The following is a case update prepared by Professor Dan Schechter, Loyola Law School, Los Angeles, analyzing a recent decision of interest:
A district court in New York has held that a liquidation trustee was not precluded by the doctrine of “in pari delicto” from asserting a breach of fiduciary duty claim against a group of corporate looters. [In re FKF 3, LLC, 2018 Westlaw 5292131 (S.D.N.Y.).]
FACTS: Three individuals looted their corporation, using its money to fund their own private investments. Eventually, an involuntary bankruptcy petition was filed against the company. The liquidation trustee brought fraudulent transfer and breach of fiduciary duty claims against the individual insiders and obtained a jury verdict of approximately $41 million.
REASONING: On appeal, one of the insider defendants argued that under applicable New York law, the trustee’s claim against him was barred by the doctrine of in pari delicto (“equal fault”), citing Kirschner v. KPMG LLP, 15 N.Y.3d 446, 938 N.E.2d 941, 912 N.Y.S.2d 508 (N.Y. 2010). That case held that when a third party colludes with an insider to loot the company, a bankruptcy trustee cannot bring suit against that third party, unless the insider’s actions were so inimical to the company as to invoke the “adverse interest” exception to the rule of in pari delicto. The Court of Appeals disagreed:
[The insider’s] interpretation of Kirschner would preclude a bankruptcy trustee from ever asserting a breach of fiduciary duty claim under New York law unless the adverse interest exception applied . . . . If adopted, this interpretation would mean that no corporation, limited liability company or other principal could assert a breach of fiduciary duty claim under New York law unless the adverse interest exception applied—that is, unless the fiduciary had “totally abandoned” the principal’s interests. Such a result is illogical and would transform the duties of care and loyalty under New York law.
AUTHOR’S COMMENT: I think that the federal courts have become disgusted by New York’s extreme tolerance for corporate misconduct and will find a way around New York’s aggressive interpretation of the doctrine of in pari delicto. There is no reason to spare insiders who loot corporate assets, and there is no reason to allow their third-party co-conspirators to shelter under that rule.
Bear in mind that the doctrine of “in pari delicto” is equitable in nature. Is it equitable to say that a bankruptcy trustee, who really represents the corporation’s creditors (and not its equity holders), is to be treated on par with those who drove the company into bankruptcy by siphoning off its assets?
The circuits are split. The Ninth Circuit has not yet definitively ruled on this issue; one can hope that common sense will eventually prevail.
These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.