A recent decision in the United States District Court for the Southern District of New York granted a motion to dismiss claims attempted to be asserted by a bankruptcy trustee on behalf of the debtor companies against Citibank for the fraud of its customer (the debtor companies), but sustained claims on behalf of investors of the debtors for aiding and abetting the fraud.
The decision, in Kenneth B. Silverman v. Citibank, 1:22-cv-5211-GHW (U.S.D.C., S.D.N.Y. Nov. 6, 2023), addressed the defense known as in pari delicto as well as the circumstances under which a bank can be held liable for the fraud of its customer.
The procedural posture of the case in Silverman guided the Court’s disposition of the motion to dismiss. The trustee in bankruptcy was seeking to assert claims against Citibank on behalf of two separate parties: (1) the debtor companies themselves and (2) investors of the debtor companies. The in pari delicto defense barred the claims on behalf of the debtors themselves, but not the claims of the investors.
The overall factual context in Silverman was as follows: From at least 2015 until his arrest in 2017, Jason Nissen ran a Ponzi scheme that defrauded investors out of tens of millions of dollars. Citibank was the primary banking institution that Nissen used for the various companies he formed to perpetrate the scheme. Nissan ultimately plead guilty to wire fraud and went to prison, and the companies filed for bankruptcy. Citibank was the obvious deep pocket from which to seek compensation for the fraud.
The bankruptcy trustee alleged that for nearly two years, Citibank allowed the accounts that Nissan opened to rack up thousands of highly suspicious transactions. After Citibank formally recommended closing his accounts on suspicion of fraud, it allegedly let its closure recommendations languish for months as Nissen continued to steal from investors.
Citibank moved to dismiss all fraud claims against it brought by the bankruptcy trustee.
In Pari Delicto
The Court granted the motion to dismiss claims on behalf of the debtors themselves based upon the defense of in pari delicto.
The New York Court of Appeals has explained the historical origins and purpose of the in pari delicto doctrine in Kirschner v KPMG LLP, 15 N.Y.3d 446 (2010). In Kirschner, the Court of Appeals was presented with two consolidated appeals in which the court was asked to consider the remedies available to creditors or shareholders of a corporation whose management engaged in financial fraud that was allegedly either assisted or not detected by the corporation’s outside professional advisers, such as auditors, investment bankers, financial advisers and lawyers.
The Court of Appeals noted that the “doctrine’s full name is in pari delicto potior est conditio defendent is, meaning ‘[i]n a case of equal or mutual fault, the position of the [defending party] is the better one.’” The Court continued:
The doctrine of in pari delicto mandates that the courts will not intercede to resolve a dispute between two wrongdoers. This principle has been wrought in the inmost texture of our common law for at least two centuries (see e.g. Woodworth v. Janes, 2 Johns.Cas. 417, 423 [N.Y.1800] [parties in equal fault have no rights in equity]; Sebring v. Rathbun, 1 Johns.Cas. 331, 332 [N.Y.1800] [where both parties are equally culpable, courts will not “interpose in favour of either”]). The doctrine survives because it serves important public policy purposes. First, denying judicial relief to an admitted wrongdoer deters illegality. Second, in pari delicto avoids entangling courts in disputes between wrongdoers. As Judge Desmond so eloquently put it more than 60 years ago, “[N]o court should be required to serve as paymaster of the wages of crime, or referee between thieves. Therefore, the law will not extend its aid to either of the parties or listen to their complaints against each other, but will leave them where their own acts have placed them” (Stone v. Freeman, 298 N.Y. 268, 271, 82 N.E.2d 571  [internal quotation marks omitted]).
Kirschner, 15 NY3d at 464 & n. 4.
The Court in Kirschner then addressed what is known as the “adverse interest exception” to the in pari delicto defense:
[F]or the adverse interest exception to apply, the agent ‘must have totally abandoned his principal’s interests and be acting entirely for his own or another’s purposes,’ not the corporation’s (Center, 66 N.Y.2d at 784–785, 497 N.Y.S.2d 898, 488 N.E.2d 828 [emphasis added] ). So long as the corporate wrongdoer’s fraudulent conduct enables the business to survive—to attract investors and customers and raise funds for corporate purposes—this test is not met (Baena, 453 F.3d at 7 [‘A fraud by top management to overstate earnings, and so facilitate stock sales or acquisitions, is not in the long-term interest of the company; but, like price-fixing, it profits the company in the first instance’] ).
The Court in Silverman explained the procedural application of this in pari delicto defense as to the claims before it:
In the context of litigation by a bankruptcy trustee, “[t]he debtor’s misconduct is imputed to the trustee because, innocent as he may be, he acts as the debtor’s representative.” In re Bernard L. Madoff Inv. Sec. LLC., 721 F.3d 54, 63 (2d Cir. 2013). In other words, “a trustee stands in the shoes of the corporation,” and the doctrine of in pari delicto bars him from “recover[ing] for a wrong that he himself essentially took part in.” Id. (citations omitted). Under New York law, the doctrine of in pari delicto is an affirmative defense. See, e.g., Kirschner, 912 N.Y.S.2d at 522. Under federal law, Rule 12(b)(6) allows a defendant to raise an affirmative defense on a pre-answer motion to dismiss “without resort to summary judgment procedure, if the defense appears on the face of the complaint.” Lateral Recovery, LLC v. Cap. Merch. Servs., LLC, 632 F. Supp. 3d 402, 436 (S.D.N.Y. 2022) (quoting Pani v. Empire Blue Cross Blue Shield, 152 F.3d 67, 74 (2d Cir. 1998).
