Limitations Imposed Upon The 'In Pari Delicto' Defense

Reprinted with permission from the December 6, 2013 issue of The Legal Intelligencer. © 2013 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

Section 541(a) of the Bankruptcy Code creates an "estate" composed generally of all legal and equitable interests of the debtor existing as of the filing date. This includes causes of action routinely brought on behalf of the bankruptcy estate arising out of the debtor's prepetition business, conduct and transactions. A key defense to such claims involves in pari delicto, an equitable doctrine that bars a plaintiff from recovering damages arising from losses for which the plaintiff bears substantial fault.

Application of the in pari delicto defense can be complicated when the "plaintiff" is the bankruptcy estate, inasmuch as Section 541 renders it a technically separate and distinct entity from the prepetition debtor. Indeed, it is often the case that the estate's representative holds no relationship or connection with the prepetition debtor, but rather is an independent bankruptcy trustee or other appointed individual, committee or trust. Thus, the separate legal status of the prepetition debtor, on the one hand, and the post-petition debtor's estate, on the other, calls into question the propriety of applying the in pari delicto defense in a civil action brought by the post-petition estate. Recently, two bankruptcy courts within the Third Circuit considered the applicability of the defense in this context.

In David Cutler Industries v. Bank of America (In re David Cutler Industries), (Adv. Proc. No. 11-0792) (Bankr. E.D. Pa.), the U.S. Bankruptcy Court for the Eastern District of Pennsylvania considered the defense in connection with a fraudulent conveyance action. The prepetition debtor had made payments to a mortgage lender alleged by the estate representative to be fraudulent transfers because they were in satisfaction of a mortgage loan owed by one of the debtor's principals (and secured by his personal residence). The defendant-transferee invoked the in pari delicto defense, arguing that, to the extent the transfers at issue were fraudulent, the debtor and its principals bore equal or greater culpability and therefore could not recover for resulting losses. The court began its analysis by reviewing Third Circuit precedent applicable to the defense, including the principle of "imputation," whereby the wrongful conduct of a corporate officer is...