Official Committee v. RF Lafferty & Co Inc

Opinions of the United

2001 Decisions States Court of Appeals

for the Third Circuit

10-9-2001

Official Committee v. RF Lafferty & Co Inc

Precedential or Non-Precedential:

Docket 00-1157

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Filed October 9, 2001

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 00-1157

OFFICIAL COMMITTEE of UNSECURED CREDITORS,

Appellant

v.

R.F. LAFFERTY & CO., INC.;

*COGEN SKLAR, L.L.P.

*(Dismissed Pursuant to Court's February 14, 2001 Order)

ON APPEAL FROM THE ORDER

OF THE UNITED STATES DISTRICT COURT

FOR THE EASTERN DISTRICT OF PENNSYLVANIA

(D.C. Civ. No: 00-cv-00519)

District Court Judge: The Honorable Edmund V. Ludwig

Argued on May 31, 2001

Before: SLOVITER, FUENTES, and COWEN, Circuit Judges

(Opinion Filed: October 9, 2001)

Barbara W. Mather (argued)

Francis J. Lawall

Matthew J. Hamilton

Pepper Hamilton LLP

3000 Two Logan Square

18th and Arch Streets

Philadelphia, PA 1903-2799

Attorney for Appellant

Stuart L. Melnick (argued)

Tanner Propp LLP

99 Park Avenue

New York, New York 10016

Attorney for Appellee

OPINION OF THE COURT

FUENTES, Circuit Judge:

This matter arises out of the bankruptcy of two lease

financing corporations, which were allegedly operated as a

"Ponzi scheme."1 Like all such schemes, this one collapsed,

leaving numerous investors with significant losses. To

operate the scheme, William Shapiro, aided by others,

allegedly caused the corporations to issue fraudulent debt

certificates, which were then sold to individual investors.

When the corporations lost any reasonable prospect of

repaying the outstanding debt, they filed for bankruptcy.

A Committee of Creditors, appointed by a bankruptcy

trustee, brought claims in the District Court on behalf of

the two debtor corporations alleging that third-parties had

fraudulently induced the corporations to issue the debt

securities, thereby deepening their insolvency and forcing

them into bankruptcy. These third-parties allegedly

conspired with the debtors' management, who were also the

_________________________________________________________________

1. A "Ponzi scheme" is "[a] fraudulent investment scheme in which

money contributed by later investors generates artificially high dividends

for the original investors, whose example attracts even larger

investments." Black's Law Dictionary 1180 (7th ed. 1999).

2

debtors' sole shareholders, in engineering the Ponzi

scheme. On these allegations, the District Court concluded

that it could not rule out the possibility of a cognizable

injury. Nevertheless, the District Court held that the

Committee lacked standing to assert its claims against the

third-parties because of the doctrine of in pari delicto. The

Committee appeals.

We conclude that "deepening insolvency" constitutes a

valid cause of action under Pennsylvania state law and that

the Committee therefore has standing to bring this action.

However, evaluating the Committee's claims "as of the

commencement" of the bankruptcy, we hold that because

the Committee, standing in the shoes of the debtors, was in

pari delicto with the third parties it is suing, its claims were

properly dismissed. Accordingly, we will affirm the

judgment of the District Court.

I.

The following allegations are taken from the Amended

Complaint of the appellant, the Official Committee of

Unsecured Creditors ("the Committee"), which was

appointed by the bankruptcy trustee and which was

authorized by stipulation to assert claims on behalf of the

debtor corporations. The essence of the Committee's

allegations is that the Shapiro family (or "the Shapiros"),

with the assistance of other defendants, including third-

party professionals,2 operated Walnut Equipment Leasing

Company, Inc., ("Walnut"), and its wholly owned subsidiary,

Equipment Leasing Corporation of America ("ELCOA"), as a

Ponzi scheme.

The scheme originated with Walnut, which was owned by

defendant Walnut Associates, Inc., and which, in turn, was

owned by William Shapiro. In 1986, Walnut was

_________________________________________________________________

2. The sixteen defendants in the original case before the District Court

are as follows: (1) William Shapiro, (2) Kenneth Shapiro, (3) DelJean

Shapiro, (4) Lester Shapiro, (5) Nathan Tattar, (6) Adam Varrenti, Jr.,

(7)

John Orr, (8) Philip Bagley, (9) Walnut Associates, Inc., (10) Welco,

Inc.,

(11) The Law Offices of William Shapiro, Esq., P.C., (12) Financial Data,

Inc., (13) Kenner Collection Agency, Inc., (14) Cogen, Sklar, L.L.P., (15)

R.F. Lafferty & Co., Inc., and (16) Liss Financial Services, Inc.

3

experiencing financial difficulties. As a result, Walnut could

not raise sufficient capital through the sale of debt

securities. In a purported effort to secure more capital for

Walnut, the Shapiro family organized ELCOA as "a limited

purpose financing subsidiary," wholly owned by Walnut, to

provide a platform to sell debt securities through a new

company with a clean financial picture.

According to the Amended Complaint, ELCOA was

fraudulently marketed as an independent business entity,

even though its only function was to acquire leases from

Walnut and to sell debt certificates to raise money. In

reality, Walnut and ELCOA were part of a network of

businesses owned and operated by the Shapiro family. This

network included defendants Welco, Inc., The Law Offices

of William Shapiro, Esq., P.C., Walnut Associates, Inc.,

Financial Data, Inc., and Kenner Collection Agency, Inc. As

part of the scheme to keep this network afloat, the Shapiros

allegedly misstated Walnut and ELCOA's financial position

in order to induce these companies to register, offer, and

sell additional debt certificates to raise capital. Numerous

investors purchased the ELCOA debt securities, and the

Committee claims that the Shapiros funneled those monies

into Walnut. At the same time, the Shapiros and their co-

conspirators continued receiving salaries and fees from

Walnut and ELCOA. Moreover, the issuance of debt

securities allegedly deepened the insolvency of Walnut and

ELCOA, and put them on the path to bankruptcy.

The Amended Complaint states that certain third-party

professionals were essential to the Shapiro family's

operation, namely, their counsel, defendant William

Shapiro, Esq. P.C., their accountant, defendant Cogen

Sklar, L.L.P. ("Cogen"), and their qualified independent

underwriters, defendant R.F. Lafferty & Co., Inc. ("Lafferty"),

and defendant Liss Financial Services, Inc. ("Liss"). Each of

these parties was responsible for professional opinions that

served as prerequisites for the registration of each public

offering and sale of ELCOA's debt securities. Each allegedly

conspired with the Shapiro family to render opinions

replete with multiple fraudulent misstatements and

material omissions concerning Walnut and ELCOA's

financial statements. The parties allegedly lacked any

foundation for their conclusions.

4

Ultimately, the artifice collapsed, leading to the

bankruptcies of Walnut and ELCOA, which became the

debtor corporations (or "the Debtors"). The companies filed

Chapter 11 petitions, and the Debtors' management, which

included members of the Shapiro family and their co-

conspirators, were removed. The Bankruptcy Court then

appointed a bankruptcy trustee. Thereafter, the trustee,

pursuant to section 1102 of the Bankruptcy Code, 11

U.S.C. S 1102, appointed the Committee to represent the

claims of unsecured creditors in connection with the

bankruptcy proceedings. The Committee is comprised

entirely of creditors; no member of the Debtors' former

management is present.

On January 19, 1999, the Bankruptcy Court approved a

Stipulation between the Committee and the Debtors

authorizing, among other things, "the Committee to

commence and prosecute . . . [l]itigation on behalf of the

Debtors' estates." Stipulation Among the Debtors and the

Official Committee of Unsecured Creditors of the Debtors

Authorizing the Committee to Commence Litigation on Behalf

of the Debtors' Estates, Bankr. No. 97-19699-DWS, at *2

(Bankr. E.D. Pa. Jan. 19, 1999). Under the Stipulation, the

Committee effectively acquired all the attributes of a

bankruptcy trustee for purposes of this case. See In re The

Mediators, Inc., 105 F.3d 822, 826 (2d Cir. 1997) ("[T]he

Committee, while not a trustee in bankruptcy, is in a

position analogous to a trustee because it is suing on

behalf of the debtor.").

