Plano Texas Bankruptcy Lawyer & Attorney : Sean McCaffity : Rochelle Hutcheson & McCullough Law Firm : Insolvency, Creditors Rights

On May 5, 2008, the United States District Court for the Southern District of New York issued an interesting opinion in Adelphia Recovery Trust v. Bank of America, N.A., 2008 U.S. Dist. LEXIS 36553 (S.D.N.Y. May 5, 2008).  This opinion is written in response to a Motion for Reconsideration and further elaborates on an earlier decision largely affirming the Bankruptcy Court's rulings on the Defendants' Rule 12(b)(6) motions.

This opinion further elaborates on a discussion by the Bankruptcy Court concerning the construction of 11 U.S.C. 541 and that provisions interplay with the equitable defense of in pari delicto.  Specifically, the Defendants argued, relying principally on the Second Circuit's opinion in Official Committee of Unsecured Creditors of Color Tile, Inc. v. Coopers & Lybrand, LLP, 322 F.3d 147 (2d. Cir. 2003), that a court could not take into account "post-petition" events when determining the equitable application of the in pari delicto defense.  As a result, the Defendants argued that post-petition events, such as the appointment of a bankruptcy trustee and the removal of miscreant management, could not be used to support an "innocent successor" exception to the in pari delicto defense.  Defendants argued that Color Tile is binding authority that when facts alleged in a plaintiff's complaint affirmatively establish the in pari delicto defense, the Court must dismiss.

The District Court rejected this argument and found that the Bankruptcy Court was correct in its construction of 11 U.S.C. 541 and that the Bankruptcy Court's application of the Fifth Circuit's decision in Matter of Educators Group Health Trust, 25 F.3d 1281 (5th Cir. 1994) was more persuasive on the issue of the construction of 11 U.S.C. 541.  The Court sidestepped Color Tile  by noting that it was a case dealing with the pleading standards under Rule 12 and did not address the construction of 11 U.S.C. 541. 

Interestingly, the District Court generally accepted the Third Circuit's construction of Pennsylvania's law surrounding the in pari delicto defense in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. 267 F.3d 340 (3rd Cir. 2001).  But rejected Lafferty's construction of 11 U.S.C. 541 when applying the defense of in pari delicto.  In fact, the Court determined that the Bankruptcy Court's and the Fifth Circuit's construction of 11 U.S.C. 541 was more persuasive than Lafferty and, ultimately, would permit the consideration of "post-petition" events in applying the in pari delicto defense in the absence of controlling Second Circuit authority on the issue.

The Bankruptcy Court, applying Educators Group Health Trust from the Fifth Circuit, noted that 11 U.S.C. 541 determines what assets or causes of action a debtor-in-possession or trustee may have at the commencement of a case, but does not address what equitable defenses may exist with respect to those claims.  Thus, the question of in pari delicto's ultimate applicablity is not addressed by 11 U.S.C. 541.  The Bankruptcy Court quoted at length from the Fifth Circuit's opinion, including the following important passage:

"It is well-established that the bankruptcy estate succeeds to the causes of action which the debtor could have brought as of the commencement of the case, subject to any defenses the debtor may have faced.  11 U.S.C. 541(a)(1).  However, the plaintiff school districts fail to cite, and we cannot find, any support for the proposition that a defense on the merits of a claim brought by the debtor precludes the debtor from bringing the claim. That the defendant may have a valid defense on the merits of a claim brought by the debtor goes to the resolution of the claim, and not to the ability of the debtor to assert the claim. The latter, of course, determines what is, or is not, property of the bankruptcy estate." 

25 F.3d at 1286.

For bankruptcy trustee's continually beating their heads against the proverbial wall when dealing with defendants asserting the imputation defense, this opinion may be helpful in establishing an "innocent succesor" exception.

Caution is warranted, however.  How significant the Court's actual opinion may be is debateable because the Court ultimately ruled that the replacement of guilty management with an innocent successor sufficient to defeat the in pari delicto defense actually occurred "pre-petition" in this particular case. 

