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Standing and In Pari Delicto Issues Arising in Bankruptcy Cases

1.  Introduction

Corporate and managerial fraud is pervasive in today’s economic climate. When fraud leaves a company insolvent and forced to seek protection under the Bankruptcy Code, oftentimes bankruptcy trustees commence legal actions against attorneys to generate recoveries for the benefit of the debtor’s estate. A common scenario goes something like this: A company is in dire financial straits before the fraud or is created as a vehicle for the fraud. The defendant is the corporation’s attorney, who assists the corporation in the fraud. The attorney is hired to ensure the company’s compliance with existing law. The attorney does the bidding of the company’s management in pursuance of their fraud. After the company’s collapse, the bankruptcy trustee sues the attorney for fraud, aiding and abetting fraud and legal malpractice.

Drawing upon the equitable defense that bars recovery by a plaintiff bearing fault with the defendant for the alleged harm, common law principles of agency imputation, and the Constitutional requirement that a plaintiff has standing to sue, a defendant may move to dismiss the lawsuit on the grounds that the bankruptcy trustee lacks standing to sue.

This Note provides an analysis of the issue whether the bankruptcy trustee has standing to bring a suit on behalf of the debtor corporation against attorneys who allegedly helped that corporation's management with the fraud.

2.  The In Pari Delicto Doctrine

a) Background

In pari delicto means “at equal fault.” It is a broadly recognized equitable principle and common law defense that prevents a plaintiff who has participated in wrongdoing from recovering damages resulting from the wrongdoing.[1] The policy behind this doctrine is to prevent one joint wrongdoer from suing another for damages that resulted from their shared wrongdoing.[2] Therefore, if a bankruptcy trustee brings a claim against an attorney on behalf of the corporation, and if the corporation is involved in the corporation’s wrongful conduct which serves as the basis for the claim, the in pari delicto may bar the claim.

The use of the doctrine against bankruptcy trustees emerged in the wave of corporate frauds in the last few decades. This novel application required the introduction of an important new element: agency law. Under agency principles, if the principal acted wrongfully through an agent in the scope of that agency relationship, then the wrongdoing of the agent is attributed to the principal.  Because the acts of corporate managers in the course of their employment are imputed to the corporation, and because a bankruptcy trustee “stands in the shoes” of a debtor corporation, the fraudulent acts of the debtor’s former managers will be imputed to the trustee—unless the trustee can show that management was acting entirely on its own interests and “totally abandoned” those of the corporation to break the chain of imputation.[3]

An analysis of the equitable defense in pari delicto at issue is separable from a standing analysis.[4] “Whether a party has standing to bring claims and whether a party’s claims are barred by an equitable defense are two separate questions, to be addressed on their own terms.”[5]   

b)  The Second Circuit’s Approach

In Shearson Lehman Hutton Inc. v. Wagoner, 944 F.2d 114 (2d Cir. 1991), the Second Circuit adopted the controversial approach of treating in pari delicto as a question of standing rather than an affirmative defense. Specifically, the standing analysis in the Second Circuit begins with the issue of whether the trustee can demonstrate that the third party professional injured the debtor in a manner distinct from injuries suffered by the debtor's creditors.[6] In many jurisdictions, the question of the trustee’s standing ends here.[7] In Wagoner, the Second Circuit went further and added a second inquiry that incorporates the equitable defense of in pari delicto.[8] By combining these two issues, the Wagoner rule blends the in pari delicto question into a rule of standing.

In Wagoner, the sole stockholder, director, and president of a corporation had used the proceeds of notes to finance fraudulent stock trading.[9] After the corporation became insolvent, the trustee brought claims against the defendant, an investment bank, for breach of fiduciary duty in allowing the company's president to engage in inappropriate transactions.[10] The court held that because the president participated in the alleged misconduct, his misconduct must be imputed to the corporation and the bankruptcy trustee. This rationale derives from the agency principle that underlies the application of in pari delicto to corporate litigants: the misconduct of managers within the scope of their employment will normally be imputed to the corporation.[11] The court ruled that the trustee lacked standing to sue the investment bank for aiding and abetting the president’s alleged unlawful activity.[12] By adopting the Wagoner rule, the Second Circuit upped the ante by making an equitable defense a threshold question of standing at the motion-to-dismiss stage, rather than an affirmative defense better resolved on summary judgment or at trial.

