In Pari Delicto Should Not Bar a Trustees Recovery

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Oct 2004

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Every bankruptcy
practitioner has heard these time-honored maxims: The bankruptcy trustee stands in the shoes of the debtor and the trustee is subject to
all defenses available against the debtor.
Without any doubt, these statements apply in the vast majority of
situations. But are they always true? Are there any exceptions? What
happens when they conflict with another well-known maxim: The bankruptcy court is a court of equity?

The first two statements have their genesis in
§541 of the Code, which provides that the estate includes "all
legal and equitable interests of the debtor in property as of the
commencement of the case." Since the estate includes the
debtor's choses in action, the trustee succeeds in the right to assert those
claims. It may also seem entirely logical that the trustee would find
himself or herself subject to all the defenses that would have been
available against the debtor.

The legislative history appears to support this
position. The House and Senate reports state that §541 was not
intended to "expand the debtor's rights against others more
than they exist at the commencement of the case,"<a href="#1" name="1a">1</a> so it might seem
that there is no room for debate on the subject. After all, set-offs are
preserved. The statutes of limitations still apply (with some statutory
extensions). Who would question the validity of payment and release as a
defense? But there is one defense for which trustees wrestle to find an
exception to the general rule—the equitable defense of in pari delicto.<a href="#2" name="2a">2</a> Is this a
defense that should be treated differently, perhaps as personally available
against the debtor and not affecting the claim of the trustee appointed in the
debtor's bankruptcy?

Typically, the issue arises when the trustee has
asserted a claim of negligence or malpractice against the debtor's
former accountant after discovering that audits of the debtor's
financial statements failed to uncover a fraud committed by the
debtor's principal owner.<a href="#3" name="3a">3</a> Claims against outside counsel for
negligently permitting corporate principals to defraud customers provide
another example.<a href="#4" name="4a">4</a> As long as the business remains under the control of the
person perpetrating the fraud, there is no reason to permit the company or
its owner to recover for the negligence of the third party in failing to
discover or prevent the fraud. To permit a recovery would reward the owner
for his or her misconduct. If the equitable defense of in pari delicto is applied, then
there is no recovery and the wrongdoer is prevented from profiting from his
or her own misdeeds.

Because a corporation acts only through its agents,
knowledge and actions of employees are generally imputed to their corporate
employer. Nonetheless, courts do recognize the distinction between the
corporation and its employees where an employee has acted in his own
interest rather than in pursuit of some advantage for the corporation.
Thus, a corporation is not subjected to defenses based on the actions of an
employee who has acted for his own benefit.<a href="#5" name="5a">5</a> However, an exception to this
rule has often been applied where the corporation is dominated or
controlled by the individual wrongdoer.<a href="#6" name="6a">6</a>

In the eyes of some, however, the equities change as
soon as a bankruptcy trustee takes over the business. The trustee is like
new management. The trustee has committed no wrongdoing, and any recovery
he or she obtains from the third party benefits the innocent creditors of
the debtor, often those who were the real victims of the fraud. When the
successor is a receiver, as opposed to a bankruptcy trustee, courts
routinely find an exemption from the in pari delicto
defense. For example, in Scholes v. Lehmann,<a href="#7" name="7a">7</a> the Seventh Circuit held that a receiver appointed at the
request of the Securities and Exchange Commission (SEC) should not be
prevented by the doctrine of in pari delicto from recovering fraudulent conveyances made by the
receiver's corporate predecessor. The court found no legal or
practical objection to permitting recovery by the receiver. Since the
wrongdoer, who formerly controlled the corporations, had been replaced by
the innocent receiver whose directive was to maximize the recovery of
creditors, equity should not impede that result.

