Plano Texas Bankruptcy Lawyer & Attorney : Sean McCaffity : Rochelle Hutcheson & McCullough Law Firm : Insolvency, Creditors Rights

A common defense that virtually every bankruptcy trustee or receiver must deal with when suing culpable third parties is the affirmative defense of in pari delicto.  The Southern District of Georgia recently issued an opinion dealing with the defense in the context of a Chapter 11 bankruptcy proceeding.  See In re:  Friedman's Inc., 2008 U.S. Dist. LEXIS 31262 (S.D. Ga. April 16, 2008).  Friedman's, Inc. was a large jewelry store chain that collapsed into Chapter 11 in 2005.  As part of the bankruptcy, the "Friedman's Creditor Trust" was created and the Trustee, on behalf of the creditor trust, filed an adversary proceeding against Friedman's former directors, officers, controlling shareholder and attorneys (Alston & Bird).  The opinion is worth reading for a whole host of reasons, but I am highlighting it because of the Court's discussion of the in pari delicto defense. 

Specifically, Alston & Bird argued that the defense of in pari delicto barred the trustee's claims because the "Trustee cannot pursue others on behalf of the company for victimizing the company, since the company is said to have victimized itself."  Id. at *10.  The Trustee argued the "adverse interest exception" applied in this case because the "company's agents have acted entirely adverse to the company."  Id. 

In arguing against the "adverse interest exception," Alston & Bird made an argument commonly made by defendants asserting the in pari delicto defense.  Namely, the Trustee cannot prevail on the adverse interest exception because it cannot be established that the agents were acting "entirely adverse" to the company.  In other words, if there was any benefit (short term or long term) to the company, then the agents were acting at least partially for the company and their knowledge or actions should be imputed to the corporate enterprise.  See id. at *13-14.  Specifically, Alston & Bird argued that Friedman's received the benefits of "stock, promissory notes, and improvement of its balance sheet" from the alleged fraudulent acts of its directors and officers and, thus, the "adverse interest exception" should have been denied as a matter of law.  Id. at 14.

The Court rejected this notion and made a couple of points worth noting.  First, the Court noted that, under Georgia law, in pari delicto is an equitable doctrine and that Georgia courts have historically exercised their equitable powers to bar the use of equitable defenses where the result would be harm to innocent third parties, such as creditors.  As the Court noted, "this is so because the doctrine of in pari delicto is based on the principle that to give the plaintiff relief would contravene public morals and impair the good of society.  Hence, it should not be applied in a case in which to withhold relief would, to a greater extent, offend public morals."  Id. at *16.  A broader "creditor exception" to the in pari delicto defense, perhaps?  It certainly makes sense and it would not be the first time a court has refused to apply this equitable defense in such a context.  See e.g., Scholes v. Lehman, 56 F.3d 750, 754 (7th Cir. 1995); Welt v. Sirmans, 3 F. Supp. 2d 1396 (S.D. Fla. 1997)

Second, the Court noted that the application of in pari delicto is a "fact intensive inquiry done on a case by case basis" and that the "entire theory of the Trustee's case is that certain directors and officers of Friedman's were acting against the interests of the corporation and solely for their own personal interests."  Id. at *17. 

Third, the Court found that "equitable considerations counsel against [in pari delicto's] application as well."  Id.  Significantly, the Court found that the $35 million in notes and $50 million in stock that Friedman's received in the allegedly fraudulent transactions were "essentially worthless paper" and that "Friedman's received no real benefit to this exchange."  Id. at *18.  The Court would not impute knowledge of the directors and officers to the corporation "where under the facts, there is no actual benefit to the corporation."  Id.

The Court did note that Alston & Bird was free to continue litigating the defense and that discovery may show that Friedman's directors were acting "on behalf of Friedman's."  Id. at *18 n.8.  At the conclusion of the opinion, however, the Court noted that "just prior to issuing this opinion," it was informed of a settlement between Alston & Bird and the Trustee.

The Court also has an interesting discussion concerning the "sole actor rule" (which is an exception to the adverse interest exception) and the so-called "innocent director" exception (which has been argued in some courts as an independent exception to in pari delicto).  The Court does appear to reject the "innocent director" rule as an independent exception to imputation of knowledge, but relies on the facts of the Friedman's case (i.e., a special committee of independent directors had been appointed to review the alleged fraudulent transactions) to find the innocent decisionmakers defeated the application of the "sole actor rule."

