In Pari Delicto Prevents Equal Wrongdoer from Seeking Damages Relating to Its Own Fraudulent Conduct

Media Source: www.nyfraudclaims.com Courts take pains to prevent a party from gaining an advantage in connection with its own wrongdoing. Examples are the doctrines of unclean hands and comparative negligence. In the context of fraud, the doctrine known as "in pari delicto" will prevent a party or those who stand in the party's shoes from asserting claims against others who allegedly failed to stop the party's own fraud. So, for example, the doctrine would arise in a derivative claim where a shareholder sues, on behalf of the corporation, the corporation's outside auditor for professional malpractice or negligence based on the auditor's failure to detect fraud committed by the corporation. The doctrine arises in many similar contexts. The New York Appellate Division, First Department, has recently issued an informative and well-reasoned decision reaffirming the in pari delicto doctrine in yet another case involving the Bernard Madoff matter, in New Greenwich Litig. Trustee, LLC v Citco Fund Services (Europe) B.V., 2016 NY Slip Op 06796 (1st Dept Oct. 18, 2016). First, some background on the doctrine is in order.

Historical Underpinnings of In Pari Delicto

The New York Court of Appeals issued a comprehensive decision explaining the historical origins and purpose of the doctrine in Kirschner v KPMG LLP, 15 N.Y.3d 446 (2010). In Kirschner, the Court of Appeals was presented with two consolidated appeals in which the court was asked to consider the remedies available to creditors or shareholders of a corporation whose management engaged in financial fraud that was allegedly either assisted or not detected by the corporation's outside professional advisers, such as auditors, investment bankers, financial advisers and lawyers. In one case on the appeal, the bankruptcy litigation trustee sought to assert claims on behalf of unsecured creditors alleging fraud, breach of fiduciary duty and malpractice against the corporate bankrupt's (1) president and CEO and other owners and senior managers; (2) investment banks that served as underwriters; (3) law firm; (4) accounting firms; and (5) several customers that participated in the allegedly deceptive loans. According to the trustee, these defendants all aided and abetted the corporate insiders in carrying out the fraud, or were negligent in neglecting to discover it. In the other case on the appeal, shareholders asserted a derivative claim against the corporation's independent auditor, claiming it did not perform its auditing responsibilities in accordance with professional standards of conduct, and so failed to detect or report the fraud perpetrated by the corporation's senior officers and had it done so, the fraudulent accounting schemes would have been timely discovered and rectified. The Court of Appeals explained the “doctrine's full name is in pari delicto potior est conditio defendent is, meaning “[i]n a case of equal or mutual fault, the position of the [defending party] is the better one.” The Court continued:

The doctrine of in pari delicto⁴ mandates that the courts will not intercede to resolve a dispute between two wrongdoers. This principle has been wrought in the inmost texture of our common law for at least two centuries (see e.g. Woodworth v. Janes, 2 Johns.Cas. 417, 423 [N.Y.1800] [parties in equal fault have no rights in equity]; Sebring v. Rathbun, 1 Johns.Cas. 331, 332 [N.Y.1800] [where both parties are equally culpable, courts will not “interpose in favour of either”] ). The doctrine survives because it serves important public policy purposes. First, denying judicial relief to an admitted wrongdoer deters illegality. Second, in pari delicto avoids entangling courts in disputes between wrongdoers. As Judge Desmond so eloquently put it more than 60 years ago, “[N]o court should be required to serve as paymaster of the wages of crime, or referee between thieves. Therefore, the law will not extend its aid to either of the parties or listen to their complaints against each other, but will leave them where their own acts have placed them” (Stone v. Freeman, 298 N.Y. 268, 271, 82 N.E.2d 571 [1948] [internal quotation marks omitted] ).

