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In Pari Delicto Doctrine in Bankruptcy In Pari Delicto Doctrine in Bankruptcy Litigation: Anticipating or Raising the Defense

Strategies for Trustee and Creditors' Committee Lawsuits Against Third‐Party Professionals

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1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific THURSDAY, NOVEMBER 4, 2010

Today’s faculty features: Phil C. Appenzeller, S hareholder, Munsch Hardt Kopf & Harr, Dallas S igmund S . Wissner-Gross, Partner, Brown & Rudnick, New Y

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IN PARI DELICTO DOCTRINE IN BANKRUPTCY LITIGATION IN BANKRUPTCY LITIGATION

by Phil C. Appenzeller, Jr 214 855 7542 214.855.7542 pappenzeller@munsch.com

INTRODUCTION

• What does it mean? - In Equal Fault
• The doctrine of In Pari Delicto is based on the principle that a party cannot sue
• thers for its own wrong doing. For example, a common issue is whether a

corporation can sue third parties for helping it commit wrongs. f

• In Pari Delicto is not the same as comparative fault or contributory negligence.

Rather, it is an affirmative defense that acts as a complete bar to recovery.

• The analysis includes, e.g., whether the plaintiff’s fault is substantial or equal to

the third party’s fault and whether the third party acted in good faith in its the third party s fault, and whether the third party acted in good faith in its dealings with the plaintiff.

• Early cases analyzed the doctrine by applying a standing analysis. More

recently, however, courts have moved away from whether or not the plaintiff h t di t b i th l i d i I P i D li t ffi ti has standing to bring the claims and now view In Pari Delicto as an affirmative defense or an equitable defense to the plaintiff’s claims.

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STANDING

This change in application was important in the bankruptcy context because if the trustee or the creditors’ committee lacks standing to bring the claims it is “game over ” bring the claims it is game over. Why It is not a standing issue:

• “Standing consists of both a case on controversy requirement
• Standing consists of both a case on controversy requirement

stemming from Article III; Section 2 of the Constitution and Sub- constitutional prudential element.” Off. Comm. Of Unsecured Creditors vs. R. F. Lafferty & Co., Inc., 267 F.3d 340, 346 (3d Cir. 2001)

• The focus of standing is whether the plaintiff has been injured. It is not

whether a party who has been injured is barred from recovery by an equitable defense such as In Pari Delicto.

• In drafting a plan of reorganization, much care must be given to

preservation of pre-petition claims and proper assignment of those claims to a trustee or creditors’ committee so standing is not an issue.

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What claims are affected by In Pari Delicto? by In Pari Delicto?

Two typical fact scenarios: Two typical fact scenarios: Scenario 1

• Company operating as a fraud or Ponzi scheme
• At center of fraud is CEO
• Bad guy cloaks company with air of legitimacy (boards, officers,

counsel, accountants, etc.)

• Eventually, the company crumbles
• Trustee or receiver discovers massive fraud, self-dealing by bad guy,

t t /l li it li t f d t h b accountants/lawyers are complicit, negligent, or found to have been acting in bad faith.

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Scenario 1

Claims:

1.

Director and Officer claims: Breach of fiduciary duties, corporate waste, self dealing, fraudulent transfers. Usually easy to overcome business judgment rule, but this is fact-dependent. Problem: If there ff is director and officer coverage, likely to bar coverage on many claims.

2.

Third-party claims: A Accountants

• A. Accountants
• B. Law firms
• C. Brokers/ Distributors, etc.

Issue: Were the third parties complicit, negligent, or acting in bad faith?

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Scenario 1

If Complicit or acting in bad faith:

• Look at acts of management - Was management acting adversely to

Look at acts of management Was management acting adversely to corporation so that it would be improper to impute their acts to the corporation (adverse-interest exception)?

