A Wrongdoers Right to Evoke In pari delicto
In recent times, we have seen the decline in the economy seemingly stimulated by mass corruption and greed. Amongst those who have found themselves in the midst of fraud have found professionals be they bankers, auditors, investors, and lawyers. We will evaluate two separate scenarios to determine the implications of in pari delicto and the standing to raise it.
Desperate Investment Co. v. Will N. Participant, Esq.
Desperate Investment Co. led by CEO Stan Afloat had fallen on hard times and was struggling to stay in business. The only strategy Stan was able to develop in order keep his business running was to develop a Ponzi scheme disguised as an investment fund. It was only a temporary fix and when the markets rebounded, he would return everything to his investors. In order to implement his plan, Stan called Desperate’s lead outside counsel, Will N. Participant. Stan explained the plan to save Desperate to Will. Even though Will had reservations, he also had a lot of money in Desperate and decided to go ahead and draft the disclosure documentation needed for the sham investment fund. Unfortunately, six months later Desperate’s Ponzi scheme was exposed and Desperate filed for bankruptcy. A court appointed trustee, Tina Tomaso, was assigned as Desperate’s Successor. After investigation, the Ponzi scheme Tina brought suit against Will N. Participant, alleging fraud, aiding and abetting fraud, and malpractice.
Scheming Investment Co. v. Noel Iddle, Esq.
Scheming Investment Co. was founded as a Ponzi scheme and hired Noel Iddle, Esq. to create disclosure papers for the sham fund. Noel was a solo practitioner fresh out of law school who drafted the disclosure documents and made the required regulatory filings. Noel did not appreciate that the fund was a Ponzi scheme. Noel had no independent knowledge about the fraud and did not find out about it until Scheming filed for bankruptcy. The court appointed, Salvador Santiago, as trustee who sued Noel for fraud, aiding and abetting fraud, and malpractice.
Apparently similar at initial review, both cases significantly differ in the eyes of the Court:
Standing in In Pari Delicto Potior Est Condition Possidentis
In pari delicto is the legal principle that a plaintiff who has participated in a wrongdoing may not recover damages from another wrongdoer.” Black’s Law Dictionary, 806 (8th Ed. 2004). The concept is most often evoked by the Court when relief is denied to both parties in a civil action because of wrongdoing by both parties; that since both parties are at fault the court will not involve itself in resolving one side’s claim over the other. In situations such as these, trustees often look at the professionals, including the attorneys, who assist the Ponzi scheme. The question that arises is whether a trustee has standing to pursue civil liability against professionals is if the claim belongs to the corporation or the investors. According to Black’s Law Dictionary, standing refers to a party’s right to make a legal claim and in Caplin v. Marine Midland Grace Trust Co. of New York, 406 U.S. 416, 433-434 (1972), that a bankruptcy trustee has standing to represent only the interests of a debtor corporation, not that of the individual investors. Therefore, the Supreme Court has effectively limited the trustees claims asserted and defenses held to those that the corporation could make. Further, in order to have standing one must be able to demonstrate a cognizable injury suffered by the plaintiff that is fairly caused to the challenged actions of the defendant and can be redressed by the Court. Lujan v. Defenders of Wildlife, 504 U.S. 555, 560-61, 112 S.Ct. 2130 (1992).
A trustee’s standing is established by section 541(a) of the United States Code, which establishes standing by a debtor to the “legal or equitable interests of the debtor in property.” United States v. Whiting Pools, Inc., 462 U.S. 198, 203, 205 n.9 (1983). Thus, a trustee has standing to claims that could have been made by the debtor. Schertz-Cibelo-Universal City, Indep. School Dis. V. Wright (In re Educators Group Health Trust), 25 F.3d 1281, 1283-84 (5th Cir. 1994). However, the reverse is true as well, if the claim belongs not to the debtor, but to the creditors then the trustee has no standing. Therefore, the issue of standing is one of who owns the cause of action – debtor or creditor.
First, section 544(a) can be used by trustees to bring an action as a successor to the debtor’s interests, which are property of the corporation. The most common theory allowing trustees standing arises from the Deeping Insolvency Theory. The Ninth Circuit held in Smith v. Arthur Anderson, LLP, 421 F.3d at 1003 (9th Cir. 2005), found that the trustee had standing to pursue breach of contracts and duties against professionals, including attorneys where the defendants intentionally concealed the financial condition of the failing business. “This allegedly wrongful expenditure of corporate assets qualifies as an injury to the firm which is sufficient to confer standing upon the Trustee.” Id.
Two lesser-used theories when trying to assert standing to professionals are standing arising from indirect injury to creditors from dissipation of debtor’s assets and trustee standing from assignment of claims. In Smith v. Arthur Anderson, LLP, 421 F.3d at 1004 it is stated that, “It is, of course, true that the dissipation of assets limited the firm’s ability to repay its debts in liquidation. Acknowledgement of this fact is not, however, a concession that only the creditors, and not (the debtor) itself, have sustained any injury. Instead, it is recognition of the economic reality that any injury to an insolvent firm is necessarily felt by its creditors.” Thus, if the actions of the professional, a lawyer, create a corporations inability to repay debt, then the professional can be held responsible by the trustee for that transgression.
