A Ponzi Scheme and a Pointless Technicality

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Mar 2002

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For the first time in the team's 43-year existence, the New England Patriots are
champions of professional football. Gone now are the long, freezing seasons of the
1960s and 1970s, when Patriots teams struggled to win more games than they
lost, struggled to keep warm and struggled to find a suitable home stadium, playing
at Boston University, Boston College, Harvard (Tufts seems to have missed out)
and, mysteriously, the 1968 season in Birmingham, Ala.—warmer, but a bit of
a hike for Beantown-based devotees.

What may not be entirely lost on throngs of joyous New Englanders is that the
Patriots may never have played in this year's Super Bowl had they not been the
beneficiaries of a hyper-technical ruling by referees that allowed the Patriots to
defeat the Oakland Raiders two weeks earlier. In the waning minutes of a playoff game
played in a snow storm, severe even by Foxboro, Mass., standards, Oakland appeared
to have forced the New England quarterback to fumble the football, all but sealing
an Oakland victory. Every sentient being on Earth seemed sure of the fumble except
for the instant-replay officials (not a popular avocation), who relied on a
little-known, recently enacted rule to conclude that the apparent fumble was no
fumble. Invoking the rule, which attempts to parse the subatomic movements of a
quarterback's forearm, allowed the Patriots to retain possession of the football and
eventually win the game, in overtime, shortly before prevailing temperatures threatened
human survival.

Oakland fans and many less-partisan gridiron enthusiasts invoke the sports epithet
"technicality" to describe the method of the Patriots' snow-bound victory. Though
tiresome in its overuse, the term is apt. A hidebound, overly technical application
of an arcane rule changes the outcome of a contest that everyone—even the on-field
officials—believes would be decided exactly the other way. A few statutory hairs are
split, and the undeserving triumph. It happens in sports. It also happens in
bankruptcy cases.

The Third Circuit's decision in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Committee of Unsecured Creditors v.
R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001)</a>, shows us
how. In affirming the district court's dismissal of a multi-faceted suit over an
alleged Ponzi scheme, the appellate court sustained the equitable defense of in pari
delicto, asserted by the alleged perpetrators of the scheme, on what appear to be
nakedly inequitable grounds. By invoking what the dissenting judge called a "pointless
technicality" rooted in Bankruptcy Code §541, the Third Circuit all but ensured
that at least some of the Ponzi scheme's architects will never be made to answer to
the scheme's victims.

In Lafferty, 16 defendants were alleged to have run (or to have assisted in
running) two lease financing corporations as a Ponzi scheme. When the scheme inevitably
collapsed, leaving many investors with substantial losses, the companies' directors (who
were also the debtors' sole shareholders) filed chapter 11 petitions for the companies
and were promptly replaced by a chapter 11 trustee.<a href="#1" name="1a">1</a> The trustee appointed an
official committee of unsecured creditors and soon entered into a stipulation under which
the committee acquired the authority to prosecute all litigation claims on behalf of the
debtors' estates. In this fashion, the court stated that the committee had
"effectively acquired all the attributes of a bankruptcy trustee for purposes of this
case."<a href="#2" name="2a">2</a>

As expected, the committee commenced a suit in the district court against the
debtors' officers, directors and outside professionals (including R.F. Lafferty &
Co.), alleging among other things fraud, mismanagement, breach of fiduciary duty,
securities law violations and professional malpractice. Many of the claims are best
understood within the rubric of "deepening insolvency"—that is, "an injury to the
debtors' corporate property from the fraudulent expansion of corporate debt and
prolongation of corporate life."<a href="#3" name="3a">3</a> The district court dismissed the action as against
the professionals, holding that "since it is pleaded that the debtors, acting through
[their sole shareholders and directors] perpetrated the Ponzi scheme...the doctrine of
in pari delicto...bars [the committee] from suing these defendants for claims arising
out of the fraud."<a href="#4" name="4a">4</a> Integral to the district court's ruling were two issues that
the circuit court felt were "separate questions, to be addressed on their own terms":
whether the committee had standing to bring the action, and whether the defendants
could properly invoke the in pari delicto equitable defense against the committee as
successor to the debtors.<a href="#5" name="5a">5</a>

