In the
United States Court of Appeals
For the Seventh Circuit
No. 10-3770
R ONALD R. P ETERSON, as Chapter 7 Trustee for
the estates of Lancelot Investors Fund, L.P., et al.,
Plaintiff-Appellant,
v.
M C G LADREY & P ULLEN, LLP, et al.,
Defendants-Appellees.
Appeal from the United States District Court
for the Northern District of Illinois, Eastern Division.
No. 10 C 274—Elaine E. Bucklo, Judge.
A RGUED S EPTEMBER 8, 2011—D ECIDED A PRIL 3, 2012
Before E ASTERBROOK, Chief Judge, and B AUER and SYKES,
Circuit Judges.
E ASTERBROOK, Chief Judge. In 2002 Gregory Bell estab-
lished five mutual funds, known as the Lancelot or
Colossus group. We call them “the Funds.” They
raised about $2.5 billion, which they reinvested in busi-
2 No. 10-3770
nesses such as Thousand Lakes, LLC, that claimed to act
as commercial factors. (For simplicity we use Thousand
Lakes as the only exemplar.) The Funds told their
investors that Thousand Lakes loaned money to oper-
ating businesses on the security of their inventories.
Most of the firms to which the Funds routed money
were controlled by Thomas Petters. He was running a
Ponzi scheme. There was no inventory. Thousand Lakes
did not finance any business transactions. Instead Petters
used new investments in Thousand Lakes to pay older
debts, siphoning off some of the money for his own use.
Ponzi schemes must grow in order to survive, and there
always comes a time when growth cannot be sustained.
When Petters was caught in September 2008, the Funds
collapsed; about 60% of the money had vanished. The
Funds entered bankruptcy, and Ronald Peterson was
appointed as Trustee to marshal and distribute what
assets remained.
Peterson filed this action under Illinois law against
the Funds’ auditor, McGladrey & Pullen, LLP, and
some affiliated entities. The complaint contends that
McGladrey was negligent in failing to discover that
Thousand Lakes lacked customers. The Funds told
their investors that the venture was low risk because
Thousand Lakes had established lockboxes to which
payments would be made when the operating
businesses sold any of their inventory. Peterson’s com-
plaint alleges that McGladrey did not detect that the
money entering these lockboxes came from Thousand
Lakes itself, not from customers of the phony businesses
No. 10-3770 3
whose inventory Thousand Lakes supposedly financed.
The Trustee maintains that an auditor must perform
spot checks that will find such deceptions. (To be more
precise, one part of an auditor’s job is to determine
whether the client’s financial controls are sufficient to
catch deceits practiced against it; otherwise the auditor
cannot be sure that the client’s financial statements ac-
curately represent its condition. Auditors must do some
independent verification to learn whether the client’s
controls are working.)
The district court dismissed the complaint without
deciding whether the auditor had done its task compe-
tently. 2010 U.S. Dist. L EXIS 117018 (N.D. Ill. Nov. 3,
2010). The judge invoked the doctrine of in pari delicto—
the idea that, when the plaintiff is as culpable as
the defendant, if not more so, the law will let the losses
rest where they fell. Illinois applies this doctrine to suits
by clients against their auditors, because a participant
in a fraud cannot claim to be a victim of its own fraud.
See First National Bank of Sullivan v. Brumleve & Dabbs, 183
Ill. App. 3d 987 (1989); Holland v. Arthur Andersen & Co.,
127 Ill. App. 3d 854 (1984); Cenco Inc. v. Seidman & Seidman,
686 F.2d 449, 454–55 (7th Cir. 1982) (Illinois law). The
Funds knew what Bell knew, for he was the head of
their management company and investment adviser. See
Prime Eagle Group Ltd. v. Steel Dynamics, Inc., 614 F.3d 375
(7th Cir. 2010) (discussing imputation of knowledge
in corporate law). So if Bell was in on Petters’s scam, then
the Funds have no claim against McGladrey for failing
to detect and warn the Funds about something that Bell,
and thus the Funds, already understood. See Community
4 No. 10-3770
College District No. 508 v. Coopers & Lybrand, 208 Ill. 2d
259 (2003). Trustee Peterson stepped into the shoes of
the Funds under 11 U.S.C. §541(a) to collect property of
the estate—here, the estate’s chose in action against its
auditor. The Trustee’s claims are subject to the same
defenses that McGladrey could have asserted had the
Funds themselves filed suit. (Which is to say, this is not
an avoiding action to recoup any transfer from the
Funds to McGladrey, an action in which a bankruptcy
trustee can take the part of any hypothetical lien
claimant, see 11 U.S.C. §544; nor is it an action on behalf
of investors. Cf. Grede v. Bank of New York Mellon, 598
F.3d 899 (7th Cir. 2010). This makes it unnecessary to
consider limits that Illinois law places on investors’ efforts
to make direct claims against auditors.)
