ABA 2010 Business Bankruptcy Committee Fall Meeting

Transcription

1 ABA 2010 Business Bankruptcy Committee Fall Meeting In Pari Delicto: Selected Case Summaries Sascha N. Rand, Quinn Emanuel Urquhart & Sullivan, LLP Beth Heifetz, Jones Day

2 Cenco Inc. v. Seidman & Siedman, 686 F.2d 449 (7 th Cir. 1982) FACTS Corrupt managers fraudulently inflated price of inventory and used increased stock price to purchase companies, borrow money and file inflated insurance claims on inventory. After a securities class action was settled, cross claims by Cenco and its auditor (Seidman) were tried before a jury, which found in favor of the auditor. HOLDING Applying Illinois law, 7th Circuit affirmed, upholding a jury instruction that self serving acts of corporate managers that benefit the company are imputed to the company. 2

3 Cenco Inc. v. Seidman & Siedman, cont d 7th Circuit (J. Posner) reasoned that: Fraud on behalf of a corporation is not the same thing as fraud against [the corporation].... Those involved in the fraud were not stealing from the company, as in the usual corporate fraud case, but were instead aggrandizing the company (and themselves) at the expense of outsiders, such as the owners of the companies... bought with [Cenco s] inflated stock, the banks that loaned Cenco money, and the insurance companies that insured its inventories. RATIONALE Judge Posner observed that liability would not advance the twin objectives of tort liability: compensation of victims or deterring wrongdoers. Compensation of victims: corrupt management would stand to benefit from any recovery. Deterrence of wrongdoers: [i]f the owners of the corrupt enterprise are allowed to shift the costs of its wrongdoing entirely to the auditor, their incentive to hire honest managers and monitor their behavior will be reduced. The Court noted that the Illinois comparative fault statute was not retroactive, but it might have changed the analysis. 3

4 Schacht v. Brown et al., 711 F.2d 134 (7th Cir. 1983) FACTS Insurance company fraudulently kept in business long after it was rendered insolvent. Company kept underwriting risky insurance without adequately reserving while parent ceded least risky and profitable business to an affiliate. Liquidator asserted RICO claim against auditors and company s officers, directors and parent. Relying on Cenco, the district court granted motion to dismiss. HOLDING The 7 th Circuit reversed, finding that the fraud could not be imputed to the company. RATIONALE 1. Continuing the company s life past the point of insolvency was not a benefit that supported imputation because artificially prolong[ing] the company s existence was overwhelmed by the harm, and under such circumstances, the prolonged artificial insolvency of Reserve benefitted only Reserve s managers and other alleged conspirators, not the corporation. 2. The policy concerns of Cenco were not present: a. given liquidation, any recovery would inure to the benefit of estate and thereby benefit policyholders and creditors, not equity holders who had a role in fraud; b. unlike Cenco, no large corporate shareholders were in a position to police the company s corrupt officers. 4

5 In re CBI Holding Co. v. Ernst & Young LLP, 529 F.3d 432 (2d Cir. 2008) FACTS Officer and other members of management of CBI, a pharmaceutical products distributor inflated earnings. Following plan confirmation, the disbursing agent brought an adversary proceeding against company s auditor, Ernst & Young LLP ( E&Y ), alleging negligence and fraud. Bankruptcy court denied E&Y s motion to dismiss, and after a 17 day bench trial, found: E&Y departed from GAAS and caused injury to the company; and No imputation, as the evidence showed that the fraud was perpetrated for the purpose of obtaining a bigger bonus for [the officer], and to preserve [the officer s] personal control over the company, and the officer was acting solely in his own interest. Following motion for rehearing, district court concluded there was sufficient evidence that the company benefitted from the fraud. HOLDING To determine whether a manager has totally abandoned the interests of the company to avoid imputation, the court must look[] principally to the intent of the managers engaged in misconduct. Some alleged benefits to the company did not preclude a finding of total abandonment. RATIONALE The 2nd Circuit observed that: the [e]vidence that CBI actually benefitted from CBI s management s fraud did not necessarily mean that managers didn t intend to solely benefit themselves and there was sufficient evidence officer solely intended to benefit himself. the benefits CBI itself received as a result of management s machinations are illusory.... 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. 5

6 Official Committee of Unsecured Creditors of Allegheny Health Educ. & Research Foundation v. PricewaterhouseCoopers, LLP ( AHERF ), 989 A.2d 313 (Pa. Feb. 16, 2010) FACTS Creditors committee filed claims on behalf of the debtor s estate alleging that PwC collaborated with management to hide mounting debts and acquire unprofitable companies. Evidence that PwC actively facilitated the financial misconduct, advising managers how to hide debt, violating accounting standards, and knowingly approving misstated financial statements. The district court granted PwC summary judgment as the Committee did not meet the adverse interest exception to imputation because there had been short term benefit to AHERF through the accumulation of new companies. CERTIFICATION The Third Circuit certified two questions to the Supreme Court of Pennsylvania: 1) What is the proper test under Pennsylvania law for determining whether an agent s fraud should be imputed to the principal when it is an allegedly noninnocent third party that seeks to invoke the law of imputation in order to shield itself from liability? 2) Does the doctrine of in pari delicto prevent a corporation from recovering against its accountants if those accountants conspired with officers of the corporation to misstate the corporation s finances to the corporation s ultimate detriment? 6

