Application of the In Pari Delicto Defense Bars Certain Claims of Innocent Successors

Journal Issue

Apr 2006

Column Name

On the Edge

Citation

ABI Journal, Vol. XXV, No. 3, p. 14, April 2006

Topic Tags

Creditors' Committee

Journal HTML Content

Should an innocent successor, like a bankruptcy
trustee or a creditors' committee, be burdened with the pre-petition

sins of the debtor? The Eleventh Circuit Court of Appeals has
recently joined several other circuits in holding that the equitable

doctrine of in pari delicto applies with equal force to
claims of a bankruptcy trustee as to claims of a debtor, and therefore

bars certain causes of action that these otherwise innocent successor
parties would ordinarily pursue to recover damages for the benefit
of the creditors of a bankruptcy estate.1

Doctrine of In Pari Delicto Under the
equitable doctrine of in pari delicto, "a plaintiff who
has participated in a wrongdoing may not recover damages resulting from

the wrongdoing."2 The common law defense of in
pari delicto "derives from the Latin in pari delicto
potior est condition defendentis: 'In a case of equal or mutual
fault...the position of the [defending] party...is the better
one.'"3 The policy behind the in pari
delicto doctrine is that "courts should not lend their good

offices to mediating disputes among wrongdoers" and
"denying judicial relief to an admitted wrongdoer is an effective

means of deterring illegality."4 The
Eleventh Circuit Finds In Pari Delicto Defense Applicable to
a Bankruptcy Trustee The debtor in the Edwards case,

ETS Payphone Inc., operated a massive Ponzi scheme defrauding
thousands of investors of hundreds of millions of dollars. ETS filed

for relief under chapter 11 and, pursuant to the confirmed
reorganization plan, a trustee was appointed to pursue recoveries for
the benefit of the creditors of ETS's bankruptcy estate.

The trustee commenced litigation against several large custodians of
individual retirement accounts (the "IRA custodians") to
recover damages for, among other claims, violations of the Racketeer

Influenced and Corrupt Organizations Act (RICO). The trustee alleged

that the IRA custodians, prior to ETS's bankruptcy proceedings,
aided ETS in defrauding investors by funneling money into ETS's
investments. According to the trustee's allegations, "by failing to

conduct appropriate due diligence and/or ignoring the facts
altogether...[t]he IRA custodians enabled thousands of investors to
partake of the ETS scheme and caused ETS to incur millions of
dollars in additional debt."5 The IRA custodians
moved to dismiss the trustee's complaint arguing, among other
things, that the doctrine of in pari delicto barred the trustee's

claims because ETS's wrongful actions prior to bankruptcy would have

prohibited a remedy for its injuries. The Eleventh Circuit
began its analysis in Edwards by examining §541(a) of
the Code, which provides that property of the debtor's estate includes

"all legal or equitable interests of the debtor in property as of

the commencement of the case."6 The legal interests
or equitable interests that constitute property of the estate
"include any causes of action the debtor may
bring."7 As the representative of the debtor's
estate, a trustee succeeds to the rights of the debtor and therefore

has standing to bring any suit that the debtor could have brought
outside of the bankruptcy case. The Edwards trustee urged
that his claims as trustee of the legal or equitable interests of
the bankruptcy estate against the IRA custodians are not subject to
the doctrine of in pari delicto. The trustee claimed that the

doctrine of in pari delicto depends on the "personal
malfeasance of the individual seeking to recover."8

Thus, ETS's malfeasance or that of its principals should not be imputed
to a bankruptcy trustee. In support of his argument, the trustee
directed the court to the legislative history of §541(d) of the

Code. The Eleventh Circuit determined that there was no need to

resort to legislative history due to the unambiguous language of
§541(a).9 The Eleventh Circuit did not find any
suggestion in the text of the Code that the trustee acquires rights
and interests greater than those of the debtor. It further noted
that the Second, Third, Eighth and Tenth Circuits had unanimously
concluded that the in pari delicto defense applies with equal

force to a trustee as to a debtor outside of
bankruptcy.10 The Eleventh Circuit determined that
"if a claim of ETS 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."11 Accordingly, the
Eleventh Circuit found that because the IRA custodians could have
asserted the in pari delicto defense against ETS, the defense

therefore extended to bar the RICO claims of the trustee.

