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RECOVERY ACTIONS IN THE WAKE OF THE 2008 RECESSION:

COMMERCIAL TORTS _________________

Southeastern Bankruptcy Law Institute,

38th Annual Conference, March 23, 2012

_________________

Mark C. Ellenberg Partner Cadwalader, Wickersham & Taft LLP

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RECOVERY ACTIONS IN THE WAKE OF THE 2008 RECESSION: COMMERCIAL TORTS

Overview of Applicable Legal Doctrine

Standing

Directors of a solvent corporation owe fiduciary duties to the corporation and to its shareholders. When the corporation is solvent, shareholders have standing to bring derivative claims to enforce such fiduciary duties, because the shareholders are the beneficiaries of the corporation’s value.1 No duties are owed to creditors of a solvent corporation.

Once the corporation is insolvent, however, the fiduciary duties normally owed to the corporation and its shareholders flow to the creditors of the corporation.2 Further, in the case of an insolvent corporation, creditors have standing to maintain derivative suits against directors for breaches of fiduciary duties because “[t]he corporation’s insolvency ‘makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value.’”3

Breach of Fiduciary Duty

Officers and directors of a corporation typically owe three fiduciary duties to the corporation: (i) the duty of care; (ii) the duty of loyalty; and (iii) the duty to act in good faith.

The duty of care demands that the directors of a corporation exercise a standard of care that an ordinary prudent business person would exercise under similar circumstances, and make informed decisions when acting on behalf of the company. The director’s duty of care applies both to the decision-making function and to the oversight function. The duty of care is breached when the director exhibits gross negligence in decision making.4

The duty of loyalty “mandates that the best interest of the corporation and its shareholders takes precedence over any interest possessed by a director.”5 To adequately plead breach of a duty of loyalty, one must establish that the director made a self-interested transaction that harmed the plaintiff.6

1 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 101(Del. 2007). 2 See id. at 92. 3 Id. at 102. 4 Official Committee of Unsecured Creditors of Fedders North America, Inc., et al. on behalf of the Debtors’ Estates v. Goldman Sachs Credit Partners L.P., et al. (In re Fedders North American, Inc., et al.), 405 B.R. 527, 539 (Bankr. D. Del. 2009). 5 Id. at 540. 6 Id.

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Lastly, the duty to act in good faith, which is a subsidiary element of the duty of loyalty, requires a higher standard of care than the fiduciary duty of care. The duty of to act in good faith is breached where the director acts intentionally to harm the corporation.7 Delaware courts have concluded that where “directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities” the duty of to act in good faith is breached.”8

Non-fiduciaries, while not subject to the standards of care detailed above, will be liable for “gross and egregious conduct” in dealing with a corporation. At least one court, in Credit Suisse v. Official Committee of Unsecured Creditors (In re Yellowstone Mountain Club, LLC) (discussed below), equitably subordinated the claims of the corporation’s secured creditor to the claims of its unsecured creditors, as a result of predatory lending practices.9

Aiding and Abetting

Aiding and abetting a breach of fiduciary duty requires (i) a fiduciary relationship, (ii) proof that the fiduciary breached its duty, (iii) proof that a defendant, who is not a fiduciary, knowingly participated in a breach, and (iv) a showing that damages to the plaintiff resulted from the concerted action of the fiduciary and the non-fiduciary.10

Deepening Insolvency

“Deepening Insolvency” refers to the harm that a corporation experiences when the defendant, either fraudulently or negligently, prolongs the life of an insolvent corporation, thereby increasing the corporation’s debt and exposure to creditors.11

The tort alleged to cause the deepening insolvency may vary. For example, plaintiffs may plead deepening insolvency on a theory of negligence or fraud. However, one essential element of any deepening insolvency claim is that the plaintiff prove that the defendant’s actions caused the injury to the corporation.12

Several courts have questioned whether deepening insolvency exists as a separate cause of action.13 However, recently in Official Committee of Unsecured Creditors v. Baldwin (In re

7 Id. at 101. 8 See Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006) (citing In re Walt Disney Co. Deriv. Litig., 906 A.2d 27, 67 (Del. 2006)). 9 No. 08-61570-11, Adv. No. 09-00014 (Bankr. D. Mont. May 12, 2009). 10 Fedders, 405 B.R. at 543-544. 11 Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001). 12 Drabkin v. L&L Constr. Assocs. (In re Latin Inv. Corp.), 168 B.R. 1 (Bankr. D.C. 1993). 13 See Trenwick Am. Litig. Trust v. Ernst & Young, LLP, 906 A.2d 168, 205 (Del.Ch.2006) (rejecting deepening insolvency as a cause of action under Delaware law).

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Lemington Home for the Aged), the Third Circuit Court of Appeals held that it is a valid cause of action in Pennsylvania.14

In Pari Delicto In pari delicto is a common-law defense, with its origins in equity jurisprudence, that has transitioned into a defense in actions at law.15 In pari delicto means that “[i]n a case of equal or mutual fault . . . the position of the [defending] party . . . is the better one.”16 “The defense is grounded on two premises: first, that courts should not lend their good offices to mediating disputes among wrongdoers; and second, that denying judicial relief to an admitted wrongdoer is an effective means of deterring illegality.”17 To establish the defense of in pari delicto, a defendant must show that the plaintiff was a willing participant in the alleged wrongdoing, and that the plaintiff’s culpable behavior was equal to, or greater than, that of the defendant.18

Selected Case Studies

A. Torch Liquidating Trust v. Stockstill, et al., 561 F.3d 377 (5th Cir. 2009)

Background

Incorporated in 1978, Torch Offshore, Inc. and its affiliates (“Torch”) provided subsea construction services for energy companies establishing oil and natural gas reservoirs on the continental shelf of the Gulf of Mexico.19 Weak demand in the Gulf led Torch to expand into deep-water operations in 2002, which required capital infusions through an IPO and additional borrowings.20 However, Torch’s business continued to deteriorate during 2003, due to adverse market forces, and, by 2004, Torch defaulted on its loans and ceased paying its vendors.21 On January 7, 2005, Torch commenced voluntary chapter 11 cases in the Eastern District of Louisiana.22

14 659 F.3d 282 (3d Cir. 2011). 15 Official Committee of Unsecured Creditors of Allegheny Health., Educ. and Research Foundation v. Pricewaterhousecoopers, LLP, 989 A.2d 313, 328 (2010). 16 Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 306 (1985). 17 Id. 18 Id. 19 Torch Liquidating Trust v. Stockstill, et al., 561 F.3d 377, 380 (5th Cir. 2009). 20 Id. 21 Id. 22 Id.

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During the bankruptcy cases, Torch sold substantially all of its assets and then filed a chapter 11 liquidation plan. Pursuant to the plan, which was confirmed on April 28, 2006, all of the debtor’s remaining assets, including certain claims against Torch’s directors, officers, and other principals, were transferred to a newly-created liquidation trust.23 A trustee was then appointed under the plan with authority to prosecute these causes of action.24

Two years after commencement of Torch’s cases, the trustee filed a complaint against Torch’s former directors and officers asserting various claims for breach of their fiduciary duties owed to creditors when Torch entered the zone of insolvency and was insolvent.25 Specifically, the trustee alleged, among other things, that the directors (i) provided inflated estimates of market value, (ii) delayed providing information regarding Torch’s souring financial condition, and (iii) “orchestrated a public relations campaign to obscure and minimize the market impact of Torch’s financial data.”26

Procedural History

Just after the trustee filed its complaint, the Delaware Supreme Court issued its opinion in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, which, held that creditors of a Delaware corporation cannot assert direct claims for breach of fiduciary duty against directors, regardless of whether the corporation is insolvent or in the zone of insolvency, but can maintain derivative claims against directors on behalf of the corporation.27

In order to comply with the new Gheewalla precedent, the trustee moved for leave to amend its complaint to assert derivative claims, rather than direct claims.28 The motion was granted by the district court and the trustee summarily amended the complaint by replacing references to “creditors” with “creditors and shareholders.”29 The trustee made clear that the matter was “in the nature of a derivative suit in that plaintiff sues on behalf of the shareholders and creditors alike of [Torch].”30

The directors moved to dismiss the complaint on the grounds that (i) the trustee lacked standing to bring the suit, (ii) the business judgment rule precluded the directors’ liability, and

23 Id. at 381. 24 Id. 25 Id. 26 Id. at 383. 27 North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 94 (Del. 2007). 28 Torch, 561 F.3d at 382. 29 Id. 30 Id.

