A recent decision of the United States District Court for the Southern District of New York (the “District Court”), affirming a decision of the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”), further enforces the application of the in pari delicto doctrine in cases decided under New York law and confirms that exceptions to its application remain extremely limited.
On January 12, 2016, United States District Judge Gregory H. Woods issued a Memorandum Opinion and Order in the case of Flaxer v. Gifford (In re Lehr Construction Corp.), Case No. 1:15-cv-4350-GHW, 2016 WL 164616 (S.D.N.Y. Jan. 12, 2016) (the “District Court Decision”). The District Court Decision affirmed the April 3, 2015, Memorandum of Decision and subsequent Order of United States Bankruptcy Judge Sean Lane, in which the Bankruptcy Court determined that the in pari delicto doctrine under New York law barred the faithless servant claim asserted by the Chapter 11 trustee of the debtor corporation (the “Trustee”) against an employee of the debtor. Flaxer v. Gifford (In re Lehr Constr. Corp.), 528 B.R. 598 (Bankr. S.D.N.Y. 2015) (the “Bankruptcy Court Decision”). The District Court, however, took significant issue with the Bankruptcy Court’s holding that “corporate insiders cannot rely on the in pari delicto defense.” The District Court rejected what it referred to as “the bankruptcy insider’s exception.” Id., at *3-*5.
By way of background, the debtor, Lehr Construction Corp., was a large general contractor that was indicted and ultimately convicted, along with certain former officers of the company, in connection with a scheme to defraud customers. The company and certain officers and employees conspired with subcontractors to inflate invoices for services by the subcontractors by billing for work that was never performed. After an investigation had been commenced by the Manhattan District Attorney’s Office, and prior to the indictments and ultimate convictions, the company had filed for protection under Chapter 11 of the Bankruptcy Code. The Trustee commenced an action against one of the debtor’s employees who had not been indicted or convicted for any criminal activity relating to the debtor’s criminal scheme, although the decision notes that the employee had entered into a cooperation agreement with the Manhattan District Attorney’s Office. Bankruptcy Court Decision, 528 B.R. at 604. In the Trustee’s action in the Bankruptcy Court, the Trustee asserted a single claim against the employee based upon New York’s “faithless servant” doctrine due to the employee’s participation in the scheme. The Trustee sought the return of any compensation paid to the employee by the debtor corporation, together with any legal fees associated with the criminal investigation. As the Bankruptcy Court was ruling on the defendant employee’s motion to dismiss on the basis of in pari delicto, the Trustee’s allegations of misconduct by the employee were accepted as being true for the purpose of deciding the motion.
What do all of these terms mean? The latin phrase in pari delicto means“equal fault,” or “equally blameworthy,” and the in pari delicto doctrine or defense generally stands for the proposition that where the plaintiff and the defendant are both wrongdoers, the courts will not interject themselves in the dispute.
Under New York law, the “faithless servant” doctrine permits an employer (or a trustee standing in the shoes of the employer) to recover compensation already paid to an employee where the employee has engaged in misconduct that constitutes a breach of the duty of loyalty or good faith. Bankruptcy Court Decision, 528 B.R. at 607. In other words, the doctrine applies when the misconduct was committed against the company rather than on its behalf. A classic example would be where an employee has embezzled funds of the employer.
The “bankruptcy insider’s exception” is the term used by the District Court that is “described in certain bankruptcy cases to preserve a bankruptcy trustee’s ability to sue the debtor’s insiders, despite the fact that their wrongdoing is imputed to the bankrupt corporation.” District Court Decision, 2016 WL 164616, at *4. As discussed below, the District Court goes to great lengths to dispel any notion as to the applicability of this exception (to the in pari delicto doctrine or defense) under New York law. Id.
So how did the courts rule in this case? The Bankruptcy Court found that the Trustee’s faithless servant claim was barred by in pari delicto and granted the defendant employee’s motion to dismiss. The District court affirmed. Both the Bankruptcy Court and the District Court note that state law determines whether the in pari delicto defense applies. See Bankruptcy Court Decision, 528 B.R. at 608; District Court Decision, 2016 WL 164616, at *4. Both the Bankruptcy Court and the District Court rely on the leading case in New York, as determined by the highest court in New York, the New York Court of Appeals, in Kirschner v. KPMG LLP, 15 N.Y. 3d. 446 (2010). They cite Kirschner for the proposition that “the doctrine of in pari delicto mandates that the courts will not intercede to resolve a dispute between two wrongdoers.” District Court Decision, 2016 WL 164616, at *4. Here, the Trustee stands in the shoes of the debtor corporation, which itself had been convicted of the scheme that formed the basis of the complaint against the employee. Id., at *8. The District Court also noted that New York’s version of the in pari delicto defense is not the same as that of all other jurisdictions that have addressed this issue, and further noted that “the [New York] Court of Appeals made that point quite clear in Kirschner, when it rejected proposals to ‘water down’ New York’s in pari delicto doctrine.” Id., at *5.
The Bankruptcy Court and the District Court cast aside the bankruptcy Trustee’s attempt to avoid the strict application under New York law of the in pari delicto defense by ruling against the Trustee’s assertions “(1) that in pari delicto cannot, and should not be, permitted as a defense to faithless servant claims, and (2) that even if in pari delicto can apply to faithless servant claims it did not apply to the [Defendant employee] because [the employee] is an insider.” District Court Decision, 2016 WL 164616, at *5 and *7.
The Bankruptcy Court rejected the Trustee’s assertion, and was affirmed on this point by the District Court, that the in pari delicto doctrine or defense does not apply to a faithless servant claim. Bankruptcy Court Decision, 528 B.R. at 611-13; District Court Decision, 2016 WL 164616, at *7. The District Court noted that “[t]he Trustee can cite to no case supporting his assertion that in pari delicto cannot bar faithless servant claims.” District Court Decision, 2016 WL 164616, at *5
The Bankruptcy Court and District Court noted the important role traditional agency principles play in an in pari delicto analysis with the acts of the agent being imputed to their principles. In its discussion, however, the Bankruptcy Court stated that there was an “insider “exception where a defendant employee’s conduct would not be imputed for the purposes of baring an in pari delicto defense. According to the Bankruptcy Court, although it ruled that the defendant employee in the case before it was not an insider, “corporate insiders cannot rely upon the in pari delicto defense.” 528 B.R. at 609. The District Court strongly disagreed and stated that there was no such exception under New York law. District Court Decision, 2016 WL 164616, at *3-5.
The District Court stated “I linger on the point here because I am concerned that the Bankruptcy Court’s description of an additional exception to imputation under New York law signals a resurgence of the confusion that Kirschner sought to eliminate.” District Court Decision, 2016 WL 164616, at *4. The District Court then went to great lengths explaining why the Bankruptcy Court was wrong in finding that “corporate insiders cannot rely on the in pari delicto defense” and dispelled any notion that New York law, as applied by the New York Court of Appeals in Kirschner, would support a “bankruptcy insider’s exception” to the in pari delicto defense. Id., at *4-*6. Indeed, the District Court stated that the only exception to Kirschner, although not applicable in the instant proceeding, would be the “adverse interest” exception, which is limited to circumstances where the agent has totally abandoned the principal’s interest and is acting entirely for his own or another’s purposes, such as in the case of embezzlement. See District Court Decision, 2016 WL 164616, at *4.
The Trustee has filed an appeal to the United States Court of Appeals for the Second Circuit.