The Third Circuit Extends the In Pari Delicto Defense to an

Official Committee of Unsecured Creditors The Eleventh
Circuit followed the same reasoning that the Third Circuit used in
Official Committee of Unsecured Creditors v. R.F. Lafferty &
Co. to allow the defense of in pari delicto to bar the
claims of an unsecured creditors' committee. In Lafferty, the

Third Circuit reviewed whether the pre-petition wrongful conduct of
the debtors' shareholder and managers could be imputed to the debtor

and, in turn, to the official committee of unsecured creditors.
Confirming that the legal and equitable interests described in
§541 include causes of action, the Third Circuit found that the
Code authorized the committee to "commence and prosecute any
action or proceeding in behalf of the estate before any
tribunal."12 These actions fall into two categories:

(a) actions brought as successor to the debtor's interest included
in the estate under §541 and (b) actions brought pursuant to
avoiding powers set forth in the Code. With regard to a
bankruptcy trustee, the Third Circuit noted in Lafferty that
it had previously held that "in actions brought by the trustee as

successor in interest to the debtor's interest under §541, the
'trustee stands in the shoes of the debtor and can only assert those

causes of action possessed by the debtor. [Conversely,] [t]he
trustee is, of course, subject to the same defenses as could have
been asserted by the defendant had the action been instituted by the

debtor.'"13 Using this same reasoning, the Third
Circuit determined that there was no difference between a bankruptcy

trustee and a creditors' committee in that the in pari delicto

defense must be evaluated "without regard to whether the committee

is an innocent successor."14 Because the fraud of
the debtors' shareholders and managers could be imputed to the
debtor and ultimately to the creditors' committee, the doctrine of

in pari delicto barred the creditors' committee, standing in
the shoes of the debtor, from asserting its claims against the
defendant. The Seventh Circuit Finds the In Pari
Delicto Defense Inapplicable to a Receiver In
Scholes v. Lehmann, the Seventh Circuit addressed the in pari

delicto defense and its applicability to a receiver pursuing
fraudulent transfer claims.15 In Scholes, a
receiver was appointed by the U.S. Securities and Exchange
Commission (SEC) to liquidate assets of three corporations whose
principal had masterminded a Ponzi scheme. The receiver in the case
pursued fraudulent-transfer actions under Illinois law to recover
assets to disburse to the corporations' creditors. According to Chief
Judge Posner, though injured by the principal, the corporations
"would not be heard to complain as long as they were controlled

by him, not only because he would not permit them to complain, but
also because of their deep, their utter, complicity in the
[principal's] fraud. This rule is that the maker of the fraudulent
conveyance and all those in privity with him—which certainly
includes the corporations—are bound by it."16

However, in contrast to the reasoning applied in Edwards and

Lafferty, the Seventh Circuit found that the appointment of
the receiver removed the wrongdoer from the picture. The
corporations were freed from the "evil zombies" of the
principal.17 "Freed from his spell, they [the
corporations] became entitled to the return of the moneys—for
the benefit not of the [principal] but of innocent
investors—that the [principal] had made the corporations
divert to unauthorized persons."18 Stated
differently, the Seventh Circuit found that "the defense of in

pari delicto loses its sting when the person who is in pari
delicto is eliminated."19 With the appointment
of the receiver whose objective is to maximize the value of the
corporate assets in order to benefit creditors, the Seventh Circuit
determined that the receiver's suit seeking to recover corporate
assets unlawfully dissipated by the principal was appropriate.

