Federal Circuit Significantly Restricts the Doctrine of Inequitable Conduct in Therasense v. Becton Dickenson

On May 25, 2011, the U.S. Court of Appeals for the Federal Circuit issued an en banc decision in Therasense v. Becton Dickenson, No. 2008-1511 (Fed. Cir., May 25, 2011), outlining a heightened standard for inequitable conduct in patent infringement cases, requiring a finding of both specific intent to deceive and a “but-for” materiality.

The doctrine of inequitable conduct is a defense to patent infringement that, if proved, bars enforcement of the patent. In making its decision, the Federal Circuit noted that the doctrine evolved from three early U.S. Supreme Court Cases, which involved particularly egregious misconduct, including perjury, the manufacture of false evidence, and the suppression of evidence, to a broader scope of misconduct including the mere nondisclosure of information to the PTO. In addition, the doctrine evolved from a mere dismissal of the suit, to the unenforceability of the entire patent and its continuations and divisionals. In order to prove inequitable conduct, the accused infringer must prove intent and materiality by clear and convincing evidence. If the infringer meets this burden, the court must then weigh the equities to determine whether the applicant’s conduct before the PTO warrants rendering the entire patent unenforceable. The Federal Circuit noted that the standards for materiality have fluctuated over time, and the standard has been weakened by placing intent and materiality on a sliding scale, thus both conflating and diluting the standards at the same time. As a result, inequitable conduct has become a significant litigation strategy, increasing the complexity, duration, and cost of patent litigation. According to the Federal Circuit, one study estimated that eighty percent of patent infringement cases included allegations of inequitable conduct. This has plagued the courts and the whole patent system.

In this en banc decision, the Federal Circuit adopted a much more restrictive test for inequitable conduct. With regard to intent, an accused infringer must now prove that the patentee acted with specific intent to deceive the PTO. For example, the accused infringer must prove by clear and convincing evidence that:

(1) the applicant knew of the reference,

(2) knew that it was material to the prosecution of the application, and

(3) made a deliberate decision to withhold it.

With regard to materiality, the Federal Circuit adopted a “but-for” standard, e.g. but-for the non-disclosure of the reference, the patent would not have issued.This is a much more restrictive standard than the prior standard and even the patent office’s own standard under Rule 56. In fact, the Federal Circuit said specifically that they do not adopt the PTO’s definition of materiality under Rule 56.

The Therasense decision has strictly limited the usefulness of the inequitable conduct doctrine as a defense to patent infringement. It is likely that this decision will help to simplify patent infringement cases and may lead to more patents being upheld and infringed.

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Visa Bulletin for June 2011

Number 33
Volume IX
Washington, D.C.

  1. STATUTORY NUMBERS1. This bulletin summarizes the availability of immigrant numbers during June. Consular officers are required to report to the Department of State documentarily qualified applicants for numerically limited visas; U.S. Citizenship and Immigration Services in the Department of Homeland Security reports applicants for adjustment of status. Allocations were made, to the extent possible, in chronological order of reported priority dates, for demand received by May 11th. If not all demand could be satisfied, the category or foreign state in which demand was excessive was deemed oversubscribed. The cut-off date for an oversubscribed category is the priority date of the first applicant who could not be reached within the numerical limits. Only applicants who have a priority date earlier than the cut-off date may be allotted a number. If it becomes necessary during the monthly allocation process to retrogress a cut-off date, supplemental requests for numbers will be honored only if the priority date falls within the new cut-off date announced in this bulletin.

    2. Section 201 of the Immigration and Nationality Act (INA) sets an annual minimum family-sponsored preference limit of 226,000. The worldwide level for annual employment-based preference immigrants is at least 140,000. Section 202 prescribes that the per-country limit for preference immigrants is set at 7% of the total annual family-sponsored and employment-based preference limits, i.e., 25,620. The dependent area limit is set at 2%, or 7,320.

    3. INA Section 203(e) provides that family-sponsored and employment-based preference visas be issued to eligible immigrants in the order in which a petition in behalf of each has been filed. Section 203(d) provides that spouses and children of preference immigrants are entitled to the same status, and the same order of consideration, if accompanying or following to join the principal. The visa prorating provisions of Section 202(e) apply to allocations for a foreign state or dependent area when visa demand exceeds the per-country limit. These provisions apply at present to the following oversubscribed chargeability areas: CHINA-mainland born, INDIA, MEXICO, and PHILIPPINES.
    4. Section 203(a) of the INA prescribes preference classes for allotment of Family-sponsored immigrant visas as follows:

    FAMILY-SPONSORED PREFERENCES

    First (F1): Unmarried Sons and Daughters of U.S. Citizens: 23,400 plus any numbers not required for fourth preference.