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(iii) the exculpatory provisions in Torch’s certificate of incorporation shielded the directors from liability for certain breaches of their fiduciary duties.31

The district court held that many of the claims in the amended complaint were still impermissible direct claims because they were asserted by the trust on behalf of Torch’s creditors for breach of fiduciary duties owed to the creditors.32 Further, the court found that the derivative claims were improperly pled because they were asserted on behalf of Torch’s creditors and shareholders, rather than Torch itself.33 Nonetheless, the directors were found to be protected by the business judgment rule.34 Consequently, the lawsuit was dismissed and a final judgment entered in favor of the directors, which the trustee timely appealed.35

Discussion

1. Standing

The Fifth Circuit Court of Appeals found the standing issue misconstrued. While the parties disputed on whose behalf the derivative claims must be asserted, the Fifth Circuit held that the trust, through the trustee, clearly had standing to bring a direct suit asserting Torch’s claims against the directors and officers.36 The causes of action were property of Torch’s estate that had been expressly transferred to the liquidation trust pursuant to the plan, confirmation order and trust agreement. Thus, to have standing to assert the claims directly, the trustee would simply need to show “(1) that it has been appointed, and (2) that it is a representative of the estate.”37 In this case, the confirmation order and trust agreement appointed the trustee and granted it authority to prosecute all D&O claims, thereby easily satisfying the first requirement. And because the proceeds of these actions were to be distributed to creditors pursuant to the plan, the trustee was considered a representative of the estate.38 Accordingly, whether the trustee could assert derivative claims was irrelevant.

2. Breach of Fiduciary Duties

Finding standing, the Fifth Circuit proceeded to hold that the trustee had failed to adequately allege a cause of action for breach of the directors’ fiduciary duties owed to Torch. As mentioned, the trustee’s amended complaint alleges that Torch’s directors breached their fiduciary duties by intentionally misrepresenting Torch’s financial condition under precarious circumstances. Under established Delaware law, “When the directors are not seeking

31 Id. at 383. 32 Id. 33 Id. 34 Id. at 384 35 Id. 36 Id. at 385. 37 Id. at 387 (citing In re Tax. Gen. Petroleum Corp., 52 F.3d 1330, 1335 (5th Cir. 1995)). 38 Id. at 387-88.

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shareholder action, but are deliberately misinforming shareholders about the business of the corporation, either directly or by a public statement, there is a violation of fiduciary duty.”39 In order to establish such a violation, a plaintiff must show “(1) deliberate misinformation either directly or through public statement; (2) reliance; (3) causation; and (4) actual, quantifiable damages.”40 In this case, the trustee did not allege that the disclosure violations were made in connection with a request for shareholder action and therefore, the more stringent pleading standard applied. However, according to the Fifth Circuit, the amended complaint only alleged harm suffered by Torch’s creditors and shareholders, rather than by Torch itself.41 Moreover, under applicable Delaware law, the trustee’s claims for failure to disclose are not actionable without a corresponding request for shareholder action.42 Thus, the dismissal of these claims was affirmed.

3. Remand to Amend

Based on the Fifth Circuit’s analysis, the trustee requested remand so that it may once again amend its complaint to allege a claim showing injury to Torch.43 Despite the trustee’s failure to move the district court for such leave, the Fifth Circuit heard and denied the request. The Fifth Circuit held that the trustee had ample opportunity to properly amend its complaint in the aftermath of Gheewalla. However, the trustee’s “find and replace” exercise switching “creditors” for “creditors and shareholders” and “direct” with “derivative” in the complaint was insufficient and “demonstrated a complete disregard for [the trustee’s] burden to allege facts that state a claim under existing law.”44 Thus, the trustee’s offer to amend the complaint again by replacing “creditors and shareholders” with “Torch” was found to be too little, too late. The Fifth Circuit added that while Gheewalla may have changed the landscape of direct creditor claims, the elements necessary to state a claim for deliberate misrepresentation in the absence of a request for shareholder action was well established and unchanged.45

B. Official Committee of Unsecured Creditors of Fedders North America, Inc., v. Goldman Sachs Credit Partners L.P., et al. (In re Fedders North American, Inc., et al.), 405 B.R. 527 (Bankr. D. Del. 2009)

Background

Fedders North America, Inc. (“Fedders”), originally a metalworking shop located in Buffalo, New York, was founded in 1896 and enjoyed a lengthy period of continued expansion and growth through the 1980s, capturing approximately thirty percent of the North American

39 Torch, 561 F.3d at 389 (citing Malone v. Brincat, 722 A.2d 5, 10 (Del. 1998)). 40 Id. 41 Id. at 390. 42 Id. at 390, n.14. 43 Id. 44 Id. at 391. 45 Id.

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market share for residential room air conditioners. In the early 1990s, however, Fedders’ business began to deteriorate under new leadership intent on pursuing new corporate strategies, such as entry into growth industries that traditionally were not part of the company’s core business and relocation of much of the company’s production to overseas plants. Fedders incurred substantial debt to pursue these strategies, including a $75 million secured credit facility with Wachovia Bank. Unfortunately, the new business strategies proved unsuccessful, and Fedders defaulted on the Wachovia credit facility in February 2007. Consequently, Wachovia began to limit Fedders’ ability to borrow under the credit facility.46

Confronting a severe liquidity crisis that threatened the company’s ability to prepare inventory for the upcoming 2007 summer selling season, Fedders initiated a search for replacement financing. In March 2007, Fedders obtained two new credit facilities aggregating to $90 million (the “Facilities”). The first facility was a $50 million revolving credit facility with Bank of America as administrative agent, collateral agent, and lender, and General Electric Capital Corporation as documentation agent and lender. The second facility was a $40 million term facility with Goldman Sachs Credit Partners L.P. as administrative agent, collateral agent, and lender. Fedders used the Facilities to pay off the defaulted Wachovia credit facility and for working capital. However, this cash infusion was not enough to save the company. By May 2007, Fedders was in covenant default on the Facilities, and on August 22, 2007, Fedders and certain of its affiliates filed voluntary chapter 11 petitions in the Bankruptcy Court for the District of Delaware.47

Procedural History

Shortly after the commencement of its chapter 11 cases, Fedders conducted several asset sales pursuant to section 363 of the Bankruptcy Code, and ultimately filed a plan of liquidation, which the bankruptcy court confirmed on August 22, 2008. Prior to confirmation, the official committee of unsecured creditors sought derivative standing to pursue certain causes of action on behalf of Fedders against the lenders and several of Fedders’ former officers and directors. The court granted the committee standing to pursue the causes of action, and entered an order permitting the committee to file a complaint but staying all other aspects of the litigation until after the effective date of the plan of liquidation. Three days later, the committee filed its complaint. Pursuant to the plan, the committee assigned the claims asserted in the complaint to a liquidation trust established under the plan. Subsequently, the Facilities lenders and the individual defendants timely filed a motion to dismiss all of the claims in the complaint.48

46 Fedders, 405 B.R. at 535. 47 Id. at 535-36. 48 Id. at 537.

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Discussion

1. Complaint

As characterized by the court, the complaint provided a “tragic narrative”, describing a number of bad business decisions dating back nearly fifteen years. Among other things, these decisions resulted in Fedders entering into markets in which it had little or no experience while simultaneously abandoning the core business and customer base that had made it a once-thriving company. The complaint specifically took issue with three relatively recent decisions, each approved by Fedders’ board of directors.49

