jail sentence.

The federal government prevailed on the district court to appoint a receiver with power to put the Petters empire into bankruptcy. And that’s what the receiver did. Five days after appointment, the receiver put the Petters business into chapter 11. The receiver became the chapter 11 trustee.

The trustee (formerly the receiver) filed a lawsuit under Minnesota law in bankruptcy court against the bank that Petters used, alleging that bankers were aware of the fraud and thereby aided and abetted a breach of fiduciary duty.

After the suit was removed to district court, the jury awarded the trustee a judgment against the bank for almost $485 million in compensatory damages and $80 million in punitive damages. The bank had raised the in pari delicto defense. The district court rejected the defense, reasoning that receivership meant that the trustee was not bound by the debtor’s prior fraudulent acts.

The bank appealed and won a reversal in a September 12 opinion for the Eighth Circuit by Circuit Judge Steven M. Colloton.

Eighth Circuit Precedent

Citing Grassmueck v. Am. Shorthorn Ass’n, 402 F.3d 833, 837 (8th Cir. 2005), Judge Colloton said that the “equitable defense of in pari delicto embodies the principle that a plaintiff who has participated in wrongdoing may not recover damages resulting from the wrongdoing.” In Minnesota, the defense kicks in when the plaintiff’s fraud was “no less than” the defendant’s.

The bank argued that the defense would bar the suit in state court because Petters orchestrated the fraud and was necessarily more culpable than the bank.

Citing Eighth Circuit precedent, Judge Colloton said that the “trustee in bankruptcy stands in the shoes of the debtor.” Again citing Grassmueck, he said that the “defense of in pari delicto is thus available in an action by a bankruptcy trustee against another party if the defense could have been raised against the debtor.”

Judge Colloton said that “[s]tate law governs whether the defense could have been raised against the debtor.” Citing the Supreme Court, he said that “state law governs a federal receiver’s rights in a state-law cause of action,” even though the receiver-trustee “was appointed by a federal court.”

As it turns out, a receiver has an escape hatch under Minnesota law, where a receiver represents the rights of the creditors of the receivership. Judge Colloton cited the Minnesota Supreme Court for holding that a receiver is therefore not bound by the fraudulent acts of former officers of the corporation. He quoted the state’s highest court:

“[W]hen an act has been done in fraud of the rights of the creditors of the insolvent corporation[,] the receiver may sue for their benefit, even though the defense set up might be valid as against the corporation itself.”

German-Am. Fin. Corp. v. Merchs.’ & Mfrs.’ State Bank of Minneapolis, 225 N.W. 891, 893 (Minn. 1929).

For Judge Colloton, the question then became whether the defense evaporated because the case had been in receivership briefly. However, he said that the trustee “is acting in this case as a bankruptcy trustee, not as a receiver.”

Once again citing Grassmueck, Judge Colloton said that a “bankruptcy trustee steps into the shoes of the debtor and is subject to any defenses that could be raised against the debtor, including the defense of in pari delicto.”

Judge Colloton described the trustee as having argued that “he stepped into the shoes of a ‘cleansed’ receivership entity that is no longer bound by its prior wrongdoing.” Under Minnesota law, however, Judge Colloton said that “the appointment of a receiver does not change the receivership entity.”

Once the receiver became the trustee, Judge Colloton said that the receiver had no claims to bring because the claims became part of the bankrupt estate, and “bankruptcy law governed his ability to bring [the estate’s] claims as the trustee.” Once again citing Grassmueck, he said the trustee became subject to any defenses that could have been raised against the debtor.

In short, Judge Colloton said that the debtor “itself was never ‘cleansed,’ so the in pari delicto defense was never ‘extinguished.’” Consequently, he said, “Bankruptcy law does not provide a vehicle for [the debtor] or its trustee to proceed unbound by [the debtor’s] own wrongdoing.”

Judge Colloton reversed and remanded with instructions to enter judgment for the bank. The district court, he said, committed legal error in deciding that the defense was unavailable against the trustee. “Even assuming that the bank aided the scheme to the degree that [the trustee] alleges, [the bank] cannot be more culpable than the entity that orchestrated the scheme.”

Observations

Judge Colloton had no choice but to rule how he did. The outcome was foreordained by Grassmueck.

Courts dealing with the in pari delicto defense in a bankruptcy case might recognize that a bankruptcy trustee since the adoption of the Bankruptcy Code does not step into the shoes of the debtor. Rather, Section 541(a) creates an estate, and the trustee is given powers in Section 704 to administer the estate. A trustee does not assume title to estate property.

In the case before the Eighth Circuit, the trustee was using the so-called strong-arm powers in Section 544 to bring claims that could have been asserted by an actual creditor or a holder of a judicial lien. Presumably under Minnesota law, a creditor of Petters could have sued the bank without facing the in pari delicto defense. If a creditor could have sued, then why not the trustee asserting the claims creditors who are immune to in pari delicto?

Eradication of the in pari delicto defense would not require a change in state law, because a bankruptcy trustee is asserting a federal right under the strong-arm powers.

One of these days, a circuit court sitting en banc should reconsider whether in pari delicto applies to bankruptcy trustees. This writer cannot fathom why a federal bankruptcy trustee is disadvantaged when compared to a federal receiver.

The opinions in this piece are those of the writer, not ABI.