The district court concluded that Bell was in the
know about the Ponzi scheme. The Trustee alleges that
Bell joined forces with Petters in February 2008. In Octo-
ber 2009 Bell pleaded guilty to wire fraud. Petters stood
trial and was convicted of multiple federal crimes.
Because Bell is criminally culpable for fraud, the district
court concluded that the Funds lack a claim against their
auditor.
The crime to which Bell pleaded guilty occurred in
2008. The Trustee’s complaint alleges that Bell began to
conspire with Petters in February 2008—and that, until
then, Bell honestly (though carelessly and perhaps even
recklessly) believed that Thousand Lakes was a real
commercial factor and that the Funds’ investments had
been successful. The Trustee does not seek damages
No. 10-3770 5
on account of anything the auditor did or omitted in
2008; the suit relates to McGladrey’s audit of the Funds’
financial statements in 2006 and 2007. The Trustee’s
theory is that, if McGladrey had done what it was sup-
posed to do, the Ponzi scheme would have been
exposed earlier, and the Funds would not have thrown
so much money down the drain in 2007 and 2008. The
district court apparently supposed that, if Bell was crimi-
nally culpable in 2008, then surely he knew about the
Ponzi scheme earlier. But this is not something a court
can assume at the complaint stage of litigation. The
court must accept the complaint’s allegations—and the
Trustee expressly alleges that, until February 2008, Bell
did not know that Petters had built a house of cards.
McGladrey observes that the Trustee is trying to have
things both ways. In a separate suit against Bell, the
Trustee alleges that Bell committed fraud during 2006
and 2007. McGladrey contends that the district court
was entitled to take the same view of matters in
the Trustee’s suit against it. But there’s no rule against
inconsistent pleadings in different suits, or for that
matter a single suit. “A party may state as many separate
claims or defenses as it has, regardless of consistency.”
Fed. R. Civ. P. 8(d)(3). What’s more, “[a] party may set out
2 or more statements of a claim or defense alternatively
or hypothetically, either in a single count or defense
or in separate ones. If a party makes alternative state-
ments, the pleading is sufficient if any one of them is
sufficient.” Fed. R. Civ. P. 8(d)(2). So if we understand
the Trustee to be alleging that Bell both did, and did not,
know of Petters’s fraud in 2006 and 2007, the pleading
6 No. 10-3770
is sufficient if either allegation is sufficient. An allegation
that Bell was negligent but not criminally culpable in
2006 and 2007 makes the claim against McGladrey suffi-
cient; the complaint therefore cannot be dismissed on
the ground the district court gave. (If the Trustee had
prevailed against Bell on a theory that his fraud began
in 2006, then the doctrine of judicial estoppel would
block the Trustee from arguing an inconsistent position
against McGladrey. See New Hampshire v. Maine, 532
U.S. 742, 749–51 (2001); Astor Chauffeured Limousine Co.
v. Runnfeldt Investment Corp., 910 F.2d 1540, 1547-48
(7th Cir. 1990). But the suit against Bell is pending; the
requirements of judicial estoppel are unmet.)
Trustee Peterson asks for relief broader than a remand
to determine what Bell knew, and when he knew it. The
Trustee asks us to knock out the pari delicto defense alto-
gether, so that the culpability of a corporate manager
never would bar recovery against a negligent auditor.
