CHAPTER 10 The In Pari Delicto Defense

• Jurisdiction: United States

CHAPTER 10: The In Pari Delicto Defense

1. Generally

Defendants of deepening insolvency claims may seek to bar the claims against them by using the in pari delicto doctrine. The phrase in pari delicto means "in equal fault" and has been defined as "[t]he principle that a plaintiff who has participated in wrongdoing may not recover damages resulting from the wrongdoing."⁴⁷³ In other words, "A plaintiff may not assert a claim against a defendant if the plaintiff bears fault for the claims."⁴⁷⁴

Under the in pari delicto doctrine, trustees, receivers and other successors-in-interest to debtors may be barred from bringing deepening insolvency claims where the agents of the debtor engaged in wrongful conduct themselves.⁴⁷⁵ The court in R.F. Lafferty & Co. , the seminal case setting the deepening insolvency theory in motion, actually dismissed the deepening insolvency claim on in pari delicto grounds because the corporate insiders engaged in wrongful conduct that was imputed to the corporate entity and its successor, the bankruptcy trustee.⁴⁷⁶

The applicability of the in pari delicto defense to a deepening insolvency claim may depend not only on the alleged wrongful conduct of the corporate insiders, but also on who exactly the plaintiff is. Courts have taken differing positions on whether in pari delicto should bar claims brought by trustees versus receivers. The analysis is complicated by the fact that both federal law and state law play a role in the analysis.⁴⁷⁷

2. Application of In Pari Delicto to Trustees

Since trustees acquire "all legal and equitable rights of the debtor as of the commencement of the case" pursuant to Bankruptcy Code § 541(a)(1), a trustee's rights can be no greater than the debtor's rights at the time of the petition. Other than with respect to claims to avoid fraudulent or preferential transfers,⁴⁷⁸ most circuits have held that, at least in bankruptcy cases, § 541 requires that the courts evaluate defenses as they existed at the commencement of the bankruptcy case and that therefore the subsequent appointment of a trustee does not change those defenses, including the applicability of the in pari delicto defense.

Some courts have tried to circumvent the application of the in pari delicto doctrine by comparing fault of the predecessor debtor to the alleged wrongful acts of the defendant.⁴⁷⁹ For example, courts have addressed the good faith of defendants, finding that "[imputation does not apply ... where the defendant materially has not dealt in good faith with the principal.... This effectively forecloses an in pari delicto defense for scenarios involving secretive collusion between officers and auditors to misstate corporate finances to the corporation's ultimate detriment."⁴⁸⁰

Accordingly, while a defendant may try to assert the in pari delicto defense because of the wrongful acts of the debtor in whose shoes the trustee stands, some courts may refuse to apply the defense based upon the defendant's own wrongful actions and the extent of any alleged conspiratorial acts of the plaintiff. The refusal to apply the in pari delicto defense to trustees based on the wrongful conduct of the defendant is occurring more frequently in cases seeking to find auditors liable on deepening insolvency or other tort theories. That issue is discussed more fully in the section on Exceptions for Auditor Misconduct later in this chapter.

3. Application of In Pari Delicto to Receivers

Earlier cases declined to apply the in pari delicto doctrine to receivers of corporate debtors who are pursuing third-party claims, and courts permitted receivers to bring suit. The Seventh Circuit in Scholes v. Lehman held that the receiver was not barred from pursuing fraudulent transfer claims because "[t]he appointment of the receiver removed the wrongdoer from the scene."⁴⁸¹ The Ninth Circuit agreed in FDIC v. O'Melveny & Meyers, stating, "A receiver, like a bankruptcy trustee and unlike a normal successor in interest, does not voluntarily step into the shoes of the [entity]; it is thrust into those shoes," so "defenses based on a party's unclean hands or inequitable conduct do not generally apply against that party's receiver."⁴⁸²

However, when the Seventh Circuit was subsequently faced with claims other than fraudulent transfer claims, it limited its holding in Scholes v. Lehman. In Knauer v. Jonathon Roberts Finance Group Inc. , it held that while the in pari delicto doctrine is not a defense against a receiver in exceptional circumstances involving avoidance of fraudulent conveyances, it may apply as a defense to other types of claims brought by a receiver against third parties.⁴⁸³Deepening insolvency claims brought by a receiver would be exactly the type of case in which deepening insolvency might apply.⁴⁸⁴