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A common defense that virtually every bankruptcy trustee or receiver must deal with when suing culpable third parties is the affirmative defense of in pari delicto.  The Southern District of Georgia recently issued an opinion dealing with the defense in the context of a Chapter 11 bankruptcy proceeding.  See In re:  Friedman's Inc., 2008 U.S. Dist. LEXIS 31262 (S.D. Ga. April 16, 2008).  Friedman's, Inc. was a large jewelry store chain that collapsed into Chapter 11 in 2005.  As part of the bankruptcy, the "Friedman's Creditor Trust" was created and the Trustee, on behalf of the creditor trust, filed an adversary proceeding against Friedman's former directors, officers, controlling shareholder and attorneys (Alston & Bird).  The opinion is worth reading for a whole host of reasons, but I am highlighting it because of the Court's discussion of the in pari delicto defense. 

Specifically, Alston & Bird argued that the defense of in pari delicto barred the trustee's claims because the "Trustee cannot pursue others on behalf of the company for victimizing the company, since the company is said to have victimized itself."  Id. at *10.  The Trustee argued the "adverse interest exception" applied in this case because the "company's agents have acted entirely adverse to the company."  Id. 

In arguing against the "adverse interest exception," Alston & Bird made an argument commonly made by defendants asserting the in pari delicto defense.  Namely, the Trustee cannot prevail on the adverse interest exception because it cannot be established that the agents were acting "entirely adverse" to the company.  In other words, if there was any benefit (short term or long term) to the company, then the agents were acting at least partially for the company and their knowledge or actions should be imputed to the corporate enterprise.  See id. at *13-14.  Specifically, Alston & Bird argued that Friedman's received the benefits of "stock, promissory notes, and improvement of its balance sheet" from the alleged fraudulent acts of its directors and officers and, thus, the "adverse interest exception" should have been denied as a matter of law.  Id. at 14.

The Court rejected this notion and made a couple of points worth noting.  First, the Court noted that, under Georgia law, in pari delicto is an equitable doctrine and that Georgia courts have historically exercised their equitable powers to bar the use of equitable defenses where the result would be harm to innocent third parties, such as creditors.  As the Court noted, "this is so because the doctrine of in pari delicto is based on the principle that to give the plaintiff relief would contravene public morals and impair the good of society.  Hence, it should not be applied in a case in which to withhold relief would, to a greater extent, offend public morals."  Id. at *16.  A broader "creditor exception" to the in pari delicto defense, perhaps?  It certainly makes sense and it would not be the first time a court has refused to apply this equitable defense in such a context.  See e.g., Scholes v. Lehman, 56 F.3d 750, 754 (7th Cir. 1995); Welt v. Sirmans, 3 F. Supp. 2d 1396 (S.D. Fla. 1997)

Second, the Court noted that the application of in pari delicto is a "fact intensive inquiry done on a case by case basis" and that the "entire theory of the Trustee's case is that certain directors and officers of Friedman's were acting against the interests of the corporation and solely for their own personal interests."  Id. at *17. 

Third, the Court found that "equitable considerations counsel against [in pari delicto's] application as well."  Id.  Significantly, the Court found that the $35 million in notes and $50 million in stock that Friedman's received in the allegedly fraudulent transactions were "essentially worthless paper" and that "Friedman's received no real benefit to this exchange."  Id. at *18.  The Court would not impute knowledge of the directors and officers to the corporation "where under the facts, there is no actual benefit to the corporation."  Id.

The Court did note that Alston & Bird was free to continue litigating the defense and that discovery may show that Friedman's directors were acting "on behalf of Friedman's."  Id. at *18 n.8.  At the conclusion of the opinion, however, the Court noted that "just prior to issuing this opinion," it was informed of a settlement between Alston & Bird and the Trustee.

The Court also has an interesting discussion concerning the "sole actor rule" (which is an exception to the adverse interest exception) and the so-called "innocent director" exception (which has been argued in some courts as an independent exception to in pari delicto).  The Court does appear to reject the "innocent director" rule as an independent exception to imputation of knowledge, but relies on the facts of the Friedman's case (i.e., a special committee of independent directors had been appointed to review the alleged fraudulent transactions) to find the innocent decisionmakers defeated the application of the "sole actor rule."

Interesting reading and a must read for any plaintiff's attorney representing bankruptcy trustees, receivers or creditor committees.

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