However, this approach has not traditionally been
followed in cases involving a bankruptcy trustee as the claimant. Equitable
considerations have lost to various legal arguments. Neither the change in
the control of the debtor nor the innocence of the ultimate beneficiaries
of the trustee's claims have proved to be persuasive.<a href="#8" name="8a">8</a>

A few courts have said that a trustee lacks standing
to bring a claim when the former owner is guilty of a fraud, in effect
holding that the existence of an affirmative defense eliminates standing.<a href="#9" name="9a">9</a>
These cases appear to misapply the concept of standing. In order for a
trustee to have standing, the corporation needs merely to have sustained an
injury separate and apart from its creditors. The potential existence of an
affirmative defense does not deprive the trustee of standing.<a href="#10" name="10a">10</a> Standing
springs from the existence of an injury to the debtor, now represented by
the trustee.<a href="#11" name="11a">11</a> If the corporation itself had brought an action against the
third party, the case would not have been dismissed on standing grounds;
instead, the defense would have been framed in terms of the appropriate
equitable defense.<a href="#12" name="12a">12</a>

In the majority of bankruptcy cases, courts have
recognized the trustee's standing, but nonetheless have applied the in pari delicto defense to bar a
recovery.<a href="#13" name="13a">13</a> Courts in these cases never examine the principles behind the
defense or the inequity of its application to a trustee's claim.
These courts generally conclude that permitting the trustee to avoid the
defense would constitute an enlargement of the claims the debtor possessed,
thus violating the tenets of §541.<a href="#14" name="14a">14</a>

At least one bankruptcy court has rejected this
approach and allowed the trustee to proceed against a third-party
tortfeasor.<a href="#15" name="15a">15</a> In In re Jack Greenberg Inc., the court determined it would violate the principles of
equity to rigidly apply an equitable defense if the result would be
inequitable. In reaching this decision, the court relied on the Supreme
Court's decision in O'Melveny &
Myers v. FDIC,<a href="#16" name="16a">16</a> which determined that state law, not federal law, controls whether
equitable defenses are available against the trustee.<a href="#17" name="17a">17</a> In O'Melveny, the FDIC, as
receiver for a failed savings & loan, sued the company's former
counsel for its alleged role in the insolvency. The Ninth Circuit held that
equitable principles would not permit equitable defenses to prevent a
recovery by the receiver.<a href="#18" name="18a">18</a> The U.S. Supreme Court then instructed the
appeals court that federal courts were to apply state law in determining
whether equitable defenses were applicable in a federal receivership.<a href="#19" name="19a">19</a> On
remand, the Ninth Circuit again held that equitable defenses are not a bar
to recovery by a receiver purely on the basis of California law.<a href="#20" name="20a">20</a>

Building on the O'Melveny decision and finding little state law on the application of
the in pari delicto
defense to a claim brought by a trustee, the Greenberg court looked to the Ninth Circuit's opinions in O'Melveny as well as
other state cases that dealt with equitable defenses and held that a
bankruptcy trustee should be treated like a receiver:

<blockquote>
[T]here are circumstances when the trustee's
position as plaintiff is different from that of the corporation, even when
bringing the corporation's claim. Accordingly, while the true and
oft-stated maxim that a trustee standing in the shoes of the corporation
takes no greater rights than the debtor is certainly the beginning of my
analysis, the inquiry does not end there.... [E]quitable defenses such as
the doctrine of imputation that may be sustainable against the corporation
may fail to act as a total bar to recovery when the beneficiaries of the
action are the corporation's innocent creditors.<a href="#21" name="21a">21</a>

</blockquote>

Although the Greenberg decision was not reversed, since it was not appealed, it
has not met with favor in the Third Circuit Court of Appeals. In Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. Inc., the Third Circuit discussed the approach taken by the Greenberg court and rejected it,
ruling that the Code required the application of the in pari delicto defense to prevent
enlargement of the trustee's rights beyond those possessed by the
debtor.<a href="#22" name="22a">22</a> The Lafferty court specifically acknowledged cases such as O'Melveny and Scholes but determined that the
Bankruptcy Code controlled, stating that those cases were "easily
distinguishable, however; unlike bankruptcy trustees, receivers are not
subject to the limits of §541."<a href="#23" name="23a">23</a>

However, the Lafferty decision was not unanimous. The dissent chose to
emphasize that equitable rules are not to be applied rigidly.