The first of these decisions was Fedders’ July 2006 execution of “change of control” agreements that would have provided five company insiders with severance payments equal to 2.9 times the recipients’ respective annual salary and average bonus for the past three years, as well as certain other benefits, in the event of a change of control of the company. The second decision was Fedders’ July 2006 execution of a new employment agreement with Salvatore Giordano, Jr., the company’s executive chairman. Pursuant to the agreement, Mr. Giordano was given the same change of control severance provisions as the other company insiders, in addition to a minimum base salary of $625,000 per year and participation in incentive, savings, and retirement plans. The agreement also provided that Giordano would not have to repay any personal loans that he had taken from the company (which aggregated to $6 million) while he remained employed by Fedders, and that the debts would be forgiven if he ever resigned or was terminated without cause, or if there was a change of control of the company. The third decision at issue in the complaint was Fedders’ March 2007 entry into the Facilities.50

Based primarily on these three decisions, the committee pursued fourteen causes of action against either the Facilities lenders or some or all of the individual defendants for breach of fiduciary duty, aiding and abetting a breach of fiduciary duty, fraudulent conveyance,51 aiding and abetting a fraudulent conveyance, waste, tortious interference with contractual relations, tortious interference with prospective business advantage, improvident lending, unjust enrichment, breach of the implied covenant of good faith and fair dealing, equitable subordination, and recharacterization.52

2. Breach of Fiduciary Duty

Pursuant to the internal affairs doctrine, only the state of incorporation has the authority to regulate a corporation’s internal affairs – matters peculiar to the relationships among or

49 Id. 50 Id. at 537-38. 51 As fraudulent conveyances are addressed by the first part of the “Recovery Actions in the Wake of the 2008 Recession” series, this case summary does not discuss the committee’s fraudulent conveyance claims. 52 Id. at 538.

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between the corporation and its officers, directors, and shareholders.53 As Fedders was incorporated in Delaware, the court applied Delaware law to evaluate each of the committee’s claims for breach of fiduciary duty.54 Under Delaware law, directors and officers of a corporation owe the shareholders a “triad” of duties: the duty of care, the duty of loyalty, and the duty to act in good faith.55 A breach of the duty of care cannot be proven without a showing a gross negligence.56 The exact behavior necessary to demonstrate gross negligence varies based on the circumstances, but generally requires a failure by the directors or officers “to inform themselves fully and in a deliberate manner.”57 In contrast, to state a claim for breach of the duty of loyalty, a plaintiff must allege facts demonstrating that a self-interested transaction occurred, and that the transaction was unfair to the plaintiff.58 The duty to act in good faith is a subsidiary element of the duty of loyalty, and requires “conduct that is qualitatively different from, and more culpable than, the conduct giving rise to a violation of the fiduciary duty of care,” such as intentional acts with a purpose other than advancing the best interests of the corporation, intentional acts to violate applicable positive law, and the intentional failure to act in the face of a known duty to act.59

a. Non-Director Insiders

The court concluded that the committee failed to state a cause of action against Fedders’ non-director insider defendants for breach of any fiduciary duty. In reaching this conclusion, the court found that each of the change of control agreements were approved by a disinterested majority of Fedders’ board of directors, and the complaint failed to allege that any of the non-director insider defendants mislead the board, failed to perform any assigned duties relating to the approval of these agreements, or otherwise acted improperly in convincing the board to adopt them. With respect to Fedders’ entry into the Facilities, the court was not persuaded by the committee’s allegations that the non-director insider defendants led Fedders’ into the financings because they were “terrified of losing control of the family business and of losing their substantial salaries, bonus compensation, and other perks.”60

Rather, the court concluded that, at bottom, the committee took issue with the wisdom of the non-director insiders’ decisions, “viewed through the prism of Fedders’ subsequent collapse.” Significantly, the court held that the mere fact that a strategy turned out poorly is insufficient to create an inference that the officers and directors who oversaw the strategy

53 Id. at 539 (citing Edgar v. MITE Corp., 457 U.S. 624, 645 (1982)). 54 Id. at 539. 55 Id. (citing Malone v. Brincat, 722 A.2d 5, 10 (Del. 1998)). 56 Id. (citing Cargill, Inc. v. JWH Special Circumstance LLC, 959 A.2d 1096, 1113 (Del. Ch. 2008)). 57 Id. (citing Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 368 (Del. 1993)). 58 Id. at 540 (citing Joyce v. Cuccia, No. Civ. A. 14953, 1997 WL 257448 at *5 (Del. Ch. May 14, 1997)). 59 Id. (citing Stone v. Ritter, 911 A.2d 362 (Del. 2006); In re Walt Disney Co. Derivative Litigation, 906 A.2d 27 (Del. 2006)). 60 Id. at 540-41.

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breached their fiduciary duties. Furthermore, the court ruled that bare allegations that a corporation was insolvent and took on further debt to continue operations is not enough to state a claim for breach of fiduciary duty, and the fact that officers and directors continued to be employed and compensated during such period, standing alone, is equally insufficient to support a claim for breach of fiduciary duty.61

b. Outside Directors

With respect to Fedders’ outside directors, the court found that the committee had not pled any facts to support a claim for either a breach of the duty of loyalty or a breach of the duty to act in good faith, as the complaint did not allege that the outside directors entered into any interested transactions in connection with the change of control agreements, Mr. Giordano’s employment agreement, or the Facilities, and also failed to allege that the outside directors had intentionally abdicated their directorial duties in the face of a known duty to act or intended to violate applicable positive law. The committee asserted that the outside directors intentionally acted against Fedders’ interests by seeking to avoid a bankruptcy filing so as to remain in office and continue collecting director fees.62 However, the court found that the committee failed to plead facts supporting this allegation, and consistent with Delaware law, held that such conclusory allegations of “entrenchment motives,” without more, were insufficient to state a claim that the outside directors were financially interested.63 Moreover, the court noted that its holding also was consistent with case law finding that the decision of whether to file for bankruptcy protection is generally a matter of directors’ business judgment.64

Unlike the duties of loyalty and good faith, the court held that the committee had stated a claim for breach of the duty of care by Fedders’ outside directors in connection with the Facilities. In so holding, the court relied on the complaint’s allegations that the outside directors had approved the financings without undertaking certain due diligence typically conducted by borrowers in similar situations. Specifically, the court was persuaded by the committee’s assertions that Fedders never obtained a financial assessment verifying that it would be able to comply with the Facilities’ covenants, and the Facilities agreements did not require a “clean” opinion by Fedders’ auditors, which the committee alleged is a standard requirement for financing transactions. However, because the committee sought only monetary damages for the breach and Fedders’ certificate of incorporation exculpated its directors from paying monetary damages for any breach of the duty of care, the court ultimately ruled that the committee failed to state a claim for which relief could be granted.65

61 Id. at 541. 62 Id. at 542. 63 Id. (citing Orman v. Cullman, 794 A.2d 5, 28-29 n. 62 (Del. Ch. 2002)). 64 Id. (citing Odyssey Partners, L.P. v. Fleming Cos., Inc., 735 A.2d 386, 416-20 (Del. Ch. 1999)). 65 Id. at 542-43.

