Update Aiding and Abetting in the Breach of a Fiduciary Duty The Appellate Decision in Sharp Electronics A Step in the Direction of Victory for Lenders

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Jun 2005

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In the October issue of the ABI
Journal, I authored an article titled "Secured Creditors Beware:
Latest Tool in the Creditors Committee Toolbox: Aiding and Abetting in
the Breach of Fiduciary Duty."<a href="#2" name="2a">2</a> The case that is most noted in the area of
aiding and abetting in the breach of a fiduciary duty is Sharp
Electronics at 281 B.R. 506 (Bankr. E.D.N.Y. 2002), affirmed by the
U.S. District Court for the Eastern District of New York at 302 B.R. 760
(E.D.N.Y. 2003). In the Sharp case, the bankruptcy court
dismissed the complaint against the lender, State Street Bank, for
failure to state a claim, specifically finding that the complaint failed
to sufficiently identify any affirmative act of participation by State
Street in the principals' fraud, and the district court affirmed the
dismissal. On April 1, 2005, the U.S. Court of Appeals for the Second
Circuit affirmed the decision of the district court and provided an
expanded discussion concerning the elements of an aiding-and-abetting
claim to date, ringing a small victory bell for secured lenders who seem
to be on the receiving end of more aggressive and creative lender
liability actions than ever before.<a href="#3" name="3a">3</a>

As stated in the October article, 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 junior stakeholders, is if the secured liens are avoided,
secured claims are disallowed or subordinated and/or if the creditors'
committee can obtain an affirmative recovery based on some lender
liability theory.<a href="#4" name="4a">4</a>

Accordingly, creditors' committees and trustees are becoming more
creative and aggressive (as well as, in my opinion, aggressively
creative!) with respect to actions brought in order to claim some piece
of the secured creditors' pie for the benefit of the unsecured
creditors.<a href="#5" name="5a">5</a> As part
of "kitchen sink"-type complaints filed by committees or trustees to
attempt to garner some sort of recovery, a claim that has evolved is a
claim that the lender(s) aided and abetted in the principals' breach of
a fiduciary duty, thereby causing harm to the unsecured creditors for
which those creditors should be compensated. The aiding-and-abetting
argument is appearing in many significant chapter 11 cases including,
but not limited to, such recent cases such as
Adelphia,<a href="#6" name="6a">6</a>
Enron<a href="#7" name="7a">7</a> and
Exide Technologies.<a href="#8" name="8a">8</a>

<h4>Elements of Aiding and Abetting Breach of a Fiduciary Duty</h4>

Under the laws of most states where an aiding-and-abetting claim is
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 knowing participation
in the breach by a defendant who is not a fiduciary and (4) are damages
proximately caused by the breach.<a href="#9" name="9a">9</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="#10" name="10a">10</a> For a more in-depth discussion of each
of the elements and the case law discussing them, see the October
2004 ABI Journal article.<a href="#11" name="11a">11</a>

<h4>The Sharp Case Prior to April 2005</h4>

Sharp was a closely held New York corporation that engaged in the
business of importing, exporting and assembling wrist watches, clocks,
pens and mechanical pencils.<a href="#12" name="12a">12</a> Three brothers purchased a 100 percent
interest in Sharp in February 1993 and continued as the sole officers of
the company through 1999. In early 1995, the brothers sold 13 percent of
the company to another entity (the "purchaser"), which entitled the
purchaser to a seat on the board and other corporate rights such as
inspecting books and records. The brothers engaged in fraudulent conduct
such as falsifying business records in order to report fictitious
revenue as well as looting fraudulently raised funds and other corporate
profits (to the tune of about $44 million) from sometime after 1997 and
continuing through October 1999.<a href="#13" name="13a">13</a> The inflated revenues were used to
induce lenders to extend financing to the company, and Sharp began
borrowing from State Street, and others, in November 1996. Specifically,
State Street approved a $20 million demand line of credit secured by the
alleged assets of Sharp, and a group of investors extended $17.5 million
through the purchase of subordinated notes.<a href="#14" name="14a">14</a>

It is reported that State Street began to suspect the fraud sometime
in 1998 when Sharp failed to comply with the accounting requirements
under the loan documents and consumed enormous sums of cash, by virtue
of the State Street officer's prior experience with another company that
had engaged in fraudulent practices. Even though Sharp was current on
its loan payments and State Street appeared to be oversecured, the State
Street officer began to take cautionary measures in the fall of 1998,
such as assigning a workout officer to the Sharp account, alerting
senior State Street employees and engaging counsel specializing in
troubled loans.<a href="#15" name="15a">15</a>

