Receiver Standing / In Pari Delicto

In an effort to raise funds for the receivership, receivers often bring actions against third parties who may be liable to the receivership estate. However, federal courts have recognized that, upon appointment, a receiver, like a trustee in bankruptcy, stands in the place of the entities for which he has been appointed receiver and is only permitted to bring any claim in their place. Scholes v. Lehmann, 56 F.3d 750, 753-754 (7th Cir. 1995). See also S.E.C. v. Holt, CV03-1825-PHX-PGR, 2007 WL 2332584, at *2-3 (D. Ariz. Aug. 13, 2007); Stenger v. World Harvest Church, Inc., CIV.A.1:04CV00151-RW, 2006 WL 870310, at *5-6 (N.D. Ga. Mar. 31, 2006). Cf. Eberhard v. Marcu, 530 F.3d 122 (2d Cir. 2008). Therefore, a receiver does not actually represent the interests of the investors or creditors of the receivership estate and cannot bring an action against a defendant simply alleging damages to the investors. As a result of such case law, defendants in an action brought by a receiver may raise the receiver’s standing to bring the action as an issue.

The issue of standing is closely related to subject-matter jurisdiction. Usually in S.E.C. cases, a receiver is appointed by a district court to recover, marshal, and conserve the assets of the receivership estate for the benefit of the defrauded investors or creditors. In the appointment order, the receiver should be vested with authority to bring legal actions based on law or equity in any state or federal court as the receiver deems necessary or appropriate in discharging his duties as receiver. Additionally, a receiver’s authority to initiate legal actions is authorized by federal statute. See 28 U.S.C. § 754 and 28 U.S.C. § 1692.

The appointment of a receiver to represent the interests of an individual or entity is an equitable event that, under most state and federal common law, can result in the disavowal of previous actions by the party. A receiver does have standing to recover funds wrongfully taken or withheld from the receivership estate so as to enable the receivership estate to pay the liabilities it has assumed to the investors in or creditors of the receivership estate. This standing is aided by the “adverse interest” doctrine, which is an exception to the normal rule that the acts and knowledge of an agent are attributed to the principal. See Scholes, 56 F.3d at 754; Tew v. Chase Manhattan Bank, N.A., 728 F. Supp. 1551, 1559-60 (S.D. Fla. 1990), opinion amended 741 F. Supp. 220 (S.D. Fla 1990). See also Warfield v. Alaniz, 453 F. Supp. 2d 1118 (D. Ariz. 2006);World Harvest Church, 2006 WL 870310, at **5-6. The adverse interest doctrine provides that where an agent acts in his own interest, and where his interest is adverse to the principle, that knowledge of that act will not be imputed to the principle. Little v. S. Cotton Oil Co., 156 S.C. 480 (1930); see Official Comm. of Unsecured Creditors of Allegheny Health Educ. & Research Found. v. PriceWaterhouseCoopers, LLP, 605 Pa. 269 (2010).

At first blush, it may seem counterintuitive that a receiver, who stands in the shoes of the wrong-doer for whom a receiver is appointed, should have a cause of action against another wrong-doer. However, in Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995), the Seventh Circuit recognized that a victimized corporation in a securities fraud scheme can provide the foundation for a fraud claim by the corporate victim once purged of the controlling bad characters, essentially finding that the defendant cannot ignore the corporate victim’s injury simply because the corporation is controlled by bad characters.23

In Tew v. Chase Manhattan Bank, 728 F. Supp. 1551 (S.D. Fla. 1990), Tew, acting as a trustee for a bankrupt securities corporation, sued a financial institution alleging inter alia, that it aided and abetted the officers and owners of the receivership corporation in defrauding the corporation’s investor clients. The bank defended by asserting that the prior culpable actions of the receivership corporation barred the action. Applying the adverse interest doctrine, the Court divorced the “principal” [the corporation now under the receiver’s control] from the prior acts of its officer “agents” [the owners and directors of the corporation], because the latter had been acting for their own enrichment not in the interests of the Company:

Normally, the acts and knowledge of an agent are imputed to the principal. …As with almost all rules, there is at least one exception. If the agent is acting adversely to the principal’s interests, the knowledge and misconduct of the agent are not imputed. …Under Florida law, the adverse interest exception applies and will bar Chase’s reliance on the misconduct of the former officers and directors. …For the reasons stated above, the court finds that the E.S.M. principals acted solely for their own personal enrichment, totally abandoning the interests of [E.S.M.]. …For this same reason, the adverse interest exception also bars Chase’s two counterclaims. These are based on the fraud and breach of contract by the former E.S.M. officers and directors. They cannot be applied to bar the suit of the trustee of [E.S.M.].24