The controversial assignment of claims function to assert standing stems from the understanding that a trustee takes an unconditional assignment of claims from creditors, thus obtains standing to assert such claims. (Logan v. JKV Real Estate Servs. (In re Bogdan), 414 F.3d 507, 512 (4th Cir. 2005)). This finding is contradictory to the courts in Coplin v. Marine Midland Grace Trust Co. of New York and Williams v. California 1st Bank, which found no standing existed as the real parties in interest were those affected and that was the debtors who were not paid back. Recently, the Seventh Circuit yet again found to the contrary in asserting a trustees right to standing in claims assigned by the investors of debtors in order to pursue third party tortfeasors. Grede v. Bank of New York Mellon, 598 F.3d 899 (7th Cir. 2010).
Even with these four legal theories on asserting standing with In Pari Delicto, many courts have limited a trustee’s standing in Ponzi scheme cases, finding that the investors and not the trustees have the standing to file third party claims. Therefore, the question of asserting standing often times translates into what state laws are enforce and what the culpability is between the plaintiff and defendant.
Asserting In Pari Delicto Potior Est Condition Possidentis
In pari delicto is based on two premises:
- That Courts should not lend their good offices to mediate disputes between wrongdoers; and
- Denying judicial relief to an admitted wrongdoer is an effective means of deterring illegality.
(Bateman Eichler, Hill Richards, Inc. v. Berner, 472 US 299, 306, 105 S.Ct. 2622 (1985).
The Supreme Court has effectively limited the doctrine to situations in which first the Plaintiff when compared to the defendant, bears at least substantially equal responsibility for the wrong doings, and second that the preclusion of the suit would not interfere with the purposes of the underlying law or contravene the public interest. Id. at 311.
Typically, the in pari delicto doctrine is generally a defense against trustee’s claims in bankruptcy. Section 541 requires that the courts evaluate defenses as they existed at the start of the case and therefore the appointment of a trustee does not affect the ability to assert in pari delicto as a defense. (Logan v. JKV Real Estate Servs. (In re Bogdan), 414 F.3d 507 (4th Cir. 2005). It appears clear in most circuits that a trustee is subject to in pari delicto, there is criticism of the application in bankruptcy claims. This hinges on the unfairness of the assumption that the trustee should by imposed with the fiction that a debtor is still a party in interest, when actually the debtor has been replaced by the trustee for the purpose of trying to recover funds for those the corporation injured in the first place.
The application of in pari delicto lies on whether the defendant acted in good faith and did not materially and intentionally collude with the principal in the wrongdoing. Official Comm. of Unsecured Creditors of Allegheny Helth Educ. & research found. V. PricewaterHouse Coopers, LLP, 989 A.2d 313 (Pa. 2010).
Conversely, “the in pari delicto doctrine to apply …the plaintiff must have been an active, voluntary participant in the unlawful activity for which the plaintiff seeks damages.” Lewis v. Brobeck (In re Brobeck), 2008 WL 5650052 *4 (Bankr. E.D. Tenn. 2008).
In pari delicto while permitted in trustee handled bankruptcy matters, is generally permitted as a defense to the defendant. The application remains in question as to when it is permitted and appears to vary based upon the venue. Weighing the Supreme Courts test of substantially equal responsibility and not contravening the public interest it appears to be valid in all cases of involving trustee claims verse professionals based on fault for bankruptcy/responsibility to debtors; however, only used as a defense to the trustees standing to sue as a gate keeping function of the Court.
Stopping In Pari Delicto Potior Est Condition Possidentis
Even if in pari delicto can be shown to be properly asserted and standing exist, state laws hold a variety of “exceptions” in its’ application. If a plaintiff can show that the defendant was acting in their own interests and to the detriment of the debtor, then several courts have found that the adverse interest doctrine will defeat the in pari delicto doctrine. Bankruptcy Servs. Inc. v. Ernst & Young (In re CBI Holding Co., Inc.), 529 F. 3rd 432 (2nd Cir. 2008. This is a sticky exception, as it appears to give the Court the burden of weighing the benefits received by both parties. The exception carries with it the notion that while the Plaintiff did wrong, the Defendant took advantage of the situation and further harmed the Plaintiff with their own wrongdoing. It is a feeling of sympathy for the Plaintiff who initiated the wrongdoing.
Another exception is when not all of the shareholders and/or decision makers are involved in the fraud, meaning that there is an innocent insider to whom the defendant could have reported their findings. Secs. Investor Protection Corp. v. BDO Seidman, LLP, 49 F. Supp. 2d 644, 650 (S.D.N.Y. 1997). The relevant factors in applying this exception are: (1) the existence of a relevant outside decision maker; (2) who would have taken action if they were aware; and (3) who could have taken action to stop the wrongdoing. In analyzing these elements, the question arises as to how this individual could be oblivious to the wrongdoing if they have the power to stop the wrongdoing. It is not an average shareholder, employee, or low-level manager it must be an individual with enough clout to stop the action, thus most likely a vital cog to initiate the action as well.
