In Pari Delicto In The Bankruptcy Courts - Big Changes In The Offing?

Thursday, June 1, 2006 - 00:00

The term in pari delicto refers to a plaintiff's participation in the same wrongdoing as the defendant. In the bankruptcy context, the principle, also known as the Wagoner rule in the Second Circuit,1 is usually invoked by defendants seeking to bar a debtor corporation from asserting a claim against them for common law fraud, or aiding and abetting fraud, in which corporate management was involved. Some courts, such as the Second Circuit, view in pari delicto as a question of standing, while other courts treat in pari delicto as an affirmative defense. Under either approach, the analysis is essentially the same, turning on whether the acts alleged are imputable to the corporation based on agency law principles.

Every bankruptcy attorney and every litigator who practices in bankruptcy court should be aware of recent developments which may presage important changes in this area of the law. Specifically, a pending appeal in the Second Circuit Court of Appeals, and potential legislation floated late last year as a proposed amendment to the recently revised Bankruptcy Code, could significantly reshape the contours of the in pari delicto doctrine, albeit in radically different ways.

Exceptions To Imputation And The Appeal In In Re CBI Holding Company

The in pari delicto doctrine is rooted in agency law. Under general agency principles, an agent's knowledge or misconduct is imputed to its principal. In the case of a corporation, which can act only through its agents, the application of in pari delicto "imputes the misconduct and knowledge of the corrupt management to the corporation if the management was acting within the scope of employment."2 When an agent, however, is engaged in a scheme to defraud a principal, solely for the agent's own benefit or the benefit of a third party, the knowledge and conduct of the agent are not imputed to the principal. In such circumstances, the plaintiff corporation is no longer deemed to be tainted by the misdeeds of the agent. This is sometimes known as the "adverse interest exception" to the in pari delicto rule.

In general, courts construe narrowly the adverse interest exception, such that the exception will be invoked only when the agent totally abandons his principal's interest and acts entirely for his own or another's purposes. Thus, the exception is not applicable when the agent acts both for himself and for the principal, even if the agent's interest is inimical to the principal. As long as there is some "short term benefit" to the corporation from the agent's actions, the adverse interest exception is not applicable and the in pari delicto defense applies.

In considering an in pari delicto defense, a court may also seek to determine whether there were innocent officers, directors or shareholders who were capable of preventing the actions taken by the agent. Some courts view the existence of such innocent insiders as an independent exception to imputation. Other courts analyze the existence of innocent insiders in the context of the "sole actor rule."

The sole actor rule will impute the conduct of the agent to the principal even if the interest of the agent is adverse to its principal, if the agent controls or dominates the principal. This rule is usually invoked where the agent committing the fraud is the sole shareholder of the corporation or, in cases involving multiple decision makers, where all relevant decision makers were involved in the fraud. The theory of the sole actor rule is that because the sole actor completely dominates the corporation, in acting for himself he is effectively acting on behalf of the corporation. Thus, whenever corrupt management completely controls the company, or where the corporation delegates all authority over a portion of its business to a particular manager or managers who perpetrate fraud, the in pari delicto rule likely will apply.

Courts have generally held that if there are multiple officers and directors, the sole actor rule will impute the misconduct to the corporation only if all "relevant" decision makers were involved in the fraud. Some courts have interpreted this to mean that if there exists at least one innocent member of management who could have and would have prevented the fraud had he known about it, the misconduct will not be imputed to the corporation, the so called "innocent insider exception."

In In re CBI Holding Company, Inc., 311 B.R. 350 (S.D.N.Y. 2004), Judge Kimba Wood of the Southern District of New York, vacated a judgment of the Bankruptcy Court which awarded a reorganization plan disbursing agent damages of nearly $70 million on its fraud, breach of contract and negligence claims against the debtor's pre-petition accounting firm. In determining that, under New York law, the fault imputed to the debtor as a result of management's fraud deprived the plan disbursing agent of its standing to pursue the fraud claims, Judge Wood engaged in a detailed analysis of in pari delicto, or the Wagoner rule, and its exceptions.

The Court rejected the application of the innocent insider exception and declined to adopt any innocent insider exception to the Wagoner rule. The Court relied heavily on the decision of Judge Posner of the Seventh Circuit in Cenco Inc. v. Seidman & Seidman, 686 F.2d 449 (7th Cir. 1982), reasoning that, "where a publicly traded company has delegated to a board of directors the owners' role of hiring and supervising managers, and where that board has failed to prevent managers from committing fraud, the managers' misconduct should be imputed to the company, so as not to disincentivize the innocent managers, board members, and owners from policing the conduct of the guilty."3 Judge Wood concluded that "misconduct by those given authority to make decisions on behalf of a company should be imputed to the company even if innocent members of management could and would have prevented the fraud had they been aware of it."4

Judge Wood's decision was appealed to the Second Circuit Court of Appeals and the appeal has been briefed and argued by the parties, who are awaiting a decision. It is now up to the appeals court to determine whether the District Court's rejection of the innocent insider exception will become the law of the Second Circuit. If it does, the doctrine of in pari delicto will be greatly strengthened. However, the proposed federal legislation referred to at the beginning of this article threatens not only to undo any such expansion of the in pari delicto defense, but to largely eliminate the defense.

