In Pari Delicto: “At Equal Fault” Defense Explained

In Pari Delicto: “At Equal Fault” Defense Explained
Written by:
Emily Stone
University of Miami School of Law; Miami
emilyrstone@gmail.com
Emily Horowitz
University of Miami School of Law; Miami
ehorowitz@law.miami.edu
W
ith a rise in the number of discovered Ponzi schemes and
bankruptcy filings has come a
growth in the number of in pari delicto
defenses.1 Over the past decade, a number of courts have been asked to consider
in what circumstances and to what extent
an in pari delicto defense should prevail.
This article explores two cases that are
on opposite sides of the discussion of
when in pari delicto should succeed as a
defense and discusses the future implications of these decisions.
First-of-a-Kind Victory
Deloitte’s Successful In Pari Delicto
Defense in USACM
A recent successful
use of in pari delicto as a defense in a
fraudulent-transfer
adversary occurred
in In USACM
Liquidating Trust
and USA Capital
Diversified Trust
Deed Fund LLC v.
Emily Horowitz
Deloitte & Touche
LLP, et al. 2 The defendant, Deloitte
& Touche, asserted in pari delicto in
1 The doctrine of in pari delicto, meaning “at equal fault,” provides that
a plaintiff may not assert a claim against a defendant if the plaintiff
bears fault for the claim. Official Comm. of Unsecured Creditors v. R.F.
Lafferty & Co., 267 F.3d 340, 354 (3d Cir. 2001). In pari delicto is used
in bankruptcy as an equitable defense against adversary claims made
by a trustee asserting that if a bankrupt company is responsible for
wrongdoing, that company should not be able to recover from the claim.
The underlying policy of in pari delicto is that courts should not become
involved in dispute resolution between wrongdoers. Instead, wrongdoers should be left to deal with the consequences. The doctrine has been
likened to the doctrine of unclean hands, which similarly stands for the
proposition that a plaintiff may not obtain an equitable remedy from
a defendant if that plaintiff has brought the suit with unclean hands.
In pari delicto is subject to a number of exceptions, two of which are
considered frequently and discussed in this article. Under the innocentinsider exception, courts hesitate to impute the actions of agents aiding
and abetting a fraud where there was at a minimum one decision-maker among the company’s shareholders and/or managers who was uninvolved in the furtherance of the fraud and could have reasonably put a
stop to it. In re CBI Holding Co. Inc., 247 B.R. 341, 365 (Bankr. S.D.N.Y.
2000). A longer-standing exception, the adverse-interest exception,
states that a court will not impute the actions of an agent to the principal where the agent defrauded the principal exclusively for that agent’s
own benefit. Its exception is subject to two exceptions itself. First, under
the sole-actor exception, where the agent is “self-dealing,” the knowledge of the fraud will be imputed notwithstanding the adverse interests
if “the party that should have been informed was the agent itself albeit
in its capacity as princip[al].” Breeden v. Kirkpatrick & Lockhart LLP,
336 F.3d 94, 100 (2d Cir. 2003). Next, according to the ratification
exception, where the agent is not the principal, the actions of the agent
will be imputed to the principal if the principal has allowed the agent’s
actions to continue or has consented to the actions of the agent.
2 USACM Liquidating Trust and USA Capital Diversified Trust Deed Fund
LLC v. Deloitte & Touche LLP, et al., No. 2:08-CV-00461-PMP-PAL,
2011 WL 570026 (D. Nev. Feb. 16, 2011).
54 June 2011
About the Authors
Emily Stone and Emily Horowitz are
law students at the University of Miami
School of Law in Miami.
response to a fraudulent-transfer claim of
aiding and abetting a breach of fiduciary
duty, asserted by the liquidating trust
created by the debtor’s reorganization
plan.3 The trust had the right to enforce
the debtor’s causes of action.
Deloitte served as an auditor for
USACM, a Nevada corporation that
functioned as a mortgage loan originator and loan servicer for its own originated loans.4 From 1998-2001, Deloitte
performed fiscal year-end audits of
USACM, providing unqualified audit
opinions and certifying that the company’s financial statements were fairly
stated. 5 USACM caught the attention
of the Nevada Financial Institutions
Division, a state regulatory agency,
for various deficiencies for which the
company was fined in 1999, 2000 and
Deloitte asserted an in pari delicto
defense to the fraudulent-transfer claims
of the trust. The fraudulent transfers
were based on tort claims possessed
by the debtor for malpractice and aiding and abetting of Deloitte against the
debtor before the debtor company filed
for bankruptcy.
