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Sixth Circuit Rules that In Pari Delicto May Not Bar Trustee’s Conversion Claim

From Ponzi schemes to fraudulent transfers, many Chapter 7 bankruptcy cases involve allegations of wrongdoing. Bankruptcy trustees, who stand in the shoes of the bankrupt entity in asserting claims, often bring actions against third parties alleging participation in, and orchestration of, fraudulent schemes. Because the alleged wrongdoing many times involves actions or transactions in which the debtor took part, defendants in such lawsuits frequently raise a defense based on the doctrine of in pari delicto

In pari delicto is a defense that provides that in the case of mutual fault between the parties, the position of the defendant prevails. This doctrine was at the heart of a recent ruling by the U.S. Court of Appeals for the Sixth Circuit (the "Sixth Circuit") in the case of Hagan v. Baird[1], an appeal that arose from a Chapter 7 business bankruptcy that was filed in the U.S. Bankruptcy Court for the Western District of Michigan. As discussed in more detail below, the Sixth Circuit analyzed the merits of the arguments raised by two litigants relative to the maxim that "as between parties in pari delicto, that is equally in the wrong, the law will not lend itself to afford relief to one as against the other, but will leave them as it finds them."

The Background Facts

The underlying bankruptcy involves a relatively complex set of facts. King Par Corporation (Old King Par (OKP)) was a golf equipment company owned by William Baird. William's wife Pamela may or may not have been a shareholder during the time period relevant to this case.

OKP was sued by Izzo Golf, Inc. (Izzo) for patent infringement in 2002. In 2007, Izzo's motion for summary judgment was granted in part. In 2009, while the lawsuit was still pending, OKP, Baird Family LLC and William entered into an asset purchase agreement with KP Acquisition Company, LLC (NKP). OKP agreed to sell all of its inventory and substantial portions of its land to NKP for $3.4 million. In addition, NKP agreed for a fee to collect OKP accounts receivable, as fiduciary, and pay OKP debts with the funds, with any remaining funds to be paid to OKP.

OKP retained "Excluded Assets" and "Excluded Liabilities," which included liability related to the Izzo litigation. At closing, at William's direction, NKP wired over $4 million to the Baird's joint personal account. OKP then changed its name to B & P Baird Holdings, Inc., and William remained the president, director and shareholder of the new entity. All excess accounts receivable collected were used to pay the Baird’s personal tax obligations or were wired to their personal account.

The litigation with Izzo continued and, ultimately, Izzo obtained a judgment in the amount of $3.28 million, and later successfully petitioned for post verdict enhanced damages, bringing its judgment to over $12 million.

B & P Baird Holdings, Inc. filed for Chapter 7 bankruptcy in September 2010. Almost a year later, the Chapter 7 trustee initiated an adversary proceeding against the Bairds and NKP alleging that the pre-bankruptcy transactions engaged in by the defendants were improper. In January 2012, the trustee filed an amended complaint alleging fraudulent transfer, violations of the Michigan Business Corporation Act, and common law and statutory conversion.

In March 2012, the bankruptcy court granted Pamela's motion to dismiss the conversion counts based on the court's determination that the trustee had not alleged that the Bairds diverted the funds for their personal use. The trustee then moved for leave to file a second amended complaint, again alleging conversion, but adding additional factual detail to support the claim. The Bairds objected to the request to amend.

The bankruptcy court ruled against the trustee. The court - on its own - raised the in pari delicto issue. It explained that the trustee's conversion claim was really a claim for embezzlement - a claim to which Michigan law applies the doctrine of in pari delicto. Because, the court reasoned, the debtor and the Bairds were "effectively one and the same," in pari delicto provides a complete defense and, thus, trustee's motion to file the second amended complaint was futile.

After the bankruptcy court denied the trustee's motion to alter or amend the order, the trustee reached a settlement with the Bairds on all claims but the conversion claim. The Bairds paid $3.775 million to the bankruptcy estate.

The trustee appealed the bankruptcy court's denial of the motions to file a second amended complaint and to alter or amend that denial to the U.S. District Court. The district court affirmed the bankruptcy court decisions, ruling that the bankruptcy court properly applied in pari delicto to bar the conversion/embezzlement claim. The trustee then appealed to the Sixth Circuit.

The Appeal

The trustee made two central arguments on appeal. First, that the bankruptcy court erred by ruling that the trustee had pled embezzlement, not conversion. The Sixth Circuit reversed the lower courts on this issue, ruling that the trustee adequately pled conversion against Pamela.

In Michigan, conversion is a tort that arises by statute as well as common law. Mich. Comp. Laws § 600.2919(a), the Michigan conversion statute, encompasses embezzlement. In other words, embezzlement is a form of conversion. The common law definition of conversion is "any distinct act of domain wrongfully exerted over another's personal property in denial of or inconsistent with the rights therein."

The Sixth Circuit further explained that a cause of action for conversion under Michigan law "need not necessarily include the intent element required for embezzlement and for the application of in pari delicto."

In this case, the Sixth Circuit reviewed the allegations in the proposed second amended complaint related to trustee's claim for common law conversion, and ruled that trustee properly alleged a claim of conversion through its allegations that the Bairds impermissibly appropriated OKP funds for personal use.

Second, the trustee challenged the lower court ruling that in pari delicto was applicable to the facts at issue and provided a defense to trustee's conversion claim. The lower courts based their rulings on the fact that the parties to the challenged transactions - the Bairds and OKP - were one in the same. Since the trustee stands in the shoes of OKP (the predecessor to the debtor), and since OKP was an alleged wrongdoer in the transaction, the trustee's recovery could be barred by OKP's wrongful conduct pursuant to the doctrine of in pari delicto.

The Sixth Circuit disagreed with the lower courts' conclusions. It began its analysis by reviewing the law of agency, noting that an agent's conduct "is generally imputed to his principal, except where the agent acts in his own interest, adversely to his principal." This exception does not apply where - as the lower courts held was the case under these facts - the agent and principal are one and the same, and in such a case the agent's fraudulent conduct will be attributed to the principal.

But, under Michigan law, there is an exception to the imputation rule. The Sixth Circuit cited Michigan case law that stands for the proposition that: "A corporate officer's fraud will not be imputed to the corporation, thus allowing the bankruptcy trustee to proceed with his claim, where there exists at least one innocent decision maker who, if he had been alerted to the fraud, could have stopped it." Thus, the Sixth Circuit explained, if the proposed second amended complaint properly pled that Pamela was an "innocent decision maker," then the bankruptcy court should not have applied the in pari delicto doctrine.

While the proposed second amended complaint contained allegations that William and Pamela acted in concert to fraudulently transfer debtor's funds, it also contained allegations that Pamela acted innocently. While these allegations were contradictory, they were not improper, as Federal Rule of Civil Procedure Rule 8 allows a pleading to include alternative, or even contradictory, claims.

The Sixth Circuit ruled, therefore, that "although the proposed amended complaint contains conflicting allegations, fairly read, it includes the alternative allegation that Pam acted innocently with regard to the conversion of Debtor funds." And, because her role in the alleged conversion had not been resolved (i.e., whether she was an innocent decision maker), it was too early to determine whether the in pari delicto doctrine bars trustee's conversion claim against Pamela. The Sixth Circuit ruled, therefore, that the motion to amend the complaint should have been granted.

If you have any questions about this case, or bankruptcy issues in general, please contact Patricia Scott at pscott@fosterswift.com.

[1] Case No. 14-1060 (6th Cir., Jan. 2, 2015)

Categories: 6th Circuit Court of Appeals, Chapter 7, Western District of Michigan

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