<blockquote>
Whatever the inflexibility is of the Bankruptcy Code,
an equitable doctrine like in pari delicto is highly sensitive to the facts and readily adapted to
achieve equitable results. What is sufficient to satisfy the doctrine, in
other words, need not be parsed like a statute.... The point of equitable
doctrines is to avoid injustice caused by overly inflexible rules....<a href="#24" name="24a">24</a>
</blockquote>

While the Lafferty majority simply accepted as controlling the concept
that §541 subjects the trustee to all defenses, the dissent focused on
the incongruity of an equitable defense creating an inequitable result.
Neither opinion examined the basic assumption that has created the dilemma
for the trustee seeking to recover for third-party negligence—that
is, the idea that the Bankruptcy Code itself requires that the trustee be
subject to all defenses available against the debtor. The logical starting
point for any court faced with this issue would seem to be an analysis of
whether statutory interpretation requires that conclusion.

The O'Melveny case provides a good parallel when examining the argument
that the legislative history of §541 requires that a trustee be
subject to all pre-bankruptcy defenses. In O'Melveny, the Supreme Court emphatically stated that there is no
federal common law on the issue of whether rules of corporate attribution
for dishonest acts apply in federal court.<a href="#25" name="25a">25</a> Thus, unless the particular
federal statute requires such attribution, relevant state law will be
determinative. Although the court in O'Melveny was interpreting the Financial Institutions Reform,
Recovery and Enforcement Act of 1989<a href="#26" name="26a">26</a> (FIRREA), not the Code, the Supreme
Court's interpretation of the language of the FIRREA supports the
same result when examining the position of a bankruptcy trustee. FIRREA
provides that the Federal Deposit Insurance Corp. (FDIC) succeeds to the
rights of the failed institution just as the Code vests the rights of the
debtor in the trustee. In discussing FIRREA, the Supreme Court said that
"the FDIC as receiver 'steps into the shoes' of the
failed S&L, obtaining the rights of the insured depository
institution" that existed prior to receivership.<a href="#27" name="27a">27</a> In light of this
characterization of the FDIC's position in its role as receiver, the
statutory history of §541 would hardly seem to offer any more
compelling rationale for the adoption of a federal rule requiring
attribution of corporate dishonesty where the Code is concerned.<a href="#28" name="28a">28</a>

However, none of the arguments against applying the in pari delicto defense have
ever had much success once the threshold between receivership and
bankruptcy has been crossed. Even in the quasi-bankruptcy arena of a
liquidation proceeding under the Securities Investor Protection Act,<a href="#29" name="29a">29</a> the
defense has generally seemed to survive, preventing the SIPA trustee from
recovering against negligent third parties. If ever there were an
appropriate vehicle for introducing the O'Melveny approach to cases under the Code, a SIPA liquidation is it.
Generally, under SIPA, the liquidation of a securities brokerage begins as
a proceeding in the district court.<a href="#30" name="30a">30</a> Once that court determines the
customers are in need of protection because of the insolvency of the member
broker, the court appoints a trustee selected by the Securities Investor
Protection Corporation (SIPC), and the case is removed to the Bankruptcy
Court.<a href="#31" name="31a">31</a> There, the case is to be conducted under the provisions of SIPA
and, like a chapter 7 case, to the extent consistent with SIPA.<a href="#32" name="32a">32</a> Thus,
a SIPA liquidation is subject to general chapter 7 principles.

Most importantly, SIPC and trustees appointed in SIPA
liquidations perform a customer protection and indemnification role not
unlike that of the FDIC in the liquidation of a bank.<a href="#33" name="33a">33</a> Considering the
trustee's unique position and the purposes of a SIPA liquidation, a
SIPA trustee should enjoy a status similar to the FDIC where the in pari delicto defense is
concerned. After all, the trustee is not a bankruptcy trustee, and
§541 applies only "to the extent consistent with" SIPA.
Yet courts have applied in pari delicto to deny a SIPA trustee's claims.<a href="#34" name="34a">34</a> Even though a SIPA
liquidation does not arise under Title 11 of the Code, the concept that
"the trustee stands in the shoes of the debtor" seems to be too
strongly rooted in bankruptcy lore to be easily overcome.<a href="#35" name="35a">35</a>