The Seventh Circuit recognized that individual investors could have
brought separate actions or even a class action to recover their
losses from the Ponzi scheme but found that, from a public-policy
perspective, the most efficient course of action was to permit the
receiver to bring the suits. "The conceivable alternative to
[the receiver's suits] for getting the money back into the pockets
of its rightful owners are a series of individual suits by the
investors, which, even if successful, would multiply
litigation...."20 The Third Circuit in
Lafferty specifically distinguished Judge Posner's ruling in
Scholes. In Lafferty, the Third Circuit noted that the

Seventh Circuit's reasoning in Scholes may have been preferable

from a public-policy perspective, but the ruling did not comport with
the plain language of §541. According to the Third Circuit,
"the bankruptcy estate 'is comprised of all legal or equitable
interests of the debtor in property as of the commencement of the
case...Congress intended the trustee to stand in the shoes of the
debtor and take no greater rights than the debtor himself had
had.'"21 The Third Circuit distinguished the
receivership proceeding in Scholes from bankruptcy cases
because "unlike bankruptcy trustees, receivers are not subject
to §541."22 The dissent in the

Lafferty decision looked to Judge Posner's reasoning in
Scholes and the public policy behind both the Code and the
doctrine of in pari delicto. According to Judge Cowen in his
dissent, permitting a trustee to pursue claims regardless of the
in pari delicto defense would deter corporate misconduct and
help compensate victims. Moreover, Judge Cowen stated that an
equitable doctrine, like the in pari delicto defense, 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."23
If the point of equitable doctrines is to avoid injustice,
"equity is the recourse of principles of justice to correct or
supplement the law as applied to particular
circumstances."24 The dissent in Lafferty

stated that the majority's conclusion involved a misinterpretation
of an equitable doctrine and a review of the Code that was too
narrow. Does §541 Control? Comparing the
analyses contained in the decisions relying on §541 and the
decision of the Seventh Circuit, if a trustee brought an action pursuant

to his or her avoidance powers rather than a cause of action
inherited from the pre-petition debtor, it seems clear that
§541 would not apply. An action brought pursuant to the
trustee's avoidance powers would be independent from an action
available to the debtor prior to its bankruptcy. The trustee would
not be "stepping into the shoes of the debtor" and, therefore,

would not be subject to the same defenses that could be asserted
against the debtor. The more difficult analysis is the
conflict between public policy considerations and a strict statutory

construction. Permitting defendants to assert the in pari
delicto defense against an innocent successor eliminates significant

sources of recovery for the benefit of a debtor's creditors, which
is counter to the policy that §541 is intended to enhance the
recovery for creditors of a debtor. One legal commentator
complaining about the decisions that have upheld the applicability
of the doctrine of in pari delicto against a trustee using
§541 stated that "[i]gnoring dissenting cries for good
sense and fidelity to bankruptcy policy, the majorities in these cases

have felt bound by this language [§541] to treat the bankruptcy
estate as though it were an individual seeking to recover under
state law from someone with whom it had been in
cahoots."25 In antitrust and securities
litigation, the Supreme Court has refused to permit the in pari
delicto defense when such defense prohibits recovery in a
lawsuit of public importance.26 In the Perma Life
Mufflers decision, the Supreme Court held "that the
doctrine of in pari delicto, with its complex scope, contents

and effects, is not to be recognized as a defense to an antitrust
action."27 The Supreme Court warned against
"invoking broad common law barriers to relief where a private
suit serves important public purposes."28 The public

policy behind the antitrust laws is to encourage competition.
"A more fastidious regard for the relative moral worth of the
parties would only result in seriously undermining the usefulness of

the private action as a bulwark of antitrust
enforcement."29 Subsequent to Perma
Life, the Supreme Court refused to apply the in pari
delicto defense to prevent "tippees" from recovery for

insider trading under federal securities laws. In Bateman
Eichler, the Supreme Court noted that the public policy goal of
the securities laws is to protect "the investing public and the

national economy through the promotion of a 'high standard of
business ethics...in every facet of the securities
industry.'"30 The Supreme Court found that the
tippee's complaint should be barred by the in pari delicto

defense only "where (1) as a direct result of his own actions,
the plaintiff bears at least substantially equal responsibility for
the violations he seeks to redress, and (2) preclusion of suit would

not significantly interfere with the effective enforcement of the
securities laws and protection of the investing
public."31 According to the Supreme Court, the tippees
in Bateman Eichler were not "equally culpable" to
the tippers who "masterminded the scheme to manipulate the
market for their own personal benefit...."32
 Conclusion Applying the in pari delicto
defense to prohibit the pursuit of claims by an innocent successor
seeking to maximize the benefit to the creditors of a debtor's
bankruptcy estate is undoubtedly a harsh result. Nevertheless, if a
cause of action available to the debtor pre-petition is pursued by
stepping into the shoes of the debtor, then the innocent successor
must recognize that courts addressing this issue so far have found
that the claims are also subject to the defenses that could be
asserted against the debtor. To avoid the implications of §541,