• If the answer is “yes,” then the trustee must distance himself from acts

f t d d i t t b li ti f I P i D li t

• f management and adverse-interest bars application of In Pari Delicto.
• Potential Obstacles:
• If the corporation actually benefitted from management’s acts,

then it is likely that the adverse-interest exception may not apply then it is likely that the adverse-interest exception may not apply.

• If “sole actor” exception applies, defendant may be able to defeat

adverse-interest exception on an alter ego-type theory.

• Risks to trustee when he pleads bad acts of management: how to plead

Risks to trustee when he pleads bad acts of management: how to plead

• r how not to plead.
• Real life example: ETS Payphones case.

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Scenario 2

• Legitimate company with “legitimate management.”
• Management overstates revenue or manipulates revenue recognition

(intentionally or negligently).

• Did the acts actually benefit the company?
• Auditors fail to catch overstatement or lack of internal controls.
• Company fails and a trustee is appointed. The trustee then sues

di auditors.

• Auditors file motion to dismiss and raise In Pari Delicto.

Sh ld th A dit b h ld li bl h it li t ( l

• Should the Auditor be held liable when it was negligent (versus grossly

negligent) but not necessarily complicit or acting in bad faith?

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Pleading Considerations

• Will have to pick your claims carefully.
• If trustee sues management for wrongdoing, potential use of those

claims by third-party defendants in support of In Pari Delicto defense. If trustee chooses not to sue management more likely to survive a

• If trustee chooses not to sue management, more likely to survive a

motion to dismiss as the In Pari Delicto defense will require discovery.

• Must consider assets and ability to collect in performing this analysis

(director and officer insurance policy exceptions erosion rate of (director and officer insurance policy, exceptions, erosion rate of policy, ownership of policy proceeds, solvency of individual defendants, etc.)

• Real life example
• Real life example.

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The IN PARI DELICTO DOCTRINE in The IN PARI DELICTO DOCTRINE in BANKRUPTCY LITIGATION

Allegheny Health, Education and Research Foundation (“AHERF”) A Case Study

presented by

Sigmund S. Wissner-Gross Brown Rudnick LLP Brown Rudnick LLP swissnergross@brownrudnick.com 212.209.4930

www.brownrudnick.com an international law firm

Background Facts

• Allegheny Health, Education and Research Foundation (“AHERF”)
• Pennsylvania not-for-profit corporation that provided healthcare

services including operating hundreds of physicians’ practices 14 services, including operating hundreds of physicians practices, 14 hospitals, and 2 medical schools.

• Beginning in the mid-1980s, AHERF pursued an aggressive

“integrated delivery system” model by acquiring hospitals and physicians’ practices that were generally losing money. physicians practices that were generally losing money.

• AHERF’s implementation of the model failed.
• By 1996, AHERF was suffering substantial operating losses.
• AHERF filed a Chapter 11 bankruptcy petition in 1998.

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Background Facts

• A group of AHERF officers was alleged to have knowingly

misstated the company’s financials that were provided to PWC, AHERF’s outside auditor for the company’s 1996 and 1997 audits AHERF s outside auditor, for the company s 1996 and 1997 audits, in order to make it appear that the company was successful.

• The Official Committee of Unsecured Creditors of AHERF brought

claims against PWC for breach of contract, professional negligence, and aiding and abetting breach of fiduciary duty and aiding and abetting breach of fiduciary duty.

• The Committee argued that PWC should have brought the

misstatements to light, but that PWC instead knowingly issued a “ l ” dit i i f h f th t i i j t “clean” audit opinion for each of those two years, causing injury to AHERF.

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Procedural History

• January 17, 2007: The District Court granted summary judgment

to PWC on the sole grounds that AHERF was in pari delicto with PWC and therefore the Committee’s claims brought on behalf of PWC and therefore the Committee s claims, brought on behalf of AHERF, were barred

• Specifically, the District Court found that notwithstanding allegations

that PWC acted improperly and colluded with management fault was that PWC acted improperly and colluded with management, fault was imputed to the company.

