in pari delicto?

In pari delicto (potior/melior est conditio possidentis), Latin for "in equal fault (better is the condition of the possessor)"^[1] is a legal term used to indicate that two persons or entities are equally at fault, whether the malfeasance in question is a crime or tort.

The phrase is most commonly used by courts when relief is being denied to both parties in a civil action because of wrongdoing by both parties. The phrase means, in essence, that since both parties are equally at fault, the court will not involve itself in resolving one side's claim over the other, and whoever possesses whatever is in dispute may continue to do so in the absence of a superior claim. The doctrine is similar to the defense of unclean hands, both of which are equitable defenses. Comparative fault and contributory negligence are not the same as in pari delicto, though all of these doctrines have similar policy rationales.

The same principle can be applied when neither party is at fault if they have equal right to the disputed property, in which case the maxim of law becomes in aequali jure (melior est conditio possidentis).^[2] Again the court will not involve itself in the dispute without a superior claim being brought before it.

The Wagoner doctrine was first established in Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, (C.A.2, 1991). There the court decided that as a matter of standing a trustee for a bankrupt corporation cannot pursue claims against those who defrauded the corporation with the cooperation of management. Under 11 U.S.C. 541-49, causes of action that do not belong to the corporation cannot be pursued by the trustee. Legally the trustee stands in the shoes of the corporation and may not reach beyond those rights which have accrued to the bankrupt entity (even if these third parties assign their claims to the trustee). See Barnes v. Schatzkin, 212 N.Y.S. 536 (N.Y.App.Div., 1925).

Thus, a key threshold question in any suit by a bankruptcy trustee is standing; in short "to whom does the claim accrue?" Most claims made by a trustee are of harm to the corporation since claims alleging harm to the corporation typically accrue to the corporation, harm to the creditors to the creditors, etc. The impact of the Wagoner decision was its determination that even where there is damage to the corporation "[a] claim against a third party for defrauding a corporation with the cooperation of management accrues to creditors, not to the guilty corporation." See Wagoner, 944 F.2d at 120 (emphasis added). This determination seems to be grounded in the idea that parties to a fraud, mutual wrongdoers, cannot recover from one another for harm done as a result of the fraud—the in pari delicto defense. As between the fraudulent parties the transfer is valid, though it can be assailed externally by the assertion of the rights of the creditors. See In re Maxwell Newspapers, Inc., 151 B.R. 63, 69 (Bkrtcy.S.D.N.Y., 1993).

Though not noted in the Wagoner decision itself, later courts—in utilizing the Wagoner decision—have emphasized the relationship between the Wagoner doctrine and the common law in pari delicto defense (roughly translated, "in equal fault"). Although conceptually distinct (one being an equitable defense, the other being an issue of standing), Second Circuit courts generally recognize that the in pari delicto defense and the Wagoner defense are essentially the same. Global Crossing Estate Rep. v. Winnick, Slip Copy, 2006 WL 2212776, FN. 16. (S.D.N.Y., 2006); cf. In re Promedicus Health Group, LLP, 359 B.R. 45, 50 (Bkrtcy.W.D.N.Y., 2006).

The corporation must, however, be guilty of the fraud. As a result, Wagoner is only applicable where agency principles allow for the imputation of the manager's actions (or whoever was cooperating with the fraud) to the corporation at large, thus making the corporation itself a participant in the fraud. As a rule, " the actions of corporate directors and officers are attributable to the corporate entity." In re Maxwell Newspapers, Inc., 151 B.R. 63, 69 (Bkrtcy.S.D.N.Y., 1993). This general rule appears to be subject to three exceptions (two of which are major exceptions, considered in every case).