c)  Approaches of Other Circuits

Although the Wagoner rule still prevails in the Second Circuit, a majority of other courts have declined to follow it, including the First, Third, Fifth, Eighth, Ninth and Eleventh Circuits. These circuits have “declined to conflate the constitutional standing doctrine with the in pari delicto defense.”[13] “Even if an in pari delicto defense appears on the face of the complaint, it does not deprive the trustee of constitutional standing to assert the claim, though the defense may be fatal to the claim.”[14]

The Eighth Circuit held that in pari delicto cannot be used at the dismissal stage.[15] On a motion to dismiss, the court is generally limited to considering the allegations in the complaint, which the court assumes to be true in ruling on the motion.[16] Because in pari delicto is an affirmative defense requiring proof of facts that the defendant asserts, it is usually not an appropriate ground for early dismissal.[17] An in pari delicto defense may be successfully asserted at the pleading stage only where “the facts establishing the defense are: (1) definitively ascertainable from the complaint and other allowable sources of information, and (2) sufficient to establish the affirmative defense with certitude.”[18] Thus, the in pari delicto defense is generally premature at this stage of the litigation, and the court must deny the motion to dismiss.

The existence of a possible defense does not affect the question of standing.[19] Standing is a constitutional question, and all a plaintiff must show is that they have suffered an injury that is fairly traceable to the defendant’s conduct and that the requested relief will likely redress the alleged injury.  In this matter, the First, Third, Fifth, Eighth, and Eleventh Circuits’ approach is more convincing. Those courts hold that whether a trustee has standing to bring a claim and whether the claim is barred by the equitable defense of in pari delicto are two separate questions and that the in pari delicto defense is appropriately set forth in responsive pleadings and the subject of motions for summary judgment and trial.    

3.  Standing Issues The Trustees Face 

a)  Background

The next question is whether the bankruptcy trustee fulfills the constitutional requirement of standing. Article III specifies three constitutional requirements for standing. First, the plaintiff must allege that he has suffered or will imminently suffer an injury. Second, he must allege that the injury is traceable to the defendant's conduct. Third, the plaintiff must show that a favorable federal court decision is likely to redress the injury.[20]

A critical issue in evaluating whether a trustee or receiver has standing to sue is whether the claim belongs to the corporate debtor entity or to the individual investors of the corporate debtor. The Supreme Court held in Caplin v. Marine Midland Grace Trust Co. of New York, 406 U.S. 416, 433-34 (1972), that a bankruptcy trustee has standing to represent only the interests of the debtor corporation and does not have standing to pursue claims for damages against a third party on behalf of one creditor or a group of creditors. Although the line is not always clear between the debtor's claims, which a trustee has statutory authority to assert, and claims of creditors, which Caplin bars the trustee from pursuing, the focus of the inquiry is on whether the trustee is seeking to redress injuries to the debtor that defendants' alleged conduct caused.[21]  

b)  The Shifting Focus of the Second Circuit

In Wagoner, the Second Circuit held that the corporation and the trustee did not have standing to bring a claim because a “claim against a third party for defrauding a corporation with the cooperation of management accrues to creditors, not to the guilty corporation.”[22] The rationale for this rule is “though a class of creditors has suffered harm, the corporation itself has not.”[23] Without cognizable injury, the trustee representing the debtor corporation failed to meet the constitutional standing requirement.

