The Claims of a Chapter 11 Trustee may be Barred by the In Pari Delicto Defense

By: Carmine A. Broccole

St. John’s University School of Law

American Bankruptcy Institute Law Review Staff Member

            The in pari delicto defense “dictates that when a participant in illegal, fraudulent, or inequitable conduct seeks to recover from another participant in that conduct, … the law will aid neither, but rather, will leave them where it finds them.”[1] In In re Yellow Cab Cooperative, Inc., the United States Bankruptcy Court for the Northern District of California held that the in pari delicto defense may be used to bar a chapter 11 trustee’s claims against a debtor’s former accountant.[2]

            Randy Sugarman (the “Trustee”), the chapter 11 trustee of debtor Yellow Cab Cooperative, Inc. (the “Debtor”), filed an action against the Debtor’s former accountant, Douglas Taylor.[3] The Trustee alleged that Taylor conspired with the directors and officers of the Debtor to divest the company of “valuable and necessary assets” in order to permit improper distributions to its members and to hide money from its creditors.[4] The Trustee also alleged that Taylor did not comply with generally accepted accounting principles by “willfully or negligently categoriz[ing] multiple personal injury lawsuits as ‘reasonably possible’ liabilities” although they were likely liabilities.[5] According to the Trustee, the result was the Debtor’s “demise through bankruptcy and the non-payment of claims and judgments against the Debtor.”[6]  Subsequently, Taylor asserted the in pari delicto defense in a motion to dismiss the Trustee’s action.[7] The bankruptcy court granted Taylor’s motion.[8]

            Section 541(a)(1) of title 11 of the United States Code (the “Bankruptcy Code”) limits the rights of a debtor by defining property of the estate as “all legal or equitable interests of the debtor in property as of the commencement of the case.”[9] Because this provision was “not intended to expand the debtor’s rights against others more than they exist at the commencement of the case,”[10] the trustee’s rights are confined to those held by the debtor “‘[w]here … a bankruptcy trustee files claims on behalf of the bankruptcy estate.’”[11] Moreover, although a bankruptcy trustee would generally not have participated in any alleged wrongdoing by a debtor, such conduct may be imputed to a trustee.[12] Thus, “in pari delicto, or any other defense available against the debtor, can be asserted against the trustee.”[13]

            Here, the Trustee argued that the “adverse interest exception” precluded Taylor’s right to use the in pari delicto defense because the Debtor’s agents “act[ed] in a manner adverse to the interests of the corporation,” thus rendering their actions unable to be “imputed to the corporation.”[14] The Trustee contended that because the actions of the agents could not be imputed to the Debtor, they likewise could not be imputed to himself.[15] However, courts have held that the adverse interest exception is subject to the “sole actor exception” which prevents a defrauded entity from escaping the imputation of knowledge under the in pari delicto defense “when the defrauded entity and the alleged bad actors are one and the same.”[16] Consistent with this theory, the court in In re Yellow Cab Cooperative, Inc. reasoned that the Debtor, a purportedly defrauded entity, was controlled by its own “bad actor” board and members, and therefore was “one and the same” within the meaning of the “sole actor exception.”[17] Consequently, the court held that the Trustee was prevented from exercising the “adverse interest exception,” and thus the in pari delicto defense barred his claims against Taylor.[18]

            In re Yellow Cab Cooperative, Inc. demonstrates how the in pari delicto defense may be used to bar trustees from pursuing claims on behalf of the estate of a debtor that engaged in “illegal, fraudulent, or inequitable conduct.”[19] A  trustee, however, may pursue claims against third-parties “not arising from and independent of” alleged “illegal, fraudulent, or inequitable conduct” of debtors.[20]