In the In re Mortgage Fund ’08 LLC case, the United States Bankruptcy Court for the Northern District of California dismissed a liquidating trustee’s adversary proceeding complaint alleging a claim for aiding and abetting breach of fiduciary duty against the lender to the debtor’s parent/manager.  The lender moved to dismiss the claim based on, among other things, the in pari delicto defense.  The in pari delicto defense bars one participant in an unlawful act from recovering damages from another participant in the unlawful act.   In dismissing the trustee’s complaint, the bankruptcy court rejected the liquidating trustee’s assertion that the defense did not apply.

What Happened and What Was The Issue Before The Court?

The liquidating trustee’s complaint alleged that while the debtor was ostensibly created by its parent/manager to make secured loans to real estate developers, money raised by the debtor for such purposes was instead funneled to the parent and its lender pursuant to a fraudulent scheme to pay returns on funds previously invested with the parent/manager and to pay the lender substantial fees and interest.  The complaint alleged that the lender knew that the parent/manager was breaching its fiduciary duty to the debtor and knowingly assisted the parent/manager in accomplishing this plan to deplete the debtor of its assets.

The lender moved to dismiss the complaint because, among other reasons, the complaint demonstrated that the in pari delicto defense blocked any recovery by the trustee against the lender.  Thus, according to the lender, the trustee was barred from recovering damages caused by the debtor’s conduct because such conduct was imputed to the trustee.

The trustee countered that the in pari delicto defense cannot be decided on a motion to dismiss because the defense implicates various factual issues.  The trustee also contended that the in pari delicto defense should not apply to her as a matter of equity and policy.

The Bankruptcy Court’s Analysis

The bankruptcy court summarily rejected the trustee’s procedural contention, noting substantial precedential support for the proposition that the in pari delicto defense may provide the basis to dismiss a complaint when the elements of the defense are clear on the face of the pleadings.

Moving on to the trustee’s argument that the in pari delicto defense did not apply to the trustee as a matter of equity or policy, the court first noted that the defense may be successfully asserted against a bankruptcy trustee or a liquidating trustee.  The bankruptcy court rejected out of hand the trustee’s argument that, because the trustee was not a party to the alleged inequitable conduct, she could not be defeated by the affirmative defense on account of the actions of her predecessors.

In addition to finding that the case law cited by the trustee did not support the proposition advanced, the court reasoned that the trustee, as the successor to the debtor, was charged with resolving claims pursuant to the terms of the debtor’s confirmed plan and disposing of the debtor’s property transferred to the trust.  That property consisted of “all legal or equitable interest of the debtor in property as of the commencement of the case.”  Accordingly, the court must consider defenses to claims asserted by a trustee as they existed at the commencement of the case.  Thus, a trustee asserting a cause of action of the estate is subject to the same defenses as if the debtor itself was bringing the action.

The court then analyzed the facts set forth in the complaint against the elements of the in pari delicto defense.  Under California law (which the court applied without explanation), the in pari delicto defense applies if (a) the agents of the plaintiff have participated in the wrongdoing for which the corporate entity seeks to recover, (b) the agents were acting consistently with the interests of the corporate entity such that the agents’ actions can be imputed to the corporate entity and, accordingly, the so-called “adverse interest” exception to the in pari delicto defense does not apply, and (c) even if the agents were acting in a manner adverse to the interests of the corporate entity, where the agents and the corporate entity are one and the same, the “sole actor” exception applies with the consequence that the in pari delicto defense will bar the claim.

Here, the court found no dispute with respect to the satisfaction of the first of the three elements.  Further, the court was not persuaded by the trustee’s invocation of the adverse interest exception in relation to the second element.  The trustee argued that the acts of the debtor’s parent should not be imputed to the debtor because the debtor was itself a victim of the parent/manager’s actions.  The court was unmoved, observing that the trustee’s complaint alleged that the debtor, in its creation and operation, was a fraudulent scheme.  Finally, the court found that even if the adverse interest exception might conceivably apply to defeat the application of the in pari delicto defense, the relationship among and conduct of the parent’s sole owners, the parent, and debtor was such that they were in effect one and the same and, accordingly, the “sole actor” exception supported the defendant’s invocation of the in pari delicto defense.

Key Takeaway

The trustee may have survived the motion to dismiss with more careful drafting of the complaint.  The “adverse interest” exception to the in pari delicto defense was, for all intents and purposes, eliminated by the complaint’s assertion that the debtor itself was a fraudulent scheme.  Debtors’ successors should take great care when drafting complaints seeking to recover in situations where the conduct of wrongdoers might be imputed to the debtor.