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3. Aiding and Abetting Breach of Fiduciary Duty

As with the claims for breach of fiduciary duty, the internal affairs doctrine compelled the court to apply Delaware law to the committee’s claims for aiding and abetting a breach of fiduciary duty.66 Under Delaware law, a valid claim for aiding and abetting a breach of fiduciary duty requires (i) the existence of a fiduciary relationship, (ii) proof that the fiduciary breached its duty, (iii) proof that a defendant, who is not a fiduciary, knowingly participated in a breach, and (iv) a showing that damages to the plaintiff resulted from the concerted action of the fiduciary and the non-fiduciary.67

Applying these principles to the complaint, the court held that the committee pled sufficient facts to support its aiding and abetting a breach of fiduciary duty claim against the Facilities lenders. As discussed above, the court concluded that the committee had stated a claim for breach of the duty of care by Fedders’ outside directors based upon the directors’ alleged failure to perform routine due diligence in connection with the Facilities. The court held that the complaint also contained enough facts to infer plausible allegations that the Facilities lenders knowingly participated in the outside directors’ breach of the duty of care and that Fedders’ was damaged as a result. Notably, the court’s conclusion that the outside directors could be held harmless for their breach of the duty of care pursuant to the exculpatory provisions of Fedders’ certificate of incorporation did not prevent prosecution of an adding and abetting claim against the Facilities lenders.68

4. Aiding and Abetting Fraudulent Conveyance

A handful of courts have recognized a cause of action for either aiding and abetting a fraudulent conveyance or conspiracy to commit a fraudulent conveyance under state law.69 However, the court held that, regardless of whether state law recognizes such claims, the committee could not pursue such claims on behalf of Fedders’ bankruptcy estates.70 In so holding, the court observed that even where a debtor (or a party, such as the committee, with derivative standing to act on behalf of the debtor) is given lien creditor’s rights under the law of a state that does recognize an action for aiding and abetting a fraudulent conveyance or a conspiracy to commit a fraudulent conveyance, bankruptcy courts have refused to permit debtors to use section 544(b) of the Bankruptcy Code to pursue such claims.71 The rationale cited by these courts is based upon the plain language of the Bankruptcy Code – specifically, a debtor’s

66 Id. at 543 (citing Allied Capital Corp. v. GC-Sun Holdings, L.P., 910 A.2d 1020, 1038 (Del. Ch. 2006)). 67 Id. at 543-44 (citing Cargill, 959 A.2d at 1125). 68 Id. at 544. 69 Fedders, 405 B.R. at 548 (citing Bondi v. Citigroup Inc., No. BER-L-10902-04, 2005 WL 975856, at *20 (N.J. Super. Ct. Law Div. Feb. 28, 2005), aff’d 878 A.2d 850 (2005)). 70 Id. at 549. 71 Id. at 548 (citing In re Hamilton Taft & Co., 176 B.R. 895 (Bankr. N.D. Cal.), aff’d, 196 B.R. 532 (N.D. Cal. 1995), aff’d, 114 F.3d 991 (9th Cir. 1997)).

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only authority to assert a hypothetical lien creditor’s state law causes of action related to fraudulent conveyances is found in section 544(b), which only permits a debtor to avoid a fraudulent transfer.72 Any other remedy, such as damages, is notably absent from section 544(b).73

Additionally, the court found that bankruptcy courts also have relied on section 550 of the Bankruptcy Code as further support for the idea that Congress did not intend to empower debtors to assert damage claims under state law for aiding and abetting a fraudulent conveyance.74 These courts reasoned that section 550 of the Bankruptcy Code, which expressly addresses a debtor’s remedy for an avoided fraudulent conveyance, only permits the debtor to recover up to the amount of the transfer from a transferee or a party for whose benefit the transfer was made.75 Moreover, to allow a debtor to pursue any other recovery could lead to a result that expands remedies beyond the scope of section 550, and courts cannot invoke state law remedies to circumvent or undermine the specific remedy legislated by Congress.76 Finally, the Court noted that the authorities were equally clear that no cause of action for aiding and abetting a fraudulent conveyance or conspiracy to commit a fraudulent conveyance exists as a matter of federal law under the Bankruptcy Code.77

5. Waste

Similar to a claim for breach of fiduciary duty, a claim for waste implicates a matter peculiar to corporations – activities concerning the relationship between and among the corporation, its directors, officers, and shareholders. Accordingly, the internal affairs doctrine required the court to apply Delaware law to the committee’s waste claim.78 Under Delaware law, a claim for waste must be supported by facts demonstrating that “the economics of the transaction were so flawed that no disinterested person of right mind and ordinary business judgment could think the transaction beneficial to the corporation.”79 Applying this standard, the court held that the committee failed to state a claim for waste against the individual defendants with respect to any action, as the complaint did not show that any of the individual defendants

72 Id. (citing Hamilton, 176 B.R. at 902). 73 Id. at 548. 74 Id. (citing In re Brentwood Lexford Partners LLC, 292 B.R. 255 (Bankr. N.D. Tex. 2003)). 75 Id. (citing Brentwood, 292 B.R. at 275). 76 Id. at 548-49 (citing Brentwood, 292 B.R. at 275). 77 Id. at 549 (citing In re McCook Metals LLC, 319 B.R. 570, 591 (Bankr. N.D. Ill. 2005); In re H. King & Assoc., 295 B.R. 246, 293 (Bankr. N.D. Ill. 2003); In re Ampat S. Corp., 128 B.R. 405, 410-11 (Bankr. D. Md. 1991). 78 Id. at 549 (citing In re First Interstate Bancorp. Consol. Shareholder Litigation, 729 A.2d 851, 862-63 (Del. Ch. 1998)). 79 Id. (citing Harbor Fin. Partners v. Huizenga, 751 A.2d 879, 893 (Del. Ch. 1999)).

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engaged in a transaction which no reasonable person could conclude made economic sense for Fedders.80

6. Tortious Interference

Claims for tortious interference with contractual relations and tortious interference with prospective business advantage are closely related – each tort is derived from the common law rule against restraints on trade.81 Accordingly, the elements for each claim are relatively similar.82 The court analyzed the committee’s tortious inference claims against the Facilities lenders under both Delaware and New Jersey law, which apply substantially similar tests for both types of tortious interference claims.83

To state a claim for tortious interference with contractual relations under Delaware law, a plaintiff must allege that there is “(i) a contract, (ii) about which the defendant knew and (iii) an intentional act that is a significant factor in causing the breach of such contract (iv) without justification (v) which causes injury.”84 The court held that the committee failed to state a cause of action for tortious interference with contractual relations under either Delaware or New Jersey Law because the complaint failed to identify a single contract between Fedders and a third party that was breached by the third party because of the Facilities lenders’ conduct. In fact, the court found that the complaint pled exactly the opposite, as it alleged that the lenders’ actions “‘induced Fedders’ creditors[,] who necessarily would interpret new financing as a positive development, to continue to do business with Fedders and stretch payables.’”85

Under Delaware law, to state a claim for tortious interference with prospective business advantage, a plaintiff must show “(i) the reasonable probability of a business opportunity, (ii) the intentional interference by defendant with that opportunity, (iii) proximate causation, and (iv) damages, all of which must considered in light of a defendant’s privilege to compete or protect his business interests in a fair and lawful manner.”86 Similar to the committee’s claim for tortious interference with a contractual relationship, the court held that the committee failed to state a claim for tortious interference with a prospective business relationship because the complaint failed to identify a single lost business opportunity.87

7. Improvident Lending

80 Id. at 549. 81 Id. at 550 (citing DeBonaventura v. Nationwide Mut. Ins. Co., 419 A.2d 941, 947 (Del. Ch. 1980), aff’d, 482 A.2d 151 (Del. 1981). 82 Id. at 550. 83 Id. at 549-550. For the sake of brevity, this case study summarizes only the Delaware law regarding tortious interference. 84 Id. (citing Aspen Advisors LLC v. United Artists Theatre Co., 861 A.2d 1251, 1266 (Del. 2004)). 85 Id. at 550. 86 Id. (citing DeBonaventura, 419 A.2d at 947). 87 Id. at 550.

