In Pari Delicto: State Law Controls Application of Equitable Defense

[1]The in pari delicto defense is a state law-based equitable defense designed to prevent a plaintiff from pursuing damages resulting from wrongful conduct in which the plaintiff itself is complicit. Its goal is to “deter[] wrongful conduct by refusing wrongdoers any legal or equitable relief and protecting the judicial system from having to use its own resources to provide an accounting among wrongdoers.”[2]

While its application varies among jurisdictions, the defense has been evolving in recent years and was most recently utilized in both the Madoff and the MF Global cases.[3] The defense has been instrumental for professionals sued by bankruptcy trustees or receivers, who have been held generally to stand in the shoes of the debtor entity, and, in certain cases, has barred those trustees or receivers from pursuing damages resulting from wrongful conduct in which the debtor’s officers, directors or employees participated.[4]

Most recently, the U.S. District Court for the Eastern District of Illinois has written on the subject.[5] The facts are well-worn and involve the Ponzi scheme orchestrated by Tom Petters.[6]

Ron Peterson was the bankruptcy trustee for the Lancelot Funds. In that capacity, he sued Edie Bailey, an accounting firm that had been hired to audit the financial statements of Thousand Lakes LLC, a special-purpose vehicle through which the Lancelot Funds loaned money to Petters to perpetuate the Ponzi scheme.[7] Peterson claimed that Edie Bailey, in issuing an unqualified audit opinion, failed to uncover the fact that Thousand Lakes was a sham.[8] Edie Bailey interposed the in pari delicto defense, noting that the founder of Lancelot Funds, Gregory Bell, pleaded guilty to wire fraud underlying the Thousand Lakes transactions. In a prior action, Peterson, as trustee, had sued three accounting firms making the same allegation. They had asserted that the trustee was barred based on the in pari delicto defense, which was sustained by the trial court and which, on appeal, the Seventh Circuit affirmed.[9] Thus, said Edie Bailey, the court in the McGladrey action had already decided that the in pari delicto doctrine applied and issue-preclusion barred the trustee’s claims. The district court agreed and granted Edie Bailey’s motion for summary judgment.

The issue as to whether the in pari delicto defense should be applied to bar claims held by trustees or receivers is a storied one. Some courts have acknowledged a public policy argument in favor of creating an exception to the doctrine when a claim is brought by a trustee standing in the shoes of the wrongdoer.[10] Other courts have recognized other exceptions to the doctrine, among which, aside from the “fiduciary duty” exception, are the “adverse interest” exception, which has been described as the most expansive, and the exception in which courts have avoided application of the in pari delicto defense even when the doctrine, by its terms, would apply. That exception has been described as one that “applies ‘when another public policy is perceived to trump the policy basis for the [in pari delicto] doctrine itself.’”[11]

The adverse-interest exception applies “when the corporate agent responsible for the wrongdoing was acting solely to advance his own personal financial interest, rather than that of the corporation.…” [12] It requires a total abandonment of the corporation’s interest, characteristic of outright theft from the company.

The somewhat diffuse public policy exception usually involves statutory schemes like the federal securities laws that largely rely on private causes of action for their enforcement.[13]

The fiduciary duty exception applies when a corporation brings suit against its own fiduciaries, the underlying justification being that “parties like receivers, trustees and stockholder derivative plaintiffs must be able to act on the corporation’s behalf to hold faithless directors and officers accountable.”[14]

Finally, in some jurisdictions, an exception at common law exists that is known as the “auditor exception,”[15] which posits that “auditors are different from genuine third parties when it comes to analyzing whether in pari delicto should apply, and they ought not be afforded the protection of that rule based on a rote application of agency law principles.”[16] The Edie Bailey court, applying Minnesota law to an in pari delicto defense, considered a collateral estoppel argument based on another court applying an in pari delicto defense under Illinois law. The trustee had argued that unlike Illinois, Minnesota law required mutual wrongdoing for application of the in pari delicto defense, and thus the Minnesota court could not use issue preclusion since the in pari delicto defenses in Minnesota and Illinois were materially different.

The Minnesota court analyzed the differences in the two states’ in pari delicto doctrines, however, and concluded that mutual wrongdoing was not in fact required under Minnesota’s application of the doctrine. Thus, “the fact that the McGladrey decisions were made under Illinois law does not prevent Edie Bailey from relying on issue preclusion to bar the Trustee from relitigating the in pari delicto defense here [under Minnesota law].”

What is fundamental to any in pari delicto analysis, made abundantly clear in AIG, supra, is that the law of the controlling state will dictate the result.[17] As noted in Stewart v. Wilmington Trust, supra, New York law differs from that of Delaware. And Delaware, as evidenced by Peterson v. Eide Bailey, LLP, supra, which applied Minnesota law, differs from that of Illinois. The Seventh Circuit has noted, “If there are relevant differences in state law, findings in one suit will not be given collateral estoppel effect in others[.]”.[18] However, as Edie Bailey made apparent, where the differences are not material, collateral estoppel may support the application of an in pari delicto defense even when its application is based on another state’s laws.