Deloitte argued that the trust should
not be able to bring a suit as the successor in interest to USACM because the
agents’ criminal conduct and knowledge should be imputed to USACM.
Therefore, Deloitte claimed that
“USACM cannot sue Deloitte for failing to stop USACM from engaging in its
own fraudulent conduct.”11 Bankruptcy
law affords a trustee expansive powers
executable on behalf of an estate; however, 11 U.S.C. § 541(a) clearly states
that the estate is comprised of “all legal
or equitable interests of the debtor in
property as of the commencement of
the case.”12 As such, the trustee (in this
case, the trust) steps into the debtor’s
shoes. In moving for summary judgment,
Student Gallery
2001. 6 USACM ultimately filed for
bankruptcy in April 2006.7
In conjunction with USAIP, a land
acquisition holding company, and
two investment funds, USACM was
run by Thomas Hantges and Joseph
Milanowski. Until USACM’s demise,
Hantges and Milanowski “never owned
less than [83] percent of USACM’s
stock.”8 Hantges and Milanowski regularly transferred large sums of money
from USACM to their other entities with
neither business reasons to do so nor any
benefit to USACM.9 After USACM filed
for bankruptcy, it was discovered that
Hantges and Milanowski were operating
a Ponzi scheme by using new investor
funds to make payments owed to prior
investors. When loan defaults became
increasingly more frequent and the funds
from new investors could not cover payments to lenders, the scheme collapsed.10
3
4
5
6
7
8
9
10
Id. at *1.
Id. at *2.
Id. at *1.
Id. at *4
Id.
Id. at *2.
Id. at *3.
Id. at *3.
Deloitte argued that imputation of the
acts and knowledge of the agents would
bar the debtor company and subsequently the trustee who stands in the shoes
of the debtor company. 13 Therefore,
under Deloitte’s theory, Hantges and
Milanowski would be barred by in pari
delicto for their fraudulent acts by being
equally at fault for the fraud, if not more,
than Deloitte.
While the trust argued that the
innocent-insider exception could apply
to minority shareholders, a third board
member who was described as a figurehead, and perhaps even to their attorney
who had a signatory power, the court
rejected each attempted application of
this exception, reasoning that none of
these people possessed the requisite control or power to have stopped the fraud
from occurring. The court further stated
that allowing whistleblowers or persons
who could perform whistleblowing acts
to qualify for the innocent-insider exception would nullify the exception’s very
11 Id. at *4.
12 11 U.S.C. § 541(a) (emphasis added).
13 Id. at *4.
ABI Journal
purpose. Likewise, the court reasoned
that the utilization of a governmental
entities’ power to stop the fraudulent
behavior is not the same as the actor possessing the power himself or herself.14
The court then conducted an analysis
to determine whether Nevada law would
call for imputation of the criminal acts
and knowledge of the agents onto the
corporation. The court concluded that
if the acting agents are the sole relevant
actors for the principal, then the acts of
those agents would be imputed to the
company. As a fallback position, the trust
argued for the adverse-interest exception,
but the court rejected this argument, concluding that it did not apply because the
sole relevant actors were responsible for
the fraudulent behavior. In the instant
case, the court determined that Hantges
and Milanowski were acting within the
course of their employment and the
scope of their authority in addition to
being the sole relevant actors.15
After the court concluded that
imputation was proper, it entertained
Deloitte’s in pari delicto defense. The
issue became whether the debtor was in
equal fault with Deloitte. If Deloitte was
found to be less culpable than the debtor,
the in pari delicto defense would stand,
equitably barring the debtor’s claim.
Ultimately, with no one having authority to override the decisions of Hantges
and Milanowski, the debtor, through its
agents, was found to have been more at
fault than Deloitte.16
An Inapplicable Defense
Who Is In Pari Delicto? I Don’t See
Anyone.…
More than a decade earlier, the
Seventh Circuit addressed the in pari
delicto defense in Scholes v. Lehmann.17
In this case, a receiver, appointed by the
Securities and Exchange Commission
(SEC), sued the ex-wife/transferee of
a Ponzi scheme. The Ponzi scheme
mastermind, Michael Douglas, created
multiple corporations that sold general
partnership interests between investors and corporations. Earlier investors
were paid their promised returns from
new investor cash flow. The scheme
was eventually discovered, and the
SEC filed suit against the principal of
the corporations, requesting the establishment of a receivership.
