Whenever a company tumbles into bankruptcy following the discovery of its management’s financial misdeeds, firms that provided the company with accounting, legal, banking and financial advisory services should prepare to defend themselves against malpractice claims by a bankruptcy trustee or other estate representative, who may seek to hold them responsible for the collapse. These claims often allege that the professionals participated in, aided and abetted, or negligently failed to detect and stop the fraudulent acts and breaches of duty perpetrated by management.

Fortunately for these defendants, courts interpreting New York law have repeatedly recognized a powerful defense that can eliminate such claims at an early stage of the litigation. The common law doctrine of in pari delicto bars a plaintiff from recovering against a third party for a fraud or other misconduct in which the plaintiff participated. Applying this doctrine in the bankruptcy context, the Second Circuit has firmly held that a “claim against a third party for defrauding a corporation with the cooperation of management accrues to creditors, not the guilty corporation.” Thus, under the so-called “Wagoner Rule,” since a bankruptcy trustee stands in the shoes of the corporation (not its creditors), he/she lacks standing to recover from third parties for participating in fraud or other misconduct perpetrated by the corporation.

Originally published in American Bankruptcy Institute Journal on September 2, 2014.