The next exception is that where there is an assignment of claims to the trustee under a litigation trust. The litigation trust must be created pursuant to a plan of reorganization and the creditors opt in to the trust by assigning their litigation claims to the litigation trustee. Sender v. Mann, 423 F.Supp.2d 1155, 1174 (D. Colo. 2006). This exception has a specific element: the trust must be created to handle creditors who “opt in” to its protection. Thus, assigning their rights to pursue additional liabilities as a “mass tort claim” instead of as individuals.
Finally, Section 544(b)1 allows a trustee to have standing to claims of creditors under state law. Based on whether state law exists, a trustee may assert any claims that a creditor could assert. Thus, if such a claim is brought the trustee may escape the in pari delicto defense because the creditor’s claim has not been tainted by the debtor’s bad acts.
Exceptions may halt a defendants right to assert an in pari delicto defense, however their application is limited and can usually be contested. Thus, the assertion of such exceptions is typically met with skepticism and debate.
Applying In Pari Delicto Potior Est Condition Possidentis
In applying in pari delicto to the facts initially presented, one must first evaluate whether a party who has engaged in fraud (or their trustee) has standing to sue a professional (lawyer) based on conduct relating to the fraud itself, or if such a claim is barred by the doctrine of in pari delicto.
Section 541(a) of the code allows the trustee to assert any claim that would have been possessed by the bankrupt corporation; did the corporation own the claim against the professional or did the creditors of the corporation own the claim? In the hypothetical fact patterns, the trustee in both cases has asserted causes of action for fraud; aiding and abetting fraud, and malpractice against Will N. Participant and Noel Iddle. It could be argued that both the trustee and the creditors own these claims against these professionals, however as discussed earlier, in order to have standing one must be able to demonstrate a cognizable injury suffered by the plaintiff that is fairly caused to the challenged actions of the defendant and can be redressed by the Court. Lujan v. Defenders of Wildlife, 504 U.S. 555, 560-61, 112 S.Ct. 2130 (1992). What injury has been suffered by the Plaintiff (trustee) that was caused by the defendant?
The most common injury asserted is the Deeping Insolvency Theory. That a corporation was injured by the professional leading it into further insolvency. In the facts that have been presented to us, both Desperate Investment Co. and Scheming Investment Co. were insolvent prior to the initiation of the Defendant Professionals wrongdoing. One created the Ponzi as a means of survival and one created it for pure fraud; neither developed deeping insolvency due to the lawyers’ actions.
Two other theories for standing were previously outlined – assignment of claims and standing for indirect injury to creditors. First, there is no indication of any assignment of claims and therefore this is moot.
Were the actions of the professional responsible for the corporation’s inability to repay debt to the creditors? If so, then they can be held responsible by the trustee for such actions. Will N. Participant intentionally participated in the Ponzi Scheme to delay or facilitate a way to forego bankruptcy. By doing such, he could be held in partial responsibility for the corporation’s inability to repay debt, if the now insolvent company had the ability to pay any creditors prior to the inception of the Ponzi. That fact is unknown. Conversely, Noel Iddle did not intentionally deceive any debtors, nor are there any debtors known when the plan is conceived. Further, there is no evidence that his participation is in any way responsible for the corporation’s inability to repay debt, as it was a sham fund that maintained no assets and no intention of paying debt.
Therefore, applying the Supreme Court two part test (highlighted above from Bateman Eichler) in which the Plaintiff when compared to the defendant, bears at least substantially equal responsibility for the wrong doings, and second that the preclusion of the suit would not interfere with the purposes of the underlying law or contravene the public interest. (Bateman Eichler, Hill Richards, Inc. v. Berner, 472 US 299, 311, 105 S.Ct. 2622 (1985). It appears that Will N. Participant, who participated with full knowledge of the Ponzi to protect both the corporation’s interest and his own, would not contravene the public interest. Meanwhile, Noel Iddle, though naïve did not intentionally commit a wrongdoing with the Plaintiff who intentionally created a fraudulent fund. To permit such a claim against Noel Iddle would interfere with the purposes of the law.
When deciding the standing to assert in pari delicto one must not overlook the exceptions:
- Adverse Interest Exception;
- Innocent Insider Exception;
- Assignment of Claims Exception; and
- State Law Exception.
Generally, theses exceptions are used to counter a defense of in pari delicto, however in our facts there is no indication of an innocent insider, assignment of claims, or state law exception. In evaluating, the adverse interest exception there must be evidence that the Defendant took advantage of the situation and further harmed the Plaintiff with their own wrongdoing. In both fact scenarios, there is no evidence of this being present and therefore no exception applies.
In conclusion based upon the facts and the in pari delicto doctrine it appears that the trustee for Desperate Investment Co. may hold Will N. Participant liable for his intentional action only if his actions are responsible for the corporations further inability to repay debt to it’s creditors. Further, the trustee for Scheming Investment Co. has failed the test established by the Court for the in pari delicto doctrine against Noel Iddle. Finally, it appears that Noel Iddle may himself have a claim based on the in pari delicto doctrine against Scheming Investment Co. if damage has been caused by their fraudulent activity to him personally and/or professionally.