Bankruptcy trustees have been getting discouraged lately, blocked from pursing recoveries for the creditors of their estates by the doctrine of in pari delicto. Courts have frequently been finding, as a threshold matter, that the affirmative defense of in pari delicto bars a trustee, who stands in the shoes of the debtor, from recovering damages from a wrongdoing defendant if the debtor also participated in that same wrongdoing. See, e.g., Grayson Consulting Inc. v. Wachovia Securities, LLC (In re Derivium Capital LLC ), 716 F.3d 355 (4th Cir. 2013).
However, trustees’ tort claims against defendants do not have to be barred by the in pari delicto doctrine as a threshold matter. Courts can, and should, take the time to analyze the facts and the law on a case-by-case basis and carefully consider whether such extraordinary relief should be applied against a trustee because it would permit a defendant to skate free of liability in a fraud case.
One opinion in a Ponzi scheme case recently analyzed the application of in pari delicto to a bankruptcy trustee. The court in that case thoughtfully wound its way through the doctrine and the layers of exceptions to the doctrine, finding that in pari delicto would not bar the trustee’s claims – at least not at the motion to dismiss phase of the case. Anderson v. Cordell (In re Infinity Business Group, Inc.), 2013 Bankr. LEXIS 4053 (D.S.C. June 19, 2013).
In Infinity Business, the court found that the trustee’s complaint sufficiently alleged that the law would not impute to the debtor the acts and knowledge of the debtor’s agents because those agents were acting fraudulently against the debtor and the agents participated in the fraud.
The court also found that the adverse interest exception to the doctrine would apply to bar imputation, and that the sole actor exception to the adverse interest exception would not apply. “Without a demonstration that liability for the Management Defendants’ acts and knowledge would be imputed to the Debtor, the MK Defendants are unable to show that the Debtor (and thus the Trustee standing in the shoes of the Debtor) bears equal or greater fault for the alleged tortious conduct as they do, and thus the defense of in pari delicto would not apply.” Id. at *56.
The court in that case speculated as to the standard that South Carolina would apply for the adverse interest exception and assumed a stringent standard of “total abandonment.” The court then found that “even under the total abandonment standard, which is the most stringent standard suggested by the MK Defendants, the Complaint sufficiently alleges facts to plausibly suggest that that there was a total abandonment of the Debtor’s interest in this case such that the adverse interest exception would be applicable to bar imputation of liability to Debtor.” Id. at *43-4.
In next considering “sole actor” exception to the adverse interest exception, the court noted the law that “even if an agent’s actions are totally adverse to the corporation, if the agent is the sole agent or sole shareholder of a corporation, the agent’s knowledge and conduct will be nevertheless imputed to the corporation and therefore in pari delicto would apply to bar the Trustee's claims.” However, the court made no such finding w in the case, because of the further exception to the exception to exception, known as the “innocent decision-maker rule.”
[W]here only some members of management are guilty of the misconduct, and the innocent members could and would have prevented the misconduct had they known of it, the culpability of the malefactors should not be imputed to the company because that imputation would punish innocent insiders (e.g. non-culpable shareholders) unfairly.Id. at *52, n.14 (citation omitted).
The court again turned to the specific allegations in the trustee’s complaint, finding that the allegations in the complaint “plainly state that the Management Defendants did not have complete control over the Debtor, that the Innocent Directors were unaware of the Management Defendants’ Scheme, and that the Innocent Directors had the authority and control necessary to stop the fraud.” Id. at *54.
While the facts of the case are important here, more significantly is the court’s willingness to recognize the gravity of the application of the in pari delicto doctrine to bar a trustee’s claims and to use the facts alleged in the complaint as the hook to avoid apply in pari delicto doctrine to bar the trustee’s claims.
The trustee’s lawyers in Infinity Business made it easy for the court. They included language in the complaint on which the court could hang its hat in not applying in pari delicto. The lesson to be learned from this case for bankruptcy trustees and their attorneys is to be very thorough at the pleading stage and to think through each of the layers of the in pari delicto doctrine before filing the complaint. Remember, there is the rule, the exception, the exception to the exception, and then the exception to the exception to the exception. If trustees stand any chance of avoiding the application of the in pari delicto doctrine, they must allege facts in their complaints that take the analysis all the way down the winding path to the finish line.