Interesting reading and a must read for any plaintiff's attorney representing bankruptcy trustees, receivers or creditor committees.

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My partner, Scott DeWolf, sent me this link the other day and I've been traveling and have not had time to stick it up on the blog.  It is an interesting news story (now a week old) picking up the comments of Joseph Stiglitz, a Columbia University professor and 2001 Nobel Laureate.  In the article, Stiglitz predicts that it is at least possible that the current economic downturn could be the worst the country has seen since the Great Depression.  As the article explains:

"[Stiglitz] explained that main cause of the current situation is historically unique -- and thus is befuddling those charged with creating solutions.

Other downturns were primarily caused by excesses in inventories or inflation; but this slowdown is due to the condition of "badly impaired" banks and financial entities, which are unwilling and/or unable to lend capital -- stymieing the very borrowers who usually drive the country back to vitality, Stiglitz said. And the Federal Reserve may have used up its ammunition -- and the faith investors and planners have put in it."

It is probably worth noting that the Fed cut interest rates yet again on April 30th.  (Making this blog entry somewhat timely).  That brings the federal funds rate to 2%.  Interestingly, the Federal Reserve also hinted that no further rate cuts would be forthcoming.  At least for now.  Perhaps a signal that the Fed has truly "used up its ammunition" or is running perilously close to being empty.

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Sallie Mae's chief executive announced today that the student lender would still retain some "core" profits in 2008, but that new loans would likely be made at a loss.  He also indicated that Sallie Mae had been predicting a crisis in the $85 billion student loan market for some time.

More evidence of the "subprime" crisis morphing over into other areas of the economy and prompting what many are now just simply referring to as "Credit Crisis."  Kevin LaCroix over at The D&O Diary has been noting the increasingly prevalent "credit crisis" lawsuits in the months following the initial wave of "subprime" mania for some time now.  It looks as if he is not alone in his assessment of the generally growing concern of a broad based credit crisis prompting numerous lawsuits in differing economic segments. 

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In a recent post here, Francis G.X. Pileggi of the Delaware Corporate and Commercial Litigation Blog highlights the District of Delaware's decision in Miller v. Mcdonald, et al., Adv. Proc. No. 07-51350 (In re World Health Alternatives, Inc., Bankr. Case No. 06-10166) (April 9, 2008).  I highly recommend a visit to Francis' blog as he has a link to the actual opinion there.  He also does a superb job on the blog on a day-to-day basis and one visit will likely get you to subscribe for his RSS feed.

In any event, Miller stands for what always seems to me as a rather unremarkable proposition:  officers share the same duties as directors of a Delaware corporation.  In Miller, the specific breach of duty was the a gross breach of the duty of oversight, more commonly referred to as a Caremark violation.  The bankruptcy trustee plaintiff in Miller alleged that the corporate officers of World Health breached their duties "by failing to implement an adequate monitoring system and/or the failure to utilize such system to safeguard against corporate wrongdoing."  Miller Op. at 24 (citing In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959, 967-71 (Del. Ch. 1996).  The Miller court imposed the Caremark duty on the general counsel of World Health because Sarbanes-Oxley imposes an affirmative duty on counsel to inspect the truthfulness of SEC filings and to report evidence of a material violation of securities laws or breaches of fiduciary duties "up-the-ladder within the company."  Id. at 26.

In what I view as a desperate effort to avoid liability, the general counsel argued that Delaware does not recognize expanding Caremark duties beyond the board of directors and to corporate officers.  After about four pages of citations to Delaware and Florida law noting that officers share the same duties as directors (can you say, "duh?"), the Court denied the general counsel's motion to dismiss for failure to state a breach of fiduciary duty claim.  But at least the opinion now makes even more clear what the state of Delaware law is for corporate officers and their fiduciary obligations. 

In addition, the Miller opinion, applying Florida law, upholds an "aiding and abetting breach of fiduciary duty" count.  The court described the elements of such a claim as follows:  "(1) a fiduciary duty; (2) a breach of this duty; (3) knowledge of the breach by the alleged aider and abetter; (4) the aider and abettor's substantial assistance or encouragement of the wrongdoing."  In finding that the bankruptcy trustee's claim against the general counsel survived the Rule 12(b)(6) motion, the Court relied on the SEC's final rule pursuant to Sec. 307 of the Sarbanes-Oxley Act, which provides a duty to inspect the truthfulness of SEC filings for general counsels.  This duty, coupled with the allegations that all of the defendants failed to "implement financial controls and proper check and balances," was sufficient to satisfy the claim.  The Court also noted that the general counsel both participated in misrepresentations and "provided substantial assistance to [the President and Chief Accounting Officer] by failing to properly report misrepresentations that were knowingly false."  Miller Op. at 35.

