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Peterson v. McGladrey & Pullen

November 3, 2010

RONALD R. PETERSON, NOT INDIVIDUALLY BUT AS CHAPTER 7 TRUSTEE FOR THE BANKRUPT ESTATES OF LANCELOT INVESTORS FUND, L.P., LANCELOT INVESTORS FUND II, L.P., LANCELOT INVESTORS FUND, LTD., COLOSSUS CAPITAL FUND, L.P., AND COLOSSUS CAPITAL FUND, LTD., PLAINTIFFS,
v.
MCGLADREY & PULLEN, LLP, MCGLADREY & PULLEN, CAYMAN, SIMON LESSER, RSM MCGLADREY, INC., AND H&R BLOCK, INC. DEFENDANTS.



The opinion of the court was delivered by: Elaine E. Bucklo United States District Judge

MEMORANDUM OPINION AND ORDER

Plaintiff is the Chapter 7 Trustee for the bankrupt estates of several investment funds (collectively, "the Funds") that failed after being revealed as instrumentalities of a Ponzi scheme orchestrated by Thomas Petters. In this action, plaintiff claims that the Funds' outside auditors, McGladrey & Pullen, LLP, McGladrey & Pullen, Cayman, and Simon Lesser (collectively, "McGladrey"), were negligent in conducting the Funds' audits, with the result that they failed to discover the Ponzi scheme, causing the Funds to lose over $1.5 billion. Plaintiff also claims that RSM McGladrey ("RSM"), a corporation related to the McGladrey firm, is vicariously liable, and liable as McGladrey's alter ego, for McGladrey's alleged negligence. Finally, plaintiff claims that H&R Block, Inc., a corporate parent of both McGladrey and RSM, was unjustly enriched by "the structure it put into place" among the three entities, and is therefore liable for equitable restitution of plaintiff's claimed losses. Each of these defendants has moved to dismiss the complaint. I grant their motions for the reasons that follow.

I.

The following factual summary is based on the amended complaint in this case and on the complaint in a separate action plaintiff filed in this district's bankruptcy court (the "Bell" case), in which plaintiff seeks to recover from Gregory Bell for the same losses alleged here.*fn1 In or around late 2001, Gregory Bell established the Funds to invest in short-term trade finance notes. The notes evidenced secured loans made to entities controlled by Petters, which purportedly engaged in the business of acquiring consumer goods such as high-end electronics, then selling the goods to retailers such as Costco. Bell "personally represented" the Funds as their agent, director, manager, or partner.

In a typical investment transaction, one of the Funds would loan money to a Petters special purpose vehicle called Thousand Lakes LLC, which would issue a promissory note to the Fund. Thousand Lakes purportedly used the loan to finance the purchase of consumer goods from suppliers called Enchanted Family Buying Company and Nationwide Resources International, Inc. Thousand Lakes then professedly sold the underlying goods to retailers pursuant to purchase orders that predated Fund's loan to Thousand Lakes. The Funds earned revenue from interest payments on the Thousand Lakes notes, which were ostensibly secured by the underlying goods, account receivables, and credit insurance. As further investment protection, the Funds purportedly had a "lock-box" arrangement with Thousand Lakes which gave the Funds control over the bank account into which the retailer was to wire payments for the underlying goods.

To induce investments, the Funds provided potential investors a Confidential Information Memorandum (or "CIM") describing the Funds' investment strategy, including the terms and protections described above.*fn2 Between 2002 and 2008, the Funds raised over $2.5 billion from individuals, retirement plans, individual retirement accounts, trusts, corporations, partnerships and other hedge funds. But in September of 2008, it was revealed that the Funds' investments were a total sham: there were no underlying goods at all, and the purchase orders and invoices purporting to relate to goods purchased by retailers like Costco from Enchanted Family Buying Company and Nationwide Resources International were fabricated. These latter entities were merely shell companies with no real operations. Early investors in the Funds were paid not out of any money raised from the sale of consumer goods but from funds invested by subsequent lenders.

Plaintiff asserts that Bell had no knowledge of the Ponzi scheme prior to the summer of 2008, but that he was negligent in managing the Funds by "failing to conduct sufficient investigations to verify the legitimacy of the activities of" the various Petters entities, "and to confirm the validity of the collateral, security interests, and guarantees that were supposed to be obtained as security for repayment of the Notes." Plaintiff also alleges that Bell affirmatively joined the Ponzi scheme on or about February 26, 2008.*fn3

Thereafter, Bell participated in concealing from investors the true nature of the Funds' "investments" by structuring "roundtrip" payments between the Funds and certain Petters entities.