Some courts follow Scholes v. Lehman and O'Melveny and hold that the in pari delicto doctrine does not bar the receiver's claims.⁴⁸⁵ Other courts, however, have followed the reasoning in Knauer, holding that the in pari delicto doctrine does apply to a receiver, unless any exceptions apply.⁴⁸⁶

4. Ways to Defeat the In Pari Delicto Defense

A. States' Laws of Imputation

The applicability of the in pari delicto defense ultimately depends on whether such a defense is appropriate under state law and that state's laws on imputation of an agent's acts to the corporate entity.⁴⁸⁷ Generally speaking, corporate agency rules dictate that the actions and knowledge of a corporation's directors and officers will bind the corporation, but states have a variety of exceptions to this general rule. The question under state law then becomes whether it is appropriate to impute the actions of a director, officer, shareholder or other agent to the debtor corporation. The acts of a corporation's agents are commonly deemed to be the acts of the corporation.⁴⁸⁸However, if the wrongful acts of the agents fall outside of the type of wrongful conduct subject to imputation in the first instance, then the in pari delicto doctrine may not apply. The in pari delicto defense thus depends on what exceptions exist in a particular state's laws to the basic rules of corporate agency.

B. The Adverse Interest Exception

The most frequently invoked exception to the in pari delicto doctrine is the adverse interest exception. Under this exception, the in pari delicto doctrine does not bar the receiver's claims if the officer acted (a) entirely in his own interests and (b) adversely to the corporation.⁴⁸⁹

However, courts have varied in applying the adverse interest exception to the in pari delicto doctrine, considering issues such as abandonment of corporate interests, agent's subjective motive, and long or short term benefits, discussed infra.

i. Total Abandonment of the Corporation's Interests

Many courts have interpreted the adverse interest exception narrowly, finding that if the corporation itself received any benefit whatsoever, then the adverse interest exception does not apply and the defendant will be able to assert the in pari delicto defense.⁴⁹⁰ In other words, the adverse interest exception generally applies when the agent has totally abandoned the interests of the corporate debtor and is acting entirely for his own purposes.⁴⁹¹

In connection with deepening insolvency claims, some courts have found a benefit to the corporation from the insider's wrongful conduct. "A fraud by top management to overstate earnings, and so facilitate stock sales or acquisitions, is not in the long-term interest of the company; but, like price-fixing, it profits the company in the first instance and the company is still civilly and criminally liable."⁴⁹²Others, however, have found no such benefit.⁴⁹³ The court in Thabault v. Chait found no benefit to the debtor corporation where an insider's conduct allowed the debtor "to continue past the point of insolvency."⁴⁹⁴

ii. The Agent's Subjective Motives

Other courts look to the agent's subjective motives rather than the benefit that the debtor received from the agent's activities. Recharacterizing the total abandonment standard as a question of intent, the court in CBI Holdings noted that "the 'total abandonment' standard looks principally to the intent of the managers engaged in the misconduct."⁴⁹⁵ "[T]he issue [is] whether mismanagement of [the company] was the vehicle by which [the manager] intended to advance his own interest or whether it was simply incidental to his continued efforts to retain some economic viability in the company."⁴⁹⁶

In Kirschner v. KPMG LLP, the Second Circuit subsequently certified to the New York Court of Appeals the question of "whether the adverse interest exception is satisfied by showing that the insiders intended to benefit themselves by their misconduct."⁴⁹⁷ The New York Court of Appeals answered in the negative,⁴⁹⁸ and the Second Circuit affirmed the application of in pari delicto and affirmed the dismissal of the trustee's claims.⁴⁹⁹

iii. Long-Term vs. Short-Term Benefits

Although a corporate insider's fraud may bar a plaintiff's claims for deepening insolvency because the fraud benefitted the corporation, courts disagree on whether a short-term benefit is sufficient to preclude the adverse interest exception and therefore bar a plaintiff's claims. Short-term benefits include loans or new investor funds that the debtor obtained by utilizing fraudulent financial statements. Some courts have held that a short-term benefit, even of limited duration, is enough to bar the receiver's claims by preventing the application of the adverse interest exception.⁵⁰⁰ These courts reason that "the ultimate fate of [the debtor] does not decide the question of benefit."⁵⁰¹ The court in Grede v. McGladrey & Pullen, for example, found, "The later demise of [the debtor] does not mean there was no benefit to [the debtor], here for quite some time, when its officers acted wrongly."⁵⁰²

Under this view, the adverse interest exception is not automatically triggered just because the misconduct may have later resulted...