Holland shows that Illinois would allow the defense if
a receiver for the Funds were suing under state law, but
the Trustee contends that federal law prevents its ap-
plication once a firm enters bankruptcy and a trustee
is appointed. The National Association of Bankruptcy
Trustees has filed a brief as amicus curiae supporting
this position. Illinois has limited the defense on public-
policy grounds in some circumstances as a matter of
its domestic law. See McRaith v. BDO Seidman, LLP,
391 Ill. App. 3d 565 (2009) (in pari delicto does not
apply to insurance liquidator’s claims against auditors);
Albers v. Continental Illinois Bank & Trust Co., 296 Ill. App.
596 (1938) (in pari delicto inapplicable to bank receiver).
No. 10-3770 7
But the Trustee and the Association pitch their argu-
ment on federal bankruptcy law. They use McRaith and
Albers to support the proposition that McGladrey can be
liable if Bell was negligent but did not commit fraud, but
that’s different from the question whether federal law
supersedes state law when the state would allow a pari
delicto defense.
Section 541(a) provides that an estate in bankruptcy
includes all of the debtor’s “property”, a word that com-
prises legal claims such as the one against McGladrey.
“Property” normally is defined by state law—and in
Illinois a claim for damages is limited by defenses such
as in pari delicto. The Trustee and the Association want
us to hold that a bankruptcy estate includes rights of
recovery, stripped of their defenses. If in pari delicto is
out, presumably the statute of limitations would be out
too, or maybe even the defense of accord and satisfac-
tion. As the Trustee and the Association see things,
“public policy” favors greater recoveries for estates
in bankruptcy, so that more money is available for dis-
tribution and so that wrongdoing by a corporation’s
“gatekeepers” (the accountants as well as Bell) may be
deterred more effectively.
This is not a new argument. It was advanced and
rejected in Butner v. United States, 440 U.S. 48 (1979). The
Court held that state law defines the “property” that
enters the bankruptcy estate, unless a provision in the
Bankruptcy Code displaces state law. Butner did not
deal with §541 or the pari delicto defense, but its prin-
ciple is general. See, e.g., Raleigh v. Illinois Department of
8 No. 10-3770
Revenue, 530 U.S. 15, 20 (2000) (“The ‘basic federal rule’ in
bankruptcy is that state law governs the substance of
claims, Butner, supra, at 57, Congress having ‘generally
left the determination of property rights in the assets of
a bankrupt’s estate to state law,’ 440 U. S., at 54”). Bank-
ruptcy is a means of administering claims that are
defined by tort, contract, and other generally applicable
bodies of law. Congress has modified these claims in
some respects, and changed some distribution priorities,
but unless the Code makes such an alteration the job of
the bankruptcy court is to gather all of the debtor’s
assets, as state law defines those assets, and distribute
them according to the creditors’ rights under state law.
In the main, bankruptcy law is designed to provide a
single forum for resolving competing claims to assets
defined by other bodies of law.
Neither the Trustee nor the Association identifies
any provision of the Code that overrides state-law limits
on the legal claims created by state law against the
debtor’s auditors. “Public policy” is not a ground on
which the federal judiciary may create such a limit—not
unless the Supreme Court first overrules Butner, Raleigh,
and similar decisions. We therefore agree with the con-
clusion of every other court of appeals that has
addressed this subject and hold that a person sued by a
trustee in bankruptcy may assert the defense of in pari
delicto, if the jurisdiction whose law creates the claim
permits such a defense outside of bankruptcy. See
Official Committee of Unsecured Creditors of PSA, Inc. v.
Edwards, 437 F.3d 1145, 1152 (11th Cir. 2006); Official
Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267
No. 10-3770 9
F.3d 340, 357 (3d Cir. 2001); In re Hedged-Investments
Associates, Inc., 84 F.3d 1281, 1285 (10th Cir. 1996).