Chief Judge Posner, of the Seventh Circuit, explained this same concept in his inimically more colorful fashion in Scholes, 56 F.3d 750. Scholes involved an action brought by a receiver who was appointed to take control of a set of closely held corporations involved in a Ponzi scheme. Judge Posner noted that the appointment of a receiver for these companies, freed them from their “evil zombie” state, entitling them to pursue claims against third parties:

How, the defendants ask rhetorically, could the allegedly fraudulent conveyances have hurt Douglas, who engineered them, or the corporations that he had created, that he totally controlled and probably (the record is unclear) owned all the common stock of, and that were merely the instruments through which he operated the Ponzi scheme?

The answer—so far as the corporations are concerned, and we need go no further—turns out to be straightforward. The corporations, Douglas’s robotic tools, were nevertheless in the eyes of the law separate legal entities with rights and duties. They received money from unsuspecting, if perhaps greedy and foolish, investors. That money should have been used for the stated purpose of the corporations’ sale of interests in the limited partnerships, which was to trade commodities. Instead Douglas caused the corporations to pay out the money they received to himself, his ex-wife, his favorite charities and an investor, Phillips, whom Douglas wanted to keep happy, no doubt in the hope that Phillips would invest more money in the Ponzi scheme or encourage others to do so. …

Though injured by Douglas, the corporations would not be heard to complain as long as they were controlled by him, not only because he would not permit them to complain but also because of their deep, their utter, complicity in Douglas’s fraud. The rule is that the maker of the fraudulent conveyance and all those in privity with him—which certainly includes the corporations—are bound by it. [citations omitted]. But the reason, of course, as the cases just cited make clear, is that the wrongdoer must not be allowed to profit from his wrong by recovering property that he had parted with in order to thwart his creditors. That reason falls out now that Douglas has been ousted from control of and beneficial interest in the corporations. The appointment of the receiver removed the wrongdoer from the scene. The corporations were no more Douglas’s evil zombies. Freed from his spell they became entitled to the return of the moneys—for the benefit not of Douglas but of innocent investors—that Douglas had made the corporations divert to unauthorized purposes. [citations omitted]. 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.25

As a result, in bringing an action on behalf of receivership entities, a receiver can argue that he is not bound nor is his right to sue on behalf of the receivership entities tainted by the improper actions of the corporate owners and officers who engineered or participated in the scheme. See Scholes, 56 F.3d 750; Donell v. Kowell, 533 F.3d 762 (9th Cir. 2008); Eberhard, 530 F.3d 122; World Harvest Church, 2006 WL 870310, at **5-6; Quilling v. Cristell, CIV.A. 304CV252, 2006 WL 316981(W.D.N.C. Feb. 9, 2006);Jones v. Wells Fargo Bank, N.A., 666 F.3d 955, 967 (5th Cir. 2012); but see Feinstein ex rel. WML Gryphon Fund LLC v. Long, 11-C-57, 2011 WL 3555727, at *6 (E.D. Wis. Aug. 11, 2011) (distinguishing Scholes from situation involving an investment fund, determining that transfers in the investment fund scenario, although poor decisions, did not harm the entity in the same way that did transfers in a Ponzi scheme). The Scholesanalysis has been widely endorsed. See Democratic Senatorial Campaign, 712 F.3d 185, Wing v. Dockstader, 482 F. App’x 361, 363 (10th Cir. 2012), Eberhard, 530 F.3d 122, Donell, 533 F.3d 762.

The inapplicability to a receiver of normal in pari delicto prohibitions is another reason that a receivership frequently is a more effective strategy for protecting the victims of fraud than a bankruptcy, as several courts have held that the Scholes reasoning applies only to a receiver, not to a trustee in bankruptcy. Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co. Inc., 267 F.3d 340 (3d Cir. 2001); In re Hedged-Invs. Assocs., 84 F.3d 1281, 1284-86 (10th Cir. 1996); Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, 1093-94 (2d Cir. 1995); Global Crossing Estate Representative v. Winnick, 04 CIV.2558(GEL), 2006 WL 2212776, at *16, n.21 (S.D.N.Y. Aug. 3, 2006); In re Derivium Capital LLC, 716 F.3d 355, 367 (4th Cir. 2013).