7 AHERF,cont d CERTIFICATION RESULT In pari delicto does not apply if the auditor was acting in bad faith (i.e. the auditor knew that corporate managers were acting without proper authority). SUBSEQUENT HISTORY The Third Circuit reversed and directed the district court to consider whether PwC dealt with AHERF in good faith. RATIONALE The Supreme Court relied on agency principles and the (Third) Restatement of Agency. The Court noted the importance of public policy generally in the in pari delicto context: [T]he judicious consideration of competing policies which may be implicated in the extension of the defense to novel settings remains within the appropriate purview of our courts. The Court disagreed with the degree to which Cenco prioritized incentivizing internal corporate monitoring over the objectives [of] compensation and deterrence in auditor liability cases. So as to protect those who transact... with corporations, the Court distinguished between auditors who deal in good faith with the principalcorporation and those who do not. Imputation could not be applied to benefit an auditor that colluded with corrupt management imputation is unavailable relative to an auditor who has not dealt materially in good faith with its client. 7

8 NCP Litig. Trust v. KPMG LLP ( NCP ), 187 N.J. 353 (N.J. 2006) FACTS Management of a health care industry software company fraudulently inflated earnings, and a litigation trustee sued the auditor, KPMG, for negligence, negligent misrepresentation, breach of contract, and breach of fiduciary duty. Trial court granted motion to dismiss, imputing managers fraud to the company; appellate court reversed. HOLDING The imputation doctrine does not prevent a litigation trustee from seeking to recover from an auditor for its negligence. RATIONALE The New Jersey Supreme Court observed that the rationale for imputation, protecting innocent third parties, breaks down in the context of a corporate audit where the allocation of risk and liability among principals, agents, and third parties becomes more complicated. Absolving negligent corporate auditors is difficult to rationalize and to justify or explain in any satisfying or comprehensive way. A limited imputation defense will properly compensate the victims of corporate fraud without indemnifying wrongdoers for their fraudulent activities. Temporary illusory company benefits do not negate management s adverse interest. Given New Jersey s comparative fault statute, imputation is not a total bar, but only a basis for apportionment of fault. 8

9 Don t Blame Me! You Made Me Do It! Recent Trends on the In Pari Delicto Defense ROBIN E. PHELAN DEBBIE J. MCCOMAS Haynes and Boone, LLP 2323 Victory Avenue, Suite 700 Dallas, Texas 75219

10 The defense of in pari delicto is based on the common law principle that a party may not sue others for its own wrongdoing. The term means literally in equal fault and the doctrine bars a plaintiff that bears substantial or equal fault to the defendant from recovering on a claim. 1 It sounds fair in principle. A corporation, for instance, should not be able to sue a third party for helping it commit fraud. But in practice, determining who is at fault, and whether that fault is substantial or equal is often complicated. This paper provides a general overview of the in pari delicto defense and highlights recent and pending decisions that could have a significant impact on how courts apply the defense. I. The General Rule. A product of state common law, application of the in pari delicto defense may vary from state to state. However, as a general rule, the in pari delicto doctrine applies to bar a plaintiff s claim against a defendant when the plaintiff played a substantial role in the conduct of which it is now complaining. 2 But there are exceptions. A plaintiff may avoid the in pari delicto doctrine if it can satisfy the adverse interest exception. The adverse interest exception bars application of the doctrine when the plaintiff corporation can show that its substantial role in the alleged misconduct was committed by management acting adverse to and not for the benefit of the corporation. 3 By way of example, the in pari delicto defense arises often in the bankruptcy context when a trustee brings claims against third parties for aiding and abetting a fraud by debtor s management. In this context, the trustee will commonly attempt to distance itself from debtor s management, arguing, for instance, that it would be inequitable to impute management s acts to the debtor because the acts were adverse to the debtor s interest. 4 The adverse interest exception serves as a complete bar to the in pari delicto defense, but it is difficult to prove. Courts generally define the exception narrowly and require proof of total abandonment of the corporation s interests to justify its application. 5 If there is any benefit to the corporation from management s acts, then most courts reject the exception. 6 However, as discussed in more detail in Part II below, what constitutes total abandonment or benefit is the subject of most of the pending litigation related to the in pari delicto defense. 1 See Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340, 354 (3d Cir. 2001) ( Lafferty ) (applying Pennsylvania law); Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, (1985). 2 Lafferty, 267 F.3d at Id. at Some have suggested that the adverse interest exception should be analyzed under agency principles as an exception to the imputation of the actor's conduct to the principal. 5 See Kirschner v. Grant Thornton LLP, No. 07 Civ , 2009 U.S. Dist. LEXIS 32581, at *20 (S.D.N.Y. Apr. 14, 2009) (finding adverse interest exception requires that manager totally abandoned the corporation s interests and acted entirely for his own or another s purposes ) (quoting In re Bennett Funding Group, Inc., 336 F.3d 94, 100 (2d Cir. 2003)); Kirschner v. KPMG LLP, 590 F.3d 186 (2d Cir. 2009) ( Kirschner II ) (certifying questions regarding imputation and the adverse interest exception to the New York Court of Appeals). 6 Kirschner, 2009 U.S. Dist. LEXIS 32581, at *22 ( [W]here a corporation benefits to any extent from the fraudulent acts of its agents, the agents cannot be said to have totally abandoned the interests of the corporation. ) (quoting Cobalt Multifamily Investors I, LLC v. Shapiro, 2008 U.S. Dist. LEXIS 25849, at *17 n.10 (S.D.N.Y. Mar. 28, 2008)). 2

