In Nisselson v. Lernout, 2006 U.S. App. LEXIS 27562 (1st Cir. November 8, 2006), (click here for opinion) the Trustee of a Litigation Trust filed suit against several parties for securities fraud, fraud, unfair trade practices, negligent misrepresentation and conspiracy.  The claims arose from a failed merger.

The basic, relevant facts are relatively straightforward. "Old Dictaphone" was a successful corporation in the telecommunications industry.  L&H  was also a purported leader in the industry and began courting Old Dictaphone.  In the process, "it described in glowing terms its financial stability and the profitable synergies that a merger could generate."  "Old Dictaphone conducted extensive due diligence investigations into L&H’s fiscal health. During the course of that review, L&H’s senior officers, investment bankers, attorneys, and auditors touted its financial prowess. Against this rose-colored backdrop, Old Dictaphone agreed to a stock-for-stock merger."

As part and parcel of the transaction, Old Dictaphone merged into Dark Acquisition Corp. (Dark), a wholly-owned subsidiary of L&H created under Delaware law for the express purpose of effectuating the merger. L&H’s chief executive officer, defendant-appellee Gaston  Bastiaens, doubled in brass as Dark’s chief executive and lone director. He also signed the merger agreement on its behalf.

Under the terms of the merger agreement, Dark inherited Old Dictaphone’s assets (including any existing legal claims) and assumed Old Dictaphone’s liabilities. This arrangement corresponded to the dictates of Delaware law. See Del. Code Ann. tit. 8, § 259(a). Dark survived the merger and Old Dictaphone ceased to exist. Dark then changed its name to Dictaphone Corporation (New Dictaphone).

The honeymoon was brief. Shortly after the merger had been consummated, L&H announced that the financial picture it had painted and displayed was not an accurate portrayal. As matters turned out, nearly two-thirds of L&H’s reported revenue from 1998 through mid-2000 had been improperly recorded, so that an apparent $ 70,000,000 net profit for that period was in fact a net loss of a similar magnitude. The price of L&H shares plummeted and, on November 29, 2000, L&H and New Dictaphone filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code.

We fast-forward to New Dictaphone’s approved plan of reorganization. As part of that plan, the corporation conveyed its interest in any claims arising out of the merger to the Dictaphone Litigation Trust (the Trust). That assignment galvanized this suit: acting on behalf of the Trust, the trustee filed a civil action in federal district court seeking damages to compensate for the "loss or diminution of [Old Dictaphone’s] value as a going concern."


The defendants filed a motion to dismiss based upon the affirmative defense of in pari delicto. The District Court granted the motion and the Trustee appealed. The elements of this defense are "(i) the plaintiff, as compared to the defendant, bears at least substantially equal responsibility for the wrong he seeks to redress and (ii) preclusion of the suit would not interfere with the purposes of the underlying law or otherwise contravene the public interest."

The first issue was to identify the appropriate parties in order to determine relative blame in order to analyze the first element of in pari delicto. The Trustee argued that his claims arose from Old Dictaphone, which was an innocent party. The court disagreed –

[H]is analysis entirely overlooks that, pursuant to both the merger agreement and the governing law, see Del. Code Ann. tit. 8, § 259(a), upon the consummation of the merger Old Dictaphone vanished into thin air and New Dictaphone inherited all of Old Dictaphone’s choses in action. Under the approved plan of reorganization incident to New Dictaphone’s bankruptcy, those litigation rights were passed along once more — this time to the Trust (and, thus, to the trustee). See 11 U.S.C. § 541(a)(1). Because the lineage of the trustee’s claims passes directly through New Dictaphone, any right that the trustee may have to assert those claims derives directly from New Dictaphone. This chain of descent means that the trustee — despite his protestations to the contrary — is not acting in the place and stead of Old Dictaphone but, rather, in the place and stead of New Dictaphone.