On February 1, 1999, the Committee, on behalf of the

Debtors' estates, commenced a civil action in the District

Court for the Eastern District of Pennsylvania against the

Debtors' officers, directors, affiliated companies (the

Shapiro family and their network of companies), and

outside professionals (Cogen and Lafferty) on the ground

that the defendants, through their mismanagement of the

Debtors and their participation in a fraudulent scheme, had

"wrongfully expanded the [D]ebtors' debt out of all

proportion of their ability to repay and ultimately forced the

[D]ebtors to seek bankruptcy protection." The Committee

brought claims against the Shapiros and their alleged co-

conspirators -- including Cogen and Lafferty -- based upon

5

violations of federal securities laws, as well as common law

fraud and negligent misrepresentation, mismanagement

and breach of fiduciary duty, breach of contract,

professional malpractice, and aiding and abetting breach of

fiduciary duty. In addition, the Committee brought claims

against some defendants -- DelJean Shapiro, Lester

Shapiro, Adam Varrenti, Jr., John Orr, and Philip Bagley --

in their capacity as directors of either Walnut or ELCOA or

both, asserting that they had mismanaged and breached

their fiduciary duties to the Debtors by allegedly failing to

supervise and oversee the Debtors' affairs.

All defendants (except Liss, who failed to appear) moved

to dismiss the Committee's Amended Complaint or,

alternatively, for summary judgment. On September 8,

1999, the District Court dismissed the claims against

Cogen and Lafferty, reasoning that, "[s]ince it is pleaded

that the [D]ebtors, acting through the Shapiros, perpetrated

the Ponzi scheme . . . the doctrine of in pari delicto . . . bars

[the Committee] from suing these defendants for claims

arising out of the fraud." Official Committee of Unsecured

Creditors v. William Shapiro, et al., No. 99-526, slip op. at

11 (E.D. Pa. Sept. 8, 1999). At the same time, however, the

District Court denied the motion to dismiss as to the other

defendants on the ground that in pari delicto did not

preclude claims against corporate insiders. Id. at 12.

Thereafter, the court severed the Committee's claims

against Cogen and Lafferty, and the Committee appealed

the dismissal of those claims. Cogen has settled with the

Committee, leaving Lafferty as the only appellee.

II.

The District Court had subject matter jurisdiction over

the case under 28 U.S.C. SS 1331 and 1334(b). We have

jurisdiction to hear the appeal under 28 U.S.C.S 1291.

We have plenary review over the District Court's

dismissal of the Committee's claims against Lafferty. See

Maio v. Aetna, Inc., 221 F.3d 472, 481-82 (3d Cir. 2000).

We apply the same standard used by the District Court,

namely, we must determine whether, under any reasonable

reading of the pleadings, the Committee may be entitled to

6

relief, accepting as true all well pleaded allegations in the

Amended Complaint and drawing all reasonable inferences

in favor of the Committee. Nami v. Fauver, 82 F.3d 63, 65

(3d Cir. 1996). The District Court's order granting the

motion to dismiss will be affirmed only if it appears that the

Committee can prove no set of facts that would entitle it to

relief. Conley v. Gibson, 355 U.S. 41, 45-46 (1957).

III.

As a preliminary matter, we believe that the District

Court's conception of the standing issue in this case was

somewhat flawed. The District Court stated that both

cognizable injury and the doctrine of in pari delicto were

elements of the standing analysis. Official Committee of

Unsecured Creditors, No. 99-526, slip op. at 6. This

formulation, however, was incorrect. In general,"[s]tanding

consists of both a `case or controversy' requirement

stemming from Article III, Section 2 of the Constitution, and

a subconstitutional `prudential' element." See The Pitt News

v. Fisher, 215 F.3d 354, 359 (3d Cir. 2000). An analysis of

standing does not include an analysis of equitable defenses,

such as in pari delicto. Whether a party has standing to

bring claims and whether a party's claims are barred by an

equitable defense are two separate questions, to be

addressed on their own terms. See In re Dublin Secs., Inc.,

133 F.3d 377, 380 (6th Cir. 1997) (analyzing in pari delicto

separately from standing).

That said, we will address both doctrines because,

together, they formed the basis of the District Court's

judgment. As a threshold requirement, standing demands

our initial attention. See Valley Forge Christian College v.

Americans United for Separation of Church & State, Inc.,

454 U.S. 464, 471-74 (1982) (discussing the fundamental

requirement of standing). Citing Warth v. Seldin , 422 U.S.

490, 501 (1975), for the proposition that standing requires

a "distinct and palpable injury," Lafferty argues that the

Committee lacks standing because the Debtors have not

sustained a "cognizable injury" separate and apart from any

injury sustained by investors who had purchased the

Debtors' debt securities. As such, Lafferty maintains that

the Committee may not bring those claims under the

7

Supreme Court's decision in Caplin v. Marine Midland

Grace Trust Co., in which the Court held that a bankruptcy

trustee has no standing to assert claims on behalf of an

estate's creditors. See 406 U.S. 416, 434 (1972).

Lafferty made the same argument to the District Court,

which rejected it on the ground that, at the motion to

dismiss stage, the court could not foreclose the existence of

a separately cognizable injury to the Debtors

distinguishable from the injuries suffered by purchasers of

the Debtors' certificates:

Here, the Committee is suing on behalf of the bankrupt

debtor corporations [Walnut and ELCOA] -- not on

behalf of the creditors themselves. The injury alleged is

that "the debtors were fraudulently induced to register,

offer and sell certificates when insolvent and thus

without ability to repay their obligations to investors.

As a result, the debtors' outstanding debt was

continually expanded out of all proportion with their

ability to repay, forcing them into bankruptcy." Compl.

PP 1, 77.

. . . .

Defendants Cogen [ ] and Lafferty maintain that the

alleged Ponzi scheme claims belong exclusively to the

creditors, citing Hirsch v. Arthur Anderson & Co., 72

F.3d 1085 (2d Cir. 1995). [However, I believe that,

w]hile the most obvious damages were those sustained

by the creditors who purchased certificates [and

securities], the possibility of a distinct and separate

injury to the debtor corporations cannot be eliminated at

this stage. See In re Plaza Mortg. and Fin. Corp., 187

B.R. 37, 41 (N.D. Ga. 1995) (denying motion to dismiss

trustee's claims against accountants who participated

in Ponzi scheme and distinguishing Hirsch where only

allegation of injury was "unpaid obligations of the

debtor to the creditors").

Official Committee of Unsecured Creditors, No. 99-526, slip.

op. at 5, 7 (emphasis added).

We agree with the District Court's evaluation. With the

exception of a single federal securities law claim, the

8

Committee brought only state common law claims on behalf

of the Debtors. According to the Amended Complaint, the

defendants (including Lafferty), through their alleged fraud

and participation in the scheme, injured the Debtors by

"wrongfully expand[ing] the [D]ebtors' debt out of all

proportion of their ability to repay and ultimately forc[ing]

the [D]ebtors to seek bankruptcy protection." In other

words, the Committee alleges an injury to the Debtors'

corporate property from the fraudulent expansion of

corporate debt and prolongation of corporate life. This type

of injury has been referred to as "deepening insolvency."

See, e.g., ALI-ABA Course of Study, Proximate Cause,

Foreseeability, and Deepening Insolvency in Accountants'

Liability Litigation, C994 ALI-ABA 201, 203 (1995).

As far as the state law claims are concerned, it is clear

that, to the extent Pennsylvania law recognizes a cause of

action for the Debtors against Lafferty, the Committee can

demonstrate the injury required for standing to sue in

federal court. Given Lafferty's arguments, the standing

analysis then consists of three inquiries: (1) whether the

Committee is merely asserting claims belonging to the

creditors, (2) whether "deepening insolvency" is a valid

theory giving rise to a cognizable injury under Pennsylvania

state law, and (3) whether, as Lafferty contends, the injury

is merely illusory.

A. Whether the Committee is merely asserting claims

belonging to creditors

Whether a right of action belongs to the debtor or to

individual creditors is a question of state law. Hirsch v.

Arthur Andersen & Co., 72 F.3d 1085, 1093 (2d Cir. 1995).

In Pennsylvania, as in almost every other state,"a

corporation is a distinct and separate entity, irrespective of

the persons who own all its stock." Barium Steel Corp. v.

Wiley, 108 A.2d 336, 341 (Pa. 1954) (citations omitted);

accord In re Erie Drug Co., 204 A.2d 256, 257 (Pa. 1964).

From this principle arises a distinction between the

property of a corporation and that of others. For example,

with respect to shareholders,

[t]he fact that one person owns all of the stock does not

make him and the corporation one and the same

9

person, nor does he thereby become the owner of all

the property of the corporation. The shares of stock of

a corporation are essentially distinct and different from

the corporate property.

