Posted by Kathy Bazoian Phelps
Although the Seventh Circuit recently vacated the dismissal of the trustee’s claim for negligence against an accounting firm, that court did not do the trustee any favors. In fact, the language in Peterson v. McGladrey & Pullen, 2012 U.S. App. LEXIS 6608 (7th Cir. April 3, 2012), is solidly against excusing a trustee from the in pari delicto doctrine. It is a backhanded slap against all trustees seeking to recover funds for the benefit of creditors of their estates where the debtor was a crook. The dismissal of the trustee’s claims was vacated, but the Seventh Circuit made clear that this was not because the in pari delicto doctrine did not apply to the trustee. The Seventh Circuit joined many other circuits in holding that a trustee’s claims are subject to the in pari delicto defense, even though a trustee acts for the benefit of the defrauded victims and not the wrongdoer.
The trustee in Peterson v. McGladrey & Pullen, joined by an amicus brief filed by the National Association of Bankruptcy Trustees, sought a ruling that the trustee is not barred by the in pari delicto doctrine. The Seventh Circuit restated the trustee’s position and summarily dismissed it as follows:
Section 541(a) provides that an estate in bankruptcy includes all of the debtor's "property", a word that comprises legal claims such as the one against McGladrey. "Property" normally is defined by state law--and in Illinois a claim for damages is limited by defenses such as in pari delicto. The Trustee and the Association want us to hold that a bankruptcy estate includes rights of recovery, stripped of their defenses. If in pari delicto is out, presumably the statute of limitations would be out too, or maybe even the defense of accord and satisfaction. As the Trustee and the Association see things, "public policy" favors greater recoveries for estates in bankruptcy, so that more money is available for distribution and so that wrongdoing by a corporation's "gatekeepers" (the accountants as well as Bell) may be deterred more effectively.
Neither the Trustee nor the Association identifies any provision of the Code that overrides state-law limits on the legal claims created by state law against the debtor's auditors. "Public policy" is not a ground on which the federal judiciary may create such a limit--not unless the Supreme Court first overrules Butner, Raleigh, and similar decisions. We therefore agree with the conclusion of every other court of appeals that has addressed this subject and hold that a person sued by a trustee in bankruptcy may assert the defense of in pari delicto, if the jurisdiction whose law creates the claim permits such a defense outside of bankruptcy.
The court remanded the action to the district court to determine whether the debtors’ principal knew of the Ponzi scheme during the time that the defendant auditor allegedly committed malpractice.
The debate over whether the in pari delicto doctrine should apply to an innocent trustee acting for the benefit of defrauded investors in a Ponzi scheme arises frequently in these cases. In my blog posted on February 22, 2012, I discussed the issues as they arose in the Madoff case when Irving Picard’s claims against JP Morgan and other banks were dismissed on these grounds, among others. JP Morgan just filed its brief in opposition to Irving Picard’s appeal to the Second Circuit asking the Second Circuit to affirm the lower court’s ruling that Picard’s claims are barred by the doctrine of in pari delicto, among other things. A copy of JP Morgan’s brief is available here.
On the issue of in pari delicto, JP Morgan relies heavily on the Wagoner Rule in the Second Circuit in asking the court to affirm the lower court’s ruling dismissing Picard’s claims. JP Morgan argues in its opposition:
Under this doctrine - known as the “Wagoner rule” - “when a bankrupt corporation has joined with a third party in defrauding its creditors, the trustee cannot recover against the third party for the damage to the creditors.” Id. at 118; accord Kirschner v. Grant Thornton LLP, 2009 WL 1286326, at *10 (S.D.N.Y. Apr. 14, 2009) (Lynch, J.), aff’d, 626 F.3d 673 (2d Cir. 2010) (applying Wagoner rule to dismiss fraud and breach of fiduciary claims where the debtor “participated in, and benefitted from, the very wrong for which it seeks to recover”); Breeden v. Kirkpatrick & Lockhart LLP (In re Bennett Funding Grp., Inc.), 336 F.3d 94, 99- 100 (2d Cir. 2003) (applying Wagoner rule to prevent trustee for Ponzi scheme operator from bringing malpractice claims); Hirsch, 72 F.3d at 1094-95 (same).
The Wagoner rule is related to the state-law doctrine of in pari delicto. The rule “derives from the fundamental principle of agency that the misconduct of managers within the scope of their employment will normally be imputed to the corporation.” Wight v. BankAmerica Corp., 219 F.3d 79, 86-87 (2d Cir. 2000). “[B]ecause a trustee stands in the shoes of the corporation, the Wagoner rule bars a trustee from suing to recover for a wrong that he himself essentially took part in.” Id. at 87; see also Kirschner v. KPMG LLP, 15 N.Y.3d Case: 11-5044 Document: 110 Page: 35 04/05/2012 572673 91 -23- 446, 464 (2010) (“The doctrine of in pari delicto mandates that the courts will not intercede to resolve a dispute between two wrongdoers.”).
In this case, the Wagoner rule and the doctrine of in pari delicto plainly prevent the Trustee from bringing claims as successor to BMIS.
The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes dedicates an entire chapter to the subject of in pari delicto, which is an important defense to block multi-million and multi-billion dollar claims in Ponzi cases.