11 Finally, even if a plaintiff proves the adverse interest exception, a defendant may still avail itself of the in pari delicto defense if it can show that the adversely-interested manager is the corporation s sole actor. Similar to an alter ego claim, the sole actor exception provides that, if an agent or manager completely dominated the entity, then the agent s or manager s conduct is imputed to the entity, even if the conduct is adverse to the entity s interest. 7 In addition to these common law defenses and counter-defenses to the in pari delicto doctrine, there is much debate surrounding whether the doctrine should apply at all in the context of a bankruptcy proceeding. Relying on principles of equity, bankruptcy trustees argue generally that the conduct of pre-petition management should not be imputed to the post-petition debtor because it is the creditors rather than the debtor that stand to benefit from any recovery. This argument, while popular in secondary sources, has been largely rejected by the courts. 8 II. When Conduct of a Bad Actor Is Imputed to the Corporate Plaintiff: Imputation and the Adverse Interest Exception. Whether the in pari delicto doctrine applies to bar a plaintiff s claim frequently turns on whether the plaintiff s management was acting for or adverse to the plaintiff. If management was acting totally adversely to the plaintiff s interests at the time of the misconduct, then the conduct will not be imputed to the plaintiff and the in pari delicto doctrine will not apply. 9 Extreme examples, such as where an individual steals directly from a corporation, are uniformly held to fall within the adverse interest exception. 10 But most cases are not that obvious, and the courts struggle with what conduct should or should not be imputed to the corporation. Most courts apply the adverse interest exception narrowly. Court in the Second Circuit, for example, have held that the adverse interest exception does not apply unless the corporate officer totally abandoned the corporation s interests and is acting entirely for his own or another s purposes. 11 Thus, according to those courts, any benefit to the company from the manager s alleged misconduct means that the manager s conduct will be imputed to the company 7 Lafferty, 267 F.3d at See infra Part IV. 9 See Kirschner, 2009 U.S. Dist. LEXIS 32581, at *20-22; Thabault v. Chait, 541 F.3d 512, 527 (3d Cir. 2008). 10 See, e.g., Schacht v. Brown, 711 F.2d 1343, (7th Cir. 1983), cert. denied, 464 U.S (1983) (rejecting in pari delicto defense where corporation was systematically looted by management); Bondi v. Bank of Am. Corp. (In re Parmalat Sec. Litig.), 383 F. Supp. 2d 587, 599 (S.D.N.Y. 2005) ( By any standard, theft from a corporation by insiders is self dealing by the insiders and not in any sense in the interest of the entity. The insiders actions and knowledge in engaging in such conduct therefore cannot be imputed to the company... [and] in pari delicto does not apply. ); Wedtech Corp. v. KMG Main Hurdman (In re Wedtech Corp.), 81 B.R. 240, 242 (S.D.N.Y. 1987) (applying the adverse interest exception to bar in pari delicto defense where the misconduct was entirely oriented toward the ultimate bleeding of [the entity] by its corrupt managers. ). For additional examples where the courts have rejected the in pari delicto defense, see Phar-Mor, Inc. v. Coopers & Lybrand (In re Phar-Mor, Inc. Sec. Litig.), 900 F. Supp. 784, (W.D. Pa. 1995) (finding that agents acted for their own benefit without regard to the corporation s interests); In re ABC-Federal Oil & Burner Co., Inc., 290 F.2d 886, 891 (3d Cir. 1961) (applying adverse interest exception under Pennsylvania law to determine agent was motivated solely by his own interest which was unrelated to the principal). 11 See Kirschner, 2009 U.S. Dist. LEXIS 32581, at *20 (quoting In re Bennett Funding Group, Inc., 336 F.3d 94, 100 (2d Cir. 2003)). 3

