Secured Creditors Beware The Latest Tool in the Creditors Committee Toolbox Aiding and Abetting in the Breach of a Fiduciary Duty

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Oct 2004

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Most chapter 11 debtors
are more leveraged than ever before. With the increased debt leverage,
secured creditors are entitled to get paid first and to receive everything.
The only hope for a meaningful recovery by unsecured creditors, as well as
any other stakeholders, is if the secured liens are avoided or the secured
claims are disallowed or subordinated.<a href="#2" name="2a">2</a> Accordingly, creditors'
committees and trustees are becoming more creative and aggressive with
respect to actions brought in order to claim some piece of the secured
creditors' pie for the benefit of the unsecured creditors. In a
recent article published in the ABI Journal, I stated that deepening insolvency was another tool that
had been added to the creditors' committee's toolbox and now
was a standard part of the "kitchen sink" complaint filed by
creditors' committees in chapter 11 cases.<a href="#3" name="3a">3</a> Another tool in the
creditors' committee toolbox is a claim of aiding and abetting in the
breach of a fiduciary duty, thereby causing harm to the unsecured creditors
for which the creditors should be compensated. Of late, the
aiding-and-abetting argument is a standard count in the "kitchen
sink" complaint lobbed at secured creditors and is appearing in
almost every significant chapter 11 case including, but not limited to,
such recent cases such as Adelphia,<a href="#4" name="4a">4</a> Enron<a href="#5" name="5a">5</a> and Exide Technologies.<a href="#6" name="6a">6</a>

<h4>The Sharp Case</h4>

Claims for aiding and abetting in the breach of
fiduciary duty began to appear with gusto after the decision in Sharp International in 2003.<a href="#7" name="7a">7</a> In
that case, the bankruptcy court dismissed the complaint against the lender
for failure to state a claim, specifically finding that the complaint
failed to sufficiently identify any affirmative act of participation by the
lender in the principals' fraud. The district court affirmed the
dismissal.

<h4>Elements</h4>

Under the laws of most states where aiding and
abetting are recognized, a claim for aiding and abetting the breach of a
fiduciary duty requires a showing that there (1) existed a fiduciary
relationship, (2) was a breach of the fiduciary's duty, (3) was a
knowing participation in the breach by a defendant who is not a fiduciary
and (4) that damages are proximately caused by the breach.<a href="#8" name="8a">8</a> Furthermore, to
the extent the underlying breaches of fiduciary duty are based on
fraudulent conduct, the complaint must meet the requirement of Rule 9(b) of
the Federal Rules of Civil Procedure, which mandates that all allegations
of fraud must be pled with particularity. However, Rule 9(b)'s
particularity requirement does not apply to "conditions of the
mind"—including knowledge—that may be averred generally.<a href="#9" name="9a">9</a>

<h4>Actual Knowledge</h4>

There is no requirement that the aider and abettor
have an intent to harm. Rather, to satisfy the knowledge prong, the
defendant must have actual knowledge of the primary violator's
underlying breach of fiduciary duty—negligence or recklessness is
generally insufficient. "Constructive knowledge" of the breach
of a fiduciary duty is legally insufficient to impose aiding-and-abetting
liability.<a href="#10" name="10a">10</a> Facts must be alleged that the defendant actually knew
about the fraud. In fact, a recent court in New York stated:

<blockquote>
Actual knowledge of a violation is necessary as New
York "has not adopted a constructive knowledge standard for imposing
aiding and abetting liability." It is thus insufficient to assert
that the [d]efendants should have known of misdeeds by [the fiduciaries].
Thus, [the plaintiffs] must allege and prove that the [d]efendants had
actual knowledge that the [fiduciaries] breached their fiduciary duties
and intentionally provided them with assistance in this connection.
</blockquote>

Lesavoy v. Lane, 304
F.Supp.2d 520, 524 (S.D.N.Y. 2004), citing
Clark v. TRO Learning Inc., No. 97 C 8683, 1998
WL 292382, at *5 (N.D. Ill. May 20, 1998). The court in the Lesavoy case specifically
found that the allegation that the defendants "knew or were reckless
in failing to know" did not satisfy the actual knowledge standard
required for an aiding-and-abetting claim.