Some courts would limit the inapplicability of in pari delicto as a defense to fraudulent conveyance actions by a receiver. The courts reason that ignoring the in pari delictodefense in a fraudulent conveyance action would be equitable because the purpose of such an action is to recover wrongfully diverted funds in the hands of the target. However, some courts have concluded that ignoring the in pari delicto defense when the target was a tortfeasor (an accountant, lawyer, or banker whose negligence contributed to the fraud), who was not holding wrongfully diverted funds, was not equitable. Knauer v. Jonathan Roberts Fin. Group, Inc., 348 F.3d 230 (7th Cir. 2003).But see Bechtle v. Master, Sidlow & Associates, P.A., 766 F. Supp. 2d 547, 555 (E.D. Pa. 2011).

However, there appears to be an emerging trend were courts are allowing the receiver or non-bankruptcy trustee to avoid the in pari delicto defense in claims against tortfeasors. F.D.I.C. v. O’Melveney & Meyers, 61 F.3d 17 (9th Cir. 1995); Trenwick Am. Litig. Trust v Ernst & Young, L.L.P., 906 A.2d 168, at 212 (Del. Ch. 2006), aff’d sub nom. Trenwick Am. Litig. Trust v. Billett, 931 A.2d 438 (Del. 2007); Hays v. Paul, Hastings, Janofsky & Walker LLP, CIV.A. 106CV754-CAP, 2006 WL 4448809 (N.D. Ga. Sept. 14, 2006); Mosier v. Stonefield Josephson, Inc., CV 11-2666 PSG EX, 2011 WL 5075551 (C.D. Cal. Oct. 25, 2011); Williamson v. PricewaterhouseCoopers, LLP, 602106/2004 (Trial Order), 2007 WL 5527944 (N.Y.Sup. Nov. 7, 2007). Since the litigation targets in the these cases (accountants, lawyers, bankers) are often immune from claims from investors because the investors do not have direct claims against these service providers, if in pari delicto were applied against the receiver, the tort feasors would escape liability for their negligence while the investors damaged by their negligence would have no recourse. The equitable key here is that any recovery would go to the innocent investors, not those that committed the fraud (since they have been replaced by the receiver).

A receiver’s standing to recover money wrongfully taken or withheld from receivership entities to pay liabilities assumed by those entities to investors as a result of the illegal activities of the defendant is clear under Scholes, 56 F.3d 750 and Tew, 728 F. Supp. 1551. See also Hays v. Adam, 512 F. Supp. 2d 1330 (N.D. Ga. 2007). However, when opposing a receiver’s standing to make a claim, defendants often argue that the receiver is attempting to bring what essentially are investor claims when he does not, in fact, represent the investors but the receivership entities. What these arguments often overlook is the differentiation between the derivative nature of the receiver’s claims and the direct claims of the investors. In fact, the civil liability of an entity defendant is often derivative and can only be pursued by the company that was in contractual privity with that defendant. For instance, in Mid-State Fertilizer v. Exchange Nat. Bank of Chicago, 877 F.2d 1333 (7th Cir. 1989), the Seventh Circuit Court of Appeals rejected the standing of investors to pursue a depository bank in a fraud scheme similar to that involved many S.E.C. enforcement actions:

The derivative nature of such injuries leads courts in antitrust cases to hold that neither investors nor employees may recover. RICO and bank tying cases have followed the path blazed in antitrust. Antitrust, RICO and bank tying cases are not off by themselves in a corner. It is commonplace to rebuff efforts by investors and employees to collect damages for injuries done to their firms. A big chunk of the law concerning corporate derivative litigation consists in separating “direct” injury (which the investor may redress through independent suit) from “derivative” injury (which the investor may redress only through litigation in the name of the corporation). The Kimmels’ injury is derivative no matter which body of rules we consult.

Good reasons account for the enduring distinction between direct and derivative injury. When the injury is derivative, recovery by the indirectly injured person is a form of double counting. “Corporation” is but a collective noun for real people—investors, employees, suppliers with contract rights, and others. A blow that costs “the firm” $100 injures one or more of those persons. If, however, we allow the corporation to litigate in its own name and collect the whole sum (as we do), we must exclude attempts by the participants in the venture to recover for their individual injuries.[cite]29[cite]

Other courts have taken a more restrictive view of standing than the Seventh Circuit inScholes. In the case of In re Bennett Funding Grp., Inc., 336 F.3d 94, 101-102 (2d Cir. 2003), the Second Circuit held that a bankruptcy trustee did not have standing to pursue a claim on behalf of the company because the actions of the sole shareholder of the company were attributed to the company, thus preventing the company from suing third parties due to the company’s “unclean hands.” The court recognized an exception to the prevailing rule: where the fraudster’s interests are adverse to those of the company (the adverse interest exception), his actions will not taint the company. However, the adverse interest exception may only be invoked if the fraudster is not the sole actor in the company and it can be shown that there was at least one person in a position to have stopped the fraud had they known of it. Since the Bennett Fundingcase involved a bankruptcy trustee instead of a receiver, it was unclear if the Second Circuit would apply the same restrictive view of standing as it applied in Bennett Funding to a receiver or the more liberal view of standing applied in the Seventh Circuit in the Scholes case.