12 and the in pari delicto doctrine will apply to bar the claims against third parties. 12 The general rule is the same in the Third Circuit as well as most other jurisdictions: an officer, director, agent or employee s conduct will be imputed to the principal where the individual acts within the scope of his or her employment and for the benefit of the principal. 13 For example, in Kirschner v. Grant Thornton LLP, claims were brought by a litigation trust created under a confirmed plan of reorganization for Refco a company that had been forced into bankruptcy following public disclosures that it had misrepresented its financial condition in order to raise capital. 14 The plaintiff trust alleged that the company s insiders had designed a fraudulent scheme to conceal its trading losses, its true operating expenses, and the fictitious nature of hundreds of millions of dollars in revenue, to create the illusion of a thriving company and to permit the insiders, shortly before the true facts were disclosed, to sell their interests in the company at inflated prices. 15 On the ground of in pari delicto, the court nonetheless dismissed claims brought against third parties alleged to have assisted in the fraudulent scheme. 16 The court held that, as a matter of law, the adverse interest exception did not apply. [T]he gravamen of the Trustee s allegations [was] not that the insiders stole assets from Refco, but rather that the insiders fraudulent scheme was to steal for Refco to inflate the value of Refco s interests on behalf of Refco itself by maintaining the illusion that Refco was fastgrowing, highly profitable, and able to satisfy its substantial working capital needs without having to borrow money. 17 The court reasoned that, regardless of any detriment the company ultimately suffered, the focus in any imputation analysis should be on the short term benefit to the corporation, which includes continued access to capital markets. 18 Where the alleged fraud produce[s] an influx of cash to the company, not an outflow... the benefit procured by the insiders [comes] at the expense of the securities purchasers, not of the company itself. 19 Similarly, in Bondi v. Bank of Am. Corp. (In re Parmalat Sec. Litig.), 20 the plaintifftrustee alleged that the defendants harmed the company by assisting it in misrepresenting its true financial condition, artificially inflating its assets and under reporting its debts,... advising and assisting Parmalat in the use of sham entities and transactions to conceal looting and squandering of corporate assets and in raising capital and loaning funds to Parmalat Id. 13 See, e.g., Lafferty, 267 F.3d at 358 (citing Nat l Bank of Shamokin v. Waynesboro Knitting Co., 172 A. 131, 134 (Pa. 1934)). 14 See Kirschner, 2009 U.S. Dist. LEXIS 32581, at * Id. at * Id. at * Id. at * Id. at *21. Judge Lynch also explained that extending credit to a distressed entity in itself does the entity no harm because [c]ash infusions expand the debt of a corporation in precise proportion to the expansion of assets in the form of new cash contributed by the underwriters and investors. Accordingly, with respect to injury to the corporate body, as distinguished from any injury thereby to creditors or prospective shareholders, the extension of credit is at worst neutral. Id. at * Thus, a corporation is not harmed by the illusion of solvency created by any extension of credit. Id. at * Id. at *32. Notably, as discussed in more detail infra at Part III, the Second Circuit in Kirschner II has certified certain issues related to in pari delicto and the adverse interest exception to the New York Court of Appeals F. Supp. 2d 504 (S.D.N.Y. 2009). 21 Id. at

13 Defendants asserted the in pari delicto defense, arguing that the company s own managers orchestrated the fraud, which benefited the company by giving it access to the significant amounts of capital it required to continue operations and to continue to grow. 22 The court held that [e]ven assuming that individual agents stole some of the money, Parmalat s officers and employees manifestly were engaged in conducting the work of Parmalat, growing and expanding the business, when they engaged in all of the activities alleged in the complaint save theft from Parmalat, including the raising of capital... despite the fact that [such] financing ultimately resulted in looting. 23 The court explained: The transactions of which plaintiffs complain are the types of transactions by which corporations conduct their businesses the issuance of financial statements, borrowing money, and so forth. The acts and knowledge of those corporate agents who effected them are the responsibility of the corporations. That some of those agents also stood to benefit personally, whether through a higher stock price... or because the corporations had more money for them to steal, as allegedly occurred here, provides no basis for allowing such corporations to avoid responsibility of that which so patently is done on their behalf. 24 Accordingly, the court rejected the adverse interest exception, granted the defendants summary judgment motion, and held that the wrongdoing of Parmalat s insiders was imputed to the company and its litigation trustee, therefore barring plaintiff s claims on in pari delicto grounds. 25 This holding is on appeal to the Second Circuit. However, some courts have imposed a more restrictive interpretation of what constitutes benefit to the company. For instance, in Thabault v. Chait, 26 the receiver of an insurance company filed a lawsuit for malpractice against the company s professionals, alleging that they assisted in mismanaging the company and increasing the company s debt load when it was already insolvent. 27 In seeking summary judgment, the defendant argued that the defense of in pari delicto barred plaintiff s claims because of management s participation in the alleged mismanagement. 28 The district court denied summary judgment on the defendants in pari delicto defense, and the Third Circuit affirmed because the conduct allowed [the company] to continue past the point of insolvency, an outcome that cannot be determined to have benefited the corporation. 29 Some courts have evaluated the subjective intent of the wrongdoers when considering whether there was a benefit to the company for purposes of the adverse interest exception. In 22 Id. at Id. at Id. at Id. at 532; see also Baena v. KPMG LLP, 453 F.3d 1, 7 (1st Cir. 2006) ( A fraud by top management to overstate earnings, and so facilitate stock sales or acquisitions, is not in the long-term interest of the company; but... it profits the company in the first instance.... ) F.3d 512 (3d Cir. 2008). 27 Id. at Id. at Id. at 529. Notably, Delaware does not recognize a cause of action for deepening insolvency. See Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 174 (Del. Ch. 2006). 5