Moreover, with respect to analyzing whether a lender
had "actual knowledge" sufficient to satisfy the standards for
a claim of aiding and abetting in a breach of fiduciary duty, case law
suggests that assertions that an alleged aider and abettor harbored
well-founded—but unconfirmed—suspicions of the primary
violator's wrongdoing are not sufficient to plead actual knowledge
simply because, with the benefit of hindsight, those suspicions turned out
to be correct.<a href="#11" name="11a">11</a> Generally, given the complexity of the cases in which the
aiding-and-abetting claim has been raised, where an alleged aider and
abettor in fact undertakes an investigation of the primary
wrongdoer's conduct, determining the precise point at which evidence
giving rise to suspicions of fraud reaches a cumulative critical mass
sufficient to support an inference of actual knowledge is factually
intensive and not easily resolved on the face of the pleadings.<a href="#12" name="12a">12</a>

Facts of motive and opportunity are also not
sufficient to support a finding of actual knowledge. Conclusory allegations
that a defendant had a motive and opportunity to formulate actual knowledge
are insufficient and will not survive a motion to dismiss.<a href="#13" name="13a">13</a> Moreover, even
if a plaintiff alleges facts of motive and opportunity that allow strong
inferences to be drawn to establish actual knowledge, it is not enough to
survive to satisfy the standard.<a href="#14" name="14a">14</a>

<h4>Knowing Participation</h4>

The "knowing participation" element of
the aiding-and-abetting claim requires more than the defendant's
knowledge of the primary violation.<a href="#15" name="15a">15</a> To state a claim, a plaintiff must
allege some sort of participation by the alleged aider and abettor in the
primary wrongdoing. Broadly speaking, the case law identifies two forms of
actionable "participation." Aiding-and-abetting liability can
attach where a defendant provides substantial assistance to the wrongdoer.<a href="#16" name="16a">16</a>

<h4>Substantial Assistance</h4>

The determination of whether the lender provided
substantial assistance requires an analysis of the nature of the act, how
much assistance was actually provided and the person's state of mind.<a href="#17" name="17a">17</a>
Substantial assistance is provided when there is affirmative assistance to
help conceal, or by virtue of failing to act when doing so enables a breach
of a fiduciary duty to proceed.<a href="#18" name="18a">18</a> Generally, inaction, such as a failure to
investigate or to alert third parties about another's misconduct,
does not constitute substantial assistance in the absence of an independent
duty to act.<a href="#19" name="19a">19</a> Further, the existence of the primary violator's duty
is not sufficient to hold a non-fiduciary secondary actor liable for
inaction based on an aiding-and-abetting theory:<a href="#20" name="20a">20</a>

<blockquote><blockquote>
<hr>
<big><center>
[I]t is unlikely that there will be much case law generated specifically on aiding and abetting the breach of fiduciary duty.
</center></big>
<hr>
</blockquote></blockquote>

<blockquote>
It is well settled that without an independent duty to
disclose, mere inaction does not amount to substantial assistance for
purposes of determining aider and abettor liability.<a href="#21" name="21a">21</a>
</blockquote>

For example, in the Sharp case, the debtor's action against its lender for
aiding and abetting the debtor's principals in the breach of
fiduciary duty was based on the debtor's assertion that the
principals caused the debtor to obtain a loan from the lender/defendant by
inflating revenues to obtain the loan. The debtor further alleged that the
lender knew of the inflation as evidenced by an independent investigation
conducted by the lender, which revealed that many of the receivables
reported by the principals were fictitious.<a href="#22" name="22a">22</a> The principals
subsequently caused the debtor to raise additional capital through a note
offering, the proceeds of which were used, in part, to pay down the
obligation to the lender, with the remaining funds inappropriately taken by
the principals. Although the court determined that actual knowledge had
been adequately pled in reciting the investigation and the information it
provided, the court ultimately granted the lender's motion to dismiss
because the debtor could not plead substantial assistance based on the
lender's inaction.

<h4>Inducing or Encouraging a Breach of Fiduciary Duty</h4>

Second, "participation" can be found even
without directly assisting the commission of the underlying wrong. A
defendant may still be liable as an aider and abettor for
"inducing" or "encouraging" a fiduciary to breach
his duties to another.<a href="#23" name="23a">23</a> The Restatement (Second) of Torts explains that
"[a]dvice or encouragement to act, in instances where 'the
act' encouraged is known to be tortious...has the same effect
upon the liability of the advisor as participation or physical
assistance."<a href="#24" name="24a">24</a> A lender is not a fiduciary of a borrower and has no
duty to act simply because it suspects or even knows of a fraud perpetuated
by the borrower's management. The legal relationship between a
borrower and a lender is a contractual one of debtor and creditor and does
not create a fiduciary relationship between the lender and the borrower.<a href="#25" name="25a">25</a>
There is very little authority setting forth exactly what conduct qualifies
as inducement.<a href="#26" name="26a">26</a> However, it is difficult for a court to hold a lender
accountable for inducing a fraudulent scheme that was underway before the
lender is alleged to have any knowledge of it. Clearly, the actors would
require no encouragement or inducement to defraud creditors when funds had
already been diverted by the time the lenders are supposed to have
discovered the fraud.<a href="#27" name="27a">27</a>

