7th Circuit: Bankruptcy Code Doesn't Override the "In Pari Delicto" Defense

Peterson v. McGladry & Pullen, LLP, 2012 WL 1088274 (7th Cir. April 3, 2012) (pdf), is an important new case from the 7th Circuit addressing the ability (or better, inability) of a bankruptcy trustee to overcome the "in pari delicto" defense on policy grounds alone.  In it, Judge Easterbrook--writing for the majority--once again grounds his opinion on the bedrock principle laid down by the US Supreme Court in Butner (1979) that "state law defines the 'property' that enters the bankruptcy estate, unless a provision in the Bankruptcy Code displaces state law."  Id. at *3.  Here are key quotes from the case:

The Trustee asks us to knock out the pari delicto defense altogether, so that the culpability of a corporate manager never would bar recovery against a negligent auditor.  Holland v. Arthur Andersen & Co., 127 Ill.App.3d 854, 82 Ill.Dec. 885, 469 N.E.2d 419 (1984), shows that Illinois would allow the defense if a receiver for the Funds were suing under state law, but the Trustee contends that federal law prevents its application once a firm enters bankruptcy and a trustee is appointed.  The National Association of Bankruptcy Trustees has filed a brief as amicus curiae supporting this position. Illinois has limited the defense on public-policy grounds in some circumstances as a matter of its domestic law.  See McRaith v. BDO Seidman, LLP, 391 Ill.App.3d 565, 330 Ill.Dec. 597, 909 N.E.2d 310 (2009) (in pari delicto does not apply to insurance liquidator's claims against auditors); Albers v. Continental Illinois Bank & Trust Co., 296 Ill.App. 596, 17 N.E.2d 67 (1938) (in pari delicto inapplicable to bank receiver).  But the Trustee and the Association pitch their argument on federal bankruptcy law.  They use McRaith and Albers to support the proposition that McGladrey can be liable if Bell was negligent but did not commit fraud, but that's different from the question whether federal law supersedes state law when the state would allow a pari delicto defense.

Section 541(a) provides that an estate in bankruptcy includes all of the debtor's “property”, a word that comprises legal claims such as the one against McGladrey.  “Property” normally is defined by state law—and in Illinois a claim for damages is limited by defenses such as in pari delicto.  The Trustee and the Association want us to hold that a bankruptcy estate includes rights of recovery, stripped of their defenses.  If in pari delicto is out, presumably the statute of limitations would be out too, or maybe even the defense of accord and satisfaction.  As the Trustee and the Association see things, “public policy” favors greater recoveries for estates in bankruptcy, so that more money is available for distribution and so that wrongdoing by a corporation's “gatekeepers” (the accountants as well as Bell) may be deterred more effectively.

This is not a new argument.  It was advanced and rejected in Butner v. United States, 99 S.Ct. 914 (1979).  The Court held that state law defines the “property” that enters the bankruptcy estate, unless a provision in the Bankruptcy Code displaces state law. Butner did not deal with § 541 or the pari delicto defense, but its principle is general.  See, e.g., Raleigh v. Illinois Department of Revenue, 120 S. Ct. 1951 (2000) (“The ‘basic federal rule’ in bankruptcy is that state law governs the substance of claims, Butner, supra, Congress having ‘generally left the determination of property rights in the assets of a bankrupt's estate to state law.’”).  Bankruptcy is a means of administering claims that are defined by tort, contract, and other generally applicable bodies of law.  Congress has modified these claims in some respects, and changed some distribution priorities, but unless the Code makes such an alteration the job of the bankruptcy court is to gather all of the debtor's assets, as state law defines those assets, and distribute them according to the creditors' rights under state law. In the main, bankruptcy law is designed to provide a single forum for resolving competing claims to assets defined by other bodies of law.

Neither the Trustee nor the Association identifies any provision of the Code that overrides state-law limits on the legal claims created by state law against the debtor's auditors. “Public policy” is not a ground on which the federal judiciary may create such a limit—not unless the Supreme Court first overrules Butner, Raleigh, and similar decisions. We therefore agree with the conclusion of every other court of appeals that has addressed this subject and hold that a person sued by a trustee in bankruptcy may assert the defense of in pari delicto, if the jurisdiction whose law creates the claim permits such a defense outside of bankruptcy. See Official Committee of Unsecured Creditors of PSA, Inc. v. Edwards, 437 F.3d 1145, 1152 (11th Cir.2006); Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 357 (3d Cir.2001); In re Hedged–Investments Associates, Inc., 84 F.3d 1281, 1285 (10th Cir.1996).

According to the Trustee, Scholes v. Lehmann, 56 F.3d 750, 754 (7th Cir.1995), commits this court to a contrary position.  Like today's case, Scholes arises from a Ponzi scheme.  The Securities and Exchange Commission appointed a receiver to marshal the assets of one participant in the scheme.  The receiver sought to recover some payments as fraudulent conveyances—for one aspect of a Ponzi scheme is handsome but unearned payments to early investors, who then drum up pigeons with promises of hefty and risk-free profits.  Some recipients of these payments invoked an equitable defense, observing that the principal fault lay with the scheme's mastermind, to which we replied that, although recovery would indeed have been inequitable while the crook was running the show, recovery of fraudulent transfers is entirely appropriate once the crook is gone and the recovery will benefit duped investors.  We added: “Put differently, the defense of in pari delicto loses its sting when the person who is in pari delicto is eliminated.”

That sentence is dictum; Scholes did not entail a pari delicto defense.  It has nothing to do with § 541 of the Bankruptcy Code, Scholes was not a bankruptcy proceeding.  And it does not stand for the proposition that federal law overrides state-law defenses; Scholes was decided under Illinois law, which, as we have observed, puts the pari delicto defense out of bounds in some situations. The state statute involved in Scholes was replaced in 1990 when Illinois enacted the Uniform Fraudulent Transfer Act, 740 ILCS 160. More importantly, the law of fraudulent conveyances—both in Illinois and under the Bankruptcy Code, see 11 U.S.C. §§ 547-50—is one of those bodies that does supersede private-law definitions of legal entitlements.  The recipient of a fraudulent or preferential transfer usually has a right to the money as a matter of contract, but when the transfer injures other creditors it can be recouped for their benefit.  Scholes should not be generalized beyond the law of fraudulent conveyances and preferential transfers.  Scholes did not mention Cenco, which applied Illinois law to block a corporation's action against an auditor when the fraud that the auditor failed to catch had been engineered by the client's managers.  By the time suit began in Cenco, the fraudsters were long gone, but that did not clear the way for collection from the deep pockets of an auditor that had been taken in by the client's former managers.