Fall 2010 • Issue 38, page 1

In Pari Delicto and the Blame Game: Should Receivers Get Caught in the Fray?

By Phelps, Kathy Bazoian*

The finger pointing begins when a receiver of a Ponzi debtor sues the Ponzi debtor’s lawyers and auditors.

  • First, the receiver claims that the auditors’ false financial statements and the attorneys’ private placement memorandum misled investors to invest.

  • These defendants then claim that the insiders of the debtor fraudulently provided false information in the first place on which they relied.

  • Next, the debtor corporation claims that it is not responsible for the wrongful conduct of its agents because they were acting outside the scope of their duties.

  • The defendants claim that the receiver, standing in the shoes of the debtor, is barred from suing them due to the bad acts of the corporation.

  • Finally, the receiver throws up his hands and says, “I wasn’t even in the room at the time.”

So… who is responsible for the damages caused by the combined wrongful conduct of the Ponzi debtor’s insiders, lawyers and auditors? Can the receiver really be held responsible for others’ bad acts that preceded his appointment?

The answer to these questions is ever-changing, governed by the applicable state laws of imputation and a court’s interpretation of the in pari delicto doctrine.

The phrase in pari delicto means “in equal fault.” The judicial doctrine prevents a plaintiff who participates in wrongdoing from recovering damages resulting from those wrongful acts. Third-party defendants may invoke the in pari delicto doctrine in receivership cases in an effort to bar the receiver’s claims against them. They attempt to impute the corporate insider’s wrongful conduct to the corporation itself, and then to the Ponzi case receiver as the corporation’s successor-in-interest.

The ultimate authority — the United States Supreme Court — says the in pari delicto doctrine is based on two grounds: (1) “courts should not lend their good offices to mediating disputes among wrongdoers”; and (2) “denying judicial relief to an admitted wrongdoer is an effective means of deterring illegality.” Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 306 (1985).

A. Application of In Pari Delicto to Receivers
Earlier cases declined to apply the in pari delicto doctrine to receivers of corporate debtors pursuing third party claims, and courts permitted receivers to bring suit. Scholes v. Lehman, 56 F.3d 750, 754 (7th Cir. 1995) (holding that a receiver is not barred from pursuing fraudulent transfer claims because “[t]he appointment of the receiver removed the wrongdoer from the scene”); FDIC v. O’Melveny & Meyers, 61 F.3d 17, 19 (9th Cir. 1995) (“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.”).

B. Subsequent Cases: The In Pari Delicto Doctrine May Apply to Receivers Excepting Exceptional Avoidance of Fraudulent Conveyance Actions
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 Fin. Group, Inc., 348 F.3d 230, 236 (7th Cir. 2003), 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.

Courts continue to struggle with the issue applicability of the in pari delicto doctrine to receivers. Some courts follow Scholes v. Lehman and O’Melveny, and hold that the in pari delicto doctrine does not bar the receiver’s claims. See, e.g., Harmelin v. Man Financial Inc., 2007 WL 2874043 (E.D.Pa.); Pearlman v. Alexis, 2009 WL 3161830 (S.D.Fla); Wuliger v. Mfrs. Life Ins. Co., 2008 WL 397591, at *8 (N.D.Ohio); Kirschner v. Wachovia Capital Markets, LLC (In re Le-Nature’s Inc.), 2009 WL 3526569 at *2 (W.D.Pa.) (holding that the appointment of a receiver just days before the filing of a bankruptcy case for the debtor was sufficient to wash the claims of the in pari delicto taint so there was “nothing to impute” to the trustee when the trustee later sued).

Other courts, howevevr, have followed the reasoning in Knauer, holding that the in pari delicto doctrine does apply to a receiver, unless any exceptions apply. See, e.g., In re Wiand, 2007 WL 963165 *6-7 (M.D.Fla.); Marwil v. Cluff, 2007 WL 2608845 *8 (S.D.Ind.); Hays v. Pearlman, 2010 WL 4510956 (D.S.C.).

C. The Adverse Interest Exception Defeats the In Pari Delicto Defense
If a receiver is in a jurisdiction that applies the in pari delicto doctrine to bar a receiver’s claims, the next question is whether any of the exceptions to the doctrine apply. If so, the receiver’s claims will still be allowed to proceed. The most frequently invoked exception is the adverse interest exception. Under this exception, the in pari delicto doctrine does not bar the receiver’s claims if the officer (a) acted entirely in his own interests and (b) adversely to the corporation. Bankruptcy Servs. Inc. v. Ernst & Young (In re CBI Holding Co., Inc.), 529 F.3d 432 (2d Cir. 2008).

However, courts have varied in applying the adverse interest exception to the in pari delicto doctrine, considering the following issues:

  1. Total Abandonment of the Corporations Interests
    Some courts hold that the in pari delicto doctrine bars the receiver’s claims only when (a) the guilty manager “totally abandoned” the interest of the principal corporation and (b) the corporation received no benefit whatsoever from the agent’s fraud. Thabault v. Chait, 541 F.3d 512, 527 (3d Cir. 2008). The agent’s looting of a corporation in a Ponzi scheme is a “classic example” of an adverse interest that does not bar the receiver’s claims under this interpretation. Baena v. KPMG, LLP, 453 F.3d 1, 8 (1st Cir. 2006).

  2. The Agent’s Subjective Motive
    Other courts look to the agent’s subjective motives instead of the benefit that the debtor received from the agent’s activities. CBI Holding, 529 F.3d at 451 (stating, “the ‘total abandonment’ standard looks principally to the intent of the managers engaged in the misconduct”). This position has been criticized, however, as making the adverse interest exception too expansive. Kirschner v. KPMG, LLC, 2010 WL 4116609 (S.D.N.Y.).