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The committee asserted a cause of action against the Facilities lenders for improvident lending. Specifically, the complaint alleged that the lenders closed on the financing transactions despite the fact that Fedders’ sales figures were shrinking and that the lenders “obtained liens on most of Fedders’ assets; collected their millions of dollars in fees (not to mention performance-based compensation for the lenders’ deal teams); saddled Fedders with their legal and other professional fees – then sat back and waited for the inevitable defaults to begin.”88 The court analyzed this claim under Delaware and New Jersey law, and began its analysis by noting that no Delaware or New Jersey state court had recognized a cause of action for improvident lending. Thus, the court next considered whether the Delaware or New Jersey Supreme Court would recognize a claim for improvident lending, and ultimately concluded that neither court would recognize any such claim.89

The court acknowledged Rosener v. Majestic Management, Inc. (In re OODC, LLC),90 a recent decision of the Bankruptcy Court for the District of Delaware which predicted that the Delaware Supreme Court would recognize an improvident lending cause of action where it is shown that a lender breached “‘a duty of care in lending’” by having “‘knowledge of the inadequacy of consideration received by the Debtor[,]’” whom the defendant bank lent funds to in connection with a leveraged buyout transaction.91 However, the court distinguished Rosener, which cited three cases in support of its ruling – each of which was decided under the law of states other than Delaware and New Jersey. As additional support, the court noted that “‘the decisions are legion which deny a cause of action for negligent underwriting of a loan through loose internal lending standards or poor business judgments’” in other states.92 Moreover, the court further observed that improvident lending claims have not fared well in other jurisdictions.93

Accordingly, the court held that, if the Delaware Supreme Court or New Jersey Supreme Court were to consider the issue, both courts would embrace the weight of authority and hold that a cause of action for improvident lending does not exist. Moreover, the court expressed its belief that in denying recognition of an improvident lending cause of action, both the Delaware Supreme Court and the New Jersey Supreme Court likely would reason that existing remedies, such as aiding and abetting a breach of fiduciary duty, lender liability premised on contractual rights, common law fraud, and fraudulent transfer, adequately protect the interest of those who deal with lenders.94

88 Id. at 550-551. 89 Id. at 551. 90 321 B.R. 128 (Bankr. D. Del. 2005). 91 Fedders, 405 B.R. at 551. 92 Id. (quoting FDIC v. Fordham (In re Fordham), 130 B.R. 632, 648 (Bankr. D. Mass. 1991)). 93 Id. (citing Price v. EquiFirst Corp., 2009 WL 917950, at *8 (N.D. Ohio April 1, 2009)). 94 Id. at 551-52.

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The court concluded its analysis by noting that, even if the Delaware Supreme Court or the New Jersey Supreme Court recognized an improvident lending cause of action, the court would nevertheless conclude that the committee failed to state a claim for improvident lending. Specifically, the court found that the committee did not plead facts that state a claim under any of the recognized theories of improvident lending, as it contained no allegation that the Facilities lenders made an affirmative misrepresentation to Fedders regarding any matter, and did not plead facts to support an inference that the lenders had knowledge that inadequate consideration was received by Fedders in connection with the financings.95

8. Unjust Enrichment

Unjust enrichment is an equitable remedy that is typically used to fill a gap that the law of contract would otherwise address, if a contract existed.96 Accordingly, under Delaware or New Jersey law, a claim for unjust enrichment will be dismissed if the complaint alleges an express, enforceable contract that controls the parties’ relationship.97 Applying these principles, the court dismissed each of the committee’s unjust enrichment claims against the Facilities lenders and the individual defendants, as the court found that each of the transfers for which the committee sought a recovery were conferred in accordance with an express contract – either the Facilities credit documents or an employment agreement – and the complaint did not challenge the existence or underlying enforceability of such contracts.98

9. Breach of Implied Covenant of Good Faith and Fair Dealing

The committee asserted claims for breach of the implied covenant of good faith and fair dealing against each of the Facilities lenders. As the Facilities credit documents contained an enforceable New York choice of law clause, the court applied New York law to determine whether the complaint stated a claim for which relief could be granted.99 Under New York law, “the implied obligation of each promisor to exercise good faith encompasses any promises which a reasonable person in the position of the promisee would be justified in understanding were included.”100 Courts have interpreted this standard to as embracing a pledge that “‘neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contact.’”101 However, the implied covenant of good faith and fair dealing is not without limits in New York, as no obligation may be implied if it is inconsistent

95 Id. at 552. 96 Id. (citing Freedman v. Beneficial Corp., 406 F.Supp. 917, 923 (D. Del. 1975)). 97 Id. (citing Rossdeustcher v. Viacom, Inc., 768 A.2d 8, 23-24 (Del. 2001) (applying New York law); ID Biomedical Corp. v. TM Tech., Inc., 1995 WL 13743, at *15 (Del. Ch. Mar. 16, 1995 (applying Delaware law); Van Orman v. Am. Ins. Co., 680 F.2d 301, 310 (3d Cir. 1982)). 98 Id. at 552. 99 Id. at 553. 100 Id. (citing Dalton v. Educational Testing Service, 87 N.Y.2d 384, 389 (1995)). 101 Id. (quoting Dalton, 87 N.Y.2d at 389).

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with other terms of the contractual relationship.102 Applying New York law, the court held that the committee failed to state a claim for breach of the implied covenant of good faith and fair dealing because the complaint did not allege that the lenders breached any promise which Fedders reasonably believed was included in its agreement or plead any fact showing conduct by the lenders that deprived Fedders of the money it borrowed under the Facilities credit documents.103

The court also found that, even if Delaware or New Jersey law were to govern the committee’s claims, the court would be obliged to dismiss the claims. Under Delaware law, which is substantially similar to New Jersey law, stating a claim for a breach of the implied covenant of good faith and fair dealing requires an allegation of “‘arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the contract.’”104 Thus, the committee’s claims also failed under Delaware and New Jersey law, as the complaint failed to allege that the lenders deprived Fedders of the money it borrowed under the Facilities credit documents.105

10. Equitable Subordination

Section 510(c)(1) of the Bankruptcy Code permits a bankruptcy court, under principles of equitable subordination, to “subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest.”106 Equitable subordination, however, is a “drastic” and “unusual” remedy.107 Furthermore, the law is well-settled that when the defendant is not an insider or fiduciary of the company, the party seeking to apply equitable subordination bears a higher burden of proof – which requires a showing that the defendant engaged in egregious conduct, such as fraud, spoliation, or overreaching.108

In evaluating the committee’s claims for equitable subordination against the Facilities lenders, the court first observed that the complaint failed to allege that the lenders were either insiders or fiduciaries of Fedders. Having determined that the committee thus bore the higher burden of proof, the court then went on to hold that the committee failed to state a claim for equitable subordination because the complaint did not plead any facts to support a finding of fraud, spoliation, or overreaching by any of the lenders.109 102 Id. (citing Murphy v. American Home Prods. Corp., 58 N.Y.2d 293, 304 (1983)). 103 Id. at 553. 104 Id. (citing ACE & Co., Inc. v. Balfour Beatty PLC, 148 F.Supp.2d 418, 426 (D. Del. 2001)). 105 Id. at 553. 106 11 U.S.C. 501(c)(1). 107 Fedders, 405 B.R. at 554 (citing In re Radnor Holdings Corp., 353 B.R. 820, 841 (Bankr. D. Del. 2006)). 108 Id. (citing Bank of N.Y. v. Epic Resorts-Palm Springs Marquis Villas, LLC (In re Epic Capital Corp.), 307 B.R. 767, 772 (D. Del. 2004); In re M. Paolella & Sons, Inc., 161 B.R. 107, 117-119 (E.D. Pa. 1993), aff’d 37 F.3d 1487 (3d Cir. 1994)). 109 Id. at 554.

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11. Recharacterization

Finally, the court considered the committee’s cause of action against the Facilities lenders which sought to recharacterize the financings as equity. Third Circuit law regarding recharacterization is well-settled, and holds that the overarching inquiry with respect to recharacterizing debt as equity is whether the parties to the transaction in question intended the loan to be a disguised equity contribution.110 The parties’ intent may be inferred from what the parties say in a contract, from what they do through their action, and from the economic reality of the surrounding circumstances.111 It bears noting, however, the recharacterization is not predicated on inequitable conduct.112

To support its claim for recharacterization, the committee alleged that the lenders knew the financings would be in default at the time the credit documents were executed. Aside from this allegation, however, the complaint otherwise did not plead any facts demonstrating that the lenders intended the money transferred to Fedders in the form of loans to be disguised capital contributions. The court found the committee’s bare allegation insufficient and held that simply alleging in a conclusory fashion that the lenders knew the loans would be in default at the time the credit documents were executed was not enough to state a claim for recharacterization.113

C. Official Committee of Unsecured Creditors of Allegheny Health Education and Research Foundation v. PricewaterhouseCoopers, LLP, 989 A.2d 313 ( 2010).

