It’s time for a primer on the Wagoner rule and the in pari delicto defense, two concepts that arise when a debtor’s fraud leads to bankruptcy.  Trustees who replace a debtor’s management often sue those involved in the corporation’s misdeeds.  But the Wagoner rule and the in pari delicto defense can shield third-party defendants from liability.

A decision issued last week shows how these concepts apply when fraud is present.  Feldman v. Kossoff & Kossoff LLP (In re TS Empl., Inc.), No. 15-10243, 2019 Bankr. LEXIS 706 (Bankr. S.D.N.Y. Mar. 7, 2019).  The debtor, TS Employment, Inc. (“TSE”), was a professional employer organization for another company, Corporate Resource Services, Inc. (“CRS”).  TSE supplied temporary workers to CRS and served as the workers’ employer of record.  CRS’s business grew fast as TSE made financial accommodations for CRS.  And among other things, TSE didn’t pay over $100 million in federal employment taxes.  In 2015, it filed chapter 11.

A bankruptcy trustee sued TSE’s accountants for accounting malpractice/negligence and fraud.  The firm had prepared TSE’s financial statements and tax returns and had access to TSE’s accounting systems.  The firm moved to dismiss the complaint citing the Wagoner rule and the in pari delicto defense.

The Wagoner rule bars bankruptcy trustees from suing third parties for damage “when a bankruptcy corporation has joined with [the] third party in defrauding its creditors.”  Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, 118 (2d Cir. 1991).  The rule denies trustees standing when the debtor corporation participated in the fraud.  “Because management’s misconduct is imputed to the corporation, and because the trustee stands in the shoes of the corporation, the Wagoner rule bars a trustee from suing to recover for a wrong that he himself essentially took part in.”  Wright v. BankAmerica Corp., 219 F.3d 79, 86-87 (2d Cir. 2000).

The in pari delicto defense is “a state law equitable defense similar to the unclean hands doctrine.”  TSE, 2019 Bankr. LEXIS 706 at *7.  Like the Wagoner rule, the in pari delicto defense bars trustees from suing third parties based on a debtor corporation’s “own wrongful conduct.”  Grubin v. Ratted (In re Food Mgmt. Group, LLC), 380 B.R. 677, 693 (Bankr. S.D.N.Y. 2008).  “The doctrine exists because, as a matter of equity, courts should not help plaintiffs profit from their wrongdoings.”  TSE, 2109 Bankr. LEXIS 706 at *7-8.

In TSE, the trustee argued that two exceptions to the rule and defense should apply: the non-statutory insider exception and the adverse interest exception.  A corporation’s insiders don’t benefit from the Wagoner rule.  “The insider exception derives from the notion that it would be inequitable to allow an insider to rely on [in pari delicto] imputation because it would essentially shield the insider[s] from the consequences of their own handiwork.”   In re PHS Grp. Inc., 581 B.R. 16, 30-31 (Bankr. E.D.N.Y. 2018).

The Bankruptcy Code defines insiders as a “director of the debtor; officer of the debtor; person in control of the debtor; partnership in which the debtor is a general partner, general partner of the debtor; or relative of a general partner, director, officer, or person in control of the debtor.”  Bankruptcy Code §101(31)(B).  

Courts have also recognized that certain parties may be “insiders” despite not being in one of the categories listed in the Bankruptcy Code.  Non-statutory insiders are those who have a close relationship to the debtor, have a high degree of involvement in the debtor’s affairs, might have had opportunities for self-dealing, or might have held a controlling interest in the debtor.  PHS, 581 B.R. at 33.  In TSE, the complaint alleged a close relationship between TSE and the accounting firm, but other factors (involvement, self-dealing, and controlling interest) “weigh against insider status.”  TSE, 2019 Bankr. LEXIS, *12-15.  But based on statements the trustee’s counsel made at oral argument, Bankruptcy Judge Martin Glenn allowed the trustee to amend the complaint to show that the accounting firm had such involvement at TSE that the non-statutory insider exception should apply. 

The adverse interest exception applies when corporate managers don’t act within the scope of their employment.  “The theory is that where an agent, though ostensibly acting in the interest of the principal, is really committing a fraud for his own benefit, he is acting outside the scope of his agency, and it would be most unjust to charge the principal with knowledge of it.”  Wright, 219 F.3d at 87.  The exception is applied when there is “outright theft or looting or embezzlement.”  Kirschner v. KPMG LLP, 15 N.Y.3d 446, 466-67 (2010). 

Judge Glenn ruled that the adverse exception wouldn’t apply because the complaint asserted the opposite of theft, looting, or embezzlement.  The accounting firm’s actions enabled TSE to “continue and even expand its business.”  TSE, 2019 Bankr. LEXIS 706 at *18.  “The Court deems this benefit sufficient to defeat the adverse interest exception.”  Id.