14 Bankruptcy Services v. Ernst & Young (In re CBI Holding Co.), 30 the Second Circuit looked to the intent of CBI s management to determine whether that management had totally abandoned the company s interests. 31 The court rejected the appellees argument that evidence of some benefit to the corporation was enough to avoid the adverse interest exception where the bankruptcy court had found that management did not intend to benefit the corporation. 32 In support of this conclusion, the Second Circuit relied upon Phar-Mor, Inc. v. Coopers & Lybrand (In re Phar-Mor, Inc. Sec. Litig.). 33 In Phar-Mor, the company sued its auditors for conspiring with insiders to overstate the company s financial performance. While the financial fraud enabled the company to raise capital and pursue an expansion strategy, this ultimately led to financial ruin for the company. The court stated in its opinion: From the evidence of record, we cannot conclude as a matter of law that the fraudulent acts of [the insiders] were intended to benefit [the company]. While we recognize that [the insiders] have all testified that the motivation behind the fraud and resultant cover up was to provide time for management to resolve [the company s] underlying business problems, such a motivation does not, in our judgment, necessarily equate to a finding that the fraudulent actors intended to benefit [the company]. Indeed, a reasonable trier of fact could conclude that the true motive of the wrongdoers was the preservation of their employment, salaries, emoluments and reputations, as well as their liberty, at the expense of [the company s] corporate well-being. 34 Thus, unlike the courts in Kirschner, or Parmalat, the Phar-Mor and CBI courts looked to the intent of the parties rather than the short-term effect on the company. The court in Buckley v. Deloitte & Touche, USA LLP 35 took a similar approach to Phar- Mor finding that despite the apparent benefits to the corporation of improving access to investors and lenders, the wrongdoers intended to benefit only themselves: [the insiders] diverted millions of dollars from [the company] with the intent of supporting their friends and/or building a personal empire. This allegation taints any other portion of the complaint in which the language might otherwise suggest that [the company] perhaps experienced some sort of benefit from the insiders actions. For example, even if [the trustee] alleges in one portion of the complaint that the insiders helped [the company] to raise capital, the Court cannot conclude that this benefited [the company] if the complaint subsequently alleges that the insiders diverted [the company s] capital to their friends and to themselves with the intent of self-dealing. Thus, [the trustee s] allegations of self-dealing are F.3d 432 (2d Cir. 2008). 31 Id. at Id. ( Evidence that CBI actually benefitted from CBI s management s fraud does not make the bankruptcy court s finding that CBI s management did not intend to benefit the company clearly erroneous. ) F. Supp. 784 (W.D. Pa. 1995). 34 Id. at No , 2007 U.S. Dist. LEXIS (S.D.N.Y. May 21, 2007). But see Kirschner II, 590 F.3d at and n.3 (generally approving of district court s rejection of the actor s subjective intent as a means to determine adverse interest, but recognizing some disagreement among authorities). 6

15 sufficient for this Court to conclude that plaintiff has alleged that the insiders were acting entirely for their own benefit in all of the improper actions they took while managing [the company], at least for purposes of this motion to dismiss, where plaintiff must be given the benefit of the doubt. 36 The requirement of a subjective intent to benefit the company, however, suffered a severe setback in the recently decided case of Official Committee of Unsecured Creditors of Allegheny Health, Education and Research Foundation v. PricewaterhouseCoopers, LLP ( AHERF III ). 37 The Third Circuit Court of Appeals certified several questions regarding the interaction between the in pari delicto doctrine and imputation of an agent s fraud to his principal to the Supreme Court of Pennsylvania. Based on responses from that court, the Third Circuit confirmed that the traditional, liberal test for corporate benefit applied. 38 While this holding obviously only technically applies to Pennsylvania law, it undercuts most of the precedent relied upon for requiring that the wrongdoers have a subjective intent to benefit the corporation before in pari delicto can apply. III. When the Defendants Conduct Is So Bad That the Plaintiff s Conduct Becomes Irrelevant: A New Approach to Equal Fault. Both the Second and Third Circuits have struggled with the balance between plaintiff s alleged bad acts and the conduct of the defendants. But federal courts are not the final word on the topic. Application of the in pari delicto doctrine requires application of state law, which is not well-developed in many states. As a result, both the Third Circuit in Official Committee Of Unsecured Creditors of the Allegheny Health, Education & Research Foundation v. PricewaterhouseCoopers, LLP 39 ( AHERF ) and the Second Circuit in Kirschner II 40 have recently certified questions to the relevant state courts seeking guidance on the application of the in pari delicto doctrine where the defendant is an alleged co-conspirator in the agent s fraud. In AHERF, the Third Circuit questioned whether the underlying objectives of tort liability could be satisfied where the party invoking that doctrine is not conceded to be an innocent third party, but an alleged co-conspirator in the agent s fraud. 41 Specifically, two issues were certified to the Pennsylvania Supreme Court: (1) What is the proper test under Pennsylvania law for determining whether an agent s fraud should be imputed to the principal when it is an allegedly non-innocent third-party that seeks to invoke the law of imputation in order to shield itself from liability? (2) Does the doctrine of in pari delicto prevent a corporation from recovering against its accountants for breach of contract, professional negligence, or aiding and abetting a 36 Buckley, 2007 U.S. Dist. LEXIS at *22-23 (citations omitted) F.3d 346 (3d Cir. 2010). 38 Id. at No. 07 Civ. 1397, 2008 U.S. App. LEXIS (3d Cir. July 1, 2008) F.3d AHERF, 2008 U.S. App. LEXIS 18823, at *