Barium Steel, 108 A.2d at 341 (citations omitted); see also

Meitner v. State Real Estate Comm'n, 275 A.2d 417, 419

(Pa. Commw. Ct. 1971) (stating that "officers of

corporations are not deemed to be the owners of corporate

property even to the extent that they are shareholders").

The legal fiction of corporate existence corresponds with

the view that an injury to the corporate body is legally

distinct from an injury to another person. Thus, it is well

established, under Pennsylvania law, that where fraud,

mismanagement, or other wrong damages a corporation's

assets, a shareholder does not have a direct cause of

action. Burdon v. Erskine, 401 A.2d 369, 370-71 (Pa.

Super. Ct. 1979) (citation omitted). Rather, it is the

corporate body that suffers the primary wrong and,

consequently, it is the corporate body that possesses the

right to sue. John L. Motley Assoc., Inc. v. Rumbaugh, 104

B.R. 683, 686-87 (E.D. Pa. 1989) (citations omitted)

(describing Pennsylvania law). Thus, "an action to redress

injuries to the corporation cannot be maintained by an

individual shareholder, but must be brought as a derivative

action in the name of the corporation." Id. (citations

omitted) (describing Pennsylvania law); see also 12

Summary of Pennsylvania Jurisprudence Business

Relationships S 7:90 (2d ed. 1993) ("creditors claiming a

beneficial interest in the corporation . . . may not[even]

maintain a derivative action").

It follows from this discussion that a corporation can

suffer an injury unto itself, and any claim it asserts to

recover for that injury is independent and separate from the

claims of shareholders, creditors, and others. We think it is

irrelevant that, in bankruptcy, a successfully prosecuted

cause of action leads to an inflow of money to the estate

that will immediately flow out again to repay creditors:

The . . . assertion that this action will benefit creditors

is not an admission that this action is being brought

on their behalf. In a liquidation case, it is

10

commonplace for a trustee to pursue an action on

behalf of the debtor in order to obtain a recovery

thereon for the estate. If the trustee is successful in the

action, the recovery which he obtains becomes property

of the estate and is then distributed pursuant to the

scheme established by S 726(a). Simply because the

creditors of a[n] estate may be the primary or even the

only beneficiaries of such a recovery does not

transform the action into a suit by the creditors.

Otherwise, whenever a lawsuit constituted property of

an estate which has insufficient funds to pay all

creditors, the lawsuit would be worthless since under

Caplin it could not be pursued by the trustee.

In re: Jack Greenberg, Inc., 240 B.R. 486, 506 (Bankr. E.D.

Pa. 1999); accord Scholes v. Lehmann, 56 F.3d 750, 754

(7th Cir. 1995) ("That the return would benefit the limited

partners is just to say that anything that helps a

corporation helps those who have claims against its

assets.").

In the instant case, the Committee sought recovery of

damage to the Debtors' property from "deepening

insolvency." We see no indication that the Committee is

attempting to recover for injuries to the creditors. Cf.

Caplin, 406 U.S. at 434 (holding that a trustee may not

assert claims on behalf of creditors). Therefore, accepting

the allegations as true and drawing all reasonable

inferences in favor of the Committee, we conclude that the

claims here belong to the Debtors, rather than to the

creditors.

B. Whether "deepening insolvency" is a valid theory that

gives rise to a cognizable injury under state law

Having established that the Committee brought claims on

behalf of the Debtors, rather than the creditors, we must

now determine whether the alleged theory of injury--

"deepening insolvency" -- is cognizable under Pennsylvania

law. Neither the Pennsylvania Supreme Court nor any

intermediate Pennsylvania court has directly addressed this

issue. In the absence of an opinion from the state's highest

tribunal, we must don the soothsayer's garb and predict

how that court would rule if it were presented with the

11

question. See Wiley v. State Farm Fire & Casualty Co., 995

F.2d 457, 459 (3d Cir. 1993). Indeed, because no state or

federal courts have interpreted Pennsylvania law on this

subject, we will rely predominantly on decisions

interpreting the law of other jurisdictions and on the policy

underlying Pennsylvania tort law to make this prediction.

See Gruber v. Owens-Illinois, Inc., 899 F.2d 1366, 1369-70

(3d Cir. 1990) (noting possible sources of authority for

making a prediction).

Drawing guidance from these authorities, we conclude

that, if faced with the issue, the Pennsylvania Supreme

Court would determine that "deepening insolvency" may

give rise to a cognizable injury. First and foremost, the

theory is essentially sound. Under federal bankruptcy law,

insolvency is a financial condition in which a corporation's

debts exceed the fair market value of its assets. 11 U.S.C.

S 101(32). Even when a corporation is insolvent, its

corporate property may have value. The fraudulent and

concealed incurrence of debt can damage that value in

several ways. For example, to the extent that bankruptcy is

not already a certainty, the incurrence of debt can force an

insolvent corporation into bankruptcy, thus inflicting legal

and administrative costs on the corporation. See Richard A.

Brealey & Stewart C. Myers, Principles of Corporate Finance

487 (5th ed. 1996) ("[B]y issuing risky debt,[a corporation]

give[s] lawyers and the court system a claim on the firm if

it defaults."). When brought on by unwieldy debt,

bankruptcy also creates operational limitations which hurt

a corporation's ability to run its business in a profitable

manner. See id. at 488-89. Aside from causing actual

bankruptcy, deepening insolvency can undermine a

corporation's relationships with its customers, suppliers,

and employees. The very threat of bankruptcy, brought

about through fraudulent debt, can shake the confidence of

parties dealing with the corporation, calling into question

its ability to perform, thereby damaging the corporation's

assets, the value of which often depends on the

performance of other parties. See Michael S. Knoll, Taxing

Prometheus: How the Corporate Interest Deduction

Discourages Innovation and Risk-Taking, 38 Vill. L. Rev.

1461, 1479-80 (1993). In addition, prolonging an insolvent

12

corporation's life through bad debt may simply cause the

dissipation of corporate assets.

These harms can be averted, and the value within an

insolvent corporation salvaged, if the corporation is

dissolved in a timely manner, rather than kept afloat with

spurious debt. As the Seventh Circuit explained in Schacht

v. Brown:

[C]ases [that oppose "deepening insolvency"] rest[ ]

upon a seriously flawed assumption, i.e., that the

fraudulent prolongation of a corporation's life beyond

insolvency is automatically to be considered a benefit

to the corporation's interests. This premise collides

with common sense, for the corporate body is

ineluctably damaged by the deepening of its insolvency,

through increased exposure to creditor liability. Indeed,

in most cases, it would be crucial that the insolvency of

the corporation be disclosed, so that shareholders may

exercise their right to dissolve the corporation in order to

cut their losses. Thus, acceptance of a rule which

would bar a corporation from recovering damages due

to the hiding of information concerning its insolvency

would create perverse incentives for wrong-doing

officers and directors to conceal the true financial

condition of the corporation from the corporate body as

long as possible.

711 F.2d 1343, 1350 (7th Cir. 1983) (citations omitted)

(emphasis added).

Growing acceptance of the deepening insolvency theory

confirms its soundness. In recent years, a number of

federal courts have held that "deepening insolvency" may

give rise to a cognizable injury to corporate debtors. See,

e.g., id. (applying Illinois law and holding that, where a

debtor corporation was fraudulently continued in business

past the point of insolvency, the liquidator had standing to

maintain a civil action under racketeering law); Hannover

Corp. of America v. Beckner, 211 B.R. 849, 854-55 (M.D.

La. 1997) (applying Louisiana law and stating that"a

corporation can suffer injury from fraudulently extended

life, dissipation of assets, or increased insolvency"); Allard

v. Arthur Andersen & Co., 924 F. Supp. 488, 494 (S.D.N.Y.