(1) Innocent Insider Exception

Courts have refused to impute the actions of agents perpetrating a fraud where there is "at least one [relevant] decision-maker in management or among its shareholders who was innocent of the fraud and could have stopped it." In re CBI Holding Co., Inc., 247 B.R. 341, 365 (Bkrtcy.S.D.N.Y., 2000) (emphasis added). This limitation stems from the courts decision in Wechsler v. Squadron, Ellenoff, Plesent & Sheinfeld, LLP where the court, seeking to clarify the scope of Wagoner to cases where the fraudulent insider is not the sole shareholder and manager stated that Wagoner is "applicable in a situation where the owners and all relevant members of the management so participated." 212 B.R. 34. This decision, seen as somewhat of an expansion of the original approach, has since become a fully accepted approach to the Wagoner doctrine, although its meaning is disputed. There are two prevailing approaches to the applicability of the "innocent insider" exception. Some courts treat it as an independent requirement—no actions will be imputed where all relevant shareholders are not joined. Other courts treat the "innocent insider" exception as a way to combat the "sole actor" exception to the "adverse interest" defense (as explained below). Compare In re Monahan Ford Corp. of Flushing 340 B.R. 1, 24 (Bkrtcy.E.D.N.Y.,2006) ("Defendants' argument that the sole actor rule applies, defeating the application of the adverse interest exception, must be rejected, at least on a motion to dismiss. . . . the complaint adequately alleges that an innocent shareholder existed who could have stopped the fraudulent scheme had she known it was being committed." with In re CBI Holding Co., Inc., 247 B.R. 341 (considering the "innocent insider" exception before and independent of consideration of the "adverse interest" exception). A fair reading of the underlying case, Wechsler v. Squadron, seems to support the first reading—that all relevant shareholders and decision-makers must be involved for the fraud to be imputed to the corporation. The Wagoner doctrine is thus limited to a rare subset of fraud cases where the company is wholly complicit. Nevertheless, in a recent case In re CBI Holding Co., Inc. (CBI II), the court attempted to settle on the latter interpretation, seemingly more consistent with traditional agency law, stating that:

"the Court nonetheless takes this opportunity to address what appears to be substantial confusion evidenced by several courts . . . regarding the nature of the so-called “innocent insider” exception. As the Court explained above, the bankruptcy court's decision in this case to not impute management's misconduct to the company due to the presence of innocent insiders was made entirely separately from the bankruptcy court's consideration of the “adverse interest” exception to the Wagoner rule. . . . Even when an agent is defrauding his principal, unless the agent has totally abandoned the interests of the principal and is acting entirely in his own, or another person's, interest, that agent is acting within the scope of his agency. Thus, unless the adverse interest exception to the presumption of imputation applies, it is immaterial whether innocent insiders exists; the agent is still acting on behalf of the company, and his actions will be imputed to the company notwithstanding the existence of those innocent insiders. . . . Where [the agents are acting totally adverse to the corporation but] only some of a corporation's owners were involved in a fraud in their role as managers, courts consider whether those insiders who were innocent and unaware of the misconduct had sufficient authority to stop the fraud. . . . When the innocent insiders lack authority to stop the fraud, the “sole actor” exception to the “adverse interest” exception applies, and imputation is thus proper, because all relevant shareholders and decisionmakers were involved in the fraud." 311 B.R. 350, 372 (S.D.N.Y.,2004)

However this doctrine is placed, this "innocent insider" exception cannot be met by a "could-a, should-a, would-a test," the insider must have been an actual person who had the power to stop the fraud, would have done so, but simply did not know about it. In re Bennett Funding Group, Inc., 336 F.3d at 101; see In re Promedicus Health Group, LLP, at 51. The "independent director" cannot be "impotent to actually do anything." In re Bennett, at 101. (It is unclear how the court would treat a significant ignorant minority shareholder or significant ignorant minority seat on the board of directors. Compare In re CBI Holding, at 365 with FDIC v. Ernst & Young, 967 F.2d 166, 171 (5th Cir., 1992); see also In re Sharp Intern. Corp., 319 B.R. 782 (Bkrtcy.E.D.N.Y., 2005)(finding that a 13% shareholder could has started a derivative action had it known of the fraud and thus qualified as an "innocent insider".)

(2) Adverse Interest Exception

Even where the actions would be otherwise imputed, a court will not impute the actions of the agent to the principal where the agent is defrauding the principal exclusively for the agent's own benefit or the benefit of another. This exception turns on the idea that the court will not presume disclosure of the agents actions to the principal—as the law usually does—where those actions would reveal the agent's fraud; essentially that at some point the actor goes outside the scope of his employment. However, "New York courts construe this exception narrowly" and the "agent must have totally abandoned his principle's interests" in favor of his own interests or the interests of another. In re Maxwell Newspapers, Inc., 151 B.R. 63. A conflict of interest is not enough, nor is it enough that the agent is not acting primarily for himself or another. Id. Furthermore, this exception is itself subject to two exceptions.

• • (a) Sole-Actor Exception: Where the agent is "self-dealing," the knowledge of the fraud will be imputed notwithstanding the adverse interests if "the party that should have been informed was the agent itself albeit in its capacity as principle." In re Bennett Funding Group, Inc., 336 F.3d 94, 100 (2nd Cir., 2003) (citing Mediators, 105 F.3d at 827).
  • (b) Ratification: Even where the agent is not also the principle, where the principle has in some way acquiesced to the actions of the agent, those actions will be deemed ratified by the principle and imputed to it even if the agent is self-dealing. Id. at 100-01 ("New York law recognizes the well-established principle of ratification, which imputes an agent's conduct to a principle who "condones those acts and accepts the benefits of them.").