Defense of In Pari Delicto Does Not Affect Trustee Standing

Posted: 5 years 40 weeks ago

By: Elizabeth L. Anderson
St. John's Law Student
American Bankrutpcy Institute Law Review Staff
Rejecting the Second Circuit’s Wagoner[1] rule and agreeing with the First, Third, Fifth, and Eleventh Circuits, United States Court of Appeals for the Eighth Circuit held that the collusion of corporate insiders with third parties to injure the corporation does not deprive the corporation’s trustee of standing to sue third parties.[2] However, such a situation may give rise to the defense of in pari delicto barring the trustee’s action.[3]

In Moratzka v. Morris, Chief Manager Murray Klane was one of two owners of Senior Cottages of America (“Senior Cottages”) and owned a 60% interest in the company.[4]  In 1998, Senior Cottages became insolvent, and as a result needed to sell its valuable assets.[5] However, rather than finding an arms-length buyer Klane created a new company, Millennium Properties, LCC (“Millennium”), and transferred all the assets of Senior Cottages to Millennium.[6]  In return, Millennium assumed the debts of Senior Cottages but paid nothing for the assets it received, which the complaint valued at $4.8 million.[7]  The trustee alleged that the company’s outside counsel committed malpractice, aided and abetted the breach of fiduciary duty by Klane, and assisted Klane in looting Senior Cottages’ assets. [8]
Throughout its analysis, the Eighth Circuit stated that there were two distinct issues that had to be addressed: the issue of standing and the issue of defenses.[9]   Unlike Second Circuit in Wagoner,[10] this court emphasized that these two issues were not one in the same and should be addressed separately.[11]  In Wagoner, the Second Circuit analyzed these issues as presenting a constitutional standing problem[12] and held that a claim against a third party for defrauding a corporation with the cooperation of management does not accrue to the trustee.[13]  This decision has been criticized by other Courts of Appeals as well as academics as confusing an in pari delicto defense with the “case or controversy” standing requirement.[14]  By adopting the majority view on this issue, the Eight Circuit has further chipped away at the idea that an in pari delicto defense deprives a trustee of standing.[15]
Although the decision of the Eight Circuit affirms the idea that trustee standing and the in pari delicto defense are two issues that should be dealt with separately, the implications of the case may be less substantial than expected.  Although the circuits disagree about whether issues of standing and in pari delicto should be separated, the Eight Circuit affirms that in pari delicto may be asserted as a defense against the trustee and could still defeat the trustee’s recovery.[16]

[1] See Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114 (2d Cir. 1991).

[2] See Moratzka v. Morris (In re Senior Cottages of America), 482 F.3d 997, 1004 (8th Cir. 2007).

[3] Id.

[4] Id. at 999 (noting as chief manager Klane was in complete control of the daily operations of the company).

[5] Id. at 1000.

[6] Id.

[7] Id.

[8] Id. at 999.

[9] Id. at 1004.

[10] 944 F.2d  at 114.

[11] See Moratzka, 482 F.3d at 1004.

[12] Wagoner, 944 F.2d at 118 (stating “in our analysis of the question presented, the ‘case or controversy’ requirement coincides with the scope of powers the Bankruptcy Codes gives a trustee, . . .”)

[13] Id. at 120 (holding cause of action for breach of fiduciary duty accrues to creditors).

[14] See Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 346 (3d Cir. 2001) (holding analysis of standing does not include analysis of in pari delicto); See also John T. Gregg, The Doctrine of In Pari Delicto: Recent Developments, 2006 Norton Annual Survey of Bankruptcy Law Part I § 5 (discussing different approaches of circuits, including Second Circuit’s mischaracterization of the in pari delicto as a standing issue).

[15] See Moratzka, 482 F.3d at 1004.

[16] See id. at 1005; see also Official Comm. of Unsecured Creditor, 267 F.3d at 354, 360 (holding while trustee had standing to bring case, they were barred by in pari delicto from bringing its claims against defendant); Jeffery Davis, Ending the Nonsense: The In Pari Delicto Doctrine Has Nothing To Do With What is § 541 Property of the Bankruptcy Law, 21 Emory Bankr. Dev. J. 519, 522 (2005) (arguing Second, Third, Sixth and Tenth Circuits have arrived at the erroneous conclusion “[i]f the debtor, prior to bankruptcy, would have been prohibited by the doctrine of in pari delicto from seeking a remedy for injuries caused by third parties in cooperation with its manages, § 541 requires the bankrupt debtor to be prohibited as well”).