<h4>Conclusion</h4>

The purpose of the in pari delicto defense is to prevent the
perpetrator of a fraud from benefiting from his wrongful act, not to shield
a negligent defendant from all liability for his actions. The reason for
the application of the defense to bar a recovery no longer exists once an
innocent fiduciary has been appointed and any recovery would compensate
innocent creditors. As the dissent in Lafferty found, equitable principles then dictate that the defense
is no longer viable. If the defense remains viable in a bankruptcy, the
equitable goals that created the in pari delicto
doctrine are being ignored in the name of statutory construction. The
defense was not fashioned by the courts for the protection of a negligent
accountant or lawyer. Despite the fact that the law should prohibit
recovery by a person guilty of dishonesty, the law should also encourage
those whose role it is to prevent that dishonesty to properly perform their
duties. Unless exposed to liability, the lawyer, accountant, appraiser or
other professional working for a sole proprietor or a single shareholder
entity has little incentive to discover and report fraud.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> S. Rep. No.
95-989, at 82; H.R. Rep. No. 95-595, at 367-68. <a href="#1a">Return to article</a>

<a name="2">2</a> Other
similar defenses are "equitable estoppel" and "unclean
hands." <a href="#2a">Return to article</a>

<a name="3">3</a> A Ponzi
scheme is a prime example. See In re The Bennett Funding
Group Inc., 336 F.3d 94 (2nd Cir. 2003). <a href="#3a">Return to article</a>

<a name="4">4</a> See In re Dublin Securities Inc., 133 F.3d 377 (6th Cir. 1997). <a href="#4a">Return to article</a>

<a name="5">5</a> See, e.g., American Export & Inland Coal Corp. v. Matthew Addy Co., 112 Ohio St. 186
(1925). <a href="#5a">Return to article</a>

<a name="6">6</a> See, e.g.,
FDIC v. Ernst & Young, No. 3-90-0490-H,
1991 WL 197111 (N.D. Tex. Sept. 30, 1991), aff'd., 967 F.2d 166 (5th Cir. 1992). <a href="#6a">Return to article</a>

<a name="7">7</a> 56 F.3d
750, 754 (7th Cir. 1995) ("Put differently, the defense of in pari delicto loses its
sting when the person who is in pari delicto is eliminated."). <a href="#7a">Return to article</a>

<a name="8">8</a> In re The Bennett Funding Group Inc., 336 F.3d 94 (2d Cir. 2003); Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co. Inc, 267 F.3d 340 (3d Cir. 2001); In re Dublin Securities Inc., 133 F.3d 377; In re Hedged-Investments Associates Inc., 84 F.3d 1281 (10th Cir. 1996). <a href="#8a">Return to article</a>

<a name="9">9</a> Bennett
Funding is a recent appellate decision
describing the trustee's problem as one of standing. <a href="#9a">Return to article</a>

<a name="10">10</a> See Warth
v. Seldin, 422 U.S. 490 (1975); Lafferty, 267 F.3d 340
(3rd Cir. 2001). <a href="#10a">Return to article</a>

<a name="11">11</a> See supra n. 6, Lafferty and Dublin Securities. <a href="#11a">Return to article</a>

<a name="12">12</a> However,
some courts have applied the lack-of-standing defense, saying only the
creditors or injured investors have suffered a loss. Hirsch v. Arthur Andersen & Co., 72
F.3d 1085 (2nd Cir. 1995). Where the corporation had otherwise been engaged
in a legitimate, viable business other than the Ponzi scheme, the
corporation also suffers a loss because it insures liability to the
creditors. <a href="#12a">Return to article</a>

<a href="#13" name="13a">13</a> See supra n. 6, Dublin Securities and Hedged-Investments. <a href="#13a">Return to article</a>