<h4>Observation</h4>

It is clear that claims for aiding and abetting the
breach of a fiduciary duty are being seen in high-stakes cases with
regularity. As with many of the new creative theories being prosecuted by
creditors' committees, it is unlikely that there will be much case
law generated specifically on aiding and abetting the breach of fiduciary
duty. Most cases are likely to result in a global settlement, of which the
aiding and abetting claim is only a small part. In fact, in the Exide case, a count for aiding
and abetting was included in the complaint against the group of lender
defendants, and the court did not specifically address the count at all
when it analyzed the probability of the success on the merits of the
various counts in order to determine whether to approve the settlement.<a href="#28" name="28a">28</a>
The court included a more general statement, which will apply to many of
the cases where a "kitchen sink" complaint is filed against the
secured lenders: "There is no doubt that this litigation involves
complex issues on a variety of topics that will require costly and
time-consuming discovery in addition to a potentially lengthy trial,
possibly delaying the debtor's exit from chapter 11."<a href="#29" name="29a">29</a>
Accordingly, given the motivation and incentive for creditors'
committees to proceed aggressively, it is likely that the
aiding-and-abetting claim is here to stay unless a strong decision is
issued by some court that would provide precedent that the claim cannot be
brought without violating the standards of Rule 11.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Ms.
Brighton is special counsel with Kennedy Covington Lobdell & Hickman,
Charlotte, N.C., in the Debt Finance Group, where she practices primarily
in the areas of bankruptcy, workouts and secured lending. She is Board Certified in Business Bankruptcy Law by the American
Board of Certification. <a href="#1a">Return to article</a>

<a name="2">2</a> See Grillo, "From
First Dibs to the Last in Line," 25 N.Y.L.J. (Col. 11) 8/18/03. <a href="#2a">Return to article</a>

<a name="3">3</a> See Brighton, Jo Ann
J.,"Deepening Insolvency—Secured Lenders and Professionals
Beware, It is not Just for Officers and Directors Anymore,"ABI Journal Vol. XXXIII,
No. 3 (April 2004). <a href="#3a">Return to article</a>

<a name="4">4</a> In re Adelphia Comm. Corp., Case
No. 02-41729 (Bankr. S.D.N.Y.). <a href="#4a">Return to article</a>

<a name="5">5</a> In re Enron Corp., Case No.
01-16034 (Bankr. S.D.N.Y); see, also, Fox and Friedman 21 No. 2 Bankr.
Strategist, "Enron Versus Wall
Street" (Dec. 2003). <a href="#5a">Return to article</a>

<a name="6">6</a> In re Exide Technologies Inc.,
299 B.R. 732 (Bankr. D. Del. 2003) (court determined creditors stated claim
against lenders for aiding and abetting debtor's breach fiduciary
duty and ultimately settled). <a href="#6a">Return to article</a>

<a name="7">7</a> In re Sharp Int'l. Corp.,
302 B.R. 760 (E.D.N.Y. 2003). <a href="#7a">Return to article</a>

<a name="8">8</a> See Exide, 299 B.R. at 749; Sharp, 302 B.R. at 770; see, also, 1 Lender Liability: Law, Prac. & Prevention §5.10 (2004). <a href="#8a">Return to article</a>

<a name="9">9</a> Fed. R.
Civ. Proc. 9(b); Sharp, 302 B.R. at 770. <a href="#9a">Return to article</a>

<a name="10">10</a> Sharp, 302 B.R. at 770 (other
citations omitted); see, also, 1 Lender Liability: Law Prac
& Prevention §5.10; Exide, 299 B.R. at 749-50; Fox
and Friedman 21 No. 2 Bankr. Strategist, "Enron Versus Wall Street" (Dec. 2003). <a href="#10a">Return to article</a>

