NY Claims For Contribution By Bankruptcy Trustees

By Shannon Scott

Under the Bankruptcy Code, a Chapter 7 bankruptcy trustee is fortified with all of the rights that the debtor had as of the petition date, which includes all causes of action the debtor could have brought prepetition.  [1]   Creative bankruptcy trustees are increasingly asserting claims for contribution under New York statutory law against third parties such as, banks, accountants and attorneys, on behalf of debtors who engaged in fraudulent behavior, such as a ponzi scheme. [2] 

Under this theory, even though a third-party may not be directly liable to the wronged investors, and may not owe them a duty of care, the bankruptcy trustee is attempting to seek contribution from the third party for amounts the trustee pays to creditors in satisfaction of the wronged investors’ allowed claims. [3]   In that scenario, the duty of care would run from the third-party alleged tortfeasor (i.e., the defendant) to the debtor (which duty was alleged to be breached). [4]   Despite a bankruptcy trustee’s creative pleading, a claim for contribution will likely not survive dismissal in the Second Circuit, mainly because of the well-established Wagoner rule.      

The Trustee’s Standing – Or Lack Thereof 

For the past twenty years, the Second Circuit has followed a principle known as the Wagoner rule, which is a variant of New York’s in pari delicto defense. [5]   In pari delicto is an equitable doctrine and is rooted in the common-law notion that a plaintiff’s recovery may be barred by his own wrongful conduct. [6]  The in pari delicto doctrine subjects claims to dismissal based on a premise that (i) courts should not mediate disputes between wrongdoers, and (ii) denying judicial relief to a wrongdoer is an effective means to deter illegal conduct. [7]  

The Second Circuit views issues of misconduct by a debtor as a matter of standing in the first instance rather than as an equitable defense such as in pari delicto. [8]   In essence, under Wagoner, a bankruptcy trustee lacks standing to pursue claims against a third party for defrauding a fraudulent debtor because the trustee stands in the shoes of that fraudulent debtor. [9]   Further, “[a] claim against a third party for defrauding a corporation with the cooperation of management accrues to creditors, not the guilty corporation.” [10]   Thus, Wagoner is a complete bar, rather than a defense, to claims asserted on behalf of a fraudulent debtor.

New York Claim for Contribution 

In New York, the statute governing claims for contribution enables a tortfeasor to sue other purported tortfeasors for their proportionate share of the claimed damages. [11]   The effect is that a tortfeasor who is forced to pay more than his share of liability could be made whole. [12]   Specifically, 1401 provides for contribution claims among “two or more persons who are subject to liability for damages for the same personal injury, injury to property or wrongful death.” [13]   “The amount of contribution to which a person is entitled shall be the excess paid by him over and above his equitable share of the judgment recovered by the injured party.  . . .The equitable shares shall be determined in accordance with the relative culpability of each person liable for contribution.” [14]   Accordingly, a claim for contribution rises and falls based on the existence of separate tortfeasors. [15]

A Bankruptcy Trustee’s Claim For Contribution

A bankruptcy trustee’s right to bring a contribution claim is derived from state law, made applicable by Section 544 of the Bankruptcy Code. [16]   It is necessary to establish which rights belonged to a debtor at the time of the bankruptcy filing in order to determine which rights the trustee has standing to assert.[17]   Generally, a bankruptcy trustee’s claim for contribution is premised on state common law claims, including fraud, aiding and abetting a fraud, breach of fiduciary duty, negligence and/or malpractice.  Fact patterns that involve bankruptcy trustees asserting a claim for contribution include, for example, an accounting or law firm that advised an entity involved in gross mismanagement prior to bankruptcy [18], and when banks held monies on behalf of ponzi scheme perpetrators. [19]  When exploring the viability of a contribution claim in New York and in the Second Circuit, the overriding issue is “what effect Wagonerhas on the contribution claim?”.  

Contribution is not, in and of itself, a basis upon which liability can be imposed.  Rather, contribution offers a vehicle for one tortfeasor to recover from another tortfeasor where: (1) an independent basis exists to hold the proposed contributor liable; and (2) the injured party has not made a direct claim against the proposed contributor. [20]   Significantly, “an action for contribution will not lie unless all the essential elements of a cause of action against the proposed contributor can be made out.” [21]  Thus, the question becomes whether Wagoner, which generally bars a trustee from asserting claims of negligence or fraud against third-parties on behalf of a fraudulent debtor, bars a claim for contribution.

The answer is yes.  Specifically, in the event Wagoner bars the underlying claims, the defendant is not “subject to liability” for fraud and/or negligence and therefore, a claim for contribution cannot be imposed. [22]   In other words, a bankruptcy trustee must be able to establish that there is a viable cause of action for which the defendant would be subject to liability in conjunction with a debtor. [23]   A bankruptcy trustee cannot circumvent his lack of standing by asserting a claim for contribution.  Thus, where dismissal of the underlying claims are mandated, so too is the claim for contribution.

