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

On September 9, 2008, the United States Court of Appeals for the Third Circuit issued an opinion in Thabault v. Chait & PriceWaterhouseCoopers, LLP, 2008 U.S. App. LEXIS 19227.  The opinion is an interesting read for a number of reasons, but I want to focus on only one portion of the Court's ruling in this entry.  Specifically, the Third Circuit appears to have crafted a specific "auditor negligence exception" to the doctrines of imputation and  in pari delicto. 

In Thabault, the Receiver for Ambassador Insurance Company was pursuing claims against Arnold Chait, the former President and CEO of Ambassador, and PwC.  Predictably, the claims asserted included breach of fiduciary duty, negligent mismanagement, fraud, negligent misrepresentation and audit malpractice. 

PwC argued that the claims asserted against it should have been barred under the doctrine of in pari delicto.  More particularly, PWC asserted that Chait's improper conduct should have been imputed to Ambassador, which would necessarily trigger the in pari delicto doctrine and relieve PwC of liability.  As described in the Third Circuit's earlier opinion in Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 347, 358 (3d Cir. 2001), "under the law of imputation, courts impute the fraud of an officer to a corporation when the officer commits the fraud (1) in the course of his employment, and (2) for the benefit of the corporation."  As the Third Circuit described, the second prong of the imputation doctrine -- benefit to the corporation -- is analyzed under "adverse interest exception."  2008 U.S. App. LEXIS 19227 at *36-37.  In other words "fraudulent conduct will not be imputed if the officer's interests were adverse to the corporation and not for the benefit of the corporation."  Id. at *36.  And, if the agent is the "sole representative of a principal, then that agent's fraudulent conduct will be imputed to the principal regardless of whether the agent's conduct was adverse to the principal's interests."  Id. at *37.  This latter rule is known as the "sole actor doctrine."  

Thus, in determining if the imputation doctrine applied, the Third Circuit needed to determine if Chait was (a) acting in the course and scope of his employment when he committed wrongdoing; (b) if the wrongdoing benefited the company; and (c) if it did not benefit the company, was Chait the only agent of Ambassador. 

Unremarkably, the Third Circuit found that "Chait's conduct was committed in the course of his employment."  Id. at *38-39.  As a result, the Court was required to analyze whether Chait's actions benefited the company or if he was the "sole actor" for Ambassador. 

The Third Circuit ruled against PwC on both issues.  Specifically, the Thabault Court, relying on the New Jersey Supreme Court's ruling in NCP Litigation Trust v. KPMG, LLP, 901 A.2d 871, 888 (N.J. 2006), found that "Chait's conduct allowed Ambassador to continue past the point of insolvency, [and, therefore], his actions cannot be deemed to have benefited the corporation."  2008 U.S. App. LEXIS 19227 at *40 (emphasis added).  Thus, the adverse interest exception applied and precluded the court from imputing Chait's knowledge or wrongful conduct to the company.  Furthermore, the Third Circuit held that the "sole actor" doctrine was inapplicable because Chait was not the "sole shareholder of the corporation" and, as such, he did not dominate the corporation.  Id. at *41.

But the Third Circuit did not stop here.  Interestingly, the Thabault Court went on to "deem applicable the 'auditor negligence' exception recognized by the New Jersey Supreme Court in NCP, which explained 'that a claim for negligence may be brought on behalf of a corporation against the corporation's allegedly negligent third-party auditors for damages proximately caused by that negligence.'"  Id.  As the Third Circuit noted, "PwC was not a victim of Chait's fraud and allowing it to avoid liability by invoking the in pari delicto doctrine would not serve the purpose of the doctrine -- to protect the innocent."  Id.  The "auditor negligence exception" is premised on the notion that "one who contributed to the misconduct cannot invoke imputation" as a bar to liability.  NCP Litig. Trust, 901 A.2d at 882.  Because PwC was not a victim of the officer's fraud, and, in fact, likely contributed to it through their own negligent acts, permitting PwC to escape liability would affirmatively frustrate the purpose of the in pari delicto doctrine.

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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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