Kirschner, 15 NY3d at 464 & n. 4. The Court held that even though fraudulent, the wrongful acts of the corporate officers are imputed to the corporation -- thereby becoming the corporation's own acts of wrongdoing for which neither the corporation nor those suing on its behalf could recover against others who allegedly fail to prevent the fraud: "[W]here conduct falls within the scope of the agents' authority, everything they know or do is imputed to their principals. ... all corporate acts—including fraudulent ones—are subject to the presumption of imputation [and], as with in pari delicto, there are strong considerations of public policy underlying this precedent: imputation fosters an incentive for a principal to select honest agents and delegate duties with care." In rejecting an argument that the agents acted in their own interest and adverse to the corporation (the “adverse interest” exception to applying in pari delicto), the Court observed: "To allow a corporation to avoid the consequences of corporate acts simply because an employee performed them with his personal profit in mind would enable the corporation to disclaim, at its convenience, virtually every act its officers undertake. '[C]orporate officers, even in the most upright enterprises, can always be said, in some meaningful sense, to act for their own interests'.” The Court of Appeals continued, "for the adverse interest exception to apply, the agent 'must have totally abandoned his principal's interests and be acting entirely for his own or another's purposes,' not the corporation's (Center, 66 N.Y.2d at 784–785, 497 N.Y.S.2d 898, 488 N.E.2d 828 [emphasis added] ). So long as the corporate wrongdoer's fraudulent conduct enables the business to survive—to attract investors and customers and raise funds for corporate purposes—this test is not met (Baena, 453 F.3d at 7 ['A fraud by top management to overstate earnings, and so facilitate stock sales or acquisitions, is not in the long-term interest of the company; but, like price-fixing, it profits the company in the first instance'] )." The Second Circuit Court of Appeals recently bolstered the in pari delicto doctrine as well in a case brought by the bankruptcy trustee of the Madoff funds against financial advisors for allegedly “facilitat[ing] [Madoff’s] Ponzi scheme by providing (well-paid) financial services while ignoring obvious warning signs.” In re Bernard L. Madoff Inv. Securities LLC., 721 F.3d 54 (2d Cir. 2013). The Second Circuit rejected these claims under the in pari delicto doctrine, ruling that the trustee stands in the shoes of the debtor – the party that orchestrated the fraud: “Under New York law, one wrongdoer may not recover against another. See Kirschner v. KPMG LLP, 15 N.Y.3d 446, 912 N.Y.S.2d 508, 938 N.E.2d 941, 950 (2010). The principle that a wrongdoer should not profit from his own misconduct “is ... strong in New York.” Id., 912 N.Y.S.2d 508, 938 N.E.2d at 964. The New York Appellate Division, First Department, has long applied the doctrine of in pari delicto to bar a debtor from suing third parties for a fraud in which he participated.” 721 F.39 at 64. The Second Circuit rejected a number of the trustee’s arguments in an attempt to preserve his claims, giving full strength to the doctrine:

[The trustee] argues that the rationale of the in pari delicto doctrine is not served here because he himself is not a wrongdoer; but neither were the trustees in the cases cited above.12 He contends that in pari delicto should not impede the enforcement of securities laws, citing Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 105 S.Ct. 2622, 86 L.Ed.2d 215 (1985); but Bateman Eichler is inapposite. See id. at 315–16, 105 S.Ct. 2622 (holding that in pari delicto would not prevent defrauded tippee from bringing suit against defrauding tipper, at least absent further inquiry into “relative culpabilities” of tippee and tipper).13 He invokes the “adverse interest” exception, which directs a court not to impute to a corporation the bad acts of its agent when the fraud was committed for personal benefit. See The Mediators, Inc. v. Manney (In re Mediators, Inc.), 105 F.3d 822, 827 (2d Cir.1997). However, “this most narrow of exceptions” is reserved for cases of “outright theft or looting or embezzlement ... where the fraud is committed against a corporation rather than on its behalf.”14 Kirschner v. KPMG LLP, 15 N.Y.3d 446, 912 N.Y.S.2d 508, 938 N.E.2d 941, 952 (2010). It is not possible thus to separate BLMIS from Madoff himself and his scheme. Finally, Picard [the trustee] argues that the district courts should not have applied the in pari delicto doctrine at the pleadings stage; but the New York Court of Appeals has held otherwise. See id., 912 N.Y.S.2d 508, 938 N.E.2d at 947 n. 3; see also Wagoner, 944 F.2d at 120. Early resolution is appropriate where (as here) the outcome is plain on the face of the pleadings.

721 F.39 at 64-65.

First Department's Latest Decision on In Pari Delicto

New Greenwich Litig. Trustee, LLC v Citco Fund Services (Europe) B.V, involved so-called feeder funds that invested in the Madoff funds. The limited partners of the feeder funds first instituted derivative claims against, among others, the funds’ manager, administrators and auditor, alleging they negligently failed to prevent the fraudulent Ponzi scheme. The bankruptcy litigation trustee then took over and asserted claims against the funds' administrators and auditor. Against the administrator defendants, the trustee asserted causes of action for breach of fiduciary duty, negligent misrepresentation, negligence and gross negligence, breach of contract, common-law fraud, unjust enrichment, and accounting. As against the auditor defendants, the trustee asserted causes of action for common-law fraud, negligent misrepresentation, professional negligence (malpractice), breach of contract, and aiding and abetting breach of fiduciary duty. Significantly, however, the trustee revamped the claims by now claiming, contrary to the prior derivative claims, that the funds themselves were not a culpable participant in the Ponzi scheme, and did not know of the scheme prior to its December 11, 2008 disclosure. The trustee was obviously trying to avoid the bar of in pari delicto by claiming that the feeder funds themselves were not responsible in any way for the fraudulent scheme. In a well-written decision by Justice Tom, the First Department wholeheartedly rejected that attempt. It found the prior allegations in the derivative action, in which the funds' managers were alleged to contribute to the fraud, very damning:

Here, it is undisputed that the derivative complaints in these actions pleaded extensive wrongdoing on the part of the funds' management. In particular, the complaints pleaded that the [fund defendants], which included the various Fairfield Greenwich Group affiliates that managed the funds, their individual directors, and the funds' outside administrators including the Citco defendants, received “hefty” management fees for their experience in selecting and monitoring fund managers, and touted their due diligence “while issuing false reports to investors presenting nonexistent, or, at the very least, highly inflated, profits, and collecting fees based on such fictitious profits.” The complaints further alleged that the general partner “completely abdicated its responsibilities to the Limited Partners and the Fund by failing to perform even minimal due diligence” into the funds' sole custodian, Bernard Madoff Investment Securities, LLC (BMIS), and, among other things, failed to “safely manage the Fund's assets”; perform due diligence; and investigate red flags regarding BMIS. In alleging demand futility, the complaints pleaded that the funds' general partner faced liability for its “total abrogation of its duty of oversight,” and “participated in, approved, or permitted the wrongs alleged herein, concealed or disguised those wrongs, or recklessly or negligently disregarded them.”

The First Department then rejected the argument that the funds' wrongful conduct had to amount to willful or intentional fund rather than negligence in order for in pari delicto to bar the claims. This is a significant reaffirmation of the in pari delicto doctrine. The Court ruled in pertinent part:

Plaintiff incorrectly claims that in pari delicto requires “immoral or unconscionable conduct” by the plaintiff, and that negligence is insufficient. Rather, the true focus of the in pari delicto doctrine is whether the defendant's wrongdoing is at least equal to that of the plaintiff's. Indeed, the case incompletely quoted by plaintiff actually provides that in pari delicto “requires immoral or unconscionable conduct that makes the wrongdoing of the party against which it is asserted at least equal to that of the party asserting it” (Stahl v. Chemical Bank, 237 A.D.2d 231, 232 [1st Dept 1997] ). The Court of Appeals, in Kirschner, further expounded that “[t]he doctrine's full name is in pari delicto potior est conditio defendentis, meaning ‘[i]n a case of equal or mutual fault, the position of the [defending party] is the better one’ “ (15 NY3d at 464 n 4 [internal citation omitted] ). The prior derivative complaints alleged that the funds sustained losses due to the Fund Defendants' gross, reckless, bad faith, willful and wrongful mismanagement of the funds' assets, and that the Fund Defendants materially misled the funds. The derivative allegations of the funds' imputed wrongdoing are at least equal to those asserted against the [managers] Citco and [auditor] PWC defendants in the amended complaints.

Thus, the Court concluded:

In this case, plaintiff’s claims are precluded under the doctrine of in pari delicto. As the funds’ bankruptcy trustee, plaintiff stands in the funds’ shoes, and is subject to a defense based on the in pari delicto doctrine to the same extent as the funds (see In re MF Global Holdings Ltd. Inv. Litig., 998 F.Supp 2d 157, 189–191 [SD N.Y.2014][applying the New York in pari delicto doctrine to claim against auditor brought by trustee appointed under Securities Investor Protection Act]; Buechner v. Avery, 38 AD3d 443, 444 [1st Dept 2007] [“the trustee was precluded from bringing the above tort claims by the doctrine of in pari delicto based upon the cooperation of the management of the bankrupt corporation with defendant third parties in committing the alleged wrongs”] ). Thus, the doctrine “prevents the trustee from recovering in tort if the corporation, acting through authorized employees in their official capacities, participated in the tort” (MF Global Holdings, 998 F.Supp 2d at 189).

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While there are continuing efforts to seek recovery on behalf of the wrongdoer itself from those who, although not directly involved in a fraud, may not have acted prudently or responsibly to uncover or stop it, as shown by the latest First Department pronouncement, those efforts are not, for the most part, viewed favorably by the courts and, therefore, likely to fail.