16 breach of fiduciary duty, if those accountants conspired with officers of the corporation to misstate the corporation s finances to the corporation s ultimate detriment? 42 Accepting certification of these two issues, the Pennsylvania Supreme Court in Official Committee of Unsecured Creditors of Allegheny Health, Education & Research Foundation v. PricewaterhousCoopers, LLP ( AHERF II ), 43 reaffirmed the vitality of the in pari delicto defense in Pennsylvania, defining the defense as a legal defense to tort claims, and rejected the argument that the adverse interest exception should be determined based on the subjective intent of the guilty agent. 44 Rather, the court adopted an objective standard under which the question generally should be whether there is sufficient lack of benefit (or apparent adversity) such that it is fair to charge the third party with notice that the agent is not acting with the principal s authority. 45 After AHERF II, the controlling question in Pennsylvania is whether there is evidence of secretive, collusive conduct between corporate agents and third parties. 46 Where a third party does not engage in intentional, knowing collusion, in pari delicto may apply to bar the claims against it. 47 In describing the secretive collusion limitation, the AHERF II court reasoned that [t]he underlying assumption that an agent will communicate all material information to his principal... does not logically pertain to instances in which there is collusion to withhold information from corporate governance. 48 This consideration was central in AHERF II, where the plaintiff alleged that an external auditor (PWC), duty-bound to inform the board of any material accounting improprieties and to withhold a clean audit opinion from any fraudulent financial statements, allegedly conspired to hide the truth from AHERF s board. 49 Absent evidence of such secretive collusion, the AHERF II court recognized that the traditional, liberal test for corporate benefit should apply, that no adverse interest exception applies unless the principal received no benefit at all from the agent s acts. 50 The Second Circuit in Kirschner has referred similar questions to the New York Court of Appeals. Specifically, the Second Circuit certified the following eight issues: (1) the over-arching question whether the allegations of the complaint in this case satisfy the adverse interest exception to the Wagoner rule of imputing insiders misconduct to their corporation, and the following subsidiary questions subsumed within that ultimate question: (2) whether the adverse interest exception is satisfied by showing that the insiders intended to benefit themselves by their misconduct; 42 Id. at * A.2d 313 (Pa. 2010). 44 Id. at Id. 46 Id. at Id. 48 Id. at Id. at Id. at 336 & n.12,

17 (3) whether the exception is available only where the insiders misconduct has harmed the corporation; (4) if harm is required, whether the analysis of such harm may include any detriment to a corporation resulting from the eventual unmasking of the misconduct; (5) if harm is required, whether such harm may be determined by considering a corporation and its related corporations as a single enterprise; (6) if harm is required and is to be determined with respect to separate though related corporations, whether the allegations of the complaint adequately allege such harm; (7) whether the exception is precluded where the misconduct conferred some benefit upon the corporation; and (8) if the adverse interest exception were otherwise available, would it be precluded by the sole actor rule? 51 The New York Court of Appeals accepted the certification on January 19, The case is scheduled for argument on September 14, IV. Bankruptcy Trustees, Standing, and the Innocent Successor As a general rule, the in pari delicto defense applies equally to claims brought by a trustee in bankruptcy. Some courts have couched the in pari delicto principles in terms of the trustee s standing to bring suit. The Second Circuit, for instance, has reaffirmed what has become known as the Wagoner Rule. The Wagoner Rule holds, similar to the in pari delicto doctrine, that a bankruptcy trustee lacks standing to seek recovery on behalf of a debtor company against third-parties for injuries caused by the misconduct of the debtor s controlling managers. 52 In Kirschner, 53 the Refco liquidation trustee sued Refco s professionals, such as accountants and lawyers, under a series of tort claims for allegedly participating in a scheme with Refco management to inflate the debtor s financial position. Because the directors were alleged to have participated in the fraudulent scheme, the district court found the trustee lacked standing to bring the action. 54 Other courts have reached a similar result by relying upon the language of section 541 of the Bankruptcy Code. 55 Section 541(a)(1) describes the bankruptcy estate as all legal or 51 Kirschner II, 590 F.3d at Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, 118 (2d Cir. 1991). But see In re Adelphia Commc ns Corp., 365 B.R. 24, 45-6 (Bankr. S.D.N.Y. 2007) (finding Wagoner rule inapplicable as not existing under Pennsylvania law); Bondi v. Bank of Am. Corp. (In re Parmalat Sec. Litig.), 383 F. Supp. 2d 587, 595 (S.D.N.Y. 2005) (noting that Wagoner rule did not apply under controlling North Carolina law). 53 Kirschner, 2009 U.S. Dist. LEXIS Id. at *5. 55 See, e.g., Sender v. Buchanan (In re Hedged-Investments Assocs., Inc.), 84 F.3d 1281, (10th Cir. 1996); Lafferty, 267 F.3d at