The receiver proceeded to initiate fraudulent-transfer lawsuits against
14
15
16
17
Id. at *16.
Id. at *10-11.
Id. at *17-19.
Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995).
ABI Journal
many insiders and friends of Douglas
and eventually met with a defense of in
pari delicto in the Lehmann case. The
defense argued that the receiver lacked
standing to bring suit for the fraudulent
transfer because it only possessed the
interests that the company would have
otherwise had to sue on the company’s
own tort claims on the company’s behalf.
The defense added that there was no way
that the transfers, for which the trustee
was suing, could have hurt the debtor
because the debtor was one in the same
as Douglas, and he orchestrated the
transfers and owned all of the stock.
In sharp contrast to the Nevada
District Court, the Seventh Circuit
rejected the defendant’s in pari delicto
argument, framing the type of fraudulent-transfer action at issue differently.
The court categorized the action as one
being asserted by the receiver on behalf
not of the debtor, but of the creditors
who would have otherwise had actions
for fraudulent transfers against the transferees. It further explained that once the
receiver was appointed, Douglas was
stripped of control and beneficial interest, and “the corporations were no more
Douglas’ evil zombies.”18 The court reasoned that because in pari delicto serves
no purpose when the person who would
have been in pari delicto is removed
from the situation, the defense failed.
Where Do We Go from Here?
Will USACM Survive on Appeal?
The trustee has appealed the district court’s application of the in pari
delicto defense in USACM.19 The case
is currently pending before the Ninth
Circuit. While scholars and practitioners
speculate that the implications of the
USACM decision may be far-reaching
and detrimental to trustees in the area
of fraudulent-transfer law, this assertion
may be overstating the consequences of
the case. In order to effectively use in
pari delicto as a defense, a defendant
must be able to not only impute the bad
acts, but also prove that debtor was, at
the very least, equally responsible for
the fraudulent acts.
The facts in USACM lend themselves well to this defense because
imputation in a situation where a
closely-held business that was run by
its shareholders who also happen to
compose the majority of the board of
directors and management leaves no
other line of defense between the actors
18 Id. at 754.
19 USACM Liquidating Trust v. Deloitte & Touche LLP, Case No. 11-15626
(9th Cir., filed March 15, 2011).
and the principal company. Therefore,
the line between actor and principal
is transparent. This transparency adds
strength to the district court’s conclusion that the sole-relevant-actor exception did not apply. Furthermore, the
actor’s intentional creation and continued maintenance of a Ponzi scheme far
outweighed Deloitte’s professional malpractice and any purported aiding and
abetting in which they may have participated. This reasoning is especially
important in this “type” of fraudulenttransfer case because these were tort
actions on behalf of the debtor company
for damages caused to the debtor company by the party being sued.
An evaluation of the Seventh
Circuit’s analysis in Scholes demonstrates that the analysis of in pari
delicto will always be fact-intensive in
nature. Yet, the facts of the two cases
are very similar. The debtor-company in
USACM was a closely-held corporation
being used for a Ponzi scheme masterminded by the very persons who owned
the company, as was the company in the
Seventh Circuit case that was placed
into receivership by the SEC, yet the
two courts came out on different sides
of the coin when presented with similar
in pari delicto defenses. Notably, however, the line between agent and principal in the Seventh Circuit case was
sharply drawn, making the distinction
between the two unmistakably clear.
Depending on how the Ninth
Circuit rules in the USACM appeal, a
seemingly sharp divide may be seen
to split fraudulent-transfer claims into
two distinct categories: those claims
that a trustee inherits from the debtor,
tort or contract claims where the debtor
was wronged by a defendant, and those
that a trustee brings on behalf of creditors victimized by the fraudulent displacement of assets to transferees that
usually turn out to be insiders.
Conclusion
Will In Pari Delicto Become the New
Defense Rule?
There are hundreds of fraudulenttransfer actions pending in connection
with the Bernard Madoff Ponzi scheme,
so is the trustee about to be overrun
with in pari delicto defenses from every
direction? While some practitioners may
now view this as the first defense to be
asserted in fraudulent-transfer actions,
the viability of this defense looks to be
limited by the type of fraudulent-transfer
action at hand. Q
Copyright 2011
American Bankruptcy Institute.
Please contact ABI at (703) 739-0800 for reprint permission.
June 2011 55