A Bankruptcy Court in Hawaii has issued a decision that the defense of in pari delicto (equal fault) cannot be asserted against a bankruptcy Trustee, where the Trustee is the Plaintiff in an avoiding power (e.g. fraudulent transfer suit), even where the defense of in pari delicto could have been asserted against the bankruptcy debtor, in a tort suit, outside of bankruptcy, brought by the debtor as plaintiff
In re Hawaiian Telcom Communications, Inc., 2012 Westlaw 6019094 (Bankr. D. Hawai’i):
Facts: A litigation trust, acting on behalf of a Chapter 11 estate, brought statutorily-based avoidance claims against an insider of the prepetition debtor. He asserted the defense of in pari delicto (“equal fault”), arguing that the prepetition debtor actively participated in the alleged wrongdoing. The litigation trust brought a motion to strike that defense, on the theory that it was inapplicable to avoidance claims arising under the Bankruptcy Code.
Reasoning: The court ruled in favor of the litigation trust, reasoning that although the defense of in pari delicto would apply to ordinary tort claims that belonged to the prepetition debtor, that defense does not apply to statutory claims arising under the Code, since the estate is not the successor of the prepetition debtor for purposes of those claims.
Author’s Comment: The holding is right, but the dicta is (or are?) questionable. It is true that courts from other circuits have held that in pari delicto applies to causes of action derived from the prepetition debtor, but the Ninth Circuit has not ruled on that issue definitively. Further, those cases from the other circuits (mostly the Second and Third) are based primarily on state law, rather than federal law; and the court in this case did not discuss state law.
I would argue that the Ninth Circuit has at least hinted that it would not follow the other circuits on this issue. See F.D.I.C. v. O’Melveny & Myers, 61 F.3d 17 (9th Cir. 1995). There, the court held that the "unclean hands" or "in pari delicto" defense might not apply to a trustee:
While a party may itself be denied a right or defense on account of its misdeeds, there is little reason to impose the same punishment on a trustee, receiver or similar innocent entity that steps into the party’s shoes pursuant to court order or operation of law. Moreover, when a party is denied a defense under such circumstances, the opposing party enjoys a windfall. This is justifiable as against the wrongdoer himself, not against the wrongdoer’s innocent creditors.
I have heard from practitioners that there are at least two in pari delicto cases now before the Ninth Circuit; if that is true, perhaps we will get additional guidance soon. For the reasons expressed by the O’Melveny court, I hope that the Ninth Circuit rejects the in pari delicto defense definitively, for all purposes.
For discussions of other cases dealing with this issue, see:
- 2008 Comm. Fin. News. 34, Even Though Corporation Is Incorporated in Delaware, Delaware’s "In Pari Delicto" Imputation Rules Do Not Apply to Cause of Action Arising in Another State.
- 2007 Comm. Fin. News. 49, Lenders Who Assist Corporate Looters May Be Held Liable to Estate, Despite "In Pari Delicto" Defense.
- 2005 Comm. Fin. News. 81, Doctrine of "Unclean Hands" Bars Bankruptcy Trustee’s Suit against Law Firm That Represented Ponzi Schemers.
The foregoing analysis is from the Insolvency Law Committee – Business Law Section of the State Bar of California