The last ruling raises an interesting point:  does the failure to have or establish adequate internal controls at the officer level of a corporation establish "substantial assistance or encouragement" to maintain an aiding and abetting theory of liability against officers not otherwise involved in more egregious breaches of fiduciary duty?  Here, there were other instances of fraud that made it easier for the Court to deny the 12(b)(6) motion, but what if the complaint rested entirely on a lack of oversight and internal controls.  Does the failure to implement controls provide "substantial assistance" or is it the breach of duty itself or does it even matter because you can have both direct and vicarious liability for the same action to capture separate wrongdoing defendants?

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Another airline, Frontier, filed bankruptcy today in New York.  You can see the Associated Press story here.  That makes four airlines in the past several weeks:  Frontier, Skybus, Aloha Airgroup and ATA Airlines. 

It looks like turbulence is ahead this summer for the airline industry as fuel prices are expected to soar.  Indeed, Southwest Airlines has specifically warned investors of rocketing fuel prices this summer.

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On March 24, 2008, Judge Brendan L. Shannon of the U.S. Bankruptcy Court in Delaware, authorized the committee of unsecured creditors in the Fedders North America, Inc. bankruptcy to file a lawsuit on behalf of the bankruptcy estate.  See In re Fedders North American, Inc., Case No. 07-11176-BLS (Bankr. Del.).  I know this is a couple of weeks old, but I wanted to track down some of the pleadings in this case and actually see what the issues were before the Court before I posted something about the new committee case being filed.  I am glad I did because the argument before Judge Shannon posed an interesting question:  what is the appropriate standard to determine whether a creditors' committee should be granted standing to sue on behalf of the debtor's estate?

The lawsuit alleges claims against three distinct groups:  (a) the Inside Directors are charged with treating Fedders as "their personal piggy bank" by extracting "lavish compensation, interest-free personal loans and rich severance packages" at a time when they knew the company was collapsing; (b) the Outside Directors are charged with "turning a blind eye to all of the Insiders' and Lenders' misconduct; and (c) the Lenders are charged with aiding and abetting or conspiring with the Inside Directors by closing on loans they knew would default simply to "pocket large fees" or to obtain "interest at the LIBOR rate -- plus 12%." 

Filing what amounted to Rule 12(b)(6) motions to dismiss, each set of defendants argued that the claims were not "colorable" because they could not prevail on the merits, for various reasons, and the cost to the estate would outweigh the potential benefit.  For instance, the Inside Directors argued that the majority, if not all, of the claims asserted against them were simply "duty of care" claims that were barred under the applicable law.  As a result, no colorable claim existed and the committee should not be allowed to pursue the claim.  The Lenders argued that the theory of recovery simply made no rational sense whatsoever because it presupposed that the defendants would have loaned millions and millions of dollars (knowing that those loans were already or would immediately be in default) simply to obtain closing fees, personal bonuses on the loan or a higher rate of interest.  As the Lenders argued, banks simply aren't in the business of loaning money that they know is going to be defaulted and subject to bankruptcy proceedings.

Judge Shannon raised an interesting issue with respect to the standards governing how a bankruptcy judge, or any judge for that matter, determines if a claim is "colorable" and worthy of pursuit by a committee.  As Judge Shannon noted in his ruling from the bench on March 24, 2008: 

"[T]hat analysis, while often the subject of discussion between counsel, is actually more subtle and much more complicated a test.  And how the standard under Rule 12(b)(6) applies or should apply here is, is difficult for me to walk through.  There is a temptation to go through and essentially conduct a motion to dismiss hearing.  And in some respects that's where counsel's argument on both sides went.  And I cannot believe that is the appropriate analysis.  Rather, I think when we consider colorability, the threshold consideration the Court has is that this is at a stage prior to the commencement of litigation, and as a general proposition, in normal civil litigation, this is prior to the commencement or exchange of formal discovery.  So the allegations, the sufficiency of the allegations simply cannot be to a Rule 12(b)(6) standard, because we haven't filed the complaint yet...So I can't assume that ... the standard requires a line by line, claim by claim analysis...I simply don't believe that that can be the standard.  In the present case, the Committee has made substantial allegations against a number of different parties...And based upon the ... threshold allegations that the Committee has made both in its motion and in its complaint, I'm satisfied that they have articulated colorable claims only so far for purposes of whether this Court should authorize the commencement of the litigation." 