13

1996) (applying New York law and stating that, as to suit

brought by bankruptcy trustee, "[b]ecause courts have

permitted recovery under the `deepening insolvency' theory,

[defendant] is not entitled to summary judgment as to

whatever portion of the claim for relief represents damages

flowing from indebtedness to trade creditors"); In re Gouiran

Holdings, Inc., 165 B.R. 104, 107 (E.D.N.Y. 1994) (applying

New York law, and refusing to dismiss claims brought by a

creditors' committee because it was possible that,"under

some set of facts two years of negligently prepared financial

statements could have been a substantial cause of[the

debtor] incurring unmanageable debt and filing for

bankruptcy protection"); Feltman v. Prudential Bache

Securities, 122 B.R. 466, 473 (S.D. Fla. 1990) (stating that

an " `artificial and fraudulently prolonged life . . . and . . .

consequent dissipation of assets' constitutes a recognized

injury for which a corporation can sue under certain

conditions", but concluding that there was no injury on the

facts). Some state courts have also recognized the

deepening insolvency theory. See, e.g., Herbert H. Post &

Co. v. Sidney Bitterman, Inc., 219 A.D. 2d 214 (N.Y. App.

Div. 1st Dep't 1996) (applying New York law and allowing a

malpractice claim for failing to detect embezzlement that

weakened a company, which already was operating at a

loss, thereby causing default on loans and forcing

liquidation); Corcoran v. Frank B. Hall & Co. , 149 A.D. 2d

165, 175 (N.Y. App. Div. 1st Dep't 1989) (applying New York

law and allowing claims for causing a company to"assume

additional risks and thereby increase the extent of its

exposure to creditors").

Significantly, one of the most venerable principles in

Pennsylvania jurisprudence, and in most common law

jurisdictions for that matter, is that, where there is an

injury, the law provides a remedy. See 37 Pennsylvania

Law Encyclopedia, Torts S 4, at 120 (1961) ("For every legal

wrong there must be a correlative legal right.") (citation

omitted). Thus, an identifiable and compensable injury is

essential to the existence of tort liability, Schweitzer v.

Consolidated Rail Corp., 758 F.2d 936, 942 (3d Cir. 1985),

but once an injury has occurred, "tort law attempts to place

the injured party in the same position he occupied before

the injury," Hahn v. Atlantic Richfield Co. , 625 F.2d 1095,

14

1104 (3d Cir. 1980) (construing Pennsylvania tort policy).

Similarly, where a contractual "breach occurs, contract law

seeks to give to the nonbreaching party the benefit of his or

her bargain, to put him or her in the position he or she

would have been in had there been no breach." 1 Summary

of Pennsylvania Jurisprudence Torts S 1.1 (2d ed. 1999).

Thus, where "deepening insolvency" causes damage to

corporate property, we believe that the Pennsylvania

Supreme Court would provide a remedy by recognizing a

cause of action for that injury.

Lafferty challenges the strong rationales for recognizing

an injury here, citing a few cases that it claims reject

"deepening insolvency." In our view, the majority of these

cases do not address "deepening insolvency," but rather,

simply apply the Supreme Court's holding in Caplin that a

bankruptcy trustee has no standing to assert claims on

behalf of creditors. See, e.g., Hirsch v. Arthur Andersen &

Co., 72 F.3d 1085, 1093-94 (2d Cir. 1995); E.F. Hutton &

Co. v. Hadley, 901 F.2d 979, 986-87 (11th Cir. 1990);

Williams v. California 1st Bank, 859 F.2d 664, 666-67 (9th

Cir. 1988). These decisions are not relevant to the present

case because, as we explained earlier, the Committee is

proceeding on behalf of the Debtors, not the creditors.

Moreover, to the extent that either the cases cited by

Lafferty or other cases suggest that a corporation may

never sue to recover damages resulting from the fraudulent

prolongation of its life past solvency, we believe, under the

same analysis conducted by the Seventh Circuit in Schacht,

that Pennsylvania courts would reject them.

We pause here to consider the 19th century case of

Patterson v. Franklin, 35 A. 205 (Pa. 1896), an arguably

applicable decision of the Pennsylvania Supreme Court. In

Patterson, an assignee standing in the shoes of an insolvent

corporation brought suit against the incorporators, claiming

that they had allegedly made false representations in the

statement of incorporation. Id. at 206. Apparently, the false

representations had allowed the corporation to contract

more debts. Id. On these allegations, the Pennsylvania

Supreme Court affirmed the dismissal of the assignee's

claims, reasoning that, because the assignee had alleged

that the corporation had benefitted from the

representations, there was no viable cause of action. Id.

15

In our view, Patterson is not controlling here. The

Patterson court never expressly considered the"deepening

insolvency" theory, as the opinion does not indicate that the

assignee presented any version of that argument to the

court. In fact, it seems that the assignee in Patterson had

not even alleged an injury to the corporation at all:

The fraud was perpetrated for its benefit. It was a

gainer, not a loser because of it. It was given a

considerable credit by the statement to which, as it is

alleged, it had no claim whatever.

Id. (emphasis added). Thus, given the allegations in the

case, it was perfectly reasonable for the court in Patterson

to affirm the dismissal. See also Kinter v. Connolly, 81 A.

905, 905 (Pa. 1911) (rejecting receiver's claim on behalf of

the corporation against the directors for fraudulent

statements that induced parties to do business with the

corporation because "there [was] no averment that any act

or omission of those of the defendants who demur caused

loss or injury to the [corporation].").

Our reading of Patterson is informed in part by its age. In

the hundred-plus years between that decision and the

present, the business practices of corporations in the

United States have changed quite dramatically. Likewise,

society's understanding of corporate theory has grown. See

William W. Bratton, Jr., The New Economic Theory of the

Firm: Critical Perspectives from History, 41 Stan. L. Rev.

1471, 1482-1501 (1989) (describing the evolution of

corporations over the last two centuries); see also Henry

Hansmann & Reinier Kraakman, The End of History for

Corporate Law, 89 Geo. L.J. 439, 440-49 (2001) (describing

the history of models for corporate structure and

governance). Therefore, we decline to draw any broad

principle from Patterson, a decision which did not directly

address "deepening insolvency."

In sum, we believe that the soundness of the theory, its

growing acceptance among courts, and the remedial theme

in Pennsylvania law would persuade the Pennsylvania

Supreme Court to recognize "deepening insolvency" as

giving rise to a cognizable injury in the proper

circumstances. We now apply this conclusion to the

allegations presented in this case.

16

C. Whether, as Lafferty contends, the injury is merely

illusory

At oral argument, Lafferty observed that, under the Ponzi

scheme alleged in the Committee's Amended Complaint,

any fraudulent debt certificates issued by the Debtors

would have created a capital flow into the Debtors, allowing

them to pay the perpetrators of the fraud, the Shapiros,

who were at the top of the pyramid. Stated in slightly

different terms, we understand Lafferty to be saying that

any injury to the Debtors caused by deepening insolvency

might be considered illusory because that injury passed

directly to the sole shareholders and wrongdoers, the

Shapiro family. See, e.g., Feltman, 122 B.R. at 473-74

(accepting "deepening insolvency" but concluding that,

because a corporation was fictitious, any injury to it was

illusory). As we discussed earlier, so long as the corporate

form is respected, the alleged "deepening insolvency" injury

to the property of the Debtors cannot be regarded as

equivalent to the Shapiro family's shareholder interest. See

Barium Steel, 108 A.2d at 341 (corporate property is

distinct from shareholder property); John L. Motley Assoc.,

104 B.R. at 686-87 (causes of action for damage to

corporate property belong to the corporation). Thus, we

think that Lafferty is essentially asking us to disregard the

corporate existence of Walnut, whose status separates the

Debtors' property, and hence, the alleged injury from the

Shapiro family's shareholder interest.3

As a result, Lafferty's argument implicitly invokes the

"piercing the corporate veil" doctrine, which treats a

corporation and its shareholders as identical for purposes

of suit, thereby imposing personal liability on shareholders.

See Kiehl v. Action Mfg. Co., 535 A.2d 571, 574 (Pa. 1987).

We doubt that the Pennsylvania Supreme Court would

apply any form of the doctrine here. The present issue, after

all, involves the defendant Lafferty invoking the doctrine to

demonstrate the lack of injury to the Debtors, whereas in

the standard scenario the plaintiff invokes the"piercing the

_________________________________________________________________

3. The corporate existence of ELCOA is irrelevant to this inquiry because

ELCOA was wholly owned by Walnut. It is Walnut's corporate existence

that provides the legal fiction separating the Debtors from the Shapiros.

17

corporate veil" doctrine to impose liability on shareholders.

Even assuming, for argument's sake, that the Pennsylvania

Supreme Court would consider the merits of the corporate

veil doctrine here, we think that, given the pleadings, the

court would not disregard Walnut's corporate form and

would not find the alleged injury to the Debtors to be

illusory.