State Street began to press for more detailed information, and its
outside counsel engaged a financial investigation firm to assist in its
examination of the business of Sharp, which produced a 60-page report
confirming many of State Street's suspicions. Thereafter, State Street
took heightened action in reviewing the financial reporting of Sharp and
requested formal confirmations of receivables from
customers.<a href="#16" name="16a">16</a>

Shortly thereafter, State Street required Sharp to obtain new
financing and pay off the debt owed to State Street. Sharp went to the
subordinated noteholders for $25 million ($10 million more than it owed
State Street). During this time, State Street did not share its
discoveries with the noteholders, nor did it pull the plug on Sharp as
it had the right to do. In March 1999, the noteholders purchased an
additional $25 million in subordinated notes, and Sharp paid State
Street about $12.25 million from the proceeds. The brothers also gave
State Street personal promissory notes for the difference of $2.75
million.<a href="#17" name="17a">17</a> In
July 1999, KPMG refused to issue 1999 audited financial statements and
withdrew its 1997 and 1998 audit opinions. In September 1999, the
noteholders commenced an involuntary bankruptcy proceeding against
Sharp.<a href="#18" name="18a">18</a>

The brothers were slapped by the bankruptcy court in November 2000
with a $44.38 million judgment and later pled guilty to criminal charges
for defrauding State Street and others.<a href="#19" name="19a">19</a>

In the complaint filed by the trustee against State Street in the
bankruptcy, the trustee alleged that State Street aided and abetted the
brothers in their breach of their fiduciary duties and that $19 million
in damages were caused by the brothers between the time State Street
first discovered the fraud and the time the bankruptcy court removed
them from power in Sharp. Further, the complaint also sought recovery of
the $12.25 million payment to State Street by the noteholders at a time
when State Street knew of the fraud. State Street moved to dismiss the
complaint. The bankruptcy court granted State Street's motion for
failure to state a claim of aiding and abetting in the breach of
fiduciary duties, finding that the complaint failed to plead that State
Street had actual knowledge of the brothers' looting of Sharp and
fraudulently raising additional funds. The bankruptcy court also found
that the complaint failed to establish that, in the alternative, State
Street "participated in" or "induced" the brothers' breach of their
fiduciary duties.<a href="#20" name="20a">20</a> The bankruptcy court specifically found
that the complaint failed to sufficiently identify any affirmative act
of participation by State Street in the principals' fraud.<a href="#21" name="21a">21</a> Sharp appealed the bankruptcy
court decision, and the noteholders commenced a separate action against
State Street in New York County Supreme Court in which they alleged,

inter alia, that State Street aided and abetted in the brothers'
fraud, which was ultimately dismissed on a motion for summary
judgment.<a href="#22" name="22a">22</a> The
district court affirmed the decision of the bankruptcy court while
arriving at its conclusion in a slightly different way than the
bankruptcy court. Interestingly, even though the bankruptcy court and
the district court opinions actually dismissed the claims against the
lender, aiding-and-abetting claims began to appear with gusto in many
creditors' committees' complaints against secured lenders after those
opinions were issued. However, the recent decision from the appeals
court, although affirming the lower courts' decisions, may curb the
enthusiasm for bringing such claims.

<h4>Appeals Court Decision in Sharp: April 2005</h4>

On April 21, 2005, the U.S. Court of Appeals for the Second Circuit
affirmed the dismissal of the complaint against State Street and
specifically found that Sharp had not pled facts sufficient to entitle
Sharp to relief under any of the legal theories advanced in the
underlying complaint.<a href="#23" name="23a">23</a> The court noted that the bankruptcy
court and district court disagreed as to whether State Street had actual
knowledge of both stages of the brothers' fraud, but concluded it did
not have to examine the issue since the complaint failed to sufficiently
allege either knowing inducement or participation.<a href="#24" name="24a">24</a> The appeals court noted that
the bankruptcy court had conceptually severed the brothers' conduct into
two distinct breaches of fiduciary duty: (1) fraudulently borrowing
funds on behalf of Sharp and (2) "looting" those funds (and others) from
Sharp.<a href="#25" name="25a">25</a> The
district court viewed the brothers' conduct as a part of a single
scheme.<a href="#26" name="26a">26</a> The
appeals court stated that it did not have to reconcile the disparate
views of the two courts as to whether there were two breaches or one
because damages were an essential element to the aiding-and-abetting
claim and the damages alleged in the complaint were based on the $19
million looted by the brothers, not their fraudulent borrowing on
Sharp's behalf.<a href="#27" name="27a">27</a>

Accordingly, the focus of the appeals court's analysis was on whether
State Street knowingly induced or participated in the brothers' looting
of the company, which resulted in the alleged $19 million in damages.