The Court then rejected the bankruptcy trustee’s argument that the adverse interest exception saved the claims on behalf of the debtors:
Plaintiff does not dispute that Nissen’s fraud, imputed to the Company, is clear on the face of the pleadings, but instead unpersuasively argues that the so-called “adverse interest exception” to the doctrine of in pari delicto applies to the claim. “This most narrow of exceptions” is reserved for cases of “outright theft or looting or embezzlement.” Kirschner, 912 N.Y.S.2d at 519. “To come within the exception, the agent must have totally abandoned his principal’s interests and be acting entirely for his own or another’s purposes. It cannot be invoked merely because he has a conflict of interest or because he is not acting primarily for his principal.” Id. (quoting Center v. Hampton Affiliates, Inc., 66 N.Y.2d 782, 784–785 (1985)). Thus, the adverse interest exception is applicable only “where the fraud is committed against a corporation rather than on its behalf.” Id. If the “fraudulent conduct enables the business to survive . . . this test is not met,” regardless of whether the conduct is against the “long-term interests” of the business. Id. at 520. “Even where the insiders’ fraud can be said to have caused the company’s ultimate bankruptcy, it does not follow that the insiders ‘totally abandoned’ the company . . . it is immaterial that it has turned out that it would have been better for the agent to have acted differently.” Id. (internal citations and quotations omitted). In fact, “any harm from the discovery of the fraud—rather than from the fraud itself—does not bear on whether the adverse interest exception applies.” Id.
Because it is plain on the face of the pleadings that Nissen did not “totally abandon” the interests of the Company in perpetrating the Ponzi scheme, the adverse interest exception does not apply. Hampton Affiliates, 66 N.Y.2d at 784. To the contrary, Plaintiff alleges that the Company benefitted from Nissen’s fraud: as a result of the scheme, the Company, a “relatively small ticket brokerage business,” attracted at least $70,000,000 in investments, including from Investors—some of which paid legitimate business expenses, given Plaintiff’s allegation that Nissen used the money “in large part” to repay investors and enrich himself—and Plaintiff admits that the scheme “prolonged” the Company’s existence. …
Investors’ Claims Against Citibank for Aiding and Abetting Fraud
The Court in Silverman applied a different analysis to the claims on behalf of the debtors’ investors, denying the motion to dismiss as those claims were not subject to the in pari delicto defense and alleged sustainable elements of aiding and abetting fraud against Citibank. After laying out the elements of the claim for aiding and abetting fraud and acknowledging the very high burden of holding banks liable for the fraud of their customers, the Court nevertheless sustained the claims against Citibank. Among other things, the Court found:
Plaintiff adequately pleads that Citibank had knowledge of the primary violation—that is, Nissen’s defrauding of the Investors. The Complaint contains substantial allegations regarding the “surrounding circumstances” from which an inference of knowledge may be drawn. Krys, 749 F.3d at 127. According to the Complaint, Citibank employees extensively documented and voiced concerns about suspicious activity in Nissen’s and the Company’s accounts, beginning almost immediately after Nissen switched to Citibank as his primary banking institution. The Complaint goes on to allege that Citibank’s concerns grew so strong that it recommended closure of Nissen’s and the Company’s accounts. It alleges that for six months after Citibank recommended closing the accounts, Santana and Crowley formally contested the closure recommendations and pressured their colleagues to continue processing transactions for Nissen, even when doing so required bending Citibank’s rules and even after their colleagues told them to stop. It also alleges that Santana and Nissen had a personal relationship and that Nissen’s and the Company’s accounts represented a substantial portion of Crowley’s book of business.
Moreover, significantly, the Complaint contains allegations that a bank employee directly aided in the fraud. The Complaint alleges that Santana lied to Taly, one of the victims of the primary violation, at Nissen’s request, about the whereabouts of funds Nissen had stolen from it. “[I]n their totality,” these allegations give rise a sufficient inference that Citibank had actual knowledge of the primary violation—Nissen’s fraud against investors, particularly Taly.
The Court found all of the rest of the elements of aiding and abetting fraud to be adequately alleged, and rejected each of Citibank’s arguments to the contrary.
Even when there is egregious wrongdoing and fraud perpetrated by those in control of corporate entities, there is no remedy on behalf of the entities themselves because the fraud is imputed to the entities and the law does not allow an equal wrongdoer to recover for fraud that it committed itself. That is the defense of in pari delicto. However, innocent third parties, such as the investors in Silverman, can seek to obtain compensation from those outside the corporate entities who enabled the fraud to take place, through causes of action such as aiding and abetting the fraud.