In Pennsylvania, "courts will disregard the corporate

entity only in limited circumstances when [the form is] used

to defeat public convenience, justify wrong, protect fraud or

defend crime." Kiehl, 535 A.2d at 574. This is a stringent

inquiry. "[C]ourt[s] must start from the general rule that the

corporate entity should be recognized and upheld, unless

specific, unusual circumstances call for an exception. . . .

Care should be taken on all occasions to avoid making the

entire theory of the corporate entity useless." Wedner v.

Unemployment Compensation Bd. of Review, 296 A.2d 792,

795 (Pa. 1972) (quoting Zubik v. Zubik, 384 F.2d 267, 273

(3d Cir. 1967)) (internal quotations omitted).

The narrow circumstances in which Pennsylvania courts

will disregard the corporate form are demonstrated by the

number of cases, outside traditional attempts to impose

liability on shareholders, that reject such arguments. See,

e.g., Kiehl, 535 A.2d at 574-75 (refusing to disregard the

corporate form between parents and subsidiaries when

applying workmen's compensation laws); Wedner , 296 A.2d

at 794-96 (reversing the determination of a board of

unemployment compensation to ignore the corporate form

to deny benefits to an employee shareholder); Shared

Communications Servs. of 1800-80 JFK Boulevard, Inc. v.

Bell Atlantic Props., Inc., 692 A.2d 570, 573-74 (Pa. Super.

Ct. 1997) (refusing, on a common law conspiracy claim, to

ignore the legal corporate form between parents and wholly

owned subsidiaries).

We conclude, on the allegations presented here, that the

circumstances for ignoring Walnut's corporate form do not

exist with certainty. Although the Committee alleged in the

Amended Complaint that the Shapiro family had made

misrepresentations through Walnut, it did not allege that

Walnut was a fictional or sham corporation. Cf. Feltman,

122 B.R. at 473-74 (concluding that a deepening insolvency

18

injury was illusory because the debtor corporations were

fictitious with no corporate identity separate from their sole

shareholder). The Committee merely identified Walnut as

an equipment leasing company, with no indication that

Walnut's business activities, apart from its debt certificates,

were anything but legitimate and real. Moreover, the record

does not support a finding that corporate formalities were

ignored. Although the Shapiros used Walnut to commit a

fraud, the Committee has not alleged that Walnut lacked a

corporate identity separate from the Shapiro family.

Thus, accepting all of the Committee's allegations as true

and reading them in the light most favorable to the

Committee, we cannot state with certainty that Walnut's

corporate existence should be disregarded such that any

deepening insolvency injury was illusory. See Weston v.

Commw. of Pennsylvania, 251 F.3d 420, 425 (3d Cir. 2001)

("We will affirm a dismissal only if it appears certain that a

plaintiff will be unable to support his claim."). We therefore

agree with the District Court that the possibility of a

distinct and separate injury to the Debtors cannot be ruled

out at the motion to dismiss stage.

Up until this point in our analysis of standing, we have

spoken only in terms of the Committee's state law claims

under Pennsylvania law. With regard to the Committee's

single federal securities claim, we are confident that the

principles we have elucidated are so well accepted that the

analysis of that claim is the same. That is, insofar as

alleged securities misrepresentations induced the Debtors

to incur excessive debt which damaged corporate property,

we think that the claim belongs to the Debtors, not to the

creditors. Cf. Caplin, 406 U.S. at 434. Furthermore, for the

reasons noted earlier, we believe "deepening insolvency" is

generally a valid theory for federal law claims. See Schacht,

711 F.2d at 1350.

Thus, because the Committee properly asserts the claims

of the Debtors, rather than the creditors, and because we

recognize deepening insolvency as a valid theory giving rise

to a claim under Pennsylvania law, we hold that the District

Court did not err in concluding that the Committee had

standing to bring the Debtors' claims against Lafferty.

19

IV.

Having determined that the Committee has standing to

bring the Debtors' claims, we now address Lafferty's

assertion of the doctrine of in pari delicto as an affirmative

defense against those claims. The doctrine of in pari delicto

provides that a plaintiff may not assert a claim against a

defendant if the plaintiff bears fault for the claim. See Feld

and Sons, Inc. v. Pechner, Dorfman, Wolfee, Rounick and

Cabot, 458 A.2d 545, 548-49 (Pa. Super. Ct. 1983); see also

American Trade Partners, L.P. v. A-1 International Importing

Enterprises, Ltd., 770 F. Supp. 273, 276 (E.D. Pa. 1991)

(under the in pari delicto doctrine, "a party is barred from

recovering damages if his losses are substantially caused

by activities the law forbade him to engage in"). Under

Pennsylvania law (as well as federal law), in pari delicto is

a doctrine of equity. See Peyton v. Margiotti , 156 A.2d 865,

868 (Pa. 1959); Reynolds v. Boland, 52 A. 19, 21 (Pa. 1902).

More generally, the broad idea captured by the doctrine

may involve a number of different defenses, depending on

whether a contract, tort, or other claim is asserted. We

nevertheless can legitimately speak of one doctrine, in pari

delicto, across the different claims because the analysis

under the various causes of action will typically be the

same. Judge Posner made this point in Cenco, Inc. v.

Seidman & Seidman:

The challenged [jury] instructions relate to the question

whether Seidman was entitled to use the wrongdoing of

Cenco's managers as a defense against the charges of

breach of contract, negligence, and fraud [which] when

committed by auditors, are a single form of wrongdoing

under different names. . . . Because these theories of

auditors' misconduct are so alike, the defenses based

on misconduct of the audited firm or its employees are

also alike, though verbalized differently. A breach of

contract is excused if the promisee's hindrance or

failure to cooperate prevented the promisor from

performing the contract. The corresponding defense in

the case of negligence is, of course, contributory

negligence. . . . [And, in the fraud context, a]

participant in a fraud cannot also be a victim entitled

to recover damages, for he cannot have relied on the

20

truth of the fraudulent representations, and such

reliance is an essential element in a case of fraud.

686 F.2d 449, 453-54 (7th Cir. 1982) (citation omitted).

Whether the in pari delicto doctrine applies here depends

on whether the Shapiro family's conduct can be imputed to

the Debtors and hence to the Committee, which, under

bankruptcy law, stands in the shoes of the Debtors.

Imputation refers to the attribution of one person's

wrongdoing to another person. For example, in the present

case, the rules of imputation determine whether or not the

Debtors will be deemed to have participated in wrongdoing

because of the acts of the Debtors' management. If

wrongdoing is imputed, then the in pari delicto doctrine

comes into play and bars a suit.

In the present case, the District Court imputed the

Shapiro family's wrongdoing to the Debtors and held that

the Committee, standing in the shoes of the Debtors, was

barred from bringing claims under the doctrine of in pari

delicto. On appeal, the Committee argues that the District

Court erred in discounting the Committee's status as an

innocent successor when applying the in pari delicto

defense. For support, the Committee relies primarily on In

re: Jack Greenberg, Inc., 240 B.R. 486 (Bankr. E.D. Pa.

1999). The crux of its argument is that, under Pennsylvania

law, courts may disallow the in pari delicto defense when its

invocation would produce an inequitable result. See id. at

504. According to the Committee, the fact of bankruptcy

and the resulting removal of the Shapiro family and their

co-conspirators from management prevents bad actors from

benefitting from a recovery to the Debtors. Because only

innocent creditors would now benefit from this suit, the

Committee argues that the imputation of the Shapiro

family's wrongdoing to the Debtors and the consequent

application of the in pari delicto doctrine are unwarranted.

The Committee's argument requires us to resolve two

related questions. First, we must decide whether, when

evaluating a claim brought by a bankruptcy trustee, a court

of law may consider post-petition events that may affect an

equitable defense, such as in pari delicto. Second, we must

decide whether, in light of our answer to the first question,

21

the Shapiro family's conduct should in fact be imputed to

the Debtors such that the doctrine of in pari delicto bars

the Committee's claims.

A.

The first question is whether post-petition events may be

considered when evaluating a claim in bankruptcy. At the

outset, we note that the application of the in pari delicto

doctrine is affected by the rules governing bankruptcies.

