United States: Limitations Imposed Upon The 'In Pari Delicto' Defense

Last Updated: December 12 2013
Article by Francis J. Lawall and James C. Carignan

Reprinted with permission from the December 6, 2013 issue of The Legal Intelligencer. © 2013 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

Section 541(a) of the Bankruptcy Code creates an "estate" composed generally of all legal and equitable interests of the debtor existing as of the filing date. This includes causes of action routinely brought on behalf of the bankruptcy estate arising out of the debtor's prepetition business, conduct and transactions. A key defense to such claims involves in pari delicto, an equitable doctrine that bars a plaintiff from recovering damages arising from losses for which the plaintiff bears substantial fault.

Application of the in pari delicto defense can be complicated when the "plaintiff" is the bankruptcy estate, inasmuch as Section 541 renders it a technically separate and distinct entity from the prepetition debtor. Indeed, it is often the case that the estate's representative holds no relationship or connection with the prepetition debtor, but rather is an independent bankruptcy trustee or other appointed individual, committee or trust. Thus, the separate legal status of the prepetition debtor, on the one hand, and the post-petition debtor's estate, on the other, calls into question the propriety of applying the in pari delicto defense in a civil action brought by the post-petition estate. Recently, two bankruptcy courts within the Third Circuit considered the applicability of the defense in this context.

In David Cutler Industries v. Bank of America (In re David Cutler Industries), (Adv. Proc. No. 11-0792) (Bankr. E.D. Pa.), the U.S. Bankruptcy Court for the Eastern District of Pennsylvania considered the defense in connection with a fraudulent conveyance action. The prepetition debtor had made payments to a mortgage lender alleged by the estate representative to be fraudulent transfers because they were in satisfaction of a mortgage loan owed by one of the debtor's principals (and secured by his personal residence). The defendant-transferee invoked the in pari delicto defense, arguing that, to the extent the transfers at issue were fraudulent, the debtor and its principals bore equal or greater culpability and therefore could not recover for resulting losses. The court began its analysis by reviewing Third Circuit precedent applicable to the defense, including the principle of "imputation," whereby the wrongful conduct of a corporate officer is "imputed" to the corporation, as well as the "sole actor" principle, whereby the conduct of a sole shareholder will be imputed to the corporation even if the shareholder was acting in his or her own interest and to the corporation's detriment. The court next considered whether the bankruptcy filing had vitiated the defense, since it was grounded upon actions of the prepetition debtor, but was now being asserted against a different entity: the post-petition representative of the bankruptcy estate.

Claims commenced by a bankruptcy estate fall into two categories: (1) prepetition claims that pass to the estate when the bankruptcy petition is filed, pursuant to Section 541(a); and (2) claims that do not arise until a bankruptcy petition is filed and are therefore not prepetition claims. Whether the in pari delicto doctrine is available depends on whether the claim to which the defense is raised falls into the first or second category. With respect to the first category, the DCI court cited the Third Circuit's decision in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001), for the proposition that "the post-petition replacement of management or equity with a bankruptcy trustee does not preclude the defendants from raising the in pari delicto defense; rather, the trustee stands in the shoes of the debtor and is subject to the same defenses as could have been asserted by the defendant had the action been instituted by the debtor." This result, the court held, is required by the plain language of Section 541(a), which is the statutory basis for the estate's acquisition of prepetition claims and which requires that prepetition, nonbankruptcy claims come into the estate subject to the same rights and defenses as existed outside of bankruptcy.

With respect to the second category of claims, the court ruled that Lafferty does not control. The court reasoned that these "avoidance action" or "strong-arm" claims are based upon provisions of the Bankruptcy Code that do not contain the same limiting language that is present in Section 541(a). "As a policy matter, the in pari delicto defense loses its sting when applied to a successor plaintiff representing the interests of innocent creditors," and because the aforementioned limiting language of Section 541(a) is not applicable, "there is no reason not to follow the better rule," the court said. As such, the court rejected the defendant's assertion of the in pari delicto doctrine in defense of the estate's avoidance action claims.

The doctrine was also considered by the U.S. Bankruptcy Court for the District of New Jersey in In re NJ Affordable Homes, (Case No.05-60442) (Bankr. D. N.J.). As in DCI, the NJ Affordable case dealt with an estate's civil actions to, among other things, avoid prepetition transfers as actually and constructively fraudulent. However, the NJ Affordable case involved one important factual distinction: In NJ Affordable, the debtor's management had been replaced by a receiver prepetition, because prior to commencement of the bankruptcy case, a federal district court had determined that the debtor had been operating a Ponzi scheme. As such, the bankruptcy court was presented with the issue of whether the debtor's receivership status, upon entering bankruptcy, immunized the estate from what would otherwise be a viable in pari delicto defense. The court held that it did.

The court thoroughly surveyed case law dealing with the effect of receivership (outside of bankruptcy) on the in pari delicto doctrine, and determined that claims normally subject to the defense were "cleansed" when the receiver was appointed prepetition. "The purpose of fraudulent conveyance statutes is that a wrongdoer not be permitted to profit from his own fraud by recovering property he parted with in an effort to defraud his creditors. ... However, the reason does not apply when the wrongdoer is removed from the scene and is replaced by an innocent successor. ... Put differently, the defense of in pari delicto loses its sting when the person who is in pari delicto is eliminated." Thus, by the time the bankruptcy case was commenced, the claims passing into the bankruptcy estate were already immune from the defense, as a result of the prepetition appointment of the receiver. By virtue of Section 541(a), the court held, the estate took the claims free of the in pari delicto defense.

Parties who find themselves immersed in litigation resulting from their prepetition dealings with an entity that later enters bankruptcy naturally focus upon the substance of the financial details of challenged transactions: the timing and amounts of payments, the purpose for which they were made, and the value given in exchange. However, as the DCI and NJ Affordable opinions demonstrate, equally as important will be the technical status and identity of the plaintiff bringing the claims as well as the procedure by which the claims were acquired. Arguably, the DCI and NJ Affordable decisions somewhat narrow the applicability of the in pari delicto defense as adopted in Lafferty, and just may provide trustees and other estate representatives with greater opportunities to recover on bankruptcy causes of action.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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