Background Allegheny Health, Education, and Research Foundation (“AHERF”), a Pennsylvania non-profit corporation filed for bankruptcy in July 1998. Prior to its liquidation, AHERF provided a wide range of healthcare services, including the operation of hospitals, educational institutions and private medical practices. During the 1980s, AHERF attempted to develop and implement an “integrated delivery system” by effectuating a series of acquisitions of hospitals, medical schools and physicians’ practices, based upon the then industry-popular theory that building such a network was profitable for large healthcare providers.114 However, the hospitals and medical practices acquired by AHERF were losing money and the integrated delivery system model ultimately failed.115 During this time, Coopers and Lybrand, now PricewaterhouseCoopers (“PwC”) served as AHERF’s auditor. Under the terms of the parties’ retention agreement, PwC provided to

110 Id. (citing In re SubMicron Systems Corp., 432 F.3d 448, 455-56 (3d Cir. 2006)). 111 Id. (citing SubMicron, 432 F.3d at 456). 112 Id. (citing In re AutoStyle Plastics, Inc., 269 F.3d 726, 748-49 (6th Cir. 2001)). 113 Id. at 554. 114 Official Committee of Unsecured Creditors of Allegheny Health., Educ. and Resarch Foundation v. Pricewaterhousecoopers, LLP, No. 07-1397, 2008 WL 3895559, at * 1 (3d Cir. July 1, 2008). 115 Id.

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AHERF’s board of trustees, its opinion on AHERF’s financial statements.116 PwC would either provide a “clean” opinion, indicating that the financial statements were accurate and in substantial compliance with accepted accounting principles, or an “adverse” opinion, indicating deficiencies in the financial statements.117 By their own admission, several corporate officers of AHERF misstated the figures they provided to PwC for its 1996 and 1997 audits in an attempt to conceal the failing management strategy.118 PwC issued a “clean” opinion to the board of trustees for both 1996 and 1997. Thus, AHERF’s board was under a false impression of the company’s financial standing and acted upon such false information by continuing to acquire additional income producing assets, despite the company’s significant operating losses.119 Following the commencement of the chapter 11 cases, the Official Committee of Unsecured Creditors of AHERF (the “Committee”), acting on behalf of the debtor corporation, filed an adversary complaint against PwC, asserting three causes of action: (1) breach of contract, (2) professional negligence, and (3) aiding and abetting a breach of fiduciary duty.120 The Committee alleged that PwC contributed to the debtor’s deepening insolvency by knowingly and actively facilitating the financial misconduct.121 Procedural History The District Court for the Western District of Pennsylvania granted summary judgment to PwC based on its asserted defense of in pari delicto, meaning “in the case of equal or mutual fault the position of the defending party is the stronger one.”122 The viability of PwC’s defense depended on two conclusions. First, the wrongful conduct of AHERF’s corporate officers must be imputed to AHERF based upon principles of agency law. Second, regardless of whether PwC knew the financial statements were false, the admitted culpable conduct of the AHERF’s corporate officers must have been at least as great as the culpable conduct of PwC. The district court noted that the fraudulent conduct of a corporate officer is imputed to the corporation if such conduct (i) was committed in the ordinary course of the officer’s employment, and (ii) benefited the corporation. The district court concluded that preparation and presentation of financial statements, even false financial statements, was within the ordinary course of employment of an officer of AHERF. The district court also concluded that AHERF

116 Id. at * 2. 117 Id. 118 Id. 119 Id. 120 Official Committee of Unsecured Creditors of Allegheny Health., Educ. and Research Foundation v. Pricewaterhousecoopers, LLP, 989 A.2d 313, 315 (2010). 121 Id. at 316, n.3. 122 Id. at 315.

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benefited from the fraudulent conduct by acquiring hospitals and educational facilities during the time period relevant to the false financial statements.123 The Committee attempted to invoke the “adverse interest” exception to the general rule of imputation. The adverse interest exception holds that a principal will not be imputed with knowledge of the offending agent’s wrongful conduct if the agent acts secretly and for his or her own purpose.124 The district court rejected this argument, holding that the adverse interest exception can only apply where the corporation received no benefit from the fraudulent conduct. The Committee appealed to the Court of Appeals for Third Circuit and the court of appeals certified two questions to the Supreme Court of Pennsylvania: (1) does the doctrine of in pari delicto prevent a corporation from recovering against its accountants for breach of contract, professional negligence, or aiding and abetting a breach of fiduciary duty, if those accountants conspired with officers of the corporation to misstate the corporation’s finances to the corporation’s ultimate detriment?; and (2) what is the proper test under Pennsylvania law for determining whether an agent's fraud should be imputed to the principal when it is an allegedly non-innocent third-party that seeks to invoke the law of imputation in order to shield itself from liability?125 Discussion The Pennsylvania Supreme Court found that the in pari delicto defense is available, in its traditional form and subject to public policy considerations, in the auditor liability context. Imputation, on the other hand, is unavailable to an auditor in the absence of good faith. Taken together, these holdings effectively foreclose the availability of the in pari delicto defense when officers of a corporation and auditors collude to misstate a corporation’s finances to the corporation’s detriment.

1. In Pari Delicto

The Supreme Court of Pennsylvania held that PwC, as auditor, was not precluded from asserting the defense of in pari delicto. To assert the defense of in pari delicto under Pennsylvania law, which adopts the traditional, common law approach, the defendant must show that the plaintiff was “an active, voluntary participant in the wrongful conduct or transaction(s) for which it seeks redress, and bear[s] ‘substantially equal [or greater] responsibility for the underlying illegality’ as compared to the defendant.”126 While other courts do not require that the degree of fault between plaintiff and defendant be equal (or the plaintiff’s culpability greater), Pennsylvania falls in line with a number of jurisdictions in finding that, to dispense with the requirement would disincentivize compliance with the law and encourage corporate officers

123 Id. at 316. 124 See id. at 316-17. 125 Id. 317. 126 Id. at 329.

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to act with the hope that the repercussions of an exposed conspiracy might be placed on the corporation’s partners in crime.127

The purpose of the in pari delicto defense is to deter illegality and to relieve courts of the burden of mediating liability between two wrongdoers. The court warned that parties asserting the defense of in pari delicto should be on notice that the “judiciary is not tolerant of fraud and illegality, and those who comes before it seeking common-law redress relative to matters in which they bear sufficient culpability may suffer disadvantage as a consequence of their own wrongdoing.”128

Although available in the auditor-liability setting, the in pari delicto defense is not without appropriate limitation. Thus, the court held, matters of public policy must be taken into account in determining the availability of such defense. The court noted the “crucial role assumed by independent auditors as a check against potential management abuses,”129 while also recognizing that the specific responsibility of an auditor in any given situation will depend on the terms of the auditor’s retention agreement. The court equally acknowledged the volume of auditor malpractice claims and the associated litigation burden plaguing the profession in general. According to the court, these factors, among others, must be weighed on a case by case basis to appropriately limit the defense.

2. Imputation

The Pennsylvania Supreme Court held that the appropriate test for determining whether to impute knowledge of an agent’s wrongdoing to a corporation in a scenario involving a non-innocent defendant, is whether or not the defendant dealt with the principal in good faith.130 The court grounded its holding in both the tenets of agency law and the general purpose of the imputation doctrine. First, the doctrine of imputation recognizes that principals generally are responsible for the acts of agents committed within the scope of their authority.131 Second, the purpose of the imputation doctrine is to protect innocent third parties, who transact business with a corporation through its agents under the belief that the agent’s conduct is with the authority of the principal.132

In so holding, the court preserved the adverse interest exception to the general rule of imputation. Where an agent acts in his own interest, and to the corporation's detriment, imputation generally will not apply.133 However, defendants that deal with the principal

127 Id. at 297. 128 Id. at 295. 129 Id. at 332 (citing United States v. Arthur Young & Co., 465 U.S. 805, 817-18 (1984). 130 Id. at 339. 131 Id. at 333. 132 Id. 133 Id. at 333.