The bankruptcy trustee -- or in this case the Committee --

is the representative of the bankruptcy estate. See 11

U.S.C. S 323(a); In re Mediators, Inc., 105 F.3d 822, 826 (2d

Cir. 1997) (suggesting that, when a committee bring claims

on behalf of a debtor, it takes on the characteristics of a

trustee). Therefore, in this case, the bankruptcy laws

authorize the Committee to "commence and prosecute any

action or proceeding in behalf of the estate before any

tribunal." Fed. R. Bankr. P. 6009; cf. 11 U.S.C. SS 1207,

1306. "Such actions . . . fall into two categories: (1) those

brought by the trustee as successor to the debtor's interest

included in the estate under Section 541, and (2) those

brought under one or more of the trustee's avoiding

powers." 3 Collier on Bankruptcy P 323.03[2] (15th rev. ed.

2001). The trustee's "avoiding" powers are not implicated

here, as they relate to the trustee's power to resist pre-

bankruptcy transfers of property.

Instead, the Committee brings claims against Lafferty as

a successor to Walnut and ELCOA's interest. Section 541

covers such claims. Under section 541, the bankruptcy

estate includes "all legal or equitable interests of the debtor

in property as of the commencement" of bankruptcy. 11

U.S.C. S 541(a) (emphasis added); see also O'Dowd v.

Trueger, 233 F.3d 197, 202 (3d Cir. 2000). These legal and

equitable interests include causes of action. 3 Collier on

Bankruptcy P 323.02[1]; accord O'Dowd, 233 F.3d at 202-

03. Given these provisions, we have held that "in actions

brought by the trustee as successor to the debtor's interest

under section 541, the `trustee stands in the shoes of the

debtor and can only assert those causes of action

possessed by the debtor. [Conversely,] [t]he trustee is, of

course, subject to the same defenses as could have been

22

asserted by the defendant had the action been instituted by

the debtor.' " Hays & Co. v. Merrill Lynch, Pierce, Fenner &

Smith, Inc., 885 F.2d 1149, 1154 (3d Cir. 1989) (quoting

Collier on Bankruptcy P 323.02[4]).

As these authorities demonstrate, the explicit language of

section 541 directs courts to evaluate defenses as they

existed at the commencement of the bankruptcy. This

direction is entirely consistent with the legislative history.

The Senate Report to the Bankruptcy Reform Act of 1978

made clear that the appropriate frame of reference for

section 541 is the state of the debtor as of the

commencement of the bankruptcy:

Though [section 541] will include choses in action and

claims by the debtor against others, it is not intended

to expand the debtor's rights against others more than

they exist at the commencement of the case. For

example, if the debtor has a claim that is barred at the

time of the commencement of the case by the statute

of limitations, then the trustee would not be able to

pursue that claim, because he too would be barred. He

could take no greater rights than the debtor himself

had.

S. Rep. No. 95-989, at 82 (1978), reprinted in 1978

U.S.C.C.A.N. 5787, 5868 (capitals in the original omitted).

The House Report contains identical language. See H.R.

Rep. No. 95-595, at 367-68 (1977), reprinted in 1978

U.S.C.C.A.N. 5963, 6323.

The answer to our first question should now be apparent.

The Committee asks us to consider post-petition events,

namely, the removal of the Shapiro family and their co-

conspirators from the Debtors' management, as well as the

Committee's status as an innocent successor, when

weighing the equities of the in pari delicto defense. The

plain language of section 541, however, prevents courts

from taking into account events that occur after the

commencement of the bankruptcy case. As a result, we

must evaluate the in pari delicto defense without regard to

whether the Committee is an innocent successor. See Bank

of Marin v. England, 385 U.S. 99, 101 (1966) ("The trustee

succeeds only to such rights as the bankrupt possessed;

23

and the trustee is subject to all claims and defenses which

might have been asserted against the bankruptcy but for

the filing of the petition."); Integrated Solutions, Inc. v. Serv.

Support Specialties, Inc., 124 F.3d 487, 495 (3d Cir. 1997)

(stating that it is a "fundamental principle that the estate

succeeds only to the nature and the rights of the property

interest that the debtor possessed pre-petition").

We thus agree with the analysis of the Tenth Circuit in In

re: Hedged-Investments Assocs., Inc., 84 F.3d 1281 (10th

Cir. 1996), which employed section 541 in applying the in

pari delicto doctrine to bar a bankruptcy trustee's suit

against a third-party. In Hedged-Investments, an individual

ran a Ponzi scheme through a solely owned corporation and

three limited partnerships. After the scheme collapsed, the

corporation and the partnerships went into bankruptcy. A

bankruptcy trustee was appointed over the four entities,

and the trustee subsequently brought suit on behalf of the

debtors against third-party investors who had profited from

the Ponzi scheme. See id. at 1282. The district court

applied the in pari delicto defense and dismissed the suit.

See id.

The trustee argued before the Tenth Circuit, as the

Committee does here, that his status as a bankruptcy

trustee prevented the application of the in pari delicto

defense. In support, he cited Scholes v. Lehmann , a case in

which the Seventh Circuit refused to apply the defense to

bar a receiver from bringing fraudulent conveyance actions

on behalf of the debtor corporations against third-parties

and others who had received funds from the corporations.

See 56 F.3d at 754-55. The Scholes court's holding rested

on the rationale that the appointment of the innocent

receiver had removed the wrongdoer from the scene and

changed the equities such that the in pari delicto doctrine

"los[t] its sting." Id. (citations omitted).

The Tenth Circuit rejected the trustee's argument and

held that the trustee could not bring suit against the third-

party investors because "one who has himself participated

in a violation of law cannot be permitted to assert . . . any

right founded upon . . . the illegal transaction." Hedged-

Investments, 84 F.3d at 1284 (internal quotations and

citations omitted). It reasoned that, while the Seventh

24

Circuit's reasoning in Scholes might be preferable from a

public policy perspective, it did not comport with the plain

language of section 541, which explicitly provided that the

bankruptcy estate "is comprised of . . . all legal or equitable

interests of the debtor in property as of the commencement

of the case." Id. at 1285. The court explained the

significance of that language:

We emphasize [that] S 541(a)(1) limits estate property to

the debtor's interests "as of the commencement of the

case." This phrase places both temporal and qualitative

limitations on the reach of the bankruptcy estate. In a

temporal sense, it establishes a clear-cut date after

which property acquired by the debtor will normally

not become property of the bankruptcy estate. In a

qualitative sense, the phrase establishes the estate's

rights as no stronger than they were when actually

held by the debtor. Congress intended the trustee to

stand in the shoes of the debtor and "take no greater

rights than the debtor himself had." Therefore, to the

extent [that the trustee] must rely on 11 U.S.C. S 541

for his standing in this case, he may not use his status

as trustee to insulate the partnership from . . .

wrongdoing . . .

. . . .

Neither the text of the [Bankruptcy] Code nor its

legislative history suggests any exceptions to the

principle that the strength of an estate's cause of

action is measured by how it stood "as of

commencement of the case."

Id. at 1285-86 (citations omitted).

We note that the Tenth Circuit is not alone. Both the

Second and Sixth Circuits have also applied the in pari

delicto doctrine to bar claims of a bankruptcy trustee,

standing in the shoes of a debtor, against third-parties,

without regard to the trustee's status as an innocent

successor. See Dublin Secs., 133 F.3d at 380 (applying Ohio

law); Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, 1093-

94 (2d Cir. 1995) (applying Connecticut law); Shearson

Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, 120 (2d Cir.

1991) (applying New York law); see also The Mediators, 105

25

F.3d at 825-27 (summarizing Hirsch and Wagoner and

applying New York law to find that a bankruptcy trustee

has no standing to assert claims against third-parties for

cooperating in the very misconduct that the debtor had

initiated). Our research reveals no courts that hold

otherwise in the bankruptcy context.

We certainly acknowledge that, in the receivership

context, several courts have declined to apply in pari delicto

to bar the receiver from asserting the claims of an insolvent

corporation on the ground that application of the doctrine

to an innocent successor would be inequitable. These

courts have thought it proper to consider events arising

after a corporation enters into receivership. See, e.g., FDIC

v. O'Melveny & Myers, 61 F.3d 17, 19 (9th Cir. 1995)

("While 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 . . . [an] innocent entity that steps

into the party's shoes pursuant to court order or operation

of law."); Scholes, 56 F.3d at 754 (stating that "the defense

of in pari delicto loses its sting when the person who is in

pari delicto is eliminated"). These cases are easily

distinguishable, however; unlike bankruptcy trustees,

receivers are not subject to the limits of section 541.

B.