<a name="11">11</a> Sharp, 302 B.R. at 771-72, citing Ryan v. Hunton & Williams, 2000 WL 1375265 (E.D.N.Y. Sept. 20, 2000); see, also, Remer v. Chase Manhattan Bank, 2000 WL 781081 at *12 (S.D.N.Y. June 16, 2000) (granting
§12(b)(6) motion to dismiss claim against a bank for aiding and
abetting customer's prime bank guarantee scam, despite bank
official's suspicions of fraud—which led them to reject one of
the customer's proposed transactions, because the complaint alleged
no "factual basis for the assertion that the bank officials actually
knew the fraud (which they suspected) was in fact, occurring"); Kolbeck v. LIT America Inc., 939
F. Supp. 240 (S.D.N.Y. 1996) (finding that brokerage firm could not be
charged with knowledge despite defendants' awareness of
plaintiff's accusations, "knowledge of accusations without more
did not give rise to duty to investigate, and did not support on inference
of actual knowledge)." <a href="#11a">Return to article</a>

<a name="12">12</a> Sharp, 302 B.R. at 772. <a href="#12a">Return to article</a>

<a name="13">13</a> See In re Compuware Sec. Litig., 301 F.Supp. 2d 672 (E.D. Mich. 2004). <a href="#13a">Return to article</a>

<a name="14">14</a> In re Stone & Webster Inc.,
Sec. Litig., 253 F.Supp.2d 102, 112 (D. Mass. 2003), quoting Greebel v. FTP Software Inc.,
194 F.3d 185, 197 (1st Cir. 1999). <a href="#14a">Return to article</a>

<a name="15">15</a> Sharp, 302 B.R. at 774; 1 Lender Liability: Law, Prac. & Prevention §5.10. <a href="#15a">Return to article</a>

<a name="16">16</a> Sharp, 302 B.R. 774. <a href="#16a">Return to article</a>

<a name="17">17</a> Sharp, 281 B.R. at 771-72; 1 Lender Liability: Law, Prac & Prevention §5.10; Restatement (Second) Torts §876
clause (b). <a href="#17a">Return to article</a>

<a name="18">18</a> Id. <a href="#18a">Return to article</a>

<a name="19">19</a> Sharp, 302 B.R. at 774; see, also, McDaniel v. Bear Stearns Co., 196 F.Supp.2d 343, 352 (S.D.N.Y. 2002); 1 Lender Liability: Law, Prac & Prevention §5.10; Calcutti v. SBU Inc., 273 F.Supp.2d 488, 494 (S.D.N.Y. 2003); Nat'l. Westminster Bank USA v. Weksel, 124 A.D. 2d 144, 511 N.Y. S.2d 626 (1st Dep't. 1987). <a href="#19a">Return to article</a>

<a name="20">20</a> Sharp, 302 B.R. at 774. <a href="#20a">Return to article</a>

<a name="21">21</a> Calcutti v. SBU Inc., 273 F.
Supp. 2d 488, 494 (S.D.N.Y. 2003). <a href="#21a">Return to article</a>

<a name="22">22</a> Sharp, 302 B.R. at 772. <a href="#22a">Return to article</a>

<a name="23">23</a> Sharp, 302 B.R. at 775, citing Kaufman, 760 N.Y.S.2d
at 169; see, also, McDaniel, 196 F.Supp. at 352. <a href="#23a">Return to article</a>

<a name="24">24</a> Restatement
(Second) of Torts §876, comment "d"; see, also, Sharp, 302 B.R. at 775, citing Lindsay v. Lockwood,
163 Misc.2d 228, 233, 625 N.Y.S.2d 393, 397 (Sup. Ct. Monroe Co. 1994) (the
archetypical aiding-and-abetting defendant is one who encourages another to
commit a tortuous act). <a href="#24a">Return to article</a>

<a name="25">25</a> Sharp, 302 B.R. at 776-77
(other citations omitted). <a href="#25a">Return to article</a>

<a name="26">26</a> Sharp, 302 B.R. at 777. <a href="#26a">Return to article</a>

<a name="27">27</a> See Sharp, 302 B.R. at 777. <a href="#27a">Return to article</a>

<a name="28">28</a> Exide, 303 B.R. at 68. <a href="#28a">Return to article</a>

<a name="29">29</a> Id. <a href="#29a">Return to article</a>

Journal Authors

Jo Ann J. Brighton

Journal Date

Friday, October 1, 2004 - 12:00

Bankruptcy Rule

2004