Official Comm. of Unsecured Creditors of Allegheny Health, Educ. & Research Found. v. PriceWaterhouse Coopers, LLP ("AHERF I"), 2007 U.S.

• Dist. LEXIS 3331 (W.D. Pa. Jan. 17, 2007).

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Procedural History

On appeal, the Court of Appeals for the Third Circuit certified two questions to the Pennsylvania Supreme Court, namely:

1 “What is the proper test under Pennsylvania law for determining whether 1. What is the proper test under Pennsylvania law for determining whether an agent's fraud should be imputed to the principal when it is an allegedly non-innocent third-party that seeks to invoke the law of imputation in order to shield itself from liability?” to shield itself from liability? 2. “Does the doctrine of in pari delicto prevent a corporation from recovering against its accountants for breach of contract professional negligence or against its accountants for breach of contract, professional negligence, or aiding and abetting a breach of fiduciary duty, if those accountants conspired with officers of the corporation to misstate the corporation's finances to the corporation's ultimate detriment?” p

Official Comm. of Unsecured Creditors of Allegheny Health, Educ. & Research Found. v. PriceWaterhouse Coopers, LLP ("AHERF II"), 2008 U.S.

• App. LEXIS 18823 (3d Cir. Pa. July 1, 2008).

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Procedural History

On February 16, 2010, the Pennsylvania Supreme Court answered the two certified questions as follows:

1 “The proper test to determine the availability of defensive imputation in

• 1. “The proper test to determine the availability of defensive imputation in

scenarios involving non-innocents depends on whether or not the defendant dealt with the principal in good faith. While one of the primary justifications for imputation lies in the protection

• f innocents, in Pennsylvania it may extend to scenarios involving auditor

negligence subject to an adverse-interest exception as well as other negligence, subject to an adverse interest exception, as well as other limits arising out of the underlying justifications supporting imputation. Imputation does not apply, however, where the defendant materially has Imputation does not apply, however, where the defendant materially has not dealt in good faith with the principal.”

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more

Procedural History

• 2. “The in pari delicto defense may be available in its classic form in the

auditor-liability setting, subject to ordinary requirements of pleading and proof (including special ones related to averments of fraud where relevant), and consideration of competing policy concerns. However, imputation is unavailable relative to an auditor which has not dealt materially in good faith with the client-principal. This effectively forecloses an in pari delicto defense for scenarios involving secretive collusion between officers and auditors to misstate corporate finances to th ti ' lti t d t i t ” the corporation's ultimate detriment.”

Official Committee of Unsecured Creditors of Allegheny Health, Educ. & Research Found v PriceWaterhouseCoopers LLP ("AHERF III") 2010 Pa LEXIS 159 (Pa

• Found. v. PriceWaterhouseCoopers LLP ( AHERF III ), 2010 Pa. LEXIS 159 (Pa.
• Feb. 16, 2010).

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Procedural History

• Applying these clarifications to the facts of AHERF, the Third Circuit

Court of Appeals vacated and remanded the case to the District Court for a determination of whether PWC acted in good faith in its Court for a determination of whether PWC acted in good faith in its dealings with AHERF, stating in relevant part:

• “While Allegheny III maintained the potential availability of in pari

delicto in the auditor-liability setting, that defense is conditioned on the auditor dealing materially in good faith with the client-principal. The District Court's analysis did not consider whether PwC dealt with AHERF in good faith, and it is appropriate for it to consider the issue in g the first instance...”

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more

Procedural History

• The Court also noted that the law in Pennsylvania is “cognizant of the

special and crucial role assumed by independent auditors against management abuses.” g

Official Comm. of Unsecured Creditors of Allegheny Health, Educ. & Research

• Found. v. PriceWaterhouse Coopers, LLP (“AHERF IV”), 2010 U.S. App. LEXIS

10920 (3d Cir Pa May 28 2010) 10920 (3d Cir. Pa. May 28, 2010).

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