In a somewhat unusual case, Vice Chancellor Morgan T. Zurn addressed the question whether in pari delicto is an equitable or a legal defense, in In the Matter of the Liquidation of Indemnity Insurance, C.A. No. 8601-VCZ, order preserving affirmative defense (Del. Ch. Oct. 4, 2019). In an earlier decision in the case, Zurn held that the claimant had brought a purely legal claim and that equitable defenses were unavailable to bar the claim even when that legal claim was brought in a court of equity. Whether the defense of in pari delicto was a legal or equitable defense would determine whether it could be asserted in the case before her.

In order to understand the posture of the case, it is necessary to review the vice chancellor's earlier opinion in In the Matter of the Liquidation of Indemnity Insurance, (Del. Ch. May 15, 2019). Delaware's insurance commissioner had seized Indemnity Insurance Corp. (IIC) under the Delaware Uniform Insurance Liquidation Act. Eventually, IIC was placed in liquidation, and the insurance commissioner administered IIC's liquidation as its receiver.

Prior to the delinquency proceedings, IIC and its controller had entered into a $5 million loan with a bank and then defaulted on their obligations. The bank's successor in interest, BB&T, brought a third-party action seeking a declaratory judgment that it had a valid and enforceable security interest in the proceeds of the loan, which had been placed in a restricted account in IIC's name. BB&T sought to prevent the loan funds from being marshaled into IIC's assets under the liquidation order. It sought a declaration that the loan funds were not an asset or possible asset of IIC under the liquidation order, that it had a first priority lien against and security interest in the funds, and that it could set-off amounts due under the loan against the funds held in the loan's collateral account.

The receiver raised affirmative defenses alleging that BB&T's predecessor committed acts tantamount to fraud, and that BB&T's purported security interest in the funds was unenforceable as a matter of equity. BB&T moved for summary judgment to exclude the receiver's affirmative defenses. In the earlier opinion, Zurn held that BB&T's action for a declaratory judgment as to its rights under the loan documents in the context of IIC's statutory liquidation was a purely legal claim, and that the receiver's equitable defenses were unavailable to bar that legal relief. More specifically, the receiver's unclean hands and quasi-estoppel defenses were unavailable because BB&T's claims did not invoke equity and were not subject to equitable defenses. The opinion directed the parties to confer and provide a status update on what issues remained for trial.

The parties disagreed as to whether the opinion, or the rationale articulated by the vice chancellor in the opinion, also precluded the receiver's affirmative defense of in pari delicto. The issue of whether in pari delicto is an equitable defense, subject to preclusion under the reasoning in Zurn's earlier decision, or a legal defense, which could be asserted against BB&T's legal claim, remained unresolved.

In her subsequent order, Zurn explained that the in pari delicto doctrine arises from the proposition that there can be no action in equity or at law from an illegal contract, and courts will not extend aid to either of the parties to a criminal act or listen to their complaints against each other, but will leave them where their own act has placed them. This prevents the courts from having to engage in "inefficient and socially unproductive" accountings between wrongdoers. Under Delaware law, in pari delicto is the legal counterpart to the equitable defense of unclean hands. While the purely equitable unclean hands defense is generally inappropriate for claims seeking legal remedies, in pari delicto can be applied at law and had been recognized as a legal defense in cases in Superior Court.

Zurn acknowledged that courts of equity have invoked the doctrine of in pari delicto, and that there were decisions by the Delaware Court of Chancery that had previously analyzed in pari delicto under the rubric of equitable defenses. Zurn understood those decisions to reflect the doctrine's foundation in fairness, but not an effort by those courts to delineate its application by either courts of equity or law. Moreover, the application of in pari delicto to legal claims is consistent with the doctrine's purpose. The doctrine is not sourced in equity as between the litigants, but rather "in a societal desire not to waste judicial resources on apportioning wrong among wrongdoers." She concludes that courts of both law and equity are empowered to implement this societal concern. Accordingly, Zurn held that the receiver's in pari delicto defense was not precluded as an equitable defense and was preserved for trial as a defense to BB&T's action at law.

According to Zurn, the defense of in pari delicto is neither fish nor fowl—neither limited to actions in equity or at law. By emphasizing that the doctrine originates from the broader societal goal of not expending precious judicial resources on adjudicating disputes between wrongdoers, as opposed to doing equity as between the litigants, Zurn avoids having to claim the doctrine as either legal or equitable in nature, and thereby countenances its invocation in both actions in equity and at law.

Barry M. Klayman is a member in the commercial litigation group and the bankruptcy, insolvency and restructuring practice group at Cozen O'Connor. He regularly appears in Chancery Court.

Mark E. Felger is co-chair of the bankruptcy, insolvency and restructuring practice group at the firm.