When a business goes bankrupt amid allegations of financial misconduct, there is usually plenty of blame to go around. The villains often include the former principals, who may have used the business to perpetrate a fraud. They may include parties who reaped some of the proceeds of the misconduct. And, many times, other third parties facilitated or participated in the debtor’s misconduct, and may have liability as a result.

Amid all those black hats, there is usually one white hat: the bankruptcy trustee. A trustee appointed over a failed business operates under the supervision of the Bankruptcy Court, and serves as a fiduciary to all creditors and parties in interest. The trustee has specific statutory duties to collect and reduce to money all property of the bankruptcy estate, to investigate the financial affairs of the debtor, and to expeditiously distribute all collected funds to all parties in interest.

Even so, victims of a fraud or other financial misconduct often have their own remedies against third parties that are a more effective route to recovery than merely waiting for a bankruptcy distribution. Sometimes, the pursuit of those remedies will lead to conflict with the bankruptcy trustee. Still, there are at least three reasons why creditors may wish to take matters into their own hands, even if that also means taking on the bankruptcy trustee.

QUESTIONABLE CLAIMS AGAINST THIRD PARTIES

A bankruptcy trustee steps into the shoes of the debtor with regard to any claims the debtor might have against third parties. This can be both a good thing and a bad thing. The good is that it enables the trustee to recover any money due and owing to the debtor from third parties. The bad is the trustee is also subject to any defenses that might be asserted by the third party against the debtor. In cases where the debtor has engaged in fraud or other financial wrongdoing, the debtor’s own bad acts may bar the trustee from recovering from other wrongdoers despite their participation in the misconduct.

Courts here and elsewhere have been increasingly restrictive of bankruptcy trustees’ authority to pursue such claims. In multiple decisions in the past several years, the U.S. Court of Appeals for the Eleventh Circuit ruled that a debtor which was itself a perpetrator of a Ponzi scheme would be barred by the doctrine of “in pari delicto” (literally, “in equal fault”) from pursuing tort or racketeering claims against other participants. More recently, the U.S. Court of Appeals for the Second Circuit similarly ruled that under New York law, “in pari delicto” barred the trustee in the Bernard Madoff Investment Securities case from asserting claims against third parties for participating in the Ponzi scheme that the debtor orchestrated. Rather, the court concluded that claims against third parties for defrauding a corporation with the cooperation of management accrue to the creditors, not to the guilty corporation.

Where a third party has participated in the debtor’s misconduct – such as a financial institution, law firm, accounting firm or other advisor – fraud victims may be in a better position than a bankruptcy trustee to pursue claims against the perpetrators. However, the bankruptcy trustee, as an inducement to settlement, may seek to offer such third parties a “bar order” protecting them from any other lawsuits, including those brought by creditors. In such situations, creditors may find themselves in a battle with the trustee to prevent their own claims from being barred. Particularly where the creditors’ direct claims are strong, and the defendants are culpable and collectible, that is a battle worth fighting: in the Rothstein Rosenfeldt Adler bankruptcy case in South Florida, creditors who pursued their own claims against TD Bank and others recovered in excess of $300 million on such claims, independently of the bankruptcy proceedings.

CLAIMS AGAINST YOU

Under the Bankruptcy Code, the trustee is responsible for pursuing and recovering certain pre-bankruptcy transfers made by the debtor — what have come to be known as “clawback” actions. These may include transfers of the debtor’s assets to friends, family or related businesses designed to shield those assets from the debtor’s creditors. In a “Ponzi” scheme or other fraudulent investment scheme, they include transfers of “profits” that investors may knowingly — or even unknowingly — receive, which the law requires to be disgorged if transferred with fraudulent intent, or if the debtor was insolvent and does not receive reasonably equivalent value in exchange. And they also include “preferential” transfers made within 90 days before the bankruptcy filing – even if the recipient has no knowledge of any improprieties, and even if the recipient is a net loser still owed money by the debtor.

Though these “clawback” actions are intended, from a macro perspective, to “even the playing field” among creditors, they can be a significant burden for individual creditors who suffered a loss but still have “preference” exposure. What’s more, they can also significantly curtail a creditor’s ability to be made whole for its losses. The Bankruptcy Code provides for the disallowance of the claim of any creditor that has not repaid an avoidable transfer — in which case the creditor will not receive any distribution from funds recovered by the trustee. Once again, such creditors will be better off seeking their own remedies against culpable parties, as they may never receive anything from the bankruptcy trustee otherwise.

NOT THE FASTEST ROUTE TO RECOVERY

Finally, creditors may be able to exercise more control over the timing of their recovery by pursuing their own remedies. Generally in a bankruptcy case, creditors will not receive distributions until substantially all of the debtor’s assets are liquidated, and if the case is in Chapter 11, until a plan of liquidation can be confirmed. Often this will take several years. By hiring their own counsel and directing their own litigation, parties can move as expeditiously as the courts will allow them. In the Rothstein case, one case was tried to a verdict, and another was settled shortly before trial, all nearly a year before the trustee confirmed a plan of liquidation enabling distributions to be made to creditors.

Though the bankruptcy trustee may wear a white hat, creditors of a failed business may often be better served pursuing their own remedies, even at the risk of creating conflict with the trustee.

FN:1O’Halloran v. First Union Nat’l Bank of Florida, 350 F.3d 1197 (11th Cir. 2003); Official Committee of Unsecured Creditors of PSA, Inc. v. Edwards, 437 F.3d 1145 (11th Cir. 2007).