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corporation in good faith in material matters may assert the in pari delicto defense.134 Thus, the defense will be available in the negligent-auditor context, subject to the adverse interest exception.135 However, the defense “breaks down completely in scenarios involving secretive, collusive conduct between corporate agents and third parties.”136

Given the holding, the court noted that if the auditors were knowing participants in providing fraudulent financial statements to AHERF’s board, the defense of in pari delicto would be unavailable to PwC, because the corporation would not be imputed with the knowledge of its agents’ fraud.

D. O’Toole v. McTaggart, et al., No. 08 B 12547, Adv. Pro. No. 11-01284 (Bankr. S.D.N.Y. Jan. 20, 2012).

Background

Marakon Associates, Inc. (“Marakon”), founded in 1978, was a closely held corporation that operated as a corporate strategy consultancy firm. Integrated Finance Limited, LLC (“IFL”), meanwhile, was a Delaware corporation that operated a hedge fund called Victoria Fund LP (the “Victoria Fund”). In February 2007, IFL was merged into Marakon to form a new Delaware corporation called Trinsum Group, Inc. (“Trinsum”). Trinsum’s certificate of incorporation contained an exculpation provision that protected its directors from personal liability for monetary damages for breaches of fiduciary duty to the fullest extent permitted by Delaware law.

In March 2007, Trinsum transferred its ownership in the Victoria Fund to QFR Capital Management, L.P. and QFR Capital Group, LLC (together “QFR”). The entire board of directors of Trinsum appointed one director, Jose Luis Daza, as the person responsible for negotiating the sale of the Fund to QFR. Daza also happened to be QFR’s owner. The entire board unanimously approved of Daza’s actions.

Around the same time as the Victoria Fund was sold, Trinsum’s directors also authorized the payment of approximately five million dollars in incentive payments to certain IFL principals and employees. The directors had no obligation to make these payments, and they did so over the protests of Trinsum’s Chief Financial Officer (“CFO”).

Procedural History

The merger between Marakon and IFL did not prove successful, in part because the new company incurred significant debt in connection with the merger. On July 3, 2008, an involuntary chapter 7 proceeding was commenced against Trinsum. Trinsum converted the case to one under Chapter 11. IFL subsequently also filed for chapter 11, and the bankruptcy court directed that the two cases be jointly administered. 134 Id. at 335. 135 Id. at 335. 136 Id. at 336.

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On November 10, 2010, the bankruptcy court confirmed the Debtors’ First Modified Joint Plan of Liquidation. The plan contained provisions authorizing a Distributing Agent (the Distributing Agent) to pursue any “claims, suits, actions and causes of action”137 belonging to the debtors or their estates. Marianne O’Toole was appointed Distributing Agent pursuant to these provisions. O’Toole filed first a complaint, then an amended complaint, alleging that Trinsum’s directors breached their fiduciary duties and committed corporate waste by authorizing (i) the sale of the Victoria Fund and (ii) the incentive payments for less than reasonably equivalent value at a time when Trinsum was insolvent.138 The Distributing Agent sought to hold Trinsum’s directors personally liable for monetary damages resulting from these alleged breaches.

The directors filed motions to dismiss in response to the Distributing Agent’s initial complaint, and filed supplemental briefs in response to the amended complaint. The court granted the defendants’ motions to dismiss, holding that the defendants had valid affirmative defenses with respect to the alleged duty of care and corporate waste claims, and that the Distributing Agent’s complaint did not adequately allege breaches of the duty of loyalty.

Discussion

1. Duty of Care

With respect to the duty of care claims, the court noted that the two contexts in which liability for a loss may be the consequence of a breach of the duty of care are “(i) where a board ‘decision’ was ill advised or the result of negligence, and (ii) where there was ‘an unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss.’”139 Such conduct must rise to the level of gross negligence, however, in order to constitute an actionable breach of the duty of care. The Distributing Agent alleged that the directors had breached the duty of care in that none of the directors other than Daza conducted any due diligence or obtained any professional assistance concerning the value of the Victoria Fund prior to its sale. The court concluded that the Distributing Agent’s allegations as to the inadequacy of the directors’ diligence were merely conclusory, however. The only specific facts alleged in the complaint tended to suggest that the directors were likely to have been able to accurately value the Fund, even without professional assistance. The complaint at one point admitted that one of the directors was a “business school professor and distinguished economist,”140 for example. Similarly, the Distributing Agent made no specific factual allegations suggesting that the directors were incapable of determining whether the amounts of the incentive payments were appropriate.

137 O’Toole v. McTaggart, et al., No. 08 B 12547, Adv. Pro. No. 11-01284, at *8 (Bankr. S.D.N.Y. Jan. 20, 2012). 138 As fraudulent conveyances are addressed by the first part of the “Recovery Actions in the Wake of the 2008 Recession” series, this case summary does not discuss the Distributing Agent’s fraudulent conveyance claims. 139 Id. at *10(citing In re Walt Disney Co. Derivative Litig., 907 A.2d 693, 749 (Del Ch. 2005)). 140 Id. at *21.

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In any case, the exculpation clauses contained in Trinsum’s certificate of incorporation shielded the directors from personal liability for breaches of the duty of care. The court noted that exculpation clauses limiting or eliminating the personal liability of corporate directors were generally permitted under Section 102(b)(7) of the Delaware General Corporation Law.141 Delaware law does forbid exculpation for certain types of liability, however, such as liability “for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.”142 Conduct that is merely grossly negligent, however, as is the case with a breach of the duty of care, does not necessarily constitute a failure to act in good faith, and thus does not necessarily fall within this exception to the validity of exculpation provisions.

The court ultimately concluded that none of the conduct alleged in the Distributing Agent’s complaint fell within Section 102(b)(7)’s bad faith exception. Thus, even if the court had accepted the Distributing Agent’s conclusory allegations as to the inadequacy of the directors’ diligence, the exculpation clauses would have shielded the directors from personal liability for breaches of the duty of care. The Distributing Agent’s duty of care claims were thus precluded in light of these exculpation provisions, and any possible liability on the part of the directors would have to be based on some other theory.

2. Duty of Loyalty

The next theory advanced by the Distributing Agent was breach of the duty of loyalty. As the court noted, the duty of loyalty requires that the corporation’s best interest take precedence over any interest of a director that is “not shared by the stockholders generally.”143 A director may not use his “position of trust and confidence” to further a “private interest,” as there may not be a conflict between a director’s duty and his self-interest.144 Furthermore, the “[c]lassic examples of director self interest in a business transaction involve either a director appearing on both sides of a transaction or a director receiving a personal benefit from a transaction not received by the shareholders generally.”145 The Distributing Agent made no allegations that any of the directors were not disinterested or independent with respect to the incentive payments, and so her breach of contract theory focused on the sale of the Victoria Fund. As noted above, the Distributing Agent alleged that Daza was the only director who did any due diligence with respect to the sale of the Victoria Fund. Because Daza was also the owner of the purchasing entity, he was on both sides of the transaction, and thus arguably was not disinterested. To support a breach of loyalty claim, however, there must also be a factual showing that “a majority of the board of directors was not both disinterested and independent.”146 The court applied this principle in holding that, in spite of Daza’s conflict of

141 Del. Ch. § 102(b)(7). 142 Id. at *15. 143 Id. at *11 (citing Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993)). 144 Id. at *11 (citing In re Walt Disney Co. Derivative Litig., 907 A.2d at 750-51). 145 Id. at *11 (citing Cede, 634 A.2d at 362). 146 Id. at *12 (citing In re Alloy, Inc. Shareholders Litig., 2011 WL 4863716 at *7 (Del. Ch. 2011) (emphasis added)).

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interest, the Victoria sale did not constitute a breach of the duty of loyalty, because the sale had been approved by the disinterested majority of Trinsum’s board.