Commentators have criticized the Wagoner rule that there is no separate injury to the corporation on several grounds. First, the court's finding that a corporation is not harmed when its assets are squandered effectively ignores the existence of the corporation during the bankruptcy process.[24] Furthermore, the Wagoner court seems to acknowledge the trustee's right to sue the guilty managers for damages done to the corporation. Such a construction leads to the absurd result that when management and its accomplices defraud a corporation, management can be sued on behalf of the corporation for the harm caused to the corporation, but the accomplices cannot be sued on behalf of the corporation because the corporation was not harmed.[25] Recognizing the faults of this rule, the Second Circuit recognized that there was “at least a theoretical possibility of some independent financial injury to the debtors” as a result of the defendant’s aid in the fraud.[26] Nevertheless, the court denied the plaintiff’s standing, relying on the observation that any damage suffered by the debtor was passed on to the investors, and “there was likely to be little significant injury that accrues separately to the Debtors.”[27] In other words, most of the alleged injuries in Hirsch were suffered by third parties, not by the debtors themselves. The Second Circuit shifted the focus of the Wagoner rule from lack-of-separate-injury (the first inquiry of the Wagoner rule) to the in pari delicto (the second inquiry) in Breeden v. Kirkpatrick & Lockhart LLP, 336 F.3d 94 (2d Cir. 2003). In that case, the court denied the trustee standing, holding that even if there was damage to the corporation, the trustee lacked standing because of the debtor’s collaboration with the corporate insiders.[28]   

c)  Approaches of Other Circuits

In Lafferty, the creditors' committee brought an action against the debtor's officers, directors and outside professionals, alleging that through participation in a fraudulent Ponzi scheme, the defendants wrongfully prolonged the debtor's life and incurred debt beyond the debtor's ability to pay, ultimately forcing the debtor into bankruptcy.[29] The Lafferty court articulated different kinds of harms to the corporation: (1) fraudulent or wrongful prolongation of an insolvent corporation's life, (2) prolongation that causes the corporation to incur more debt and become more insolvent, and (3) diminution of corporate value had prolongation not occurred.[30] Recognizing that conduct driving a corporation deeper into debt injures not only the corporate creditors, but the corporation itself, the Third Circuit held the committee had standing to sue the outsiders on behalf of the debtor.[31] The court also noted that although the Tenth and Sixth Circuits had applied the in pari delicto doctrine to bar claims of a bankruptcy trustee, those courts assumed that the bankruptcy trustee at least has standing to bring the claim.[32]

The Eighth Circuit held that a trustee who had alleged sufficient injury traceable to the actions of the defendants had standing to sue.[33] The court held that the defendant law firm and attorneys participated in stripping the corporation's assets and that the injury was traceable to the activities of the lawyers who engineered the transaction to the detriment of their client.[34] In addition, the Eighth Circuit noted that the Third Circuit in Lafferty and the Ninth Circuit (in Smith v. Arthur Andersen LLP 421 F.3d at 1004) rejected the argument that a cause of action for harm to an insolvent corporation belongs to the creditors rather than the corporation. The Eighth Circuit adopted the rationale of Lafferty that simply because the creditors may be the beneficiary of recovery does not transform an action into a suit by the creditors.[35]

The Ninth Circuit found that the trustee had standing to pursue breach of contracts and duties against attorneys, auditors and investment bankers where, if defendants had not concealed the financial condition of debtor, the debtor might have filed for bankruptcy sooner and additional assets might not have been spent on a failing business.[36] “This allegedly wrongful expenditure of corporate assets qualifies as an injury to the firm which is sufficient to confer standing upon the Trustee.”[37] The court stated that “We rely only on the dissipation of assets in reaching the conclusion that the debtor was harmed.”[38] “A receiver has standing to bring a suit on behalf of the debtor corporation against third parties who allegedly helped that corporation's management harm the corporation.”[39]

To sum up, when a director or officer enlists the help of attorneys to misstate the financial health of a company, it causes significant harm to a corporation. Harms include: (1) the fraudulent and concealed accrual of debt which can lessen the value of corporate property, (2) legal and administrative costs of bankruptcy, (3) operational limitations on profitability, (4) the undermining of business relationships, and (4) failed corporate confidence.

If court were to afford standing to trustee, third parties would be deterred from negligent, reckless, or other wrongful behavior. It will provide a means for increasing attorneys' liability for the wrongs they commit. While limitless liability for attorneys is not the solution, increasing liability will require attorneys to answer in court when they fail to detect fraud or manipulation on the part of directors and officers that a reasonable attorney would discover.