a trustee should consider bringing actions pursuant to his or her
avoidance powers rather than asserting claims available to the debtor

pre-petition that may be vulnerable to the imputation of the debtor's
bad actions. <img src="/AM/graphics/spacer.gif" align="LEFT" border="0" hspace="5" vspace="5"><blockquote> <blockquote>

</blockquote></blockquote><hr><h3>Footnotes </h3>1 Official Comm.
of Unsecured Creditors of PSA Inc. v. Edwards, et al., 2006

WL 212219 (11th Cir. Jan. 30, 2006). 2 Black's Law
Dictionary, 806 (8th Ed. 2004). 3 Edwards, 2006 WL
212219, at *6 (quoting Bateman Eichler, Hill Richards, Inc. v.
Berner, 472 U.S. 299, 306 (1985)). 4 Id. 5

Id. at *1. 6 Id. 7 Id.
(quoting Official Comm. of Unsecured Creditors v. R.F.
Lafferty & Co., 267 F.3d 340, 356 (3d Cir. 2001)). 8
Id. at *3. (internal quotations omitted). 9 "Under
the plain meaning of §541(a), the debtor [sic] estate includes
all 'legal and equitable interests of the debtor as of the commencement
of the case...A bankruptcy trustee stands in the shoes of the debtor
and has standing to bring any suit that the debtor could have
instituted'...." Id. The Eleventh Circuit also noted that
the trustee's reliance upon the legislative history of §541(d)
was inapplicable to the matters at issue. 10 See Grassmueck v.

The Am. Shorthorn Assoc., 402 F.3d 833 (8th Cir. 2005);

Official Comm. of Unsecured Creditors of Color Tile Inc. v. Coopers

& Lybrand LLP, 322 F.3d 147 (2d Cir. 2003); Official
Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267
F.3d 340 (3d Cir. 2001); In re Dublin Securities Inc., 133 F.3d

377 (6th Cir. 1998); Sender v. Buchanan, 84 F.3d 1281 (10th
Cir. 1996). 11 Edwards, 2006 WL 212219 at *4. 12
Lafferty, 267 F.3d at 356. 13 Id. at 356
(quoting Hays & Co. v. Merrill Lynch, Pierce, Fenner &

Smith Inc., 885 F.2d 1149, 1154 (3d Cir. 1989)). 14
Id. at 357. 15 Scholes v. Lehmann, 56 F.3d 750 (7th

Cir. 1995). 16 Id. at 754. 17 Id. (emphasis
added). 18 Id. 19 Id. 20 Id.

21 Lafferty, 267 F.3d at 357-58 (quoting In re
Hedged-Investments Assocs. Inc., 84 F.3d 1281 (10th Cir. 1996)).
22 Id. at 358. 23 Id. at 362. 24
Id. (quoting Black's Law Dictionary 560 (7th ed. 1999)).

25 Davis, Prof. Jeffrey, "Ending the Nonsense: The In
Pari Delicto Doctrine Has Nothing to Do with What Is §541
Property of the Estate," 21 Emory Bankr. Dev. J. 519 (2005).
26 See Bateman Eichler, Hill Richards Inc. v. Berner, 472
U.S. 299 (1985); Perma Life Mufflers Inc. v. Int'l. Parts
Corp., 392 U.S. 134 (1968). 27 Perma Life Mufflers,
392 U.S. at 140. 28 Id. 29 Id. 30

Bateman Eichler, 472 U.S. at 315 (citing SEC v. Capital Gains

Research Bureau Inc., 375 U.S. 180, 186-87 (1963)). 31
Id. at 310-11. 32 Id. at 312-13.

Journal Authors

Jeffrey W. Warren

Journal Date

Saturday, April 1, 2006 - 12:00

Bankruptcy Rule

2006

541

none