McGladrey audited the Funds' financial statements for the years ending 2007 and 2008.*fn4 In planning and preparing its audit, McGladrey relied, in part, on the CIM. In each of McGladrey's audit reports for the Funds, McGladrey stated that "[a]n audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements." Nevertheless, McGladrey failed to discover, for example, that the documents relating to the sale of fictitious underlying goods by shell corporations were fraudulent, or that the wire transfers into the Thousand Lakes "lock-box" accounts were made not by retailers but by entities controlled by Petters.

II. A. McGladrey's motion

McGladrey asserts four grounds for dismissal: 1) the "exculpatory clause" in the parties' contract bars the action; 2) the doctrine of in pari delicto bars the plaintiffs' claims; 3) the complaint fails to allege causation; and 4) the complaint fails adequately to allege damages. Several of these grounds may have merit; but because it is clear that plaintiff's claims are barred by the doctrine of in pari delicto, I grant McGladrey's motion on that basis.

The doctrine of in pari delicto--whose name finds its roots in the Latin sentence, in pari delicto potior est conditio defendantis, which means, "where the wrong of both parties is equal, the position of the defendant is the stronger," Knauer v. Jonathon Roberts Financial Group, Inc., 348 F.3d 230, 236 (7th Cir. 2003)---"embodies the principle that a plaintiff who has participated in wrongdoing may not recover damages resulting from the wrongdoing." King v. First Capital Financial Services Corp., 828 N.E. 2d 1155, 1173 (Ill. 2003) (citation omitted). As the Supreme Court has explained, "the equitable defense of in pari delicto...is rooted in the common-law notion that a plaintiff's recovery may be barred by his own wrongful conduct." Pinter v. Dahl, 486 U.S. 622, 632 (1988). McGladrey argues that plaintiff's allegations of wrongdoing by Bell, acting as the Funds' agent, mandate the conclusion that plaintiff is at least at equal fault for plaintiff's injury and thus cannot recover from defendants.

Plaintiff's tripartite response is that: in pari delicto does not apply to trustees in bankruptcy; that even if the doctrine applies to bankruptcy trustees, the allegations against Bell do not constitute sufficient wrongdoing to subject plaintiff to the defense; and that any wrongdoing by Bell was adverse to the Funds' interest and therefore outside the scope of the in pari delicto doctrine. Plaintiff is wrong on all counts.

Plaintiff acknowledges that there is no controlling authority in the Seventh Circuit or Illinois on whether the defense of in pari delicto is available against a bankruptcy trustee. But the First, Second, Third, Sixth, Eighth, Tenth, and Eleventh Circuits, as well as a recent decision from a district court in this circuit, have all held that it is, in some cases expressly distinguishing the authority and arguments on which plaintiff relies. E.g., Official Committee of Unsecured Creditors of P.A., Inc. v. Edwards, 437 F.3d 1145, 1152 (11th Cir. 2006) (allowing defense of in pari delicto against bankruptcy trustee and distinguishing Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995), which involved a state law receiver, rather than a bankruptcy trustee); Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 357 (3rd Cir. 2001) (same, agreeing with the court's reasoning in In re Hedged-Investments Associates, Inc., 84 F.3d 1281, 1285 (10th Cir. 1996), that the public policy underlying Scholes does not prevail in the bankruptcy context because it does "not comport with the plain language of section 541 [of the Bankruptcy Code].") See also Nissel v. Lernout, 469 F.3d 143, 153 (1st Cir. 2006) ("[T]here is no 'innocent successor' exception available to a bankruptcy trustee in a case in which the defendant successfully could have mounted an in pari delicto defense against the debtor."); Mosier v. Callister, Nebeker & McCullough, 546 F.3d 1271, 1276 (10th Cir. 2008) ("[I]t is well established that in pari delicto may bar an action by a bankruptcy trustee against third parties who participated in or facilitated wrongful conduct of the debtor")(citing precedent from the Second, Third, Sixth, and Eighth Circuits); Grede v. McGladrey & Pullen LLP, 421 B.R. 879, 885 (N.D. Ill 2009) (bankruptcy trustee not immune" to defense of in pari delicto because "[t]he ...


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