A Ponzi Scheme and a Pointless Technicality

A Ponzi Scheme and a Pointless Technicality

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For the first time in the team's 43-year existence, the New England Patriots are champions of professional football. Gone now are the long, freezing seasons of the 1960s and 1970s, when Patriots teams struggled to win more games than they lost, struggled to keep warm and struggled to find a suitable home stadium, playing at Boston University, Boston College, Harvard (Tufts seems to have missed out) and, mysteriously, the 1968 season in Birmingham, Ala.—warmer, but a bit of a hike for Beantown-based devotees.

What may not be entirely lost on throngs of joyous New Englanders is that the Patriots may never have played in this year's Super Bowl had they not been the beneficiaries of a hyper-technical ruling by referees that allowed the Patriots to defeat the Oakland Raiders two weeks earlier. In the waning minutes of a playoff game played in a snow storm, severe even by Foxboro, Mass., standards, Oakland appeared to have forced the New England quarterback to fumble the football, all but sealing an Oakland victory. Every sentient being on Earth seemed sure of the fumble except for the instant-replay officials (not a popular avocation), who relied on a little-known, recently enacted rule to conclude that the apparent fumble was no fumble. Invoking the rule, which attempts to parse the subatomic movements of a quarterback's forearm, allowed the Patriots to retain possession of the football and eventually win the game, in overtime, shortly before prevailing temperatures threatened human survival.

Oakland fans and many less-partisan gridiron enthusiasts invoke the sports epithet "technicality" to describe the method of the Patriots' snow-bound victory. Though tiresome in its overuse, the term is apt. A hidebound, overly technical application of an arcane rule changes the outcome of a contest that everyone—even the on-field officials—believes would be decided exactly the other way. A few statutory hairs are split, and the undeserving triumph. It happens in sports. It also happens in bankruptcy cases.

The Third Circuit's decision in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001), shows us how. In affirming the district court's dismissal of a multi-faceted suit over an alleged Ponzi scheme, the appellate court sustained the equitable defense of in pari delicto, asserted by the alleged perpetrators of the scheme, on what appear to be nakedly inequitable grounds. By invoking what the dissenting judge called a "pointless technicality" rooted in Bankruptcy Code §541, the Third Circuit all but ensured that at least some of the Ponzi scheme's architects will never be made to answer to the scheme's victims.

In Lafferty, 16 defendants were alleged to have run (or to have assisted in running) two lease financing corporations as a Ponzi scheme. When the scheme inevitably collapsed, leaving many investors with substantial losses, the companies' directors (who were also the debtors' sole shareholders) filed chapter 11 petitions for the companies and were promptly replaced by a chapter 11 trustee.1 The trustee appointed an official committee of unsecured creditors and soon entered into a stipulation under which the committee acquired the authority to prosecute all litigation claims on behalf of the debtors' estates. In this fashion, the court stated that the committee had "effectively acquired all the attributes of a bankruptcy trustee for purposes of this case."2

As expected, the committee commenced a suit in the district court against the debtors' officers, directors and outside professionals (including R.F. Lafferty & Co.), alleging among other things fraud, mismanagement, breach of fiduciary duty, securities law violations and professional malpractice. Many of the claims are best understood within the rubric of "deepening insolvency"—that is, "an injury to the debtors' corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life."3 The district court dismissed the action as against the professionals, holding that "since it is pleaded that the debtors, acting through [their sole shareholders and directors] perpetrated the Ponzi scheme...the doctrine of in pari delicto...bars [the committee] from suing these defendants for claims arising out of the fraud."4 Integral to the district court's ruling were two issues that the circuit court felt were "separate questions, to be addressed on their own terms": whether the committee had standing to bring the action, and whether the defendants could properly invoke the in pari delicto equitable defense against the committee as successor to the debtors.5

The standing issue turns out to have been the more simple of the two. Starting from the proposition, espoused most notably in the Supreme Court decision in Caplin v. Marine Midland Grace Trust Co.6 that a bankruptcy trustee lacks standing to pursue claims on behalf of the estate's creditors, the court set out to resolve the standing issue by answering three questions: (1) whether the committee was asserting creditors' claims, (2) whether "deepening insolvency" was a cognizable injury under Pennsylvania law, and (3) whether the injury alleged was more than just "illusory."7

Likening the committee's action against the Lafferty defendants to a traditional derivative suit brought by a shareholder on behalf of the company (as opposed to his own individual behalf), the court concluded that the committee was not attempting to recover for injuries to the creditors, notwithstanding that creditors would likely be the sole beneficiaries of any recovery.8 The suit was intended to obtain a recovery on behalf of the debtors—that the debtor's creditors would actually receive the recovery was a happenstance of bankruptcy law.