The second question we must answer is whether, viewing

the Committee as if it had brought its claims as of the

commencement of the bankruptcy, as section 541

commands, the Shapiro family's conduct should, in fact, be

imputed to the Debtors such that the doctrine of in pari

delicto bars the Committee's claims. While bankruptcy law

mandates that the trustee step into the shoes of the debtor

when asserting causes of action, state law generally

provides the substantive law governing imputation for state

law claims. See O'Melveny & Myers v. FDIC, 512 U.S. 79,

84, 85, 87-89 (1994) (holding, in the FDIC receivership

context, that, without an "explicit federal statutory

provision" or special federal interest, state law"governs the

imputation of knowledge to corporate victims of alleged

negligence").

26

Under the law of imputation, courts impute the fraud of

an officer to a corporation when the officer commits the

fraud (1) in the course of his employment, and (2) for the

benefit of the corporation. See Waslow v. Grant Thornton (In

re Jack Greenberg, Inc.), 212 B.R. 76, 83 (Bankr. E.D. Pa.

1997) (citing Rochez Bros., Inc. v. Rhoades, 527 F.2d 880,

884 (3d Cir. 1975), and deriving a federal rule that is

consistent with Pennsylvania law); see also Nat'l Bank of

Shamokin v. Waynseboro Knitting Co., 172 A. 131, 134 (Pa.

1934) (describing Pennsylvania agency law).

The allegations in the Amended Complaint leave no doubt

that the first part of the imputation test is satisfied -- the

fraud allegedly perpetrated by the Shapiro family took place

in the course of their employment for the Debtors. As the

District Court explained:

William Shapiro is the sole shareholder of Walnut

Associates, Inc, which in turn owns debtor Walnut,

which owns debtor ELCOA. William Shapiro is

president and a director of the debtors. Kenneth

Shapiro is debtors' vice-president and a director.

Defendants Walnut Associates, William Shapiro, P.C.,

Welco, Financial Data, and Kenner Collection Agency,

which are owned by William Shapiro, are alleged to

have played a role in the fraudulent certificate

offerings. The debtor corporations are alleged to have

been part of the Shapiro Organization -- i.e. , owned

and controlled by the Shapiros.

Official Committee of Unsecured Creditors, No. 99-526, slip.

op. at 10 (citations omitted). The Committee's central

allegation, that the Shapiros "were able to perpetuate their

fraudulent scheme for years through the assistance of

several `affiliated' companies, including Walnut[and]

ELCOA," demonstrates the relationship described by the

District Court.

The second part of the imputation test -- whether

fraudulent conduct was perpetrated for the benefit of the

debtor corporation -- is often analyzed under the"adverse

interest exception." Under this exception, fraudulent

conduct will not be imputed if the officer's interests were

adverse to the corporation and "not for the benefit of the

27

corporation." See Waslow, 212 B.R. at 84 (citing Resolution

Trust Corp. v. Farmer, 865 F. Supp. 1143, 1155-56 (E.D.

Pa. 1994)); see also Solomon v. Gibson, 615 A.2d 367 (Pa.

Super. Ct. 1992) (same).

The Committee argues that the Shapiro family's fraud

was adverse to the interests of the Debtors, and indeed,

caused damage to them through "deepening insolvency."

Thus, the Committee maintains that the Shapiros did not

act for the benefit of the Debtors and their fraudulent

conduct cannot be imputed to those corporations. However,

even assuming that the Shapiros' interests were adverse to

the Debtors' interests, the Committee cannot prevail

because the "adverse interest exception" is itself subject to

an exception -- the "sole actor" exception. The general

principle of the "sole actor" exception provides that, if an

agent is the sole representative of a principal, then that

agent's fraudulent conduct is imputable to the principal

regardless of whether the agent's conduct was adverse to

the principal's interests. See Waslow, 212 B.R. at 86. The

rationale for this rule is that the sole agent has no one to

whom he can impart his knowledge, or from whom he can

conceal it, and that the corporation must bear the

responsibility for allowing an agent to act without

accountability. See id. (citing First National Bank of Cicero

v. Lewco Secs. Corp., 860 F.2d 1407, 1417-18 (7th Cir.

1988) and William M. Fletcher et al., Fletcher Cyclopedia of

the Law of Private Corporations S 827.10, at 160 (perm. ed.

rev. vol. 1994)). Pennsylvania has recognized the"sole

actor" exception. See Gordon v. Continental Cas. Co., 181 A.

574, 577 (Pa. 1935).

The "sole actor" exception has been applied to cases in

which the agent who committed the fraud was also the sole

shareholder of the corporation. See, e.g., In re Mediators,

105 F.3d at 827. Courts have additionally applied the

exception to cases in which the agent "dominated" the

corporation. See, e.g., PNC Bank v. Hous. Mortgage Corp.,

899 F. Supp. 1399, 1405-06 (W.D. Pa. 1994) (dismissing

corporation's claims against accountants because sole

shareholders and officers of corporation participated in

alleged fraud).

28

In the present case, the Shapiros clearly dominated

Walnut and ELCOA. They were the sole representatives in

the alleged fraud with Lafferty. Additionally, William

Shapiro was the sole shareholder. And, according to the

Amended Complaint, the Shapiros dominated the

ownership and control of Walnut and ELCOA. Thus, the

"sole actor" exception applies. Further, we reject the

Committee's argument that the exception should not apply

because several of the Debtors' directors merely acted

negligently and did not perpetrate the fraud. The possible

existence of any innocent independent directors does not

alter the fact that the Shapiros controlled and dominated

the Debtors. See Vail Nat'l Bank v. Finkelman , 800 P.2d

1342, 1345 (Colo. Ct. App. 1990) (acknowledging that

domination justifies invocation of the "sole actor"

exception); FDIC v. Nat'l Surety Corp., 281 N.W.2d 816, 821

(Iowa 1979) (doctrine applies to board of directors or

corporation subject to agent's control).

In sum, we will impute the fraudulent conduct of the

Shapiros to the Debtors because the Shapiros perpetrated

the alleged fraud in the course of their employment, and

because, although the Shapiros may have acted adversely

to the interests of the Debtors, they were the sole actors

engaged in the alleged fraudulent conduct. Viewing the

claim as of the commencement of bankruptcy, we find that

the in pari delicto doctrine bars the Committee, standing in

the shoes of the Debtors, from bringing its claims against

Lafferty.

V.

For the reasons stated, we will affirm the judgment of the

District Court.

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COWEN, Circuit Judge, dissenting:

In this case we confront a regrettably common scenario.

Using a type of Ponzi scheme, William and Kenneth Shapiro

along with others fraudulently induced the appellant to

invest in the Shapiros' companies long past the point where

those companies could repay the funds. In the ensuing

bankruptcy, the appellant formed a creditors' committee

and, acting as the equivalent of a bankruptcy trustee,

sought to recover some of its losses by pursuing claims that

the debtor corporations have against various professionals,

such as accountants and underwriters, who allegedly

facilitated the Shapiros' fraud. The majority holds that

these creditors -- and indeed any creditors in a case like

this -- are barred from obtaining relief in bankruptcy from

the professionals. I believe the majority's reasoning rests on

a mistaken interpretation of the bankruptcy code,

needlessly thwarts recovery for innocent creditors, and

insulates from civil liability those who help perpetrate

fraud. Under the majority's reasoning, no matter how

egregious the conduct is of a professional who facilitated a

fraudulent sale of securities, creditors cannot recover from

that professional in the likely event that the corporation

winds up in bankruptcy.

Despite my disagreement with the outcome reached by

the majority, I agree with much of the majority's reasoning.

In particular, I agree with the majority that the creditors'

committee has standing to sue. The creditors' committee

received an assignment of the debtor corporations' claims,

and it is well settled that an "assignee of a claim has

standing to assert the injury in fact suffered by the

assignor." Vermont Agency of Natural Resources v. United

States ex rel. Stevens, 529 U.S. 765, 774, 120 S.Ct. 1858,

1863 (2000). The question then reverts to whether the

debtor corporations have standing. As the majority points

out, a corporation has a distinct legal existence from its

officers and owners, and economic losses wrongfully

suffered by a corporation are sufficient injuries to confer

standing. See, e.g., Barlow v. Collins , 397 U.S. 159, 90

S.Ct. 832 (1970); Hardin v. Kentucky Utils. Co. , 390 U.S. 1,

88 S.Ct. 651 (1968); FCC v. Sanders Bros. Radio Station,

309 U.S. 470, 60 S.Ct. 693 (1940). The only reason to

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suppose that a corporation lacks standing in a case like

this one is that there is an allegedly valid affirmative

defense available against the corporation's claims. But as a

general matter, the ultimate merits of an affirmative

defense do not raise questions about a plaintiff 's standing,

or else the moment the court was poised to rule in favor of

the defendant on the affirmative defense, the court would

lose jurisdiction and there would be no binding judgment.

