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Ninth Circuit Advantages of Pursuing Claims for Third Party Pre-Bankruptcy

10/2/2008 Articles

Most large Chapter 11 cases are filed in Delaware or New York, even for companies headquartered in California.  This is understandable since Ninth Circuit law presents difficulties on key issues of case administration, and the New York and Delaware bankruptcy courts and law firms have extensive experience with large cases.  Once a large bankruptcy case is pending in New York or Delaware, inertia and convenience often lead to the filing of ancillary litigation on behalf of the debtor, estate, creditors' committee or litigation trust in the same district where the bankruptcy case is pending-even though case law there limits claims against third parties. 

There is a good reason to consider the Ninth Circuit for filing debtor claims against third parties. Outside California and the Ninth Circuit, the doctrine of in pari delicto (in equal fault) often prevents the debtor in possession, trustee, or successor from suing for pre-bankruptcy misconduct in which the debtor participated.  Delaware law also creates standing difficulties for creditors with breach of fiduciary duty claims against directors.  Second Circuit law goes even further, broadly holding that a trustee has no standing to pursue many claims for conduct involving the pre-bankruptcy debtor.  Those rules do not apply in California and the Ninth Circuit.

Obstacles to Filing Suit Against Third Parties in the Second and Third Circuits

In pari delicto

In pari delicto is a state law affirmative defense.  It bars an estate representative's recovery from a third party for misconduct where the debtor participated in the wrongful conduct.  In re Grumman Olson Industr., Inc., 329 B.R. 411, 424 n.5 (Bankr. S.D.N.Y. 2005).  It is based on the idea that "where parties are equally at fault, the defending party is in the stronger position."  Ross v. Bolton, 904 F.2d 819, 824 (2d Cir. 1990.)  Courts have explained that they should not mediate disputes between wrongdoers, and denying judicial relief to wrongdoers deters illegal conduct.  In re Food Management Group, LLC, 380 B.R. 677, 694 (Bankr. S.D.N.Y. 2008).

In pari delicto is not applied to bar fraudulent transfer or preference claims, which courts treat as only coming into existence at the bankruptcy filing.  The doctrine's application to other claims depends on whether the bad actor's conduct can be imputed to the debtor and hence to the estate representative.  Id. at 694 (citing Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340, 355 (3d Cir. 2001)).  Numerous jurisdictions, including the Second and Third Circuits, have applied the in pari delicto doctrine broadly to bar claims of trustees and creditors' committees for pre-petition misconduct.  See Official Comm. Of the Unsecured Creditors of Color Tile, Inc. v. Coopers & Lybrand, LLP, 322 F.3d 147, 149 (2d Cir. 2003) (creditors' committee); Lafferty, 267 F.3d at 355 (same); Terlecky v. Hurd (In re Dublin Sec., Inc.), 133 F.3d 377 (6th Cir. 1997) (chapter 7 trustee); Sender v. Buchanan (In re Hedged-Investments Assoc., Inc.), 84 F.3d 1281 (10th Cir. 1996) (same); Knauer v. Jonathon Roberts Fin. Group, 348 F.3d 230, 238 (7th Cir. 2003) (receiver's claims barred).

Standing in New York and the Second Circuit

The law in the Second Circuit and New York law is particularly hostile to claims for pre-petition misconduct brought by trustees, debtors in possession, and other successors in interest.  The Second Circuit adopted the controversial "Wagoner rule" to bar these claims on standing grounds.  See Shearson Lehman Hutton, Inc., v. Wagoner, 944 F.2d 114, 118 (2d Cir. 1991).  The Wagoner rule converts the state law equitable defense of in pari delicto into a blanket prohibition on standing by a trustee or debtor in possession to bring a claim against third parties for pre-petition conduct where management was involved in the alleged wrongdoing.  Id. at 120. 

Its rationale is that "management's misconduct is imputed to the corporation, and because a 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."  In re Food Management Group, 380 B.R. at 695 (quotations and citations omitted); see also Bankruptcy Services, Inc. v. Ernst & Young LLP (In re CBI Holding Co., Inc.), 529 F.3d 432, 448 (2d Cir. 2008) (same).  The same rule applies to a creditors' committee suing in place of the trustee as the estate's representative.  See In re Mediators, Inc., 105 F.3d 822, 825-826 (2d Cir. 1997); see also Color Tile, 322 F.3d at 163.

Standing Complications under Delaware Law

The Supreme Court of Delaware further complicated claims against insiders when it recently held that creditors of an insolvent debtor have no standing to sue the debtor's directors for breach of fiduciary duty.  North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 103 (Del. Supr. 2007) ("we hold that individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors") (emphasis in original).  Prior Delaware case law in the zone of insolvency established a fiduciary duty to creditors as well as shareholders.  Gheewalla limits remedies for breach of that fiduciary duty.  A creditor in Delaware may only pursue derivative claims on behalf of the corporation or direct non-fiduciary claims against directors.  Id.   As discussed above, however, even if the claims are brought as derivative claims in bankruptcy, the in pari delicto defense may bar them.   