The appeals court noted that inducement was the "act or process of
enticing or persuading another person to take a certain course of
action."<a href="#28" name="28a">28</a>
Further, the appeals court noted that a person knowingly participates in
a breach of a fiduciary duty only when he or she provides "substantial
assistance" to the primary violator.<a href="#29" name="29a">29</a> As had been stated in other cases, the
appeals court noted that "substantial assistance" does not mean mere
inaction, but rather that the alleged aider or abettor "affirmatively
assists, helps conceal or fails to act when required to do so, thereby
enabling the breach to occur."<a href="#30" name="30a">30</a>

All of the appeals court's discussions as to what the standards are
for "knowing participation" or "substantial assistance" have been stated
before by other courts. What is significant is the appeals court's
application of those standards with respect to the facts of the
Sharp case and, specifically, State Street's actions to protect
its own best interest. The appeals court took note that there were five
acts cited in the complaint that supposedly rose to the level of aiding
and abetting in the brothers' breach of their fiduciary duties and
ultimately concluded in a very forceful statement: "[T]he complaint says
no more than that State Street relied on its own wits and resources to
extricate itself from peril, without warning persons it had no duty to
warn." In the court's opinion, the five alleged "acts" on behalf of
State Street can be viewed as follows:

1. State Street demanded that Sharp obtain new sources of
financing to pay off its own debt. The appeals court noted that even
if this was true, the allegation cannot be characterized as
participation or substantial assistance in the brothers' breach of their
fiduciary duties. The appeals court also noted that while the demand for
payment could possibly be viewed as an inducement in the broadest sense,
it actually constituted no more than a demand for what it had a
contractual and legal right to—repayment (even if it determined
that foreclosure would not bring about repayment). The appeals court
reiterated the findings of the district court in that the demand for
repayment could not induce the brothers to engage in a fraud that had
already begun before the demand for repayment. Accordingly, the appeals
court found that "demand for repayment of a bona fide debt is not a
corrupt inducement that would create aider or abettor
liability."<a href="#31" name="31a">31</a>

2. State Street deliberately concealed its knowledge of the fraud;
3. State Street elected not to foreclose on the loan; and 4. State
Street avoided the noteholders' repeated attempts to reach it concerning
the Sharp credit. The court included these three allegations
concerning State Street's conduct in one discussion point having to do
with State Street's supposed failure to act. It is important to note
that the appeals court viewed these three allegations as "artful
pleading." The appeals court reiterated that "substantial assistance"
has to do with an affirmative assistance or assistance with concealing,
and therefore failure to act, absent some other duty to act, cannot
satisfy the standard for substantial assistance. The appeals court noted
that it is established that the legal relationship between borrower and
lender is a contractual one of debtor and creditor and does not create a
fiduciary relationship. Accordingly, State Street had no affirmative
duty under New York law to inform Sharp, its creditors or future
creditors of the brothers' fraud.<a href="#32" name="32a">32</a> In the appeals court's opinion, even if
State Street was hoping that a less diligent lender would take it out,
"silence and forbearance did not assist in the fraud
affirmatively."<a href="#33" name="33a">33</a>

5. State Street participated in the brothers' fraud by providing
consent to the noteholders purchase of the subordinated notes. The
appeals court was not convinced that State Street's provision of its
contractually required consent to the noteholders' purchase of the
subordinated notes constituted "affirmative assistance." While in the
appeals court's view State Street's consent was affirmative in that it
had to write a consent, it was not "assistance" in that it was a mere
forbearance: "[I]t did no more than remove a contractual impediment that
was reserved to [itself] to invoke or not in its own interest." The
appeals court was clear that although State Street had the right to
provide consent or not, the existence of that right did not include a
duty to take into account anyone else's interests but its own. The
appeals court concluded that State Street's exercise of the right to
provide consent (and, in turn, protect its own interest) rather than its
"improvident creditors" did not constitute participation in the
brothers' fraud that would warrant a finding of aiding and abetting in
the breach of the brothers' fiduciary duties.<a href="#34" name="34a">34</a>

