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The Far Reaches of In Pari Delicto in the Lernout Case

By Myron A. Bloom

The insolvency proceedings of Lernout & Hauspie, a European monolith that built itself into an international leader in the health care speech and language applications market, generated significant ripples here in the United States, as most recently evidenced in last week’s decision from the 1st U.S. Circuit Court of Appeals in Nisselson v. Lernout.

In 2000, Lernout & Hauspie (L&H) aggressively sought out an entry into the American markets. To that end, it approached Dictaphone, an established corporation that had established itself as a force in the industry. L&H wooed Dictaphone by lauding its financial stability and presented Dictaphone with a rosy view of the long-term and profitable synergies that could be achieved by a combination of their two companies.

Dictaphone conducted extensive due diligence. Throughout the due diligence period, L&H’s executives, investment bankers, attorneys and auditors spoke to L&H’s financial prowess. Ultimately, Dictaphone agreed to a merger in which L&H acquired all of Dictaphone’s stock in exchange for L&H stock, valued at almost $1 billion. As part of the merger, L&H set up a Delaware subsidiary corporation (Dark Acquisition Corp.) and transferred all of Dictaphone’s stock into the subsidiary, which was quickly renamed Dictaphone (New Dictaphone).

Under the terms of the merger agreement, New Dictaphone inherited all of Dictaphone’s assets and assumed all of its liabilities. This was all done in accordance with Delaware law. L&H’s chief executive officer, in connection with the merger, doubled as New Dictaphone’s chief executive and only officer; he also signed the merger agreement on Dark’s behalf. The old Dictaphone ceased to exist.

Shortly after the consummation of the merger, the truth about L&H came out — its revenues were not as stated and, in fact, the $70 million net profit it had recorded for the years 1998 through mid-2000 was in fact a net loss of about the same amount. The share price of L&H plummeted and both L&H and New Dictaphone filed for Chapter 11 relief.

New Dictaphone was able ultimately to confirm a plan of reorganization. As part of the Plan, New Dictaphone transferred any claims it might have arising out of the merger to a litigation trust. The trust’s trustee brought suit in federal district court against myriad L&H officers, directors, lawyers, auditors and investment bankers, seeking damages to recover for the “loss or diminution of [old Dictaphone’s] value as a going concern.”

The trustee alleged that over a four year period, the officers, directors, attorneys, auditors and investment bankers of L&H had engaged in a “fraudulent scheme designed to inflate the value of L&H’s stock,” and when the truth came out, rendering the L&H shares given to old Dictaphone worthless, the result was that the consideration given by L&H to old Dictaphone was non-existent. The trustee sued under a variety of federal and state grounded theories including federal securities fraud, common law fraud, unfair trade practices, negligent misrepresentation and conspiracy.

Several of the defendants moved to dismiss the trustee’s complaint. Their primary arguments were that first, the trustee lacked standing, and second, the claims were barred by the in pari delicto doctrine. The district court dismissed the trustee’s case on both grounds, and the trustee appealed.

The 1st Circuit spoke to three distinct issues. The first was whether or not the district court could even consider a motion to dismiss under Fed.R.Civ. P. 12(b)(6) when so many of the allegations of the complaint contained allegations of fact. This argument the circuit court dismissed summarily: “While most Rule 12(b)(6) motions are premised on a plaintiff’s putative failure to state an actionable claim, such a motion may sometimes be premised in the inevitable success of an affirmative defense.”

Dismissing a case under Rule 12(b)(6) based on an affirmative defense requires that the facts establishing the defense are definitively ascertainable from the complaint and other allowable sources of information, and those facts suffice to establish the affirmative defense with certitude. It was in this context, the circuit court stated, that it would view the defendants’ motions to dismiss.

The second issue was whether the trustee had standing to sue. The district court had viewed both the in pari delicto doctrine and the absence of a cognizable injury as issues involving standing, but the circuit court disagreed. In pari delicto, stated the court, does not implicate a plaintiff’s standing but rather constitutes an affirmative defense. However, the court ultimately chose not to deal with the “cognizable injury” issue.

While this issue is often considered first, it is addressed first because the issue often calls into question a federal court’s Article III power to hear a case. Here, at least for purposes of their motions to dismiss, defendants decided to not contest the trustee’s assertion that the conduct attributed to them resulted in an injury that could result in redress. Instead, they argued that even if Article III standing existed, the claims asserted belong exclusively to the old Dictaphone shareholders and thus, prudential standing, rather than Article III standing, was implicated. This type of standing, unlike Article III standing, does not require resolution as an initial matter.