Proposed New Legislation

In the bankruptcy context, the in pari delicto doctrine may be raised in defense to an adversary proceeding brought by a bankruptcy trustee seeking to recover funds for the bankruptcy estate, under section 541 of the Bankruptcy Code, based on allegations that third-party professionals, such as attorneys, accountants, placement agents, indenture trustees or banks, either conspired with or aided and abetted senior members of the debtors' management in a scheme to defraud the debtors' investors and creditors. Under section 541(a)(1) of the Bankruptcy Code, the bankruptcy estate generally includes "all legal and equitable interests of the debtor in property as of the commencement of [bankruptcy]." These legal and equitable interests include legal claims and causes of action of the debtor against third parties. Most courts hold that while a trustee stands in the shoes of the debtor and can assert those causes of action belonging to the debtor, the trustee is subject to the same defenses that could have been raised against the debtor had the action been instituted by the debtor prior to bankruptcy. Thus, tort claims asserted by a trustee or debtor-in-possession may be subject to application of the in pari delicto doctrine as if there had been no intervening bankruptcy filing.

Provisions of a draft bill prepared by Senator Jon Kyl, titled "Bankruptcy Reform Technical Amendments Act of 2005," would alter this, thereby significantly disadvantaging defendants in post-petition litigation brought against them by representatives of debtors' estates. The American Bar Association reported on March 14, 2006, that the legislation has not been formally introduced but was circulated to key members of the Senate Judiciary Committee in September 2005 for review.

Specifically, section 301 of the Act, titled "Inapplicability of In Pari Delicto To Trustee Actions," proposes to eliminate the defenses of " in pari delicto," " contra bonos mores " and "unclean hands" to any claims by a bankruptcy trustee on behalf of the estate. This section of the Act proposes to supplement 11 U.S.C. 541(a)(1) by inserting the following language: "A trustee asserting [claims of the debtor against any person] shall not be subject to any defense based on the principles of in pari delicto, contra bonos mores , or unclean hands . . . [N]or shall the knowledge or conduct of any officer, director, partner, member, employee, or other agent or representative of the debtor be imputed to the trustee."

This language would legitimize the contentions made for some time by plaintiff-trustees, but regularly rejected by courts, that the act of filing for bankruptcy, and the subsequent elimination of the senior management's interest in the debtor, essentially cleanse the debtor of the bad acts of management. In rejecting that position, courts have explained that the trustees' argument conflicts with the plain language of 541(a)(1) of the Bankruptcy Code, that provides that the bankrupt estate consists of the debtor's legal and equitable interests "as of the commencement of the case." Thus, the subsequent removal of the debtor's senior management after bankruptcy should be of no consequence.

If the proposed legislation were to become law, it would (i) alter established law that the acts of senior management of a company are generally imputed to the company when done in the course of such manager's employment, (ii) give bankruptcy trustees the ability to assert claims of a debtor with immunity from certain recognized defenses, (iii) limit, in the context of bankruptcy trustees, the well-settled rule that when claims are transferred from one party to another, the transferee takes such claims subject to any defenses which could have been asserted against the transferor, and (iv) overturn precedent in most of the jurisdictions which have addressed these issues.

Conclusion

Neither the release by the Second Circuit of a decision on the appeal in the CBI Holding Company case, nor formal action on the proposed Bankruptcy Reform Technical Amendments Act, are on a fixed timetable. But practitioners would be well-advised to follow the status of these pending matters, as each clearly has the potential to have a major impact on the scope and, in certain cases, the very existence, of the in pari delicto doctrine in the bankruptcy courts.1 Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114 (2d Cir. 1991).
2 In re Sharp International Corp. v. KPMG LLP, 278 B.R. 28, 36 (E.D.N.Y. 2002).
s In re CBI Holding Company, Inc. at 372.
4 Id.
5 11 U.S.C. §541(a)(1) (emphasis added).
6 See 3 Collier on Bankruptcy, 323.03[2].

Steven P. Caley is a Partner in the New York City office of Kelley Drye & Warren LLP. He gratefully acknowledges the assistance of Jay Heinrich in the preparation of this article.

Please email the author at scaley@kelleydrye.com.