Moreover, with respect to any negligence claims against third parties, a claim for contribution should be based on the breach of a defendant’s duty to the fraudulent debtor, and not on any tort committed against the investors/creditors directly.  A complaint against a defendant that had dealings with a fraudulent debtor prior to the bankruptcy filing generally will not survive the pleadings requirement set forth in Achcroft v. Ibqal. [24]   For example, speculative allegations of negligence in which a trustee asserts that a defendant breached its duty of care by providing negligent advice which, in turn, managed to defraud thousands of other people, is simply unavailing.  The harm alleged would have likely occurred whether or not the third party accountant or attorney gave advice, good or bad.

Likewise, in finding a proximate cause of the injury, it is mere conjecture that “but for” the defendant’s alleged negligence, the fraudulent scheme occurred, when in truth, it was admittedly intended by the debtor by perpetrators such as Nicholas Cosmo and Bernard Madoff. [25]   Moreover, the claims could not survive because it is obvious that the victims, i.e., the injured parties, to such a scheme are the creditors, and not the fraudulent debtor.  Consequently, since the merits of the negligence claims would also be subject to dismissal, a claim for contribution would similarly be subject to dismissal.

Finally, in reality, a bankruptcy trustee’s obligation to pay creditors for their losses arises only from the Bankruptcy Code and not based on any adjudication of the debtor’s liability.  In fact, establishing a debtor’s liability is an event that will never occur, and arguably, a trustee’s contribution claim is therefore, unripe. [26]   At any rate, the assertion that proofs of claims filed against the estate is a sufficient showing of a debtor’s liability is erroneous insofar as a debtor is in no danger of being held liable for more than its fair share, and thus, contribution, as contemplated under New York law is flawed. [27]   It is not pragmatic to seek recovery from a third-party defendant to apportion damages to an estate that recovers, for example, approximately one-third of the amounts outstanding to creditors.  Such recovery is simply not in keeping with the contribution statute.

In the Second Circuit, a bankruptcy trustee cannot circumvent his lack of standing for his direct claims by seeking relief under the guise of a contribution claim. [28]   A party that is confronted with a claim of contribution must be aware that the when standing is divested and an adjudication of the underlying claims can never be reached, a claim for contribution is similarly subject to dismissal.  Consequently, the suggested strategy is to immediately seek dismissal of such claims under the Federal Rules of Bankruptcy Procedure Rule 7012(b)(6).

[1]   Hirsch v. Arthur Anderson & Co., 72 F.3d 1085. 1094 (2d Cir. 1995).

[2]   See e.g., Picard v. J.P.Morgan Chase & Co. , 460 B.R. 84 (S.D.N.Y. 2011), appeal docketed, No. 11-5044 (2d Cir. Dec. 7, 2011); Picard v. HSBC Bank PLC, 454 B.R. 25 (S.D.N.Y. 2011), appeal docketed,  No. 11-5207 (2d Cir. Dec. 15, 2011); Silverman v. Meister Seelig & Fein, LLP (In re Agape World, Inc.), 467 B.R. 556  (E.D.N.Y. 2012).

[3]   Id.

[4]   Id.

[5]  Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114 (2d Cir. 1991); see also, e.g., Am. Tissue, Inc. v. Arthur Andersen, L.L.P., 275 F. Supp.2d 398, 404, 406 (S.D.N.Y. 2003) (noting that Wagoner is controlling authority).

[6]   Pinter v. Dahl, 486 U.S. 622, 632 (1988).

[7] Goldin v. Primavera Familienstiftung (In re Granite Partners, L.P), 194 B.R. 318, 338 (S.D.N.Y. 1996); Symbol Technologies, Inc. v Deloitte & Touche, LLP, 2008 N.Y. Misc. LEXIS 9586 (Sup. Ct., Suffolk Co.).

[8]   The Wagoner construct is not followed by any other circuit unless New York law is deemed to control. By contrast, the in pari delicto defense has been recognized as a valid defense against bankruptcy trustees asserting claims against third parties in at least six circuits.  Baena v. KPMG LLP, 453 F.3d 1 (1st Cir. 2006); Official Comm. Of Unsecured Creditors v. R.F. Laffert & Co., 267 F.3d 340 (3d Cir. 2011); Terlecky v. Hurd (In re Dublin Sec., Inc.), 133 F.3d 377 (6th Cir. 1997); Moratzka v. Morris (In re Senior Cottages of Am., LLC), 482 F.3d 997 (8th Cir. 2007); Sender v. Buchanan (In re Hedged-Invs. Assocs., Inc.), 84 F.3d 1281 (10th Cir. 1986) and Official Comm. Of Unsecured Creditors of PSA, Inc. v. Edwards, 437 F.3d 1145 (11th Cir.).