    Second: Spouses and Children, and Unmarried Sons and Daughters of Permanent Residents: 114,200, plus the number (if any) by which the worldwide family preference level exceeds 226,000, plus any unused first preference numbers:

    A. (F2A) Spouses and Children of Permanent Residents: 77% of the overall second preference limitation, of which 75% are exempt from the per-country limit;

    B. (F2B) Unmarried Sons and Daughters (21 years of age or older) of Permanent Residents: 23% of the overall second preference limitation.

    Third (F3): Married Sons and Daughters of U.S. Citizens: 23,400, plus any numbers not required by first and second preferences.

    Fourth (F4): Brothers and Sisters of Adult U.S. Citizens: 65,000, plus any numbers not required by first three preferences.

    On the chart below, the listing of a date for any class indicates that the class is oversubscribed (see paragraph 1); “C” means current, i.e., numbers are available for all qualified applicants; and “U” means unavailable, i.e., no numbers are available. (NOTE: Numbers are available only for applicants whose priority date is earlier than the cut-off date listed below.)

    Family-
    Sponsored
    All Chargeability
    Areas Except
    Those Listed
    CHINA-
    mainland born
    INDIA MEXICO PHILIPPINES
    F1 01MAY04 01MAY04 01MAY04 01MAR93 22FEB96
    F2A 22AUG07 22AUG07 22AUG07 22JUL07 22AUG07
    F2B 15APR03 15APR03 15APR03 22AUG92 08JUN00
    F3 01JUN01 01JUN01 01JUN01 15NOV92 08MAR92
    F4 08MAR00 08MAR00 08MAR00 15FEB96 01MAY88

    *NOTE: For June, F2A numbers EXEMPT from per-country limit are available to applicants from all countries with priority dates earlier than 22JUL07. F2A numbers SUBJECT to per-country limit are available to applicants chargeable to all countries EXCEPT MEXICO with priority dates beginning 22JUL07 and earlier than 22AUG07. (All F2A numbers provided for MEXICO are exempt from the per-country limit; there are no F2A numbers for MEXICO subject to per-country limit.)
    5. Section 203(b) of the INA prescribes preference classes for allotment of Employment-based immigrant visas as follows:

    EMPLOYMENT-BASED PREFERENCES

    First: Priority Workers: 28.6% of the worldwide employment-based preference level, plus any numbers not required for fourth and fifth preferences.

    Second: Members of the Professions Holding Advanced Degrees or Persons of Exceptional Ability: 28.6% of the worldwide employment-based preference level, plus any numbers not required by first preference.

    Third: Skilled Workers, Professionals, and Other Workers: 28.6% of the worldwide level, plus any numbers not required by first and second preferences, not more than 10,000 of which to “*Other Workers”.

    Fourth: Certain Special Immigrants: 7.1% of the worldwide level.

    Fifth: Employment Creation: 7.1% of the worldwide level, not less than 3,000 of which reserved for investors in a targeted rural or high-unemployment area, and 3,000 set aside for investors in regional centers by Sec. 610 of P.L. 102-395.

    On the chart below, the listing of a date for any class indicates that the class is oversubscribed (see paragraph 1); “C” means current, i.e., numbers are available for all qualified applicants; and “U” means unavailable, i.e., no numbers are available. (NOTE: Numbers are available only for applicants whose priority date is earlier than the cut-off date listed below.)

    Employment-
    Based
    All Chargeability Areas Except Those Listed CHINA-
    mainland born
    INDIA MEXICO PHILIPPINES
    1st C C C C C
    2nd C 15OCT06 15OCT06 C C
    3rd 15SEP05 15MAY04 22APR02 22DEC04 15SEP05
    Other Workers 08NOV03 22APR03 22APR02 08NOV03 08NOV03
    4th C C C C C
    Certain Religious Workers C C C C C
    5th
    Targeted Employment Areas/ Regional Centers and Pilot Programs
    C C C C C

    *Employment Third Preference Other Workers Category: Section 203(e) of the Nicaraguan and Central American Relief Act (NACARA) passed by Congress in November 1997, as amended by Section 1(e) of Pub. L. 105-139, provides that once the Employment Third Preference Other Worker (EW) cut-off date has reached the priority date of the latest EW petition approved prior to November 19, 1997, the 10,000 EW numbers available for a fiscal year are to be reduced by up to 5,000 annually beginning in the following fiscal year. This reduction is to be made for as long as necessary to offset adjustments under the NACARA program. Since the EW cut-off date reached November 19, 1997 during Fiscal Year 2001, the reduction in the EW annual limit to 5,000 began in Fiscal Year 2002.

