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In bankruptcy proceedings, assets of the estate include the debtor’s prepetition claims. The trustee then prosecutes these claims on the debtor’s behalf. Claims may include those against the debtor’s prepetition officers and directors for breaches of their fiduciary duties. Other potential targets include those who aided the officers and directors in their wrongdoing, such as accounting firms, law firms, lenders and advisors. Recently, various jurisdictions issued opinions that may limit the trustee’s ability to bring these claims. The equitable affirmative defense of in pari delicto has existed for some time; however, with the increasing number of claims brought by trustees against third-party professionals, the defense is burgeoning. This article briefly outlines this doctrine and focuses on its recent applications. The in pari delicto defense is invoked when the plaintiff participated in the same wrongdoing as the defendant. See Bateman Eichler, Hill Richards Inc. v. Berner, 472 U.S. 299, 306 (1985). This equitable principle and affirmative defense prevents a wrongdoer from recovering damages resulting from his own wrongdoing. Tolz v. Proskauer Rose LLP (In re Fuzion Techs. Group Inc.), 332 B.R. 225, 230 (Bankr. S.D. Fla. 2005). The defense focuses on the state-law concept of imputation. In re Advanced RISC Corp., 324 B.R. 10, 14 (D. Mass. 2005) (citing Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co. Inc., 267 F.3d 340, 355-56 (3d Cir. 2001)); see also O’Melveny & Myers v. FDIC, 512 U.S. 79, 83 (1994). The imputation analysis and the defenses thereto are jurisdictionally dependent; further, this issue is one of first impression in many jurisdictions. A bankruptcy trustee stands in the debtor’s shoes. Thus, while the trustee can pursue the debtor’s claims, defenses to the debtor’s claims can also be used against the trustee. Because a corporation only acts by and through its officers and directors, the fundamental question in the doctrine’s application is whether the officers’ and directors’ acts are imputed to the corporation. The general rule is that acts may be imputed to the corporation, unless the officers and directors were acting adverse to the corporation’s interest. This “adverse interest exception” bars the application of the in pari delicto defense. If, however, the corporation was run by a sole shareholder who was practically one and the same with the corporation, then his acts may be imputed to the corporation. This is known as the “sole-actor exception” to the adverse-interest exception. Confused? So are many jurisdictions. The framed issue is this: Is a bankruptcy trustee, standing in the shoes of the debtor corporation, saddled with the debtor’s bad acts and therefore barred from bringing claims against third parties that assisted the debtor in those bad acts? The 1st U.S. Circuit Court of Appeals held that the in pari delicto doctrine barred claims by a Chapter 7 trustee against an auditor because management’s acts were imputed to the corporation. Baena v. KPMG LLP, 453 F.3d 1, 4 (1st Cir. 2006). The court refused to apply the adverse-interest exception because, in its opinion, the corporation benefited from the fraud by acquiring target companies and securing loans based on its inflated financial condition. Baena hinged on the finding that management did not act adversely to the company’s interests because, although the corporation was driven to insolvency, it received a short-term benefit from the fraudulent financial reporting. Other courts have reached the opposite conclusion, finding that corporations do not benefit when management fraudulently conceals insolvency. See In re Huff, 109 B.R. 506, 512 (Bankr. S.D. Fla. 1989); Schacht v. Brown, 711 F.2d 1343, 1347-48 (7th Cir. 1983). While a company for a time appears profitable and obtains new investors, the ultimate effect of such financial accounting fraud is “to put the corporation farther and farther into debt by incurring more and more liability and to give the corporation the false appearance of profitability in order to obtain new investors.” In re Huff, 109 B.R. at 512. Another court emphasized that “a corporation is not a biological entity for which it can be presumed that any act which extends its existence is beneficial to it.” In re Investors Funding Corp., 523 F. Supp. 533, 541 (S.D.N.Y. 1980). The Baena opinion relies on Massachusetts tort cases in which state courts applied the imputation doctrine. See Baena, 453 F.3d at 4 (citing Stewart v. Roy Bros. Inc., 265 N.E.2d 357 (Mass. 1970)). But the cited cases could be interpreted as not supporting the 1st Circuit’s decision to apply the doctrine. For example, in Choquette v. Isacoff, 836 N.E.2d 329 (Mass. App. Ct. 2005), the court held that there are well-established exceptions to the doctrine’s application, such as when public interest requires it or when public policy is more outraged by the conduct of one party than of the other. Also, in GTE Prods. Corp. v. Broadway Elec. Supply Co., 676 N.E.2d 1151 (Mass. App. Ct. 1997), the court noted that when an agent and a third party have colluded against the principal, the agent’s knowledge is generally not imputed to the principal, even if there is some possibility that the principal benefited from the acts. These decisions may cause some to disagree with the 1st Circuit’s interpretation. Repleading in ‘Parmalat’ In another recent bankruptcy case, involving Italian company Parmalat Finanziaria SpA, the trustee brought claims against Bank of America Corp. for structuring transactions that defrauded the debtor by “permitting corrupt insiders to loot the companies with impunity.” In re Parmalat Securities Litigation, Bondi v. Bank of Am. Corp., 412 F. Supp. 2d 392, 394 (S.D.N.Y. 2006). The complaint alleged a series of fraudulent financial transactions designed to conceal the company’s insolvency. The bankruptcy court granted the bank’s motion to dismiss, holding that the in pari delicto doctrine barred recovery “because the original complaint’s detailed allegations made it ‘quite clear that the Parmalat entities were crucial actors in the . . . transactions.’ ” Id. (quoting Bondi v. Bank of Am. Corp., 383 F. Supp. 2d 587, 596 (S.D.N.Y. 2005)). The court found the deals were intended to benefit Parmalat and relied on the complaint’s assertions that Parmalat engaged in fraud and that the agents were acting for the company. The trustee filed an amended complaint outlining essentially the same financial transactions, but casting them in a new light. The trustee now alleged that Parmalat did not benefit from the fraudulent transactions and that the only benefit was to the corrupt managers who made the company appear creditworthy when it was not. Because the amended complaint lacked allegations regarding the company’s own participation in the fraud, the court declined to accept the defendant’s in pari delicto defense. The court did not accept the bank’s argument that the insider’s knowledge be imputed to the company, stating instead that “the [amended complaint] specifically alleges that [the insiders] were acting wholly in their own interests and outside the scope of their employment in looting the Company.” 412 F. Supp. 2d at 400. Because the insiders were not acting within the scope of their employment, the court concluded that their acts and knowledge could not be imputed to Parmalat. Id. at 401. This recent case demonstrates the importance of carefully crafting pleadings to de-emphasize any “benefit” that may have inured to the corporation. On a motion to dismiss, the court found nothing in the complaint to support barring the claims based on in pari delicto because it focused on the insider’s corrupt acts, how those acts were self-serving and how the company realized no benefit. Because applicability of the in pari delicto defense depends on imputation of corrupt acts to the corporation, it is important to draft the pleadings in a manner that highlights facts supporting the adverse-interest exception to imputation. Another case, Sender v. Mann, 423 F. Supp. 2d 1155, 1160 (D. Colo. 2006), involved claims against attorneys arising from their participation in a ponzi scheme. The court noted that “in pari delicto generally bars a trustee from bringing claims on behalf of a debtor acting under � 541 against a third party in a ponzi scheme situation.” Id. at 1174. The court emphasized the importance of distinguishing “between claims that the defendant participated in the ponzi scheme itself, and claims that the defendant acted outside of the ponzi scheme to steal from or loot the corporation.” Id. This distinction is important because if the harm arose from the defendant attorney’s acts outside the corporation’s activities in the ponzi scheme, then the corporation was not complicit in that specific illegal conduct. Based on this, the court denied application of the in pari delicto doctrine. This suggests that courts analyze the alleged harm to determine whether the corporation is complicit in the acts from which the harm arises. No benefit to the corporation NCP Litig. Trust v. KPMG LLP, 901 A.2d 871, 872 (N.J. 2006), a recent case from the New Jersey Supreme Court, analyzed similar claims to those in Baena v. KPMG. But the court reached a different conclusion. Two corporate officers misrepresented financial details to the company’s accounting firm. For years, the firm failed to detect the misrepresentations. When the fraud was finally revealed, the corporation was forced to restate its financials, report millions in losses and, ultimately, declare bankruptcy. The litigation trust filed suit against the auditor for negligent auditing. The trial court granted KPMG’s motion to dismiss based on the imputation of the fraudulent acts to the litigation trust. The New Jersey Supreme Court disagreed, and held that “the imputation doctrine does not bar corporate shareholders from recovering through a litigation trust against an auditor who was negligent within the scope of its engagement by failing to uncover or report the fraud of corporate officers and directors.” Id. While the fraudulent numbers were being reported, the corporation was able to issue stock for sale to the public, acquire another company and report increased revenues and income. Thus, the company arguably enjoyed a short-term benefit. But, once the financials were restated, the stock price plummeted and the effect of the disclosures was disastrous. Because of the company’s damages, the court concluded, “inflating a corporation’s revenues and enabling a corporation to continue in business ‘past the point of insolvency’ cannot be considered a benefit to the corporation.” Id. at 888. The allegations supported a finding that the acts of the high-ranking managers “did not benefit the corporation, but rather, led to the corporation’s ultimate demise.” Id. Thus, imputation did not bar the trustee’s recovery. This holding seems to contradict the Baena decision. Courts are in conflict regarding in pari delicto’s application to a bankruptcy trustee. What can be gleaned from these cases, however, is that this defense is increasingly being asserted as a shield in trustee litigation. Because of this, a bankruptcy trustee should evaluate several factors before embarking on litigation against potential third-party defendants:

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