Having so stated, the court elected to not grapple with what it concluded to be an “often elusive distinction between direct and derivative claims”, a distinction with it characterized as “tenebrous.” And because the court believed that it had a clear basis for ruling on the appeal without delving into the issue of standing, it chose to “bypass these uncharted waters” in what it believed were the unique facts presented here, namely, a stock-for-stock merger.

The third issue, and the crux of the court’s opinion, dealt with the in pari delicto affirmative defense. The court began its analysis by recognizing that the doctrine is grounded on two premises — one is that “courts should not lend their good offices to mediating disputes between wrongdoers,” and the second is that “denying judicial relief to an admitted wrongdoer is an effective means of deterring illegality.”

Over time, stated the court, courts have expanded the doctrine’s sweep. Early expansions went so far as to dismissing suits whenever a plaintiff played any role, no matter how modest, in harm-producing activity. As it has evolved, though, the doctrine has evolved into a two-pronged test, covering situations in which a plaintiff bears “at least substantially equal responsibility” for the wrong, and preclusion of the suit would “not interfere with purposes of underlying law or otherwise contravene public policy.”

Here, since the trustee did not request that the district court differentiate between the application of the doctrine as it applies to state law, the court adopted one test, that set forth above.

Using the two-pronged test, the court first addressed the trustee’s argument that the innocent party here is old Dictaphone; after all, it bore no responsibility for the fraud, and certainly bore less responsibility that any of the defendants. The circuit court rejected this argument. Even assuming that old Dictaphone would be a proper party to sue, the trustee overlooked the fact that old Dictaphone ceased to exist by virtue of the merger and any rights the trustee had to make the claims asserted “passes directly through New Dictaphone.”

This chain means that the trustee was not acting in place of and through old Dictaphone, but in place of and through New Dictaphone. The question thus presented was whether New Dictaphone could have asserted these claims pre-bankruptcy in the face of the in pari delicto doctrine, since if New Dictaphone lost those claims pre-petition, the filing of a bankruptcy cannot revive them.

Having concluded that the doctrine must be utilized looking at the trustee as the successor to New Dictaphone, the court concluded that the first “prong” of the doctrine would bar the trustee’s suit. Using state law, the court stated that while generally a parent and subsidiary are separate entities, courts may disregard that separation to defeat fraud practiced by those controlling the subsidiary.

The court concluded that this was a case where application of this exception was appropriate, since both L&H and New Dictaphone were controlled by the same core group — indeed, Dark was, even according to the trustee, created by L&H for the express purpose of furthering the fraud. This conduct, stated the court, must be imputed to New Dictaphone.

The trustee advanced a number of arguments in an attempt to alter the conclusion. First, he argued that the directors of old Dictaphone became directors of New Dictaphone, suggesting that this militated against a finding of control. The court was not swayed; it stated that the it is the unlawful activity at the time the activity occurs that is the focus of the inquiry, and at the time of the activity, L&H was in total control of Dark. Other arguments, including the adverse interest exception to the in pari delicto doctrine, were similarly unavailing — in fact, New Dictaphone actually benefited by the alleged fraud, netting it almost $1 billion (the assumed value of old Dictaphone).

After reviewing the first prong, the court turned to the second prong of the doctrine, namely, the public policy considerations. The trustee argued that use of the doctrine to prevent a recovery for a wrong would frustrate public policy.

In response, the court noted the following: one, the trustee is not bringing suit on behalf of an innocent target, but rather, on behalf of a complicit party; second, to allow the suit would in effect allow New Dictaphone, a perpetrator, to reap the rewards of its actions and then collect again from the defrauders but not for the benefit of those defrauded; and third, that the trustee’s assertion that the recovery would go to those who were the innocent victims was not necessarily correct.

The final argument raised by the trustee was one with seeming appeal. He argued that unless the dismissal were reversed, the innocents — creditors of old Dictaphone — would have no opportunity for redress, as they may not be in privity with the alleged wrongdoers (the lawyers, auditors, investment bankers, officers and directors of L&H).

The court responded by stating the even if the trustee’s premise were true, its holding did not “break any new ground,” and that the potential for default in this case “is something about which creditors had notice — something that should have been priced into their decisions to extend credit. Equity does not require courts to provide a belt when creditors had fair warning that they ought to have purchased suspenders.”

The result is not one most would expect. But then again, the transaction underlying the court’s opinion is not present in the typical case of this type. One thing is certain. The doctrine of in pari delicto is not only alive and well, but can drive some pretty interesting results in certain circumstances.

This article is reprinted with the permission from the November 17, 2006 issue of The Legal Intelligencer.  Copyright 2006 ALM Properties, Inc.  Further duplication without permission is prohibited.  All rights reserved.