    6. The Department of State has a recorded message with visa availability information which can be heard at: (202) 663-1541. This recording is updated on or about the tenth of each month with information on cut-off dates for the following month.

  2. DIVERSITY IMMIGRANT (DV) CATEGORYSection 203(c) of the INA provides up to 55,000 immigrant visas each fiscal year to permit additional immigration opportunities for persons from countries with low admissions during the previous five years. The NACARA stipulates that beginning with DV-99, and for as long as necessary, up to 5,000 of the 55,000 annually-allocated diversity visas will be made available for use under the NACARA program. This resulted in reduction of the DV-2011 annual limit to 50,000. DV visas are divided among six geographic regions. No one country can receive more than seven percent of the available diversity visas in any one year.

    For June, immigrant numbers in the DV category are available to qualified DV-2011 applicants chargeable to all regions/eligible countries as follows. When an allocation cut-off number is shown, visas are available only for applicants with DV regional lottery rank numbers BELOW the specified allocation cut-off number:

    Region All DV Chargeability
    Areas Except Those Listed Separately
    AFRICA 49,300 Except: Egypt 34,300
    Ethiopia 28,525
    Nigeria 17,150
    ASIA 28,600
    EUROPE 29,450 Except: Uzbekistan 27,800
    NORTH AMERICA
    (BAHAMAS)
    12
    OCEANIA 1,300
    SOUTH AMERICA,
    and the CARIBBEAN
    1,300

    Entitlement to immigrant status in the DV category lasts only through the end of the fiscal (visa) year for which the applicant is selected in the lottery. The year of entitlement for all applicants registered for the DV-2011 program ends as of September 30, 2011. DV visas may not be issued to DV-2011 applicants after that date. Similarly, spouses and children accompanying or following to join DV-2011 principals are only entitled to derivative DV status until September 30, 2011. DV visa availability through the very end of FY-2011 cannot be taken for granted. Numbers could be exhausted prior to September 30.

  3. ADVANCE NOTIFICATION OF THE DIVERSITY (DV) IMMIGRANT CATEGORY RANK CUT-OFFS WHICH WILL APPLY IN JULYFor July, immigrant numbers in the DV category are available to qualified DV-2011 applicants chargeable to all regions/eligible countries as follows. When an allocation cut-off number is shown, visas are available only for applicants with DV regional lottery rank numbers BELOW the specified allocation cut-off number:
    Region All DV Chargeability
    Areas Except Those Listed Separately
    AFRICA 57,600 Except: Egypt 35,000
    Ethiopia 30,650
    Nigeria 18,500
    ASIA 33,775
    EUROPE 33,000 Except: Uzbekistan 28,200
    NORTH AMERICA
    (BAHAMAS)
    12
    OCEANIA 1,400
    SOUTH AMERICA,
    and the CARIBBEAN
    1,400
  4. VISA AVAILABILITY IN THE EMPLOYMENT SECOND PREFERENCE CATEGORYAs mentioned in the May Visa Bulletin, Section 202(a)(5) of the Immigration and Nationality Act (INA) prescribes rules for the use of potentially “otherwise unused” Employment numbers. During May the India Employment Second preference cut-off date is governing the use of such numbers, because India had reached its Employment Second annual limit.

    Since October there has been heavy demand by applicants “upgrading” their status from Employment Third to Employment Second preference. The rapid forward movement of the India Employment Second preference cut-off date in May had the potential to greatly increase such demand. Therefore, the determination of the June cut-off dates was delayed in order to monitor this demand. At this time the amount of new “upgrade” demand has been minimal; this has allowed the Employment Second preference cut-off date governing the use of the Section 202(a)(5) numbers to advance significantly for June. The same cut-off date will apply to both China and India Employment Second preference. Note that under INA Section 203(e) all of the “otherwise unused” numbers must be provided strictly in priority date order regardless of the applicant’s chargeability.