In Eberhard v. Marcu, 530 F.3d 122 (2d Cir. 2008), the Second Circuit seems to have adopted the Scholes interpretation of standing for a receiver pursuing a fraudulent conveyance claim. In Eberhard, the receiver was appointed over the assets of the individual defendant who caused the corporate defendants to make fraudulent conveyances. The Court closely examined the Scholes case and another Seventh Circuit case also written by Judge Posner two years after ScholesTroelstrup v. Index Futures Grp., Inc., 130 F.3d 1274 (7th Cir. 1997). In its analysis, the Second Circuit opined that the two cases read together stand for the proposition that if the receiver is appointed over the assets of an individual who caused the fraud, the receiver will not have standing to pursue fraudulent conveyances whereas if the receiver is appointed over the assets of corporation involved in the fraud, the receiver would have standing to pursue the fraudulent conveyance (because the evil zombie is removed from the corporation and replaced by the receiver). In the Eberhard case, the receiver was appointed only over the assets of the individual fraudulent actor and not the corporation which actually conveyed the assets and therefore the receiver lacked standing. The Court noted that “had the scope of the receivership not been narrowed, the entire issue [of standing] might have been avoided.” Eberhard, 530 F.3d at 134.

In addition to the Seventh and Second Circuits, the Third, Fifth, Ninth, and Tenth Circuits have also endorsed the Scholes analysis. Marion v. TDI Inc., 591 F.3d 137 (3d Cir. 2010); Democratic Senatorial Campaign, 712 F.3d 185; Donell, 533 F.3d 762 (9th Cir. 2008); Wing v. Dockstader, 482 F. App’x 361, 362-63 (10th Cir. 2012). The Fifth Circuit analyzed the matter specifically in Janvey v. Democratic Senatorial Campaign Comm., Inc., 712 F.3d 185 (5th Cir. 2013), where it corrected its previous standing analysis, explaining:

[A] federal equity receiver has standing to assert only the claims of the entities in receivership, and not the claims of the entities’ investor-creditors, but the knowledge and effects of the fraud of the principal of a Ponzi scheme in making fraudulent conveyances of the funds of the corporations under his evil coercion are not imputed to his captive corporations. Thus, once freed of his coercion by the court’s appointment of a receiver, the corporations in receivership, through the receiver, may recover assets or funds that the principal fraudulently diverted to third parties without receiving reasonably equivalent value.

See also Alguire, 2013 WL 4647293. Additionally, the Tenth Circuit found Scholesmore persuasive than analogous bankruptcy case law, which would have found a lack of standing in a fraudulent transfer proceeding. Dockstader, 482 F. App’x at 363. However, the Tenth Circuit’s limited analysis oddly characterizes Scholes as holding that “a receiver of an entity which was used to perpetrate a Ponzi scheme has standing to recover fraudulent transfers as though the receiver were a creditor of the scheme.” Id. This characterization is contrary to the general principle iterated in Scholes that receivers stand in the shoes of the entity in the receivership estate and not the creditors, and oversimplifies the Scholes holding to eliminate the explanation of how the standing is based on the injury of the entity. As the Ninth Circuit explained when engaging in itsScholes analysis in Donell v. Kowell, “[t]he Receiver has standing to bring this suit because, although the losing investors will ultimately benefit from the asset recovery, the receiver is in fact suing to redress injuries that [the company] suffered when its managers caused [the company] to commit waste and fraud.” Donell, 533 F.3d at 777.

The right of a receiver to assert rights against property that could be asserted by the receivership entity includes the right to sell property held by a trust which has been placed in receivership where the trust agreement grants such authority to the trustee.Holt, 2007 WL 2332584.


 

23 In Troelstrup v. Index Futures Group, Inc., 130 F.3d 1274 (7th Cir 1997), decided two years after Scholes and also written by Judge Posner, the author of the Scholesopinion, the Court held that a receiver could not bring action on behalf of the individual who perpetrates the fraud scheme, only the entity the individual controlled after the fraud actor was removed.

 

24 728 F.Supp. at 1559-1560. [bracketed information provided and excerpts omitted through ellipses].

 

25 56 F.3d at 754. [Citations and excerpts omitted through ellipses]
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