  3. Long Term vs. Short Term Benefit
    If the agent’s fraud resulted in benefit to the corporation, it may bar the receiver’s claims by preventing the application of the adverse interest exception to the in pari delicto doctrine. However, courts disagree on whether a short benefit is sufficient to bar the receiver’s claims. Such a short term benefit might come from a loan 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. These courts further conclude that “the ultimate fate of [the debtor] does not decide the question of benefit.” Grede v. McGladrey & Pullen, LLP, 2009 WL 3094850 *6 (N.D. Ill. 2009); Baena v. KPMG, LLP, 453 F.3d 1, 7 (1st Cir. 2006) (holding that the adverse interest exception is not automatically triggered whenever misconduct contributes to a future financial harm).

    However, other courts have found that this short term benefit is illusory and should not qualify as benefit to the corporation that negates the adverse interest exception. CBI Holding, 529 F.3d at 453 (“Prolonging a corporation’s existence in the face of ever increasing insolvency may be ‘doing no more than keeping the enterprise perched at the brink of disaster.’”); Thabault v. Chait, 541 F.3d at 528-29 (“inflating a corporation’s revenues and enabling a corporation to exist beyond insolvency could not be considered a benefit to the corporation”).

  4. Sole Actor Limitation
    An exception to the adverse interest exception makes the in pari delicto doctrine even more complex. It is known as the “sole actor” rule. If the agent principal of the debtor corporation and the principal are essentially one and the same, then the misconduct of the agent principal will be imputed to the debtor corporation and in pari delicto will bar the receiver’s claims even if the adverse interest exception might otherwise allow them. See Breeden v. Kirkpatrick & Lockhard LLP (In re Bennett Funding Group), 336 F.3d 94, 100 (2d Cir. 2003); Grassmueck v. Am. Shorthorn Assoc., 402 F.2d 833, 838 (8th Cir. 2005) (“where the principal and agent are alter egos, there is no reason to apply an adverse interest exception to the normal rules imputing the agent’s knowledge to the principal, because ‘the party that should have been informed [of the fraudulent conduct] was the agent itself albeit in its capacity as principal.’”).

  5. “Innocent Decision Maker” Exception
    The sole actor exception to the adverse interest exception has its own exception in some jurisdictions where courts add a step after the “sole actor” analysis to consider whether there were innocent decision makers in the corporate structure that could have or would have stopped the wrongful conduct had they been aware of it. See, e.g., Official Comm. of Unsecured Creditors of PSA, Inc. v. Edwards, 437 F.3d 1145 (11th Cir. 2006). If not all of the “shareholders and/or decision makers are involved in the fraud” so that there was at least one innocent insider to whom the defendants could have reported their findings, then the in pari delicto doctrine does not bar the claims. Secs. Investor Protection Corp., v. BDO Seidman, LLP, 49 F. Supp. 2d 644, 650 (S.D.N.Y. 1999).

    However, many courts have rejected the “innocent decision maker” doctrine. See, e.g., Baena v. KPMG LLP, 453 F.3d 1, 9 (1st Cir. 2006) (court rejected the innocent maker doctrine as a “radical alteration” that “clearly deviate[d] from traditional agency doctrine”).

D. A Special Exception for Auditors
Some courts appear to have created a special exception to the in pari delicto doctrine for auditors and allowed a receiver’s claim against an auditor when the auditor was engaged in negligent or collusive behavior. The New Jersey Supreme Court held that thein pari delicto doctrine does not bar a negligence claim against a corporation’s auditors. NCP Litig. Trust v. KPMG LLP, 901 A.2d 871, 882-83 (N.J. 2006) (claim permited “against an auditor who was negligent within the scope of its engagement by failing to uncover or report the fraud of corporate officers and directors”).

The Pennsylvania Supreme Court similarly refused to apply in pari delicto where “the defendant materially has not dealt in good faith with the principal.” Official Comm. Of Unsecured Creditors of Allegheny Health Educ. & Research Found. v. PriceWaterhouseCoopers, LLP, 989 A.2d 313, 339 (Pa. 2010) (“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.”).

These courts conclude that the auditors were engaged to detect the fraud in the first place and cannot use the fraud they failed to detect to bar claims against them. E.S. Bankest, 2010 WL 1417732 at *10; Thabault v. Chait, 541 F.3d at 529 (holding that the auditor was not a victim of the agent’s fraud and that “allowing the auditor to invoke the in pari delicto doctrine would not serve the purpose of the doctrine—to protect the innocent.”).

On the other hand, some courts place the blame on the debtor’s insiders rather than the auditors and reach the opposite conclusion. “[I]f the owners of the corrupt enterprise are allowed to shift the costs of its wrongdoing entirely to the auditor, their incentives to hire honest managers and monitor their behavior will be reduced.” Cenco Inc. v. Seidman & Seidman, 686 F.2d 449, 456 (7th Cir. 1982).

The New York Court of Appeals (that state’s highest court) recently issued a significant decision, holding that even negligent and collusive auditors can assert the in pari delicto defense to bar the claims against them. Kirschner v. KPMG, LLC, 2010 WL 4116609 (S.D.N.Y.). This decision clearly sides with the auditors and potentially other third party defendants, providing them a safe harbor even in the face of collusive behavior. Hence, at least in New York, fingers will be pointed back at the innocent successor-in-interest receiver, and the receiver may quite likely be barred from pursuing third party claims.

*Kathy Bazoian Phelps, Esq. is a partner in the Los Angeles office of Diamond McCarthy LLP. She has special expertise in all areas of bankruptcy and receivership law and in representing trustees and receivers in large-scale litigation involving fraudulent and Ponzi schemes. She is a Board Member of the Los Angeles/Orange County Chapter of the California Receivers Forum.