    Cut-off date movement for upcoming months cannot be guaranteed, and because of the variables involved, no assumptions should be made until the dates are formally announced. Should there be a sudden or significant increase in India and China Employment Second preference demand it may be necessary to slow, stop, or retrogress that cut-off date as we approach the end of fiscal year 2011.

  5. OBTAINING THE MONTHLY VISA BULLETINThe Department of State’s Bureau of Consular Affairs offers the monthly “Visa Bulletin” on the World Wide Web. The Web address to access the Bulletin is:

    http://travel.state.gov

    From the home page, select the VISA section which contains the Visa Bulletin.

    To be placed on the Department of State’s E-mail subscription list for the “Visa Bulletin”, please send an E-mail to the following E-mail address:

    listserv@calist.state.gov

    and in the message body type:
    Subscribe Visa-Bulletin First name/Last name
    (example: Subscribe Visa-Bulletin Sally Doe)

    To be removed from the Department of State’s E-mail subscription list for the “Visa Bulletin”, send an e-mail message to the following E-mail address:

    listserv@calist.state.gov

    and in the message body type:
    Signoff Visa-Bulletin

    The Department of State also has available a recorded message with visa cut-off dates which can be heard at: (202) 663-1541. The recording is normally updated by the middle of each month with information on cut-off dates for the following month.

    Readers may submit questions regarding Visa Bulletin related items by e-mail at the following address:

    visabulletin@state.gov

    (This address cannot be used to subscribe to the Visa Bulletin.)

Department of State Publication 9514
CA/VO:May 11, 2011

The Hacker Who Avoided a False Marking Claim

The U.S. Court of Appeals for the Federal Circuit affirmed a lower court’s dismissal, with prejudice, of a false marking complaint, finding that the complaint failed to properly allege an “unpatented article” under 35 U.S.C. § 292.  Juniper Networks, Inc. v. Shipley, Case No. 10-1327 (Fed. Cir., Apr. 29, 2011) (Rader, J.).

Defendant Peter M. Shipley is an alleged computer hacker who maintained a website for the hacker community.  In 1995 and 1996, Shipley developed software known as Dynamic Firewall, a self-modifying active firewall filter designed to defend against network monitors and tools.  In 1997, Shipley provided information on a “Current Projects” portion of his website regarding the Dynamic Firewall.  The website stated that the Dynamic Firewall was patented.

Plaintiff Juniper filed its false marking complaint against Shipley after the current owner of the Dynamic Firewall patents accused Juniper of infringing those patents in a separate lawsuit.  Relying on information obtained during the discovery phase of that suit, Juniper alleged that an embodiment of the Dynamic Firewall was used as a component of the website.  The Dynamic Firewall, however, was destroyed in 1999 due to a hard drive crash in a computer in Shipley’s home.  Thereafter, no other prototype or product embodying the Dynamic Firewall was created.

In its original complaint, Juniper alleged that Shipley falsely marked the website and any firewall or services operating thereon from 1999 (the date the Dynamic Firewall was destroyed) to the present.  The lower court dismissed Juniper’s original complaint and, later, Juniper’s amended complaint, finding that Juniper failed to plead facts showing that Shipley had marked an “unpatented article.”  The lower court reasoned that the markings displayed on the website referred only to the Dynamic Firewall, and not to software operating on the website, as alleged by Juniper.  Juniper appealed.

The Federal Circuit affirmed, emphasizing that Juniper only alleged that the falsely marked “unpatented article” was the Website itself.  As a side note, the Court noted that had Juniper alleged that the Dynamic Firewall was itself falsely marked, such a claim would be barred because the sole embodiment of the Dynamic Firewall was destroyed in 1999 and §292 requires that the mismarked article actually exist.

However, the Court did note that a website may qualify as an “unpatented article” under §292 because websites may both embody intellectual property and contain identifying markings.  Turning to Shipley’s website and markings appearing therein, the Court focused on whether the markings related to the website itself.  The Court reasoned that the markings appeared on the “Current Projects” page, which was intended to provide the viewer with “a list of current projects and research underway.”  The page also stated that “[m]ost or all of these projects will be released to the public upon completion.”  Accordingly, the Court found that the website categorized the Dynamic Firewall as a “current project” that was “underway.”  Additionally, nowhere did the website indicate that the Dynamic Firewall was operating on the website.  Therefore, the Court found that “when considered in context, the allegedly affixed marks relate to [the] Dynamic Firewall as opposed to the Website, software operating on the Web-site, or pages generated by the Website.”