Moreover, as I explain below, I think the defense fails in

this case.

Like the majority, I agree that in evaluating the

affirmative defense at issue here -- the in pari delicto

doctrine -- we apply state law for the plaintiffs' state causes

of action, see O'Melveny & Meyers v. FDIC, 512 U.S. 79,

83-85, 114 S.Ct. 2048, 2052-53 (1994), and federal law for

federal causes of action. Id. (citing Schact v. Brown, 711

F.2d 1343, 1347 (7th Cir. 1983)). And I also agree with the

majority that, regardless of whether federal or state (in this

case Pennsylvania) law is applied, the in pari delicto

doctrine is best understood as a broad equitable principle

that encompasses a variety of different, more specific legal

rules and defenses drawn from torts, contracts, or other

areas of law depending on the underlying cause of action at

issue. See Cenco Inc. v. Seidman & Seidman, 686 F.2d 449,

453-54 (7th Cir. 1982). Broadly, the idea behind in pari

delicto is that "a plaintiff who has participated in

wrongdoing may not recover damages resulting from the

wrongdoing." Black's Law Dictionary 794 (7th ed. 1999).

Because the wrongdoers here were officers of the debtor

corporations, a special case of the in pari delicto doctrine

comes into play -- the standards covering when to impute

the acts of a corporation's officers to the corporation itself.

If those officers remain in control of the corporation or

stand to benefit from any recovery, then the officers'

conduct plainly would be imputed to the corporation. See,

e.g., Cenco, 686 F.2d at 455-56; Rochez Bros., Inc. v.

Rhoades, 527 F.2d 880, 884 (3d Cir. 1975).

But, as Judge Posner has explained, the equitable

principles underlying the doctrines of imputing misconduct

and in pari delicto lead to a different result when the

miscreant officers are removed and no wrongdoer will

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receive the benefit of recovery. See Scholes v. Lehman, 56

F.3d 750, 753-55 (7th Cir. 1995) (citing McCandless v.

Furland, 296 U.S. 140, 160, 56 S.Ct. 41, 47 (1935)

(Cardozo, J.)). No longer will it be true that, as Black's

definition puts it, one "who has participated in wrongdoing

[will] . . . recover damages resulting from the wrongdoing."

Instead, allowing the corporation to impose liability on

professionals who wrongfully facilitated the fraud will both

help deter that professional misconduct and help

compensate victims who may otherwise go away empty-

handed. The Ninth Circuit has recognized this point as well

and refused to apply in pari delicto when the recovery would

not benefit the wrongdoers. FDIC v. O'Melveny & Myers, 61

F.3d 17, 18, (9th Cir. 1995). Nothing suggests that

Pennsylvania would interpret in pari delicto and the rules of

imputation differently than the Seventh and Ninth Circuits

have.

As I understand the majority, they accept that if the

wrongdoers within a corporation are removed and the

benefit of the recovery will ultimately help victims of the

fraud, then the corporation can proceed with its claims.

The reason the majority concludes nevertheless that the

creditors' committee is barred from recovery is that at the

moment the bankruptcy petition was filed, the majority

maintains that the wrongdoers had not actually been

removed yet. The majority's argument tracks a Tenth

Circuit decision, In re Hedge-Investments Assoc., Inc., 84

F.3d 1281 (10th Cir. 196). That case refused to follow

Scholes and the Ninth Circuit's decision in O'Melveny,

which both involved receiverships, because the Tenth

Circuit thought that a contrary result was compelled by a

provision in the bankruptcy code, 11 U.S.C. S 541(a). The

court explained that under S 541(a) the debtor's estate is

formed at the time the bankruptcy petition is filed. Since

the bad corporate officers were only removed post-petition,

the court reasoned that S 541(a) dictates that the removal

cannot be considered. That is, because the officers were

still in control at the moment the petition was filed, in pari

delicto still erected a bar at that moment. 84 F.3d at 1285.

There are a number of problems with this reasoning. The

first and most obvious is that, whatever the inflexibility is

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of the bankruptcy code, an equitable doctrine like in pari

delicto is highly sensitive to the facts and readily adapted to

achieve equitable results. What is sufficient to satisfy the

doctrine, in other words, need not be parsed like a statute.

Even if we assume that we can look no further than the

filing of the bankruptcy petition, it can scarcely be denied

that as soon as the Shapiros' companies were placed in

bankruptcy, the Shapiros lost any ability to benefit further

from their Ponzi scheme. The bankruptcy court would not

have allowed itself to become an instrument of their fraud.

Some time, of course, would elapse before the full process

of bankruptcy proceedings took their course, but there is

nothing in the equitable doctrine of in pari delicto that

insists those formalities must be completed before the

doctrine is triggered.

The point of equitable doctrines is to avoid injustice

caused by overly inflexible rules: equity is "[t]he recourse to

principles of justice to correct or supplement the law as

applied to particular circumstances." Black's Law

Dictionary 560 (7th ed. 1999). Here the majority injects a

pointless technicality into an equitable doctrine. For

example, one court has distinguished the Tenth Circuit's

decision that the majority follows by noting that if the

debtor corporation is placed in receivership prior to the

filing of the bankruptcy petition, there is no in pari delicto

bar on an action by the corporation. See, e.g. , Hanover

Corp. of America v. Beckner, 221 B.R. 849, 859 (M.D. La.

1997). It is difficult to understand what is accomplished by

forcing future plaintiffs to take that extra step or denying

these plaintiffs relief because they failed to take it. Equity

does not turn on that kind of empty technicality.

A second problem with the majority's reasoning is that,

while it is certainly true that a trustee (or a creditor's

committee acting as trustee) assumes the same causes of

action and is subject to the same defenses as the debtor,

see Bank of Marin v. England, 385 U.S. 99, 101, 87 S.Ct.

274, 276 (1966); Integrated Solutions, Inc. v. Serv. Support

Specialities, Inc., 124 F.3d 487, 495 (3d Cir. 1997), that

rule does not mandate that in evaluating a trustee's claims

on behalf of an estate, post-petition events can never be

considered. Segal v. Rochell, 382 U.S. 375, 86 S.Ct. 511

33

(1966). The rule that the trustee must be restricted to the

debtor's causes of action and is subject to the same

defenses as the debtor does not mandate that post-petition

events are never considered in evaluating those causes of

action and defenses inherited by the trustee.

In Segal, the question before the Court was whether a

trustee could claim as property of the estate a tax loss-

carryback refund for a taxable year that ended post-

petition. Significantly, even though under the Internal

Revenue Code the refund could not be claimed until the

end of the taxable year, which occurred after the petition

date, the Supreme Court agreed with the trustee that the

refund was property of the estate. The refund was

"sufficiently rooted in the pre-bankruptcy past and so little

entangled with the bankrupt's ability to make an

unencumbered fresh start that it should be regarded as

"property." 382 U.S. at 380, 86 S.Ct. at 514.

So too in this case the losses suffered by the debtor

corporation all took place before the bankruptcy and the

only obstacle to the corporations' recovery is the removal of

the Shapiros, an event as inevitable as that completion of

the taxable year in Segal. More important, since our case

involves corporations, there is no concern about the

competing fresh-start policy for individuals that the

Supreme Court had to weigh in Segal. Corporations do not

get fresh starts.

One last point is worth noting parenthetically. Under the

majority's logic, the claims brought by the creditors'

committee against the Shapiros themselves and other

corporate insiders should be barred as well as the claims

against the outside professionals. After all, the corporations

and the insiders were as much in pari delicto as the

corporation and the outside professionals. The District

Court did not dismiss the claims against the insiders, but

inexplicably failed to explain why those creditors' claims,

which apparently were also on behalf of the corporation,

were not subject to the same reasoning that the court

applied in dismissing the claims against Lafferty. Although

the claims against the insiders are not properly before us,

having been severed below to create a final judgment, it is

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especially disturbing that the majority's reasoning applies

with equal force to them.

In short, the majority's position retards the normal goals

of tort law, misinterprets equitable doctrine, and reads the

bankruptcy code too narrowly. I dissent.

A True Copy:

Teste:

Clerk of the United States Court of Appeals

for the Third Circuit

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