[9]   Wagoner, 944 F.2d 114; see also, e.g.’s Mediators, Inc. v. Manney (In re Mediators, Inc.), 105 F.3d 822 (2d Cir. 1997); Hirsch v. Arthur Anderson & Co., 72 F.3d 1085, 1094 (2d Cir. 1995); Breeden v. Kirkpatrick & Lockhart, LLP, 268 B.R. 704 (S.D.N.Y. 2001).

[10] Id.; see also, e.g., Picard v. J.P.Morgan Chase & Co., 460 B.R. 84, 91 (S.D.N.Y. 2011) (“there is no doubt that the common law causes of action in the Amended Complaints, premised on a Ponzi scheme of unprecedented scope and duration orchestrated by [Madoff], belong to the creditors, not to [Madoff].”); In re Granite Partners, L.P), 194 B.R. at 324 (S.D.N.Y. 1996) (the bankruptcy code does not permit the trustee to assert the personal, direct claims of creditors for the benefit of the estate or for a particular class of creditors).

[11]   See CPLR 1402 (McKinney’s 2013).

[12] Graphic Arts Mut. Ins. Co. v. Bakers Mut. Ins. Co., 45 N.Y.2d 551, 557 (1978).

[13]   Civil Practice Law & Rules (“CPLR”) 1401 (McKinney’s 2013).

[14]   CPLR 1402 (McKinney’s 2013).

[15]   AG Capital Funding Partners, L.P. v. State St. Bank & Trust Co., 5 N.Y.3d 582, 594 (2005) (citations omitted); see also, United States of America, 2011 U.S. Dist. LEXIS 51648, *22 ft. 6.

[16]   11 U.S.C. 544.

[17]   (In re Granite Partners, L.P), 194 B.R. at 324 (citations omitted).

[18] Silverman v. Meister Seelig & Fein, LLP, 467 B.R. 556.

[19] See e.g., Picard v. J.P.Morgan Chase & Co., 460 B.R. 84; Picard v. HSBC Bank PLC, 454 B.R. 25.

[20] CPLR 1401 (McKinney’s 2013).

[21] Silverman v. Mesiter Seelig & Fein LLP (In re Agape World, Inc.), 467 B.R. 556 (E.D.N.Y. 2012) (citing Calcutti v. SBU, Inc., 273 F. Supp. 2d 488, 497 (S.D.N.Y. 2003).

[22] United States of America v. Staten Island University Hospital, 2011 U.S. Dist. LEXIS 51648, * 17 (2011) (A contrary holding is belied by the statute itself which was developed in response to the unfairness of allowing one tortfeasor to be held liable for injuries caused by another tortfeasor).

[23]   For example, in Hill v. Day (In re Today’s Destiny, Inc.), 388 B.R. 737, 753 (S.D. Tex. 2008), a Texas bankruptcy court did not dismiss a claim for contribution, only after an explicit finding that in pari delicto does not bar standing to bring the underlying claims in the Fifth Circuit.

[24] Ashcroft v. Iqbal, 556 U.S. 662 (2009)(holding that under Rule 12(b)(6) of the Federal Rules a complaint must be dismissed unless it alleges facts that if accepted as true, state a claim to relief that is plausible on its face.) (quoting Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)).

[25] For example, Nicholas Cosmo, the president and sole shareholder of Agape, et al., is the admitted Ponzi scheme perpetrator in the In re Agape World, Inc. bankruptcy matter, Case No. 11-9170-reg, United States Bankruptcy Court, Eastern District of New York.  In re Agape Litigation, 681 F.Supp2d 352 (E.D.N.Y. 2010) (Cosmo sentenced to 21 months imprisonment and three years of supervised release after he pleaded guilty to fraud).  Likewise, in Securities Investment Protection Corporation v. Bernard L. Madoff Investment Securities LLC (In re Madoff Securities), SIPA Liquidation (substantively consolidated), Adv. Pro. No. 08-01789, the fraudulent scheme was admitted.

[26] See e.g., CD Liquidation Trust v. Martillo (In re CD Liquidation Co., LLC), 462 B.R. 124 (2011).

[27]   Parenthetically, it can be argued that because a proof of claim is analogous to the commencement of an adversary proceeding, that the filing of claims satisfies the requirement of the debtor’s liability.  SeeNortec Trading Corp. v. Newfield, 311 F.2d 163, 164 (2d Cir. 1962) (the Second Circuit adopting the tenet that the filing of a proof of claim is analogous to the commencement of an action within the bankruptcy proceeding).

[28]   Devon Mobile Commc’ns Liquidating Trust v. Adelphia Commc’ns Corp. (In re Adelphia Commc’ns Corp.), 322 B.R. 509, 529 (S.D.N.Y. 2005) (“This standing requirement cannot be circumvented by the expedient of filing a third-party complaint and denominating the . . . claims as claims for contribution[.]”).