Shannon Stapleton/ReutersIrving H. Picard, the court-appointed trustee in the Madoff fraud case.Most investors lose almost all of their money once a Ponzi scheme collapses, and the trustees appointed to clean up the mess try to find any deep pocket available to recover something. Unfortunately for the trustees, the legal doctrine of “in pari delicto,” Latin for “in equal fault,” may block any recovery.
The doctrine is based on the principle that a court will not adjudicate a civil dispute between two wrongdoers when one tries to claim that the other has some responsibility for the losses. When both are culpable, the court lets the losses rest where they fell and dismisses any claims for repayment.
In the Ponzi scheme context, the trustee appointed on behalf of investors steps into the shoes of the perpetrator of the fraud. The effect is that any knowledge of wrongdoing is attributed to the trustee, so that a claim against another participant in the scheme runs into the in pari delicto doctrine just as if the person who defrauded the investors was suing.
Just a few months before the collapse of Bernard L. Madoff’s investment firm, federal prosecutors charged Thomas Petters with conducting a Ponzi scheme that defrauded investors out of more than $3.5 billion. That was an unthinkable sum until Mr. Madoff’s $17 billion fraud came to light.
Trustees for investors in the two Ponzi schemes have been trying to get around the in pari delicto defense to obtain damages from those they claim aided the fraud.
For investors in Mr. Petters scheme, there is a ray of hope. Last week, the United States Court of Appeals for the Seventh Circuit in Chicago, in Peterson v. McGladrey & Pullen, LLP, reversed a district court’s dismissal of a claim against an accounting firm that served as the outside auditor for a group of mutual funds that invested almost $2.5 billion in Mr. Petters’s fraud.
The adviser to the funds was Gregory Bell, who created them in 2002 to invest in a factoring business run by Mr. Petters. In fact, that business was a sham, and when the fraud came to light investors lost most of their money in the funds.
Mr. Bell pleaded guilty to wire fraud, admitting that he started conspiring with Mr. Petters in February 2008 to let the fraud continue. The knowledge of Mr. Bell is attributable to the funds, and it would usually preclude the trustee from suing the outside auditor for negligence in not detecting the fraud because of the in pari delicto defense.
The Seventh Circuit found that Mr. Bell acknowledged in his guilty plea that he learned of the fraud in February 2008, but the trustee’s claim against the accounting firm alleges that it was negligent in 2006 and 2007. According to the court, “The Trustee’s theory is that, if [the accountant] had done what it was supposed to do, the Ponzi scheme would have been exposed earlier, and the Funds would not have thrown so much money down the drain in 2007 and 2008.”
Because the court has permitted the case to move forward, the trustee has a chance to recover a portion of the losses. There is no guarantee of a recovery, however, because the negligence claim is still subject to dismissal under the in pari delicto doctrine if it can be shown Mr. Bell was aware of Mr. Petters’s fraud before February 2008.
Irving H. Picard, the trustee for Mr. Madoff’s firm, has filed lawsuits seeking billions of dollars from JPMorgan Chase and a number of European banks, including HSBC and UniCredit, for helping the Ponzi scheme to thrive. The claims are on behalf of the customers, including those who did not deal directly with Mr. Madoff’s firm but instead had their money funneled through intermediaries.
Two Federal District Court judges in Manhattan, Jed S. Rakoff and Colleen McMahon, dismissed Mr. Picard’s claims on two grounds: first, that he did not have standing to pursue claims on behalf of anyone other than Mr. Madoff’s firm, and second, that even if he could pursue those claims, the in pari delicto defense would block any recovery on behalf of the firm. Both judges found that Mr. Picard had stepped into Mr. Madoff’s shoes, so he was saddled with the firm’s knowledge that stretched back to whenever Mr. Madoff began defrauding investors.
Mr. Picard has filed a challenge in a brief filed with the United States Court of Appeals for the Second Circuit in Manhattan. The leading decision from the court on the in pari delicto defense is Shearson Lehman Hutton, Inc. v. Wagoner, in which the court held that a “claim against a third party for defrauding a corporation with the cooperation of management accrues to creditors, not to the guilty corporation.”
Mr. Picard argues that the defense should not apply to a trustee appointed under the Security Investors Protection Act to gather assets to compensate customers of a brokerage firm. He asserts that the in pari delicto doctrine is intended to keep wrongdoers from suing one another over the harms they caused. The trustee, who did not participate in the misconduct and is trying to help customers, should be allowed to avoid its application, he says.
The problem Mr. Picard faces is that courts take a fairly broad view of the defense, and are wary about recognizing an exception based on the particular circumstances of a case. So I expect it will be difficult to persuade the court to allow him to avoid the in pari delicto defense even though it would mean that those who helped Mr. Madoff could escape liability.
If Mr. Picard is unsuccessful, then individual investors would have to pursue their own claims against the banks. That may be especially difficult for those who live in other countries because local laws do not allow them to seek damages for securities fraud the way United States law does.
The in pari delicto doctrine is intended to keep the bad guys from suing one another. But often it ends up doing more harm than good when innocent investors lose out on a claim to recover some of their losses.