The Law in California and the Ninth Circuit is More Favorable to Plaintiffs

In pari delicto

The Ninth Circuit, applying California law, has held that a trustee or receiver is not subject to equitable defenses like in pari delictoFederal Deposit Ins. Corp. v. O'Melveny & Myers, 61 F.3d 17 (9th Cir. 1995).  The court held that under California law "defenses based on a party's unclean hands or inequitable conduct do not generally apply against that party's receiver.  Id. at 19 ("[w]hile a party may itself be denied a right or defense on account of its misdeeds, there is little reason to impose the same punishment on a trustee, receiver or similar innocent entity that steps into the party's shoes pursuant to court order or operation of law""  Id.  The court further explained: 

[T]he receiver becomes the bank's successor as part of an intricate regulatory scheme designed to protect the interests of third parties who also were not privy to the bank's inequitable conduct.  That scheme would be frustrated by imputing the bank's inequitable conduct to the receiver, thereby diminishing the value of the asset pool held by the receiver and limiting the receiver's discretion in disposing of the assets.

Id.

A trustee or creditors' committee asserting claims against the debtor's directors and officers would place themselves in a much stronger position by filing suit in California and the Ninth Circuit.  Defendants in California and the Ninth Circuit cannot bar claims of trustees, receivers and creditors' committees through equitable defenses, like in pari delicto.  California and Ninth Circuit plaintiffs have a significant advantage over plaintiffs in Delaware and New York.  Even in typical fraudulent transfer cases not subject to the in pari delicto defense, there may be other additional claims and causes of action that could be brought in the Ninth Circuit or California that would be barred in the Second or Third Circuits.

Standing to Bring Claims against Directors

The decision in Davis v. Yageo Corporation, 481 F.3d 661, 674 (9th Cir. 2007), illustrates the Ninth Circuit's liberal approach to claims against insiders.  Davis involved a fight among the majority and minority shareholders for control of the debtor.  Id. at 667-668.  The minority shareholders were also unsecured creditors of the debtor.  Id. at 666-668.  To prevent the minority shareholders/creditors from voting in two of the debtor's five board members, the majority shareholder filed for Chapter 11 bankruptcy protection.  Id. at 667-668.  The minority shareholders' equity was eliminated by the Chapter 11 plan that the bankruptcy court approved.  Id. at 668.  The bankruptcy court also, however, approved an assignment to the minority shareholders/creditors of all the debtor's pre-petition claims against the majority shareholder and its directors.  Id.

The minority shareholders/creditors sued the majority shareholder and directors for breach of fiduciary duty, alleging that the majority shareholders and directors failed to consider alternatives to a bankruptcy filing that would have produced greater value for the company and its shareholders.  Id. at 669, 673.  The majority shareholder and directors argued that the minority shareholders/creditors lacked standing because they had suffered no harm.  Id.  The jury rejected this argument, and the Ninth Circuit affirmed.  Id. at 674.  The majority shareholders and directors made the decision to file for bankruptcy protection six days before they filed the petition.  Id.  The minority shareholders/creditors' stock had value before the decision, which was lost immediately after the decision was made.  Id.  The Ninth Circuit held, therefore, that the minority shareholders/creditors could bring a claim for pre-petition breach of fiduciary duty against the majority shareholder and directors.  Id.

While no courts have noted the difference between this Ninth Circuit decision and the law in other circuits, Davis highlights three advantages of Ninth Circuit and California law for plaintiffs pursuing claims against insiders for pre-petition misconduct.  First, a debtor's claims assigned to the creditors for the pre-petition decision to file bankruptcy were not barred by the in pari delicto defense, although the decision to file bankruptcy was made by the corporation itself.  Second, and similarly, the Wagoner rule did not apply to bar standing, even though the debtor's management was directly involved in the alleged wrongdoing.  Third, the Ninth Circuit held that creditor/shareholders who got the claim by assignment had standing to bring those claims directly because of the harm they had suffered.  Creditors can argue that Davis opens the door for them to assert direct breach of fiduciary duty claims against a debtor's directors and officers. 

Taking Advantage of the Favorable Law in the Ninth Circuit

Plaintiffs who file their lawsuits in the Ninth Circuit are more likely to take advantage of favorable Ninth Circuit and California law.  In federal question cases, federal courts apply the federal law of the circuit in which they sit.  Newton v. Thomason, 22 F.3d 1455, 1460 (9th Cir. 1994).  A district court in the Ninth Circuit therefore applies the Ninth Circuit's interpretation of federal law, allowing plaintiffs there to take advantage of Davis and O'MelvenySee id

In diversity cases, federal courts apply the choice of law rules of the state in which they sit.  Muldoon v. Tropitone Furn. Co., 1 F.3d 964, 965 (9th Cir. 1993).  While a particular state's choice of law rules do not necessarily lead a court to apply the substantive law of the state in which it sits, there is a greater likelihood that that it will do so when there are strong connections to the state.  California applies the substantive law of the state which has the strongest interest in application of its law, which is often informed by the locations of the parties and the alleged violation.  Butler v. Adoption Media, LLC, 486 F. Supp. 2d 1022, 1036-1054 (N.D. Cal. 2007).  Therefore, a plaintiff has a strong chance of persuading a California court to apply California law if the case has a strong connection to California.

Although venue may be proper in a federal district court in California, a defendant may attempt to transfer venue to a district outside the Ninth Circuit for convenience under 28 U.S.C. § 1404(a).  If the defendant is successful, the transferee court will apply its own circuit's interpretation of federal law, but it still may apply California law to state law questions.  Muldoon, 1 F.3d at 965.  The transferee court must apply the choice of law rules of the state in which the action was originally filed.  Id.  Filing suit in a federal district court in California increases the chances that favorable California law will apply, even if venue is transferred for convenience grounds.

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