Standing and In Pari Delicto Issues Arising in Bankruptcy Cases

1.  Introduction

Corporate and managerial fraud is pervasive in today’s economic climate. When fraud leaves a company insolvent and forced to seek protection under the Bankruptcy Code, oftentimes bankruptcy trustees commence legal actions against attorneys to generate recoveries for the benefit of the debtor’s estate. A common scenario goes something like this: A company is in dire financial straits before the fraud or is created as a vehicle for the fraud. The defendant is the corporation’s attorney, who assists the corporation in the fraud. The attorney is hired to ensure the company’s compliance with existing law. The attorney does the bidding of the company’s management in pursuance of their fraud. After the company’s collapse, the bankruptcy trustee sues the attorney for fraud, aiding and abetting fraud and legal malpractice.

Drawing upon the equitable defense that bars recovery by a plaintiff bearing fault with the defendant for the alleged harm, common law principles of agency imputation, and the Constitutional requirement that a plaintiff has standing to sue, a defendant may move to dismiss the lawsuit on the grounds that the bankruptcy trustee lacks standing to sue.

This Note provides an analysis of the issue whether the bankruptcy trustee has standing to bring a suit on behalf of the debtor corporation against attorneys who allegedly helped that corporation’s management with the fraud.

2.  The In Pari Delicto Doctrine

a) Background

In pari delicto means “at equal fault.” It is a broadly recognized equitable principle and common law defense that prevents a plaintiff who has participated in wrongdoing from recovering damages resulting from the wrongdoing.[1] The policy behind this doctrine is to prevent one joint wrongdoer from suing another for damages that resulted from their shared wrongdoing.[2] Therefore, if a bankruptcy trustee brings a claim against an attorney on behalf of the corporation, and if the corporation is involved in the corporation’s wrongful conduct which serves as the basis for the claim, the in pari delicto may bar the claim.

The use of the doctrine against bankruptcy trustees emerged in the wave of corporate frauds in the last few decades. This novel application required the introduction of an important new element: agency law. Under agency principles, if the principal acted wrongfully through an agent in the scope of that agency relationship, then the wrongdoing of the agent is attributed to the principal.  Because the acts of corporate managers in the course of their employment are imputed to the corporation, and because a bankruptcy trustee “stands in the shoes” of a debtor corporation, the fraudulent acts of the debtor’s former managers will be imputed to the trustee—unless the trustee can show that management was acting entirely on its own interests and “totally abandoned” those of the corporation to break the chain of imputation.[3]

An analysis of the equitable defense in pari delicto at issue is separable from a standing analysis.[4] “Whether a party has standing to bring claims and whether a party’s claims are barred by an equitable defense are two separate questions, to be addressed on their own terms.”[5]

b)  The Second Circuit’s Approach

In Shearson Lehman Hutton Inc. v. Wagoner, 944 F.2d 114 (2d Cir. 1991), the Second Circuit adopted the controversial approach of treating in pari delicto as a question of standing rather than an affirmative defense. Specifically, the standing analysis in the Second Circuit begins with the issue of whether the trustee can demonstrate that the third party professional injured the debtor in a manner distinct from injuries suffered by the debtor’s creditors.[6] In many jurisdictions, the question of the trustee’s standing ends here.[7] In Wagoner, the Second Circuit went further and added a second inquiry that incorporates the equitable defense of in pari delicto.[8] By combining these two issues, the Wagoner rule blends the in pari delicto question into a rule of standing.

In Wagoner, the sole stockholder, director, and president of a corporation had used the proceeds of notes to finance fraudulent stock trading.[9] After the corporation became insolvent, the trustee brought claims against the defendant, an investment bank, for breach of fiduciary duty in allowing the company’s president to engage in inappropriate transactions.[10] The court held that because the president participated in the alleged misconduct, his misconduct must be imputed to the corporation and the bankruptcy trustee. This rationale derives from the agency principle that underlies the application of in pari delicto to corporate litigants: the misconduct of managers within the scope of their employment will normally be imputed to the corporation.[11] The court ruled that the trustee lacked standing to sue the investment bank for aiding and abetting the president’s alleged unlawful activity.[12] By adopting the Wagoner rule, the Second Circuit upped the ante by making an equitable defense a threshold question of standing at the motion-to-dismiss stage, rather than an affirmative defense better resolved on summary judgment or at trial.