<a name="14">14</a> Section
541 "establishes the estate's rights as no stronger than they
were when actually held by the debtor." Hedged-Investments, 84 F.3d at 1285. <a href="#14a">Return to article</a>

<a name="15">15</a> In re Jack
Greenberg Inc., 240 B.R. 486 (Bankr. E.D.
Pa. 1999). <a href="#15a">Return to article</a>

<a name="16">16</a> 512 U.S.
79 (1994). <a href="#16a">Return to article</a>

<a name="17">17</a> In re Jack Greenberg Inc., 240
B.R. at 501. <a href="#17a">Return to article</a>

<a name="18">18</a> FDIC v.
O'Melveny, 969 F.2d 744, 751-52
(9th Cir. 1992). <a href="#18a">Return to article</a>

<a name="19">19</a> O'Melveny, 512 U.S. at 83. <a href="#19a">Return to article</a>

<a name="20">20</a> O'Melveny, 61 F.3d 17 (9th Cir. 1995). <a href="#20a">Return to article</a>

<a name="21">21</a> In re Jack Greenberg Inc., 240
B.R. at 506. <a href="#21a">Return to article</a>

<a name="22">22</a> 267 F.3d at 340. <a href="#22a">Return to article</a>

<a name="23">23</a> Id. at 358. <a href="#23a">Return to article</a>

<a name="24">24</a> Id. at 362. <a href="#24a">Return to article</a>

<a name="25">25</a> 512 U.S.
at 84. <a href="#25a">Return to article</a>

<a name="26">26</a> 12 U.S.C.
§1821 (2004). <a href="#26a">Return to article</a>

<a name="27">27</a> O'Melveny, 512 U.S. at 86 (internal citation omitted). <a href="#27a">Return to article</a>

<a name="28">28</a> In fact,
one could argue that "standing in the shoes" of one's
predecessor is more limiting. After all, the history of §541 speaks to
the rights of the debtor, not the defenses available to the defendant. <a href="#28a">Return to article</a>

<a name="29">29</a> 15 U.S.C.
§78aaa—78lll (1987) (referred to hereinafter only as
"SIPA"). <a href="#29a">Return to article</a>

<a name="30">30</a> See SIPA §78eee. <a href="#30a">Return to article</a>

<a name="31">31</a> SIPA
§78eee(b)(3) and (4). <a href="#31a">Return to article</a>

<a name="32">32</a> SIPA
§78fff(b). <a href="#32a">Return to article</a>

<a name="33">33</a> SIPA
§78ccc and 78ddd. At least one court has held that the D'Oench, Duhme doctrine,
originally applied to protect the FDIC in a bank insolvency, should also be
available to protect the trustee in a SIPA liquidation. In re Fitzgerald, De Arman & Roberts Inc. 129 B.R. 652, 1991 Bankr. LEXIS 975 (Bankr. N.D. Okla. 1991). <a href="#33a">Return to article</a>

<a name="34">34</a> See, e.g., Securities Investor
Protection Corp. v. Munninghoff Lange & Co. (In re Donahue Securities
Inc.), 2003 Bankr. LEXIS 964, *18-19 (Bankr.
S.D. Ohio 2003) (holding trustee in a SIPA liquidation possesses the same
rights as a trustee in bankruptcy); Bondy v.
Chemical Bank, 1975 U.S. Dist. LEXIS 15538, *5
(S.D.N.Y. 1975) (finding that even if a SIPA trustee could bring an action
on behalf of the debtor, the complaint would be barred by the in pari delicto defense). But, see In re Bell & Beckwith, Case No.
C 83-1071 (N.D. Ohio June 26, 1984) (unreported), where the
defendant's motion to dismiss based on in
pari delicto and standing arguments was
denied. <a href="#34a">Return to article</a>

<a name="35">35</a> The author
must disclose that he currently represents the SIPA trustee in Adv. No.
01-1027 (Bankr. S.D. Ohio). <a href="#35a">Return to article</a>

Journal Authors

Gerald L. Baldwin

Journal Date

Friday, October 1, 2004 - 12:00

Bankruptcy Rule

2004