4.  Conclusion

Attorneys are equipped with the tools to prevent fraud. An attorney may always report fraud to the appropriate authority or refuse to participate in the fraud. However, attorneys may not want to jeopardize important client relationships unless the consequence of inaction makes reporting more beneficial. Given the turmoil of the financial markets since 2008, increased liability for attorneys could help alleviate corporate fraud and bolster consumer confidence in this distressed market.  

For the above reasons, the bankruptcy trustee has standing to bring a suit on behalf of the debtor corporation against attorneys who allegedly helped that corporation's management with the fraud.

[1] Terlecky v. Hurd (In re Dublin Sec., Inc.), 133 F.3d 377, 380 (6th Cir.1997).

[2] In re Parmalat Sec. Litig., 383 F. Supp. 2d 587, 596 (S.D.N.Y. 2005).

[3] Wight v. Bank American Corp., 219 F.3d 79, 87 (2d Cir. 2000).

[4] See generally Jeffrey Davis, Ending the Nonsense: the In Pari Delicto Doctrine Has Nothing to Do with What is Section 541 Property of the Bankruptcy Estate, 21 Emory Bankr.Dev. J. 519 (2005); Gerald L. Baldwin, In Pari Delicto Should Not Bar a Trustee's Recovery, 23-8 Am. Bankr.Inst. J. 8 (2004); Tanvir Alam, Fraudulent Advisors Exploit Confusion in The Bankruptcy Code: How In Pari Delicto Has Been Perverted To Prevent Recovery for Innocent Creditors, 77 Am. Bank. L.J. 305 (2003); Robert T. Kugler, The Role of Imputation and In Pari Delicto in Barring Claims Against Third Parties, 1 No. 14 Andrews Bankr.Litig. Rep. 13 (2004); Making Sense of the In Pari Delicto Defense: “Who's Zoomin' Who?” 23 No. 11 Bankr. Law Letter 1 (Nov.2003).

[5] Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co.,267 F.3d 340, 346-47 (3d Cir.2001).

[6] Wagoner, 944 F.2d at 118.

[7] R.F. Lafferty & Co., 267 F.3d at 340.

[8] Wagoner, 944 F.2d at 118.

[9] Id. at 116.

[10] Id. at 116-17.

[11] Wight, 219 F.3d at 86.

[12] Wagoner, 944 F.2d at 120.

[13] In re Senior Cottages of America LLC, 482 F.3d 997, 1003 (8th Cir. 2007) (collecting cases).

[14] Id. at 1004.

[15] Id. at 1002.

[16] Wilchombe v. Tee Vee Toons. Inc., 555 F.3d 949, 959 (11th Cir. 2009).

[17] Knauer v. Jonathon Roberts Financial Group, Inc., 348 F.3d 230, 237 n. 6 (7th Cir. 2003).

[18] Gray v. Evercore Restructuring, LLC, 544 F.3d 320, 325 (1st Cir. 2008).

[19] Novartis Seeds, Inc. v. Monsanto Co., 190 F.3d 868, 872 (8th Cir. 1999).

[20] Allen v. Wright, 468 U.S. 737, 756-58 (1984).

[21] Smith v. Arthur Andersen, LLP, 421 F.3d 989, 1002 (9th Cir. 2005).

[22] Wagoner, 944 F.2d at 120.

[23] Id.

[24] 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. Dev. J. 519, 525 (2005).

[25] Id. at 527.

[26] Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, 1087 (2d Cir. 1995).

[27] Id.

[28] Id. at 100.

[29] Lafferty Co., 267 F.3d at 348-49.

[30] Id.

[31] Id. at 354.

[32] Id. at 358. 

[33] In re Senior Cottages Of America, LLC, 482 F.3d 997.

[34] Id.

[35] Id. at 1001.

[36] Smith v. Arthur Andersen, LLP, 421 F.3d at 1003 (9th Cir. 2005).

[37] Id.

[38] Id. at 1004.

[39] Id.

© Copyright 2022 Rui LiNational Law Review, Volume I, Number 152

About this Author

Rui Li is a second-year law student at University of Iowa College of Law.

Rui Li is a second-year law student at University of Iowa College of Law. He graduated from Renmin University of China with a bachelor degree in law. He served as an extern at the Wisconsin Supreme Court and the U.S. District Court for Northern District of Iowa.