Having identified New Dictaphone as the appropriate party in privity with the Trustee, the issue became whether any misconduct could be imputed from L&H to New Dictaphone —

The trustee himself has observed that in pari delicto cases often result in imputation of fraudulent conduct to a corporation when those responsible for the scheme are "the sole decision-maker[s] for such entity, exercising complete control over its management." Appellant’s Br. at 43 n.21. This observation accurately reflects the case law. …  Since New Dictaphone, not Old Dictaphone, is the proper focal point of our imputation inquiry, see supra Part II (C), this case fits snugly within that integument. We explain briefly.

Here, the amended complaint leaves no doubt but that L&H played the primary role in contriving the scheme to acquire Old Dictaphone under false pretenses. The amended complaint also establishes that L&H created New Dictaphone (nee Dark) for the express purpose of furthering this artifice. L&H’s control over New Dictaphone during the course of the scheme is indisputable. In addition to owning all of New Dictaphone’s stock, L&H installed its president, Bastiaens, as New Dictaphone’s chief executive officer and sole director. Bastiaens, in turn, ensured New Dictaphone’s complicity in the fraud’s climactic event when he executed the merger agreement on its behalf.

These uncontroverted facts are telling. Because the amended complaint shows beyond hope of contradiction that L&H created and controlled New Dictaphone in order to perpetrate the harm-producing fraud, we have no principled choice but to impute its conduct to New Dictaphone for the purpose of applying the in pari delicto paradigm.

 That the officers and directors of Old Dictaphone became officers and directors of New Dictaphone after the merger was not relevant, as the inquiry focuses on the unlawful activity that is the subject of the suit.  The Court also dismissed the Trustee’s adverse interest exception —

In this instance, the allegations of the amended complaint make manifest that New Dictaphone benefitted from the fraud: it was the surviving entity in a merger that netted it over $ 900,000,000. New Dictaphone, as a beneficiary of L&H’s chicanery at the time the fraud was consummated,  cannot rely on the adverse interest exception to avoid imputation. After all, a party cannot accept the avails of fraudulent conduct without also bearing responsibility for that conduct 

To summarize succinctly, L&H was the main player in the alleged fraud and its parlous behavior must be imputed lock, stock, and barrel to its offspring (New Dictaphone). It follows inexorably that New Dictaphone, in contemplation of law, bears at least as much responsibility for the asserted wrongdoing as any of the defendants. Hence, the moving defendants have satisfied the first requirement for establishing an in pari delicto defense.

 The Court then moved to the second element of the in pari delicto defense.  

The trustee also asserts that withholding application of the in pari delicto doctrine would promote the goal of "discourag[ing] wrongdoers from engaging in future fraudulent schemes and violations of the securities laws." Appellant’s Br. at 38. That resupinate reasoning turns reality on its head. To permit the trustee to proceed in these circumstances would be equivalent to giving New Dictaphone a second bite at the cherry, allowing it first to reap the benefits of the fraud and then to attack the defrauders. …
Finally, the trustee strives to persuade us that we should repel the defendants’ in pari delicto defense because, in the absence of that defense, the creditors of Old Dictaphone ultimately would receive the fruits of any recovery. We find this argument unconvincing; despite the interposition of the in pari delicto defense, the creditors remain free to proceed in their own right, untainted by New Dictaphone’s role in the alleged wrongdoing. …

This arrangement is especially preferable because the Trust beneficiaries may well include parties (most notably L&H) who were themselves complicit in the underlying fraud. If we were to suspend the operation of the in pari delicto defense in this case, creditors with unclean hands would profit equally with innocents. If, however, each creditor must proceed by individual suit, the righteous may recover while the tainted, unable to circumvent the in pari delicto bar, will be hoist by their own petard. …

[C]reditors (or the trustee, on their behalf) may well succeed in suits against Old Dictaphone’s former directors, controlling shareholder, and outside accounting professionals. See supra note 1. Second — and more important — our holding today breaks no new ground. As such, the potential for default under these circumstances 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 Court, therefore, affirmed the lower court’s holding and in a relatively reare occurrence, the defendants prevailed on their affirmative defense via a Rule 12(b)(6) motion.