The in pari delicto doctrine raised its ugly head once again to bar a trustee from recovering for the benefit of innocent creditors.
The decision on Jan. 12 by District Judge Gregory H. Woods in Manhattan further limited the exceptions available to a trustee when confronted with an in pari delicto defense. He held there is no “innocent insider” exception under New York law.
The case involved a general contractor in cahoots with subcontractors to defraud customers. The company inflated invoices for subcontractors’ services by billing for work that was never done. The company then split the overcharges with the subcontractors.
The company’s bankruptcy trustee sued an employee who kept track of how much the subcontractors were required to kick back to the general contractor. The trustee attempted to invoke the faithless servant doctrine to recover compensation he received plus legal fees in connection with a criminal investigation. Bankruptcy Judge Sean Lane dismissed the suit under the in pari delicto rule.
Judge Woods, who was elevated to the bench in November 2013, upheld dismissal but said that the bankruptcy judge incorrectly believed that the notion of innocent insider was an exception to in pari delicto under New York law.
The opinion turned on Judge Woods’ interpretation of the 2010 decision in Kirschner v. KPMG LLP, the definitive statement by the New York Court of Appeals on in pari delicto under state law. The Court of Appeals is the highest authority in the New York state system.
Kirschner is based on the principle from equity jurisprudence that “courts will not intercede to resolve disputes between two wrongdoers.” According to Kirschner, the New York Court of Appeals recognizes only one exception to in pari delicto: the adverse-interest exception that allows suit when the agent has “totally abandoned his principal’s interest” and is acting entirely for his own benefit.
The bankruptcy court’s confusion, Judge Woods said, arose from the Second Circuit’s 1991 decision in Shearson Lehman Hutton v. Wagoner, which held that trustees lack “standing to seek recovery from third parties where corporate insiders engaged in wrongdoing.” Wagoner went on to say that creditors hold the “claim against a third party for defrauding a corporation with the cooperation of management.”
Judge Woods said that federal courts cannot water down New York rules on in pari delicto by referring to Wagoner and assuming “that the doctrines are substantively the same for all purposes.”
In pari delicto applies in bankruptcy because a trustee steps into the debtor’s shoes and is thus infected by the debtor’s fraud. Curiously, in pari delicto does not apply to equity receivers.