The court also noted the "growing acceptance of the deepening insolvency theory" among federal and state courts and concluded that the Pennsylvania Supreme Court would be inclined to recognize such a cause of action.9 Finally, the court dispensed with Lafferty's admirably creative argument that "any fraudulent debt certificates issued by the debtors would have created a capital flow into the debtors, allowing them to pay the perpetrators of the fraud...that any injury to the debtors caused by deepening insolvency might be considered illusory because that injury passed directly to the sole shareholders and wrongdoers."10 Because, as the court noted, the alleged perpetrators of the scheme preserved the integrity of the debtors' corporate form, the court concluded that the injury was to the corporation, not the shareholders themselves.11

Having resolved the first issue of standing in the committee's favor, the court then turned to the in pari delicto defense and whether Lafferty and the other defendants could avail themselves of that equitable defense to the committee's claims. As the court described, "the doctrine of in pari delicto provides that a plaintiff may not assert a claim against a defendant if the plaintiff bears fault for the claim," that is, "if his losses are substantially caused by activities the law forbade him to engage in."12 Considering the obvious point that the committee itself was certainly not a participant in the Pozni scheme, the court's critical doctrinal step in sustaining the in pari delicto defense was this: "Whether the in pari delicto doctrine applies here depends on whether the [wrongdoers'] conduct can be imputed to the debtors and hence to the committee, which, under bankruptcy law, stands in the shoes of the debtors."13

Wholly disregarding the seemingly meritorious argument that the committee was but an innocent successor-in-interest that should not have its predecessors' bad conduct imputed to it, the court determined that the "explicit language" of Bankruptcy Code §541 was all that was needed to resolve the question.14 Stated differently, the court believed that §541 can clearly determine whether former management's misdeeds forever taint a committee that had not been formed until after management was removed, thereby preventing the committee from seeking to redress those misdeeds.

The court believed itself constrained to apply a hyper-technical reading to the provision in §541 that provides that the estate is comprised of all interests of the debtor-in-property "as of the commencement of the case." It is a "warts-and-all" concept: The estate succeeds to property (such as causes of action) subject to any adverse claims or defenses (such as in pari delicto) that existed as of the petition date.15 Citing legislative history for that section, the court reiterated Congress' statement that a trustee "could take no greater rights than the debtor himself had."16 Accordingly, the court reasoned, because the debtors themselves were subject to the in pari delicto defense, so too was the committee. As a result, the court held, the committee's claims were properly dismissed.

Ascribing management's bad acts to a statutory committee that did not even exist until after management's departure and the Ponzi scheme's collapse turns equity on its head. The court seems to have almost blithely disregarded the committee's argument that the in pari delicto defense is an equitable defense, and that applying it to an innocent successor is a wholly inequitable result. In doing so, the court paused only momentarily to note that the committee's position "might be preferable from a public policy perspective"—something that at least three other circuits (the Tenth, the Second and the Sixth) have also done in sustaining an in pari delicto defense while disregarding a trustee's status as an innocent successor.17

It is difficult to discern an agenda in the Lafferty decision or in comparable decisions from other circuits. None of these courts seemed to believe that it was necessarily fair or equitable to rule as they did, and at least the Third Circuit purported to feel compelled (to do the wrong thing) by clear statutory language. And perhaps that is the agenda—to compel Congress to amend §541 in such a way as to avoid this type of patently inequitable result. These courts may be implicitly challenging Congress to fix this problem, saying in essence, who better than legislators to fashion a rule that prevents Ponzi perpetrators from—in the sensational terms of our popular media—"getting off on a technicality?"

The problem is writing such a rule. Crafting language that would free a debtor's innocent successor from the debtor's personal misdeeds in this narrow context would likely go too far. For example, should a chapter 7 trustee be entitled to a full recovery in a simple personal injury action despite that the debtor herself was contributorily negligent? Should a trustee take real property free of environmental claims if the debtor's management, before its removal, had been polluting? Yes, these examples compel more obvious answers than the in pari delicto dilemma presented in Lafferty, but that is precisely the point. Casting just the right statutory net to catch only the bad results like the one in Lafferty—the "pointless technicality"—may be too daunting for even the most capable of legislative drafters. Equitable principles—rarely, if ever, a part of a legislator's vocabulary—are designed to coax a fair result out of an unfair collision between particular facts and inflexible statutory language. Carving out narrow, painstakingly justified, equitable exceptions to broad statutory rules is not what legislatures do. It's what courts do.


Footnotes

1 267 F.3d at 344-45. Return to article

2 Id. at 345. Return to article

3 Id. at 347. Return to article

4 Id. at 346, quoting Official Committee of Unsecured Creditors v. Shapiro, 1999 U.S. Dist. LEXIS 14517 (E.D. Pa. Sept. 8, 1999). Return to article

5 267 F.3d at 364. Return to article

6 406 U.S. 416 (1972). Return to article

7 The court devoted considerable time and text to the intricacies of these three questions despite the apparent ease with which each could be answered. See 267 F.3d at 348-54. Return to article

8 Id. at 349. Return to article

9 Id. at 349-52. Return to article

10 Id. at 352. Return to article

11 Id. at 353. Return to article

12 Id. at 354 (internal quotations and citations omitted). Return to article

13 Id. at 355. Return to article

14 Id. at 356. Return to article

15 Id. Return to article

16 Id., citing S. Rep. No. 95-989 at 82 (1978) and H.R. Rep. No. 95-595 at 367-68 (1977). Return to article

17 See Hedged-Investments Assocs., 84 F.3d 1281 (10th Cir. 1996); Hirsch v. Arthur Andersen & Co., 72 F.3d 1085 (2d Cir. 1995); In re Dublin Securities Inc., 133 F.3d 377 (6th Cir. 1997). The Seventh and Ninth Circuits appear to hold otherwise. See Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995); FDIC v. O'Melveny & Myers, 61 F.3d 17 (9th Cir. 1995). Return to article

Journal Date: 
Friday, March 1, 2002