18 equitable interests of the debtor in property as of the commencement of the case. 56 In Official Committee of Unsecured Creditors v. Lafferty & Co., 57 the Third Circuit found that the explicit language of section 541 directs courts to evaluate defenses as they existed at the commencement of the bankruptcy. 58 Looking to the legislative intent, the court reasoned that Congress intended the trustee to stand in the shoes of the debtor and take no greater rights than the debtor himself had. 59 Thus, the court concluded, the fact that the trustee was bringing the claims instead of the corporation along with its bad actors was of no import. Because the in pari delicto defense applied at the commencement of the bankruptcy, the fact that the trustee brought the claims post-petition was irrelevant. Consistent with this holding, the majority of courts have applied the in pari delicto defense even where the alleged bad actors were dismissed before the bankruptcy petition was filed. 60 However, reliance on Section 541 of the Bankruptcy Code has led some plaintiffs to argue that the in pari delicto doctrine should not apply where the bad actors are no longer with the company at the time the bankruptcy is filed. 61 This so-called innocent successor defense is fairly simple: Section 541 of the Bankruptcy Code provides that the estate consists of all legal and equitable interests of the debtor in property as of the commencement of the case. Courts have held that the explicit language of section 541 directs courts to evaluate defenses as they existed at the commencement of the bankruptcy U.S.C.A. 541(a)(1). See Sec. Investor Prot. Corp. v. Bernard L. Madoff Inv. Secs. LLC, Adv. Pro. No (Bankr. S.D.N.Y. Aug. 3, 2010) (recognizing that a trustee acquires prepetition claims as property of the estate under Bankruptcy Code 541(a)(1) subject to whatever infirmities (such as an in pari delicto [sic] defense) that may have existed, but finding in pari delicto not relevant to court s preliminary determination of whether proceedings are subject to the automatic stay) (quoting Grubin v. Rattet (In re Food Mgmt. Group, LLC), 380 B.R. 677, 693 (Bankr. S.D.N.Y. 2008)) F.3d 340 (3d Cir. 2001). 58 Id. at Id. at (citing S. Rep. No , at 82 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5868). 60 See Baena, 453 F.3d at 3 (in pari delicto applied where culpable agents left company before bankruptcy); Nisselson v. Lernout, 469 F.3d 143, (1st Cir. 2006) (affirming dismissal based on in pari delicto defense where wrongdoers left surviving company three weeks before bankruptcy); Seidman & Seidman v. Gee, 625 So. 2d 1, 1 (Fla. Dist. Ct. App. 1992) (imputing fraud of corporate officer who left company just prior to its liquidation ); MCA Fin. Corp. v. Grant Thornton, LLP, 687 N.W.2d 850, 852 (Mich. Ct. App. 2004) (imputing conduct of officers who were terminated before bankruptcy). 61 Most notably, the Plaintiff has made this argument in Adelphia Recovery Trust v. Bank of America, N.A., No. 05 Civ (S.D.N.Y.) in response to the Defendants motion for summary judgment on in pari delicto. In an order denying the defendants motions to dismiss on in pari delicto grounds, the district court noted that the removal of the Rigas family and other members of management was a pre-petition event that the Court is to consider. Adelphia Recovery Trust v. Bank of Am., 2008 U.S. Dist. LEXIS 36553, at *15-16 (S.D.N.Y. 2008). However, the district court did not draw conclusions as to the effect of the pre-petition removal of the Rigas management on its final determination of whether the in pari delicto doctrine would apply to bar the plaintiff s claims. At the time of writing this paper, the issue was fully briefed and was pending before the district court but no decision had been issued. As noted infra, though, the plaintiff s position appears to be seriously undermined by the recent decision in AHERF II discarding the innocent successor defense under the controlling Pennsylvania law. 62 Lafferty, 267 F.3d at 356; see also Adelphia Recovery Trust v. Bank of Am., N.A., 390 B.R. 64, 79 (S.D.N.Y. 2008). 10