c)  Approaches of Other Circuits

Although the Wagoner rule still prevails in the Second Circuit, a majority of other courts have declined to follow it, including the First, Third, Fifth, Eighth, Ninth and Eleventh Circuits. These circuits have “declined to conflate the constitutional standing doctrine with the in pari delicto defense.”[13] “Even if an in pari delicto defense appears on the face of the complaint, it does not deprive the trustee of constitutional standing to assert the claim, though the defense may be fatal to the claim.”[14]

The Eighth Circuit held that in pari delicto cannot be used at the dismissal stage.[15] On a motion to dismiss, the court is generally limited to considering the allegations in the complaint, which the court assumes to be true in ruling on the motion.[16] Because in pari delicto is an affirmative defense requiring proof of facts that the defendant asserts, it is usually not an appropriate ground for early dismissal.[17] An in pari delicto defense may be successfully asserted at the pleading stage only where “the facts establishing the defense are: (1) definitively ascertainable from the complaint and other allowable sources of information, and (2) sufficient to establish the affirmative defense with certitude.”[18] Thus, the in pari delicto defense is generally premature at this stage of the litigation, and the court must deny the motion to dismiss.

The existence of a possible defense does not affect the question of standing.[19] Standing is a constitutional question, and all a plaintiff must show is that they have suffered an injury that is fairly traceable to the defendant’s conduct and that the requested relief will likely redress the alleged injury.  In this matter, the First, Third, Fifth, Eighth, and Eleventh Circuits’ approach is more convincing. Those courts hold that whether a trustee has standing to bring a claim and whether the claim is barred by the equitable defense of in pari delicto are two separate questions and that the in pari delicto defense is appropriately set forth in responsive pleadings and the subject of motions for summary judgment and trial.

3.  Standing Issues The Trustees Face 

a)  Background

The next question is whether the bankruptcy trustee fulfills the constitutional requirement of standing. Article III specifies three constitutional requirements for standing. First, the plaintiff must allege that he has suffered or will imminently suffer an injury. Second, he must allege that the injury is traceable to the defendant’s conduct. Third, the plaintiff must show that a favorable federal court decision is likely to redress the injury.[20]

A critical issue in evaluating whether a trustee or receiver has standing to sue is whether the claim belongs to the corporate debtor entity or to the individual investors of the corporate debtor. The Supreme Court held in Caplin v. Marine Midland Grace Trust Co. of New York, 406 U.S. 416, 433-34 (1972), that a bankruptcy trustee has standing to represent only the interests of the debtor corporation and does not have standing to pursue claims for damages against a third party on behalf of one creditor or a group of creditors. Although the line is not always clear between the debtor’s claims, which a trustee has statutory authority to assert, and claims of creditors, which Caplin bars the trustee from pursuing, the focus of the inquiry is on whether the trustee is seeking to redress injuries to the debtor that defendants’ alleged conduct caused.[21]

b)  The Shifting Focus of the Second Circuit

In Wagoner, the Second Circuit held that the corporation and the trustee did not have standing to bring a claim because a “claim against a third party for defrauding a corporation with the cooperation of management accrues to creditors, not to the guilty corporation.”[22] The rationale for this rule is “though a class of creditors has suffered harm, the corporation itself has not.”[23] Without cognizable injury, the trustee representing the debtor corporation failed to meet the constitutional standing requirement.

Commentators have criticized the Wagoner rule that there is no separate injury to the corporation on several grounds. First, the court’s finding that a corporation is not harmed when its assets are squandered effectively ignores the existence of the corporation during the bankruptcy process.[24] Furthermore, the Wagoner court seems to acknowledge the trustee’s right to sue the guilty managers for damages done to the corporation. Such a construction leads to the absurd result that when management and its accomplices defraud a corporation, management can be sued on behalf of the corporation for the harm caused to the corporation, but the accomplices cannot be sued on behalf of the corporation because the corporation was not harmed.[25] Recognizing the faults of this rule, the Second Circuit recognized that there was “at least a theoretical possibility of some independent financial injury to the debtors” as a result of the defendant’s aid in the fraud.[26] Nevertheless, the court denied the plaintiff’s standing, relying on the observation that any damage suffered by the debtor was passed on to the investors, and “there was likely to be little significant injury that accrues separately to the Debtors.”[27] In other words, most of the alleged injuries in Hirsch were suffered by third parties, not by the debtors themselves. The Second Circuit shifted the focus of the Wagoner rule from lack-of-separate-injury (the first inquiry of the Wagoner rule) to the in pari delicto (the second inquiry) in Breeden v. Kirkpatrick & Lockhart LLP, 336 F.3d 94 (2d Cir. 2003). In that case, the court denied the trustee standing, holding that even if there was damage to the corporation, the trustee lacked standing because of the debtor’s collaboration with the corporate insiders.[28]

