Restructuring

Contributed by Kyle J. Ortiz
Most debtors find themselves in chapter 11 due to a liquidity crisis, or an unexpected change in their business environment, but occasionally a debtor ends up in chapter 11 because of a fraud or some other wrongdoing on the part of the debtor.  While in typical chapter 11 cases the management is able to continue as debtors in possession, cases involving criminal wrongdoing on the part of the debtor often result in the appointment of a trustee, an assets trust, or other similar entity to dispense of the debtor’s assets.  The mission of such an entity is to marshal as many assets into the estate as permissible so as to be able to maximize distributions to creditors.  One way that trustees have historically tried to bring assets into the estate is to pursue cases against other, preferably deep-pocketed, entities that allegedly either participated in or were complicit to the fraudulent conduct of the debtor.  The efforts of Irving Picard in the Madoff case are a notable recent example.
However, bringing such actions may be more difficult following a recent decision out of the Southern District of Ohio, In re National Century Financial Enterprises Inc., No. 2:04-cv-1090 (S.D. Ohio, April 12, 2011), which made clear that the doctrine of in pari delicto prevents assets trusts, appointed to dispense of a wrongdoing-debtor’s assets, from pursuing cases against other alleged participants in the fraud or wrongdoing.
In pari delicto, which means “in equal fault,” is a defense “grounded on two premises:  (1) that courts should not lend their good offices to mediating disputes among wrongdoers; and (2) that denying judicial relief to an admitted wrongdoer is an effective means of deterring illegality.” Bateman Eichler, Hill Richards, Incorporated v. Berner, 472 U.S. 299, 310-11 (1985).
In National Century, the Unencumbered Assets Trust (the UAT), an assets trust established under the debtors’ plan for the purpose of liquidating the debtors’ assets for distribution to certain creditors, brought a variety of claims against Credit Suisse for its alleged role in assisting National Century’s founders in committing a $2 billion fraud that allegedly looted the funds of two of National Century’s subsidiaries.
Credit Suisse moved for summary judgment on all counts under the doctrine of in pari delicto, contending that the UAT, standing in the shoes of the debtor, could not recover for injuries caused by the debtor’s own wrongdoing.  Although the UAT was ultimately acting for the benefit of creditors, its power to gather assets was grounded in its role as successor-in-interest of the debtor.  Once it stepped into the debtors’ shoes, the acts of the debtors were imputed to the UAT, and thus the court held that the UAT was barred under the doctrine of in pari delicto from bringing actions against parties allegedly involved in the fraud.  In light of this, the court granted Credit Suisse’s motion for summary judgment.
The in pari delicto defense is only available when: (1) the plaintiff is at least equally responsible for the wrongs as the defendant, and (2) public interest would not be harmed by precluding the case.  In National Century the fact that the debtors’ founders committed a massive fraud was undisputed.  All three of the founders had been convicted.  The fraud was perpetrated by the founders when they used the debtors’  subsidiaries to issue investment-grade notes, representing them to be secured by high quality healthcare receivables.  In fact, the majority of the receivables purchased by the debtors’ subsidiaries were worthless or did not exist.  Most of these “receivables” were purchased from companies in which the founders had a financial interest and were essentially advances of monies to these companies with no receivables ever provided in return.  Put simply, the noteholders invested money with the subsidiaries who passed that money into companies in which the founders had interest for nothing in return.
With the founders’ culpability clearly paramount, there was no issue of fact.  The real question faced by the court was one of imputation.  Should the founders’ conduct be imputed to the debtors and ultimately to the UAT?  The court, looking to state law in conducting its analysis, stated that the general rule of agency is that a principal is liable for the conduct committed by its agents within the scope of their employment.  The court noted that, “an exception exists if the agent acts adversely to the principal and entirely for its own, or another’s purpose.”  Typically, courts will find that an agent that uses its office to loot corporate assets has acted adversely to its principal.  But there is an exception to the exception under the “sole actor rule” where an agent’s wrongdoing is directly attributed to the principal if it “so dominated and controlled” the principal that it “had no separate mind, will, or existence of its own.”  In National Century, the debtors’ subsidiaries had no employees or decision makers other than the founders (other than a few close associates of the founders who were involved in the fraud).  In light of this, the court found that the founders and the subsidiaries had no separate corporate existence and thus fell under the exception to the exception.
The UAT did not dispute that the founders were liable, but nonetheless argued that the in pari delicto doctrine could not be invoked because Credit Suisse was knowingly complicit in the fraud.  The court held that the inquiry was not whether or not Credit Suisse was innocent, but, instead, whether Credit Suisse was at least equally responsible for the injuries suffered by the subsidiaries’ noteholders.  The court stated that even if the allegations against Credit Suisse were true, the bulk of the fault still rested squarely with the debtors through the conduct of the founders.  Having established that the debtors were primarily responsible, the court stated that it was excused under the in pari delicto doctrine “from further parsing out fault.”
The UAT also argued that equitable considerations required that the court deny summary judgment because preclusion of the suit would “significantly interfere” with the purposes of law and harm the public interest.  The court was not persuaded by this argument and noted that allowing Credit Suisse to prevail on the in pari delicto defense would not mean that it would necessarily escape liability.  If the allegations of its wrongdoing were true, those actually harmed by such acts, namely, the noteholders, could bring civil suits against Credit Suisse (as many already had).  For purposes of the UAT’s action, however, the court returned to its central point – that the debtors were the primary wrongdoers and thus could not seek damages from equal or lesser wrongdoers.
If other courts follow the National Century decision, plaintiffs that have stepped into the shoes of a previous wrongdoer may find their claims barred under the doctrine of in pari delicto – an outcome that could have an impact on some high profile cases stemming from the recent financial crisis.  As the National Century court makes clear, however, in pari delicto won’t necessarily absolve them of all liability, as those who claim to have been harmed by a fraud or wrongdoing may still have other remedies they may pursue.