The standing issue turns out to have been the more simple of the two. Starting
from the proposition, espoused most notably in the Supreme Court decision in Caplin
v. Marine Midland Grace Trust Co.<a href="#6" name="6a">6</a> that a bankruptcy trustee lacks standing to
pursue claims on behalf of the estate's creditors, the court set out to resolve the
standing issue by answering three questions: (1) whether the committee was asserting
creditors' claims, (2) whether "deepening insolvency" was a cognizable injury under
Pennsylvania law, and (3) whether the injury alleged was more than just
"illusory."<a href="#7" name="7a">7</a>

Likening the committee's action against the Lafferty defendants to a traditional
derivative suit brought by a shareholder on behalf of the company (as opposed to his
own individual behalf), the court concluded that the committee was not attempting to
recover for injuries to the creditors, notwithstanding that creditors would likely be
the sole beneficiaries of any recovery.<a href="#8" name="8a">8</a> The suit was intended to obtain a recovery
on behalf of the debtors—that the debtor's creditors would actually receive the recovery
was a happenstance of bankruptcy law.

The court also noted the "growing acceptance of the deepening insolvency theory" among
federal and state courts and concluded that the Pennsylvania Supreme Court would be
inclined to recognize such a cause of action.<a href="#9" name="9a">9</a> Finally, the court dispensed with

Lafferty's admirably creative argument that "any fraudulent debt certificates issued by
the debtors would have created a capital flow into the debtors, allowing them to pay
the perpetrators of the fraud...that any injury to the debtors caused by deepening
insolvency might be considered illusory because that injury passed directly to the sole
shareholders and wrongdoers."<a href="#10" name="10a">10</a> Because, as the court noted, the alleged perpetrators
of the scheme preserved the integrity of the debtors' corporate form, the court
concluded that the injury was to the corporation, not the shareholders themselves.<a href="#11" name="11a">11</a>

Having resolved the first issue of standing in the committee's favor, the court
then turned to the in pari delicto defense and whether Lafferty and the other
defendants could avail themselves of that equitable defense to the committee's claims.
As the court described, "the doctrine of in pari delicto provides that a plaintiff
may not assert a claim against a defendant if the plaintiff bears fault for the
claim," that is, "if his losses are substantially caused by activities the law forbade
him to engage in."<a href="#12" name="12a">12</a> Considering the obvious point that the committee itself was
certainly not a participant in the Pozni scheme, the court's critical doctrinal step
in sustaining the in pari delicto defense was this: "Whether the in pari delicto

doctrine applies here depends on whether the [wrongdoers'] conduct can be imputed to the
debtors and hence to the committee, which, under bankruptcy law, stands in the shoes
of the debtors."<a href="#13" name="13a">13</a>

Wholly disregarding the seemingly meritorious argument that the committee was but an
innocent successor-in-interest that should not have its predecessors' bad conduct imputed
to it, the court determined that the "explicit language" of Bankruptcy Code §541
was all that was needed to resolve the question.<a href="#14" name="14a">14</a> Stated differently, the court
believed that §541 can clearly determine whether former management's misdeeds forever
taint a committee that had not been formed until after management was removed, thereby
preventing the committee from seeking to redress those misdeeds.

The court believed itself constrained to apply a hyper-technical reading to the
provision in §541 that provides that the estate is comprised of all interests of
the debtor-in-property "as of the commencement of the case." It is a
"warts-and-all" concept: The estate succeeds to property (such as causes of action)
subject to any adverse claims or defenses (such as in pari delicto) that existed as
of the petition date.<a href="#15" name="15a">15</a> Citing legislative history for that section, the court
reiterated Congress' statement that a trustee "could take no greater rights than the
debtor himself had."<a href="#16" name="16a">16</a> Accordingly, the court reasoned, because the debtors
themselves were subject to the in pari delicto defense, so too was the committee.
As a result, the court held, the committee's claims were properly dismissed.