c)  Approaches of Other Circuits

In Lafferty, the creditors’ committee brought an action against the debtor’s officers, directors and outside professionals, alleging that through participation in a fraudulent Ponzi scheme, the defendants wrongfully prolonged the debtor’s life and incurred debt beyond the debtor’s ability to pay, ultimately forcing the debtor into bankruptcy.[29] The Lafferty court articulated different kinds of harms to the corporation: (1) fraudulent or wrongful prolongation of an insolvent corporation’s life, (2) prolongation that causes the corporation to incur more debt and become more insolvent, and (3) diminution of corporate value had prolongation not occurred.[30] Recognizing that conduct driving a corporation deeper into debt injures not only the corporate creditors, but the corporation itself, the Third Circuit held the committee had standing to sue the outsiders on behalf of the debtor.[31] The court also noted that although the Tenth and Sixth Circuits had applied the in pari delicto doctrine to bar claims of a bankruptcy trustee, those courts assumed that the bankruptcy trustee at least has standing to bring the claim.[32]

The Eighth Circuit held that a trustee who had alleged sufficient injury traceable to the actions of the defendants had standing to sue.[33] The court held that the defendant law firm and attorneys participated in stripping the corporation’s assets and that the injury was traceable to the activities of the lawyers who engineered the transaction to the detriment of their client.[34] In addition, the Eighth Circuit noted that the Third Circuit in Lafferty and the Ninth Circuit (in Smith v. Arthur Andersen LLP 421 F.3d at 1004) rejected the argument that a cause of action for harm to an insolvent corporation belongs to the creditors rather than the corporation. The Eighth Circuit adopted the rationale of Lafferty that simply because the creditors may be the beneficiary of recovery does not transform an action into a suit by the creditors.[35]

The Ninth Circuit found that the trustee had standing to pursue breach of contracts and duties against attorneys, auditors and investment bankers where, if defendants had not concealed the financial condition of debtor, the debtor might have filed for bankruptcy sooner and additional assets might not have been spent on a failing business.[36] “This allegedly wrongful expenditure of corporate assets qualifies as an injury to the firm which is sufficient to confer standing upon the Trustee.”[37] The court stated that “We rely only on the dissipation of assets in reaching the conclusion that the debtor was harmed.”[38] “A receiver has standing to bring a suit on behalf of the debtor corporation against third parties who allegedly helped that corporation’s management harm the corporation.”[39]

To sum up, when a director or officer enlists the help of attorneys to misstate the financial health of a company, it causes significant harm to a corporation. Harms include: (1) the fraudulent and concealed accrual of debt which can lessen the value of corporate property, (2) legal and administrative costs of bankruptcy, (3) operational limitations on profitability, (4) the undermining of business relationships, and (4) failed corporate confidence.

If court were to afford standing to trustee, third parties would be deterred from negligent, reckless, or other wrongful behavior. It will provide a means for increasing attorneys’ liability for the wrongs they commit. While limitless liability for attorneys is not the solution, increasing liability will require attorneys to answer in court when they fail to detect fraud or manipulation on the part of directors and officers that a reasonable attorney would discover.

4.  Conclusion

Attorneys are equipped with the tools to prevent fraud. An attorney may always report fraud to the appropriate authority or refuse to participate in the fraud. However, attorneys may not want to jeopardize important client relationships unless the consequence of inaction makes reporting more beneficial. Given the turmoil of the financial markets since 2008, increased liability for attorneys could help alleviate corporate fraud and bolster consumer confidence in this distressed market.

For the above reasons, the bankruptcy trustee has standing to bring a suit on behalf of the debtor corporation against attorneys who allegedly helped that corporation’s management with the fraud.