Transcript at 97-98.

What is interesting is that Judge Shannon both appears to reject a claim-by-claim analysis in favor of a colorability in toto analysis.  In other words, taken as a whole, the creditors' committee's proposed complaint seemed viable and stated causes of action, but Judge Shannon was quick to point out that he did not go so far as to actually employ a Rule 12(b)(6) analysis to those claims.  And, in doing so, he also implies that so long as the claims are substantial (in that they are serious and worth large amounts of dollars?) the claims are colorable.  In making this decision, he appears to part ways with In re G-I Holdings, Inc., 313 B.R. 612, 628 (Bankr. D.N.J. 2004), aff'd in part, rev'd in part, 2006 WL 1751793 (D.N.J. June 21, 2006). 

In re G-I Holdings, Inc. appears to clearly import the Rule 12(b)(6) motion to dismiss standard into the colorability analysis, stating that "[b]ecause the creditors' committee is not required to present its proof, the first inquiry is much the same as that undertaken when a defendant moves to dismiss a complaint for failure to state a claim."  Id. at 631.  The court then goes on to further discuss motions to dismiss standards, even going so far as stating that if an affirmative defense is revealed on the face of the pleadings that such a claim should not be allowed to proceed.  See id.  ("A complaint may be subject to dismissal for the failure to state a legally cognizable claim when an affirmative defense appears on its face.").

Judge Shannon's approach certainly seems to make more intuitive sense given the nature of a pre-litigation request to sue.  After all, in many cases where derivative standing is being sought there is no complaint on file or even a proposed complaint for a court to examine under a Rule 12(b)(6) standard.  But at the same time, why allow someone to waste the court's time and expose defendants to unnecessary costs when there is no chance a claim would survive an initial challenge to the pleadings.

It will be interesting to see if Judge Shannon's "substantial claim" analysis will be imported into future colorability cases.

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Fed Chairman Ben Bernanke said today that he thought a "recession is possible."

Really?  I could have sworn we were in a major boom.  I understand the Fed Chairman wanting to display confidence in the economy so as to not create even more skittish markets or prompt even further flagging consumer confidence, but at some point the reality of the economic situation and the rhetoric from the leader of U.S. monetary policy needs to match.  He's getting closer.

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Charles Perez at Trial Presentation Blog has posted an entry that refers to one of my very favorite principles:  Occam's Razor.  I love this principle and not just because it has a cool sounding ring to it.  Perez's post highlights this principle well and I look forward to reading in upcoming entries about his trial adventures  foreshadowed in this post.

In fact, as I write this I am looking at an article that I cut out of a copy of The Economist entitled "Keep It Simple."  I cut it out of the magazine almost four years ago as a way to simply help me remember that things can be made simpler, if we try.  I taped it right to the top shelf of my office credenza hutch, directly above my monitor when I use my computer.  It's not specifically tied to lawyers or the legal community, just a nice little article about how things are getting increasingly complex in our society.

It daily reminds me that a sound principle, and one that I have found consistently works well in commercial litigation, is to keep things simple when describing the complex.  From a trial lawyer's perspective, one of the best ways to begin the process of making things simpler is to figure out what human motivation is at the root of the transaction or series of transactions you are trying to tackle.  Greed?  Embarassment?  Pride?  Laziness?  Those base emotions are simple to describe and invariably connect with judge or jury.  They are also invariably the driver behind any number of large and complex commercial transactions that may be the basis or the subject of the dispute you are handling.   Anyway, that oftentimes is a good place to start when trying to reduce things to their simpler forms, even in commercial litigation.  It won't always work, but it often does.

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I posted here about the lack of clarity regarding direct appeals from a bankruptcy court to the court of appeals.  I noted that the Fifth Circuit had requested supplemental briefing on the jurisdictional issues and I was eagerly anticipating some decent dialogue between the Court and appellate counsel about this.  The Fifth Circuit, however, did not ask any questions about the issue and I suppose we will now have to wait to see if they decide to keep the case and rule on the merits or punt the case on jurisdictional grounds.  They certainly punted the jurisdictional issue at oral argument.

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