The Claims of a Chapter 11 Trustee may be Barred by the In Pari Delicto Defense
By: Carmine A. Broccole
St. John’s University School of Law
American Bankruptcy Institute Law Review Staff Member
The in pari delicto defense “dictates that when a participant in illegal, fraudulent, or inequitable conduct seeks to recover from another participant in that conduct, … the law will aid neither, but rather, will leave them where it finds them.” In In re Yellow Cab Cooperative, Inc., the United States Bankruptcy Court for the Northern District of California held that the in pari delicto defense may be used to bar a chapter 11 trustee’s claims against a debtor’s former accountant.
Randy Sugarman (the “Trustee”), the chapter 11 trustee of debtor Yellow Cab Cooperative, Inc. (the “Debtor”), filed an action against the Debtor’s former accountant, Douglas Taylor. The Trustee alleged that Taylor conspired with the directors and officers of the Debtor to divest the company of “valuable and necessary assets” in order to permit improper distributions to its members and to hide money from its creditors. The Trustee also alleged that Taylor did not comply with generally accepted accounting principles by “willfully or negligently categoriz[ing] multiple personal injury lawsuits as ‘reasonably possible’ liabilities” although they were likely liabilities. According to the Trustee, the result was the Debtor’s “demise through bankruptcy and the non-payment of claims and judgments against the Debtor.” Subsequently, Taylor asserted the in pari delicto defense in a motion to dismiss the Trustee’s action. The bankruptcy court granted Taylor’s motion.
Section 541(a)(1) of title 11 of the United States Code (the “Bankruptcy Code”) limits the rights of a debtor by defining property of the estate as “all legal or equitable interests of the debtor in property as of the commencement of the case.” Because this provision was “not intended to expand the debtor’s rights against others more than they exist at the commencement of the case,” the trustee’s rights are confined to those held by the debtor “‘[w]here … a bankruptcy trustee files claims on behalf of the bankruptcy estate.’” Moreover, although a bankruptcy trustee would generally not have participated in any alleged wrongdoing by a debtor, such conduct may be imputed to a trustee. Thus, “in pari delicto, or any other defense available against the debtor, can be asserted against the trustee.”
Here, the Trustee argued that the “adverse interest exception” precluded Taylor’s right to use the in pari delicto defense because the Debtor’s agents “act[ed] in a manner adverse to the interests of the corporation,” thus rendering their actions unable to be “imputed to the corporation.” The Trustee contended that because the actions of the agents could not be imputed to the Debtor, they likewise could not be imputed to himself. However, courts have held that the adverse interest exception is subject to the “sole actor exception” which prevents a defrauded entity from escaping the imputation of knowledge under the in pari delicto defense “when the defrauded entity and the alleged bad actors are one and the same.” Consistent with this theory, the court in In re Yellow Cab Cooperative, Inc. reasoned that the Debtor, a purportedly defrauded entity, was controlled by its own “bad actor” board and members, and therefore was “one and the same” within the meaning of the “sole actor exception.” Consequently, the court held that the Trustee was prevented from exercising the “adverse interest exception,” and thus the in pari delicto defense barred his claims against Taylor.
In re Yellow Cab Cooperative, Inc. demonstrates how the in pari delicto defense may be used to bar trustees from pursuing claims on behalf of the estate of a debtor that engaged in “illegal, fraudulent, or inequitable conduct.” A trustee, however, may pursue claims against third-parties “not arising from and independent of” alleged “illegal, fraudulent, or inequitable conduct” of debtors.
 In re Yellow Cab Coop., Inc., 602 B.R. 357, 360 (Bankr. N.D. Cal. 2019) (citing In re Mortg. Fund '08 LLC, 527 B.R. 351, 366 (N.D. Cal. 2015) (quoting Case v. U.S. Bank. Nat. Assn., 26 Cal.Rptr.3d 401, 404 n. 1 (Cal. Ct. App. 2005)).
 In re Yellow Cab Coop., Inc., 602 B.R. 357, 362 (Bankr. N.D. Cal. 2019).
 Id. at 358.
 Id. at 359.
 Id. at 358.
 Id. at 359.
 Id. at 358.
 See id. at 362–63.
 11 U.S.C.A. § 541(a)(1).
 In re Mortg. Fund ’08 LLC, 527 B.R. at 367 (quoting H.R. Rep. 95–595, at 367–68, reprinted in 1978 U.S.C.C.A.N. 5963, 6323).
 Id. (citing In re Crown Vantage, Inc., No. 02-3836 MMC, 2003 WL 25257821, at *6 (N.D. Cal. Sept. 25, 2003)).
 See id. at 362; See In re Mortg. Fund ’08 LLC, 527 B.R. at 367-68 (holding that the actions of the debtor’s owner, member, and manager were to be imputed to the debtor and thus the trustee); See also In re Crown Vantage, Inc., 2003 WL 25257821, at *6, aff'd sub nom. Crown Paper Liquidating Tr. v. Pricewaterhousecoopers LLP, 198 F. App'x 597 (9th Cir. 2006) (“Although the Ninth Circuit has not had occasion to directly address the issue, every Circuit to have considered the question has held that in pari delicto can be asserted against a trustee bringing a claim on behalf of a debtor in bankruptcy.”).
 In re Yellow Cab Coop., Inc., 602 B.R. at 361 (quoting In re Crown Vantage, Inc., 2003 WL 25257821, at *6–7).
 See id. at 362. (“The ‘adverse interest exception’ provides that where corporate agents act in a manner adverse to the interests of the corporation, the actions of the agents are not imputed to the corporation.”).
 Id. (“The ‘sole actor’ exception provides that a defrauded entity cannot escape the imputation of knowledge under the in pari delicto doctrine when the defrauded entity and the alleged bad actor are one and the same.”) (citing In re Mortg. Fund ’08 LLC, 527 B.R. at 351 (citing In re Crown Vantage, Inc., 2003 WL 25257821, at *7)).
 See id. at 360 (citing In re Mortg. Fund '08 LLC, 527 B.R. at 366) (quoting Case v. U.S. Bank. Nat. Assn., 26 Cal.Rptr.3d at 404 n. 1).
 In re Yellow Cab Coop., Inc., 602 B.R. at 362–63 (“Trustee may have an independent claim for malpractice against Taylor not arising from and independent of the alleged fraud of the debtor and its members. The court will therefore dismiss all claims in the Complaint, with leave to amend the accounting malpractice claim.”).