In Pari Delicto – “in equal fault.” This is a powerful defense that can completely bar a plaintiff’s claims against a third party where both the plaintiff and defendant were engaged in wrongful conduct.
A recent bankruptcy decision ratified an infrequently used tactic to avoid the bar of in pari delicto to a trustee’s claims – the appointment of a receiver before the bankruptcy is filed. See In re NJ Affordable Homes Corp., 2013 Bankr. LEXIS 4798 (Bankr. D.N.J. Nov. 8, 2013).
Generally speaking, bankruptcy trustees, standing in the shoes of the collapsed Ponzi schemer, are subject to the defenses that existed as of the date of the bankruptcy filing under § 541(a) of the Bankruptcy Code, including the in pari delicto defense. See The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes at § 14.04.
In NJ Affordable Homes, the court acknowledged that the Third Circuit, in Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 354 (3d Cir. 2001), had adopted that widely-held view.
However, the court found that Lafferty only partly controlled because “Lafferty did not involve a pre-petition receiver.” The court cited language from Lafferty itself that distinguished trustees from receivers: “These cases are easily distinguishable, however; unlike bankruptcy trustees, receivers are not subject to the limits of Section 541.” NJ Affordable Homes at *101 (citing Lafferty, 267 F.3d at 358).
The NJ Affordable Homes court found, “[I]t remains an open question in the Third Circuit whether a trustee is barred from suit, under 11 U.S.C. § 541 as well as his avoidance powers, pursuant to the in pari delicto defense and the parallel doctrine of unclean hands when he succeeds a pre-petition receiver.”
In resolving that question, the court relied heavily on two other circuit decisions, FDIC v. O’Melveny & Myers, 61 F.3d 17, 18 (9th Cir. 1995), and Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995).
Scholes is often cited for the proposition that a receiver is an innocent successor and that “the defense of in pari delicto loses its sting when the person who is in pari delicto is eliminated.” O’Melveny is cited to emphasize that a receiver is appointed “as part of an intricate regulatory scheme designed to protect the interests of third parties who also were not privy to the [entity’s] inequitable conduct.”
The court also considered it important that the earlier appointment of a receiver further removed the trustee from the debtor’s wrongful conduct. It cited In re Edgewater Med. Ctr., 332 B.R. 166, 170-72 (Bankr. N.D. Ill. 2005), in which a receiver had been appointed pre-petition, followed by a custodian, and then ultimately by the trustee in that case, leaving the trustee in that case “two levels removed from any wrongful acts.”
Stressing the significance of the pre-petition appointment of a receiver, the NJ Affordable Homes court held that the trustee’s action was not barred by in pari delicto:
[T]he in pari delicto defense and the doctrine of unclean hands [are] inapplicable to causes of action that could have been brought by the Receiver under the circumstances sub judice.
From this holding, it is only a short step to the conclusion that the Trustee as a successor-in-interest stands in a similar position. For the purposes of 11 U.S.C. § 541, the Receiver was in place at the commencement of this bankruptcy case. The Trustee took cleansed causes of action, limited to those provided to the Trustee under the Bankruptcy Code, as an innocent successor.Although the court did not cite it, Kirschner v. Wachovia Capital Markets, LLC (In re Le-Nature’s Inc.), 2009 U.S. Dist. LEXIS 98700 (W.D. Pa. Oct. 23, 2009), came to the same result and determined that there was nothing to impute from the debtor to the trustee.
In seeking a way “to promote the equitable distribution in bankruptcy,” the NJ Affordable Homes court used the pre-petition appointment of a receiver as the hook to get to the result it thought was equitable – to allow the trustee to bring claims by declining to apply the in pari delicto doctrine as a bar.
So why does the case law generally refuse to apply an equitable rationale to bankruptcy trustees? Trustees are innocent successors. They are removed from the debtor’s wrongful acts, and they seek to bring claims against third parties for the purpose of benefitting the creditors, not the debtor. Applying in pari delicto to a trustee only serves to harm the creditors of the estate.
Historically, a trustee’s main hope in dodging in pari delicto was to find an equitable loophole under state law since in pari delicto is a state law defense which courts find applicable to a trustee under § 541. However, the approach taken in NJ Affordable Homes and Le-Nature’s Inc. – crediting the pre-petition appointment of a receiver with washing claims of the in pari delicto defense – gives creditors an alternative path to create distance from the wrongful conduct of the debtor and the in pari delicto bar. Creditors should seriously consider a receiver pit stop on the road to the debtor’s bankruptcy.