Bankruptcy Court, Approving In Pari Delicto Defense, Grants Motion to Dismiss Trustee's Legal Malpractice and Fiduciary Duty Claims Against Debtors' Pre-Petition Counsel
In re Scott Acquisition Corp., 364 B.R. 562 (Bankr. D. Del. 2007) (Judge Peter J. Walsh)
The Chapter 7 Trustee of the estate of debtors Scott Acquisition Corporation and Scotty’s Inc. filed a complaint against the debtors’ pre-petition counsel, asserting legal malpractice, breach of fiduciary duty and fraudulent transfer claims. The claims arose from a series of transactions between the debtors and insiders of the debtors, in which the defendants represented both the debtors and the insiders. The defendants filed a motion to dismiss the legal malpractice and breach of fiduciary duty claims, asserting that the trustee was estopped from prosecuting those claims by the equitable defense of in pari delicto. The United States Bankruptcy Court for the District of Delaware granted the motion, finding the in pari delicto defense barred those claims, but permitted the fraudulent transfer count to go forward.
Defendant Robert F. Mallett was the sole member of co-defendant Robert F. Mallett, LLC and a partner in the firm of Broad and Cassel P.A.. Mallett represented debtors Scott Acquisition Corporation and Scotty’s Inc. The plaintiff in this adversary proceeding, the Chapter 7 trustee of the debtors’ estates, filed a complaint alleging legal malpractice, breach of fiduciary duty and fraudulent transfer claims.Operating in Florida, the debtors operated the Do-It-Best chain of home improvement stores, which they acquired in a 1998 purchase when the debtors’ management team purchased the chain from its prior owners. The plaintiff alleged that Mallett represented the debtors and several members of the management team in negotiating the purchase of the chain. The debtors financed this acquisition with a loan and line of credit from Congress Financial Corporation secured by virtually all of the debtors’ assets.
The trustee also alleged that Mallett represented both the debtors and insiders of the debtors in connection with a series of transactions in which the insiders purchased from the debtors various assets that the insiders then leased back to the debtors. The trustee alleged that the purchase price in each of these sales was below market, and was sufficient only to get Congress to release its liens. These transactions were not approved by shareholders, but were approved by the insider directors and the debtors’ general counsel. Several of the insiders thereafter sold the assets for considerable profits. Although the debtors and insiders executed conflict waivers, the trustee asserted that the defendants engaged in impermissible dual representations.
The trustee also alleged that the defendants engaged in further improper dual representations when the defendants represented the debtors and insiders in certain debenture and loan transactions under which the debtors borrowed funds from the insiders at high interest rates. Again, conflict waivers were executed by the parties.
The defendants moved to dismiss the complaint, contending that the claims were barred by the doctrine of in pari delicto, and that the statutes of limitation had expired. The defendants also contended that the trustee should be barred from bringing any claims benefiting Congress because Congress should not benefit from its role in the debtors’ wrongdoing.
The trustee argued that (1) the in pari delicto defense was limited to instances of fraud, a Ponzi scheme or criminal conduct; (2) in any event, the in pari delicto defense was inconsistent with Florida’s comparative fault statute; (3) the wrongful acts of the insiders cannot be imputed to the debtors because the insiders acted for their own benefit, and on their own initiative; and (4) the debtors’ wrongdoing cannot be imputed to a Chapter 7 trustee.
The court rejected the trustee’s argument that Florida law limited the in pari delicto defense to instances of fraud, a Ponzi scheme or criminal conduct. On the contrary, the court found that, under Florida law, the fraud or misbehavior of an agent is imputed to the principal under the in pari delicto doctrine. The absence of allegations or fraud, criminal conduct or a Ponzi scheme is irrelevant to the analysis.
The trustee also contended that Fla. Stat. § 768.81(2), which provides for comparative fault with respect to certain claims, including those sounding in professional malpractice, applied, and therefore trumped the in pari delicto doctrine. However, as the court noted, that statute expressly applied only to negligence cases. As the trustee did not claim negligence, and in fact alleged an intentional course of dealing by the defendants with the debtor, that section was held to be inapplicable. Moreover, the court noted that, even in negligence cases, Florida courts apply the in pari delicto doctrine without mention of the comparative fault statute. Accordingly, the court rejected the trustee’s argument that Florida’s comparative fault statute trumped the defendants’ in pari delicto defense.
The court also held that the adverse interest exception did not apply to estop the defendants from asserting the in pari delicto defense. Under the adverse interest exception, the wrongful acts of an agent are not imputed to the principal when the agent’s actions are adverse to the principal’s interests. The principal must benefit in no way from the agent’s actions. The trustee argued that the insiders’ wrongful acts could not be imputed to the debtors because the insiders acted for their own benefit. The court disagreed, noting that, although the insiders benefited, so too did the debtors, even if the benefits to the debtors were slight. However, the adverse interest exception did not apply unless there was no benefit at all to the principal. The court also noted that, even if the adverse interest exception applied, the sole actor exception to the adverse interest exception itself would impute the insiders’ actions to the debtor. Under the adverse interest exception, when the agent who acts adversely to the interests of the principal is the sole representative of the principal, the actions of the agent are imputed to the principal. Because the board of directors unanimously approved the transactions underlying this litigation, and the board of directors is a sole actor, the adverse interest exception would apply.
The trustee also argued that the in pari delicto defense could not be imputed from the debtors to a bankruptcy trustee. The court rejected this argument, finding that 11 U.S.C. § 541(a)(1), which states that the bankruptcy estate consists of “all legal and equitable interests of the debtor in property as of the commencement of the case, includes causes of action and supports the notion that the in pari delicto defense applies equally if a trustee asserts a cause of action on behalf of the debtor’s estate. Moreover, the court stated, every circuit court that has addressed the issue has found that the in pari delicto defense imputes to a bankruptcy trustee.
The defendants asserted that the trustee should also be estopped from asserting claims on behalf of Congress, contending that Congress knew about, participated in, agreed to and encouraged the transactions that resulted in payment of Congress’ loans to the debtor. The court rejected that argument, finding that the complaint did not allege such facts, and that, on a motion to dismiss, the court accepts as true all allegations in the complaint and draws all reasonable inferences from those facts, in a light most favorable to the plaintiff. Applying that standard, the court could not infer that Congress was a wrongdoer. Also, there was no evidence presented that Congress would be a beneficiary of any recovery, as it was not shown that Congress was a creditor of the Chapter 7 estate.
Finally, the parties’ briefing did not address the fraudulent transfer count, and because in pari delicto is not a defense to such a claim under Third Circuit precedent in Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., the court allowed the fraudulent transfer count to go forward. However, the court dismissed the legal malpractice and breach of fiduciary duty claims.