The court observed that there are limits to a disinterested majority’s ability to sanitize a transaction, however, stating that even with majority approval by disinterested and independent directors, a breach of the duty of loyalty may be found if the challenged decision “is so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.”147 The court concluded, however, that the Distributing Agent had failed to allege facts sufficient to establish that the Victoria sale was “beyond the bounds of reasonable judgment.”148 The court thus dismissed the Distributing Agent’s claims with respect to the directors’ alleged breaches of the duty of loyalty.

3. Corporate Waste

With regard to the Distributing Agent’s corporate waste claim, the court found that the defendants had another powerful affirmative defense, namely the business judgment rule. As the court noted, this rule establishes a presumption that business decisions made by corporate directors are made on an informed basis, in good faith, and in the honest belief that the actions taken are in the corporation’s best interest. This presumption applies as long as fraud, bad faith, or self-dealing are not present. In the absence of plausible allegations of interestedness or disloyalty to the corporation, the rule precludes a court from second-guessing the decisions of the corporation’s directors, provided that the directors used a “rational process” to reach their decisions and “availed themselves of all material and reasonably available information.”149

Because of the business judgment rule, a party claiming that a transaction authorized by a board decision constitutes corporate waste has the burden of proving that the resulting exchange was “so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.”150 Furthermore, because corporate waste is an act of bad faith, a court will not substitute its judgment for a director’s absent allegations of bad faith. The court found that the Distributing Agent had not alleged any facts suggesting sufficient bad faith on the part of the directors to overcome the business judgment rule, and that this rule thus justified dismissal of the Distributing Agent’s corporate waste claim.

E. Credit Suisse v. Official Committee of Unsecured Creditors (In re Yellowstone Mountain Club, LLC), No. 08-61570-11, Adv. No. 09-00014 (Bankr. D. Mont. May 12, 2009).

Background In late 1999, Timothy Blixseth (“Blixseth”) and his former wife formed the Yellowstone Mountain Club, LLC and a number of affiliated limited liability companies (“collectively,

147 Id. at *12 (citing Alloy, 2011 WL 4863716 at *7). 148 Id. at *23. 149 Id. at *18 (citing In re Citigroup Inc. Shareholder Derivative Litig., 964 A.2d 106, 124 (Del. Ch. 2009)). 150 Id. at *19 (citing In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 74 (Del. 2006)).

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Yellowstone”) in order to develop the world’s only ski and golf community near Yellowstone National Park. Yellowstone and its affiliated companies controlled by Blixseth as the sole Class A Shareholder. Approximately 13% of the Club was owned by minority, Class B members. In 2004, Credit Suisse approached Blixseth about taking out a “syndicated loan,” a new type of loan product that Credit Suisse was marketing as something akin to a home-equity loan. The “syndicated loans” were secured by the assets of an LLC or other entity, but allowed the entity’s equity holders to take most of the loan proceeds out as a profit dividend, leaving the entity saddled with debt. Following a period of negotiations, Blixseth took out a syndicated loan. Before approving the loan, Credit Suisse conducted some due diligence, including hiring an appraisal firm, Cushman & Wakefield (“Cushman”), to assess Yellowstone’s value. The appraisal firm initially performed a fair market appraisal. Dissatisfied with the results of this appraisal method, Credit Suisse assisted Cushman in developing a new appraisal methodology, called “total net value,” that produced a valuation significantly higher than the fair market appraisal. The “total net value” appraisal relied exclusively on historical and future projections provided by Blixseth and the debtors. Based on this “total net valuation,” Credit Suisse entered into a credit agreement under which it lent $375 million to Yellowstone. The credit agreement designated up to $209 million of the loan proceeds to be used as “distributions or loans” for “purposes unrelated” to Yellowstone.151 This portion of the loan proceeds ultimately found its way into the personal accounts of Blixseth and his wife. Blixseth treated these distributions as “loans” from Yellowstone for accounting purposes, and he gave Yellowstone a promissory note for the amount of these “loans.” Blixseth never directed Yellowstone to make a demand on this promissory note, however, even as the company descended into insolvency. Procedural History Unable to meet its financial obligations, Yellowstone filed for chapter 11. The official committee of unsecured creditors of Yellowstone (the “Committee”) moved for leave to file a complaint seeking to disallow and subordinate Credit Suisse’s secured claim for the amount due on the syndicated loan. In response, Credit Suisse filed an adversary complaint seeking a declaratory judgment confirming the validity of its secured claim. The court ultimately granted the Committee’s motion for authorization to file a complaint and immediately consolidated the Committee’s complaint into the adversary proceeding commenced by Credit Suisse. Discussion On May 12, 2009, the Bankruptcy Court for the District of Montana issued a Partial & Interim Order in the adversary proceeding, subordinating Credit Suisse’s secured claim to the

151 Credit Suisse v. Official Committee of Unsecured Creditors (In re Yellowstone Mountain Club, LLC), No. 08-61570-11, Adv. No. 09-00014, at *5 (Bankr. D. Mont. May 12, 2009).

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claims of Yellowstone’s unsecured creditors. Under 11 U.S.C. § 510(c), a court may subordinate for purposes of distribution all or a part of one claim or interest to all or part of another claim or interest based on equitable considerations. The court concluded that equitable subordination pursuant to 11 U.S.C. § 510(c) was an appropriate remedy in this case because Credit Suisse’s conduct was “so far overreaching and self-serving that they shocked the conscience of the court.”152 The court noted that, in the Ninth Circuit, equitable subordination generally requires three findings: “(1) that the claimant engaged in some type of inequitable conduct, (2) that the misconduct injured creditors or conferred unfair advantage on the claimant, and (3) that subordination would not be inconsistent with the Bankruptcy Code.”153 The court further noted that, when the remedy of equitable subordination involves a non-insider, “the level of pleading and proof is elevated: gross and egregious conduct will be required before a court can equitably subordinate a claim.”154 Nothing in the record suggested that the loan between Credit Suisse and Blixseth was not an arm’s length transaction,155 meaning that Credit Suisse and its agents were non-insiders. Nonetheless, the court found that Credit Suisse’s actions were sufficiently egregious to warrant the equitable subordination of a non-insider. Specifically, the court found that Credit Suisse, through its loan scheme, encouraged real estate developers like Blixseth to take out unnecessary loans. Credit Suisse encouraged such unnecessary borrowing because Credit Suisse earned fees based on the size of the loans. The higher the loan amount, the “fatter”156 the fee to Credit Suisse. “This program,” the court stated, “essentially puts the fox in charge of the hen house and was clearly self-serving for Credit Suisse.”157 According to the court, the “most shocking”158 aspect of Credit Suisse’s conduct was that Credit Suisse had “not a single care”159 how Blixseth used a majority of the loan proceeds. As a sophisticated lender, the court reasoned, Credit Suisse had to have known what a distribution of the loan proceeds to Blixseth would do to Yellowstone’s finances, yet Credit Suisse proceeded with the loan in order to charge its large fee.

152 Id. at *8. 153 Id. at *7 (citing Feder v. Lazar (In re Lazar), 83 F.3d 306, 309 (9th Cir. 1996)). 154 Id. (citing In re First Alliance Mortg. Co., 497 F.3d 977, 1006 (9th Cir.2006)). 155 Id. at 5. 156 Id. 157 Id. 158 Id. 159 Id.

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The court also found that Credit Suisse’s due diligence was “all but non-existent.”160 Specifically, Credit Suisse commissioned Cushman to employ a new valuation methodology in order to achieve a loan to value ratio that would make the loan more marketable to loan participants. Unlike Cushman’s original valuation, which was based on an appraisal of Yellowstone’s assets, the new valuation methodology relied almost exclusively on Yellowstone’s future financial projections, which bore no relation to Yellowstone’s historical or present reality. The court concluded that Credit Suisse’s “syndicated loan” product resulted in enormous fees to Credit Suisse, but resulted in financial ruin for Yellowstone. Credit Suisse had thus “lined its pockets on the backs of [Yellowstone’s] unsecured creditors.”161 The only equitable remedy for Credit Suisse’s overreaching and predatory lending practices, the court determined, was to subordinate Credit Suisse’s first lien position to the allowed claims of Yellowstone’s unsecured creditors.

160 Id. at *9. 161 Id.