19 On the day bankruptcy was filed, only innocent individuals remained and the misconduct had ceased. Because of this, imputation is broken, and the defense of in pari delicto cannot be raised against the innocent successor. There is some support for this argument. In the case of Le-Nature s Inc. v. Wachovia Capital Markets, LLC, the company s entire board of directors was removed in the days leading up to the petition date. 63 The court stated that because of the departure of the culpable insiders, the doctrine of in pari delicto could not apply and there was nothing to impute at the time of the bankruptcy filing. 64 Leaving aside the technical aspect of the argument regarding exactly when the culpable parties left the company and what the effect of section 541 is, the argument can also be articulated in a much simpler and broader fashion. Essentially, in pari delicto is an equitable defense, and when it is applied in the bankruptcy context to bar the claims of a trustee, it can have the appearance of barring the recovery of an innocent plaintiff. 65 This argument has met with great support in the commentaries but has not been widely accepted by the courts. 66 Even with the equitable slant that parties often try to put on it, though, the argument regarding the departure of culpable parties is a bit difficult to accept because it makes logical sense that the pre-petition removal of alleged corporate wrongdoers would be irrelevant to determining whether a plaintiff is in pari delicto with those being sued. It is not the case that a corporate defendant somehow is cleansed of alleged wrongdoing simply because the alleged corporate wrongdoers are removed, even when the corporation is sued and forced into bankruptcy. Rather, a corporation s culpability vel non must be based on its status at the time the alleged illegality occurred. 67 Further undermining this argument is the fact that the appellate courts to have addressed the issue agree that a bankruptcy trustee s status as a purported innocent successor has no effect on an in pari delicto analysis. 68 The Second Circuit has also implicitly rejected the argument by repeatedly permitting the use of the in pari delicto defense against section 541 trustees. 69 And, in response to a certified question from the Third Circuit, the Pennsylvania Supreme Court recently made clear that an alleged wrongdoer 63 No , 2009 U.S. Dist. LEXIS 85151, at *24 (W.D. Pa. Sept. 16, 2009). 64 Id. at * See In re Personal and Business Insurance Agency, 334 F.3d 239, 246 (3d Cir. 2003) (considering certain purely equitable arguments in deciding whether to allow the defense of in pari delicto). 66 See, e.g., Jeffrey Davis, Ending the Nonsense: The In Pari Delicto Doctrine Has Nothing to Do with What Is 541 Property of the Bankruptcy Estate, 21 EMORY BANKR. D.J. 519 (2005); Gerald L. Baldwin, In Pari Delicto Should Not Bar a Trustee s Recovery, 23 AM. BANKR. INST. J. 8 (Oct. 2004). 67 Nisselson, 469 F.3d at See Baena, 453 F.3d at 3 (in pari delicto applied where culpable agents left company before bankruptcy); Nisselson, 469 F.3d at (affirming dismissal under in pari delicto where wrongdoers left surviving company three weeks before bankruptcy); Lafferty, 267 F.3d at ; In re Dublin Secs., Inc., 133 F.3d 377, 380 (6th Cir. 1997), cert. denied, 525 U.S. 812 (1998); Grassmueck v. Am. Shorthorn Ass n, 402 F.3d 833, (8th Cir. 2005); In re Hedged-Investments Assocs., Inc., 84 F.3d at 1285; Official Comm. of Unsecured Creditors of PSA, Inc. v. Edwards, 437 F.3d 1145, (11th Cir. 2006). 69 See, e.g., Official Comm. of Unsecured Creditors of Color Tile, Inc. v. Coopers & Lybrand, LLP, 322 F.3d 147, (2d Cir. 2003); Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, 1094 (2d Cir. 1995). 11

20 could prevail on summary judgment on in pari delicto grounds against an innocent successor such as a creditors committee absent evidence that the defendant colluded with company management to defraud the company. 70 Thus, notwithstanding the commentators arguments for equity, the weight of authority supports application of the in pari delicto doctrine to claims brought by a trustee in bankruptcy, regardless of whether the bad actors left pre-petition. V. Conclusion In sum, in pari delicto appears to be alive and well as a defense when a plaintiff is of substantial fault in the complained of conduct, even as against trustees in bankruptcy when the alleged bad actors left pre-petition. And although the adverse interest exception varies by state, the overwhelming majority of courts define the exception narrowly and require a showing that the alleged bad actor has totally abandoned the plaintiff s interests and is acting without any benefit to the plaintiff to invoke the defense. However, the New York Court of Appeals may provide greater clarity on the issue through the certified questions in the Refco appeal. 70 See AHERF II, 989 A.2d at 328 n.16 (rejecting the application of Universal Builders, Inc. v. Moon Motor Lodge, Inc., 244 A.2d 10 (Pa. 1968) in the in pari delicto context). 12