According to the Trustee, Scholes v. Lehmann, 56 F.3d
750, 754 (7th Cir. 1995), commits this court to a contrary
position. Like today’s case, Scholes arises from a Ponzi
scheme. The Securities and Exchange Commission ap-
pointed a receiver to marshal the assets of one
participant in the scheme. The receiver sought to
recover some payments as fraudulent conveyances—
for one aspect of a Ponzi scheme is handsome but un-
earned payments to early investors, who then drum
up pigeons with promises of hefty and risk-free prof-
its. Some recipients of these payments invoked an equita-
ble defense, observing that the principal fault lay with
the scheme’s mastermind, to which we replied that,
although recovery would indeed have been inequitable
while the crook was running the show, recovery of fraudu-
lent transfers is entirely appropriate once the crook is
gone and the recovery will benefit duped investors. We
added: “Put differently, the defense of in pari delicto
loses its sting when the person who is in pari delicto
is eliminated.”
That sentence is dictum; Scholes did not entail a pari
delicto defense. It has nothing to do with §541 of
the Bankruptcy Code; Scholes was not a bankruptcy pro-
ceeding. And it does not stand for the proposition
that federal law overrides state-law defenses; Scholes
was decided under Illinois law, which, as we have ob-
served, puts the pari delicto defense out of bounds in
some situations. The state statute involved in Scholes
10 No. 10-3770
was replaced in 1990 when Illinois enacted the Uniform
Fraudulent Transfer Act, 740 ILCS 160. More importantly,
the law of fraudulent conveyances—both in Illinois and
under the Bankruptcy Code, see 11 U.S.C. §§ 547–50—
is one of those bodies that does supersede private-
law definitions of legal entitlements. The recipient of a
fraudulent or preferential transfer usually has a right
to the money as a matter of contract, but when the
transfer injures other creditors it can be recouped for
their benefit. Scholes should not be generalized beyond
the law of fraudulent conveyances and preferential trans-
fers. Scholes did not mention Cenco, which applied
Illinois law to block a corporation’s action against an
auditor when the fraud that the auditor failed to catch
had been engineered by the client’s managers. By the
time suit began in Cenco, the fraudsters were long gone,
but that did not clear the way for collection from
the deep pockets of an auditor that had been taken in
by the client’s former managers.
Two other arguments in this case require only brief
attention.
First, the Trustee contends that the pari delicto defense
is inapplicable, as a matter of Illinois law, because Bell
was acting adversely to the interest of the Funds. The
district court sensibly concluded that Cenco dooms
this argument. Cenco predicted that Illinois would
hold that fraud by corporate managers is imputed to
the corporation where “managers are not stealing from
the company—that is, from its current stockholders—
but instead are turning the company into an engine of
No. 10-3770 11
theft against outsiders”. Cenco, 686 F.2d at 454. Thirty
years have passed, and no court in Illinois has disagreed
with this understanding. Bell was not stealing from the
Funds, whether or not he was using them to snooker
people who had money to invest.
Second, McGladrey defends its judgment by pointing
to a clause in the engagement contract exculpating
the auditor if the client (i.e., the Funds) makes material
misrepresentations. The Trustee asks us to ignore this
clause, calling it vague. There’s no “vague clause” excep-
tion to contract law, however, and anyway this clause is
not vague. “Material” is one of those protean legal terms
that cannot be reduced to an algorithm. If McGladrey
can show that material misrepresentations made by its
own client affected the performance of its duties, it
receives the benefit of this clause. But it supplies a
defense; its negation is not an element of a plaintiff’s
claim for relief. Complaints need not anticipate and
plead around defenses. Gomez v. Toledo, 446 U.S. 635
(1980). If the complaint itself demonstrated that the
Funds made material misrepresentations to McGladrey,
then the Trustee could have pleaded himself out of
court. The complaint does not contain any fatal admis-
sions, however. At oral argument, counsel for McGladrey
maintained that, according to the complaint, Bell told
the auditor that Thousand Lakes had a lockbox mech-
anism for collecting money when the businesses
sold their inventory. This is a “misrepresentation,” how-
ever, only if Bell knew it to be false; otherwise he was
just passing along what others had said, and one
function of an auditor is to check whether the client is
12 No. 10-3770
being bilked by the likes of Petters. The state of Bell’s
knowledge cannot be determined at the complaint stage
of this litigation.
The judgment of the district court is vacated, and the
case is remanded for proceedings consistent with this
opinion.
4-3-12