Ascribing management's bad acts to a statutory committee that did not even exist
until after management's departure and the Ponzi scheme's collapse turns equity on its
head. The court seems to have almost blithely disregarded the committee's argument that
the in pari delicto defense is an equitable defense, and that applying it to an
innocent successor is a wholly inequitable result. In doing so, the court paused only
momentarily to note that the committee's position "might be preferable from a public
policy perspective"—something that at least three other circuits (the Tenth, the Second
and the Sixth) have also done in sustaining an in pari delicto defense while
disregarding a trustee's status as an innocent successor.<a href="#17" name="17a">17</a>

It is difficult to discern an agenda in the Lafferty decision or in comparable
decisions from other circuits. None of these courts seemed to believe that it was
necessarily fair or equitable to rule as they did, and at least the Third Circuit
purported to feel compelled (to do the wrong thing) by clear statutory language. And
perhaps that is the agenda—to compel Congress to amend §541 in such a way as to
avoid this type of patently inequitable result. These courts may be implicitly
challenging Congress to fix this problem, saying in essence, who better than
legislators to fashion a rule that prevents Ponzi perpetrators from—in the sensational
terms of our popular media—"getting off on a technicality?"

The problem is writing such a rule. Crafting language that would free a debtor's
innocent successor from the debtor's personal misdeeds in this narrow context would likely
go too far. For example, should a chapter 7 trustee be entitled to a full recovery
in a simple personal injury action despite that the debtor herself was contributorily
negligent? Should a trustee take real property free of environmental claims if the
debtor's management, before its removal, had been polluting? Yes, these examples
compel more obvious answers than the in pari delicto dilemma presented in Lafferty,

but that is precisely the point. Casting just the right statutory net to catch only
the bad results like the one in Lafferty—the "pointless technicality"—may be too daunting
for even the most capable of legislative drafters. Equitable principles—rarely, if
ever, a part of a legislator's vocabulary—are designed to coax a fair result out of
an unfair collision between particular facts and inflexible statutory language. Carving
out narrow, painstakingly justified, equitable exceptions to broad statutory rules is
not what legislatures do. It's what courts do.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d at 344-45</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> Id. at 345. <a href="#2a">Return to article</a>

<a name="3">3</a> Id. at 347. <a href="#3a">Return to article</a>

<a name="4">4</a> Id. at 346, quoting Official Committee of Unsecured Creditors v. Shapiro, 1999 U.S. Dist. LEXIS 14517 (E.D. Pa.
Sept. 8, 1999). <a href="#4a">Return to article</a>

<a name="5">5</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d at 364</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S. 416 (1972)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> The court devoted considerable time and text to the intricacies of these three questions despite the apparent ease with which each could be
answered. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d at 348-54</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> Id. at 349. <a href="#8a">Return to article</a>

<a name="9">9</a> Id. at 349-52. <a href="#9a">Return to article</a>

<a name="10">10</a> Id. at 352. <a href="#10a">Return to article</a>

<a name="11">11</a> Id. at 353. <a href="#11a">Return to article</a>

<a name="12">12</a> Id. at 354 (internal quotations and citations omitted). <a href="#12a">Return to article</a>

<a name="13">13</a> Id. at 355. <a href="#13a">Return to article</a>

<a name="14">14</a> Id. at 356. <a href="#14a">Return to article</a>

<a name="15">15</a> Id. <a href="#15a">Return to article</a>

<a name="16">16</a> Id., citing S. Rep. No. 95-989 at 82 (1978) and H.R. Rep. No. 95-595 at 367-68 (1977). <a href="#16a">Return to article</a>

<a name="17">17</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Assocs., 84 F.3d 1281 (10th Cir. 1996)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Arthur Andersen & Co., 72 F.3d
1085 (2d Cir. 1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Dublin Securities Inc., 133 F.3d 377 (6th Cir. 1997)</a>. The Seventh and Ninth
Circuits appear to hold otherwise. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Lehmann, 56 F.3d 750 (7th Cir. 1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. O'Melveny & Myers,

61 F.3d 17 (9th Cir. 1995)</a>. <a href="#17a">Return to article</a>

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