After discussing the specific acts of State Street alleged in the
complaint, the appeals court recognized that while on the one hand State
Street's knowledge that there would be victims of the brothers' fraud,
while ensuring they were not among them, was "repugnant;" on the other
hand, the officer at State Street's discovery of the brother's fraud was
an "asset" of State Street and State Street had a fiduciary duty of its
own to use that asset to protect its own shareholders. The appeals court
likened it to State Street failing to "tell someone their coat is on
fire, or...grabbing a seat when the music stops." The appeals court
acknowledged that moral analysis "contributes little." In the appeals
court's view, any other diligent lender could have also found out the
information about the fraud, and State Street had no obligation to blow
the whistle on the fraud. Accordingly, failure to "blow the whistle" was
not actionable, and State Street was not liable for aiding and abetting
in the breach of the brothers' fiduciary duty.

<h4>Conclusion</h4>

Prof. Dan Schechter has suggested that perhaps this case walks the
line and could have easily come out the other way.<a href="#35" name="35a">35</a> I am not sure that I agree
with Prof. Schechter's conclusions.<a href="#36" name="36a">36</a> Perhaps State Street's actions screamed
of self-preservation, and perhaps they even crossed the "moral" dividing
line—specifically, allowing the noteholders to loan money to Sharp
solely for the purpose of repaying State Street when it knew of the
brothers' fraudulent behavior. However, I agree with the appeals court
in that the noteholders had every opportunity to discover the fraud for
themselves and that State Street owed them no affirmative duty to warn
them or protect them from making a bad investment. Had State Street
actually misrepresented the condition of Sharp to the noteholders, or
denied that Sharp was in default of its obligations to State Street,
then the reasoning of the appeals court would likely have led the court
to conclude that State Street had engaged in an "affirmative" act rising
to the level of substantial participation. It was a close line, yes, but
State Street did not cross over it in a way that satisfied the standards
to establish that State Street had aided and abetted in the breach of
the brothers' fiduciary duties.

In the meantime, the conclusions reached by the appeals court could
provide some comfort and encouragement to secured lenders who have
lately been under fire from aggressive and creative creditors'
committees and trustees. Most importantly, lenders can find some solace
in the appeals court's determination that mere inaction by a secured
lender, or actions motivated by preservation of its own best interest,
will not satisfy the standard necessary to establish an affirmative act
sufficient to warrant imposition of liability based on the theory of
aiding and abetting a breach of a fiduciary duty. However, the reality
is that it is likely that most of these claims will continue to be
settled as part of a global settlement of a multiple-count complaint
designed to bring about some sort of recovery where no other recovery
can be had. Without settlement of these types of claims, as well as the
other creative claims of late such as deepening insolvency and
recharacterization, all parties understand that these types of claims
are factually intensive, expensive to litigate, and may delay bankruptcy
cases and, ultimately, delay the recovery to secured lenders and
creditors alike.

<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 area of
bankruptcy, workouts and secured lending. She serves on the ABI
Journal Editorial Board and is certified in Business Bankruptcy by
the American Board of Certification. <a href="#1a">Return to article</a>

<a name="2">2</a> Brighton, Jo Ann J.,

ABI Journal, Vol. XXIII, No. 8 (October 2004). <a href="#2a">Return to article</a>

<a name="3">3</a> 2005 U.S. App. LEXIS 5241
(2d Cir. April 1, 2005). <a href="#3a">Return to article</a>

<a name="4">4</a> See Grillo, "From
First Dibs to the Last in Line," 25 N.Y.L.J. (Col. 11) 8/18/03. <a href="#4a">Return to article</a>

<a name="5">5</a> In another article
published in the ABI Journal, I stated that deepening insolvency
was also a tool that had been added to the creditors' committee's
toolbox and that now appears as a standard part of the "kitchen sink"
complaint filed by creditors' committees in chapter 11 cases. See
Brighton, Jo Ann J., "Deepening Insolvency - Secured Creditors and
Professionals Beware: It Is Not Just for Officers and Directors
Anymore," ABI Journal, Vol. XXIII, No. 3 (April 2004). <a href="#5a">Return to article</a>

<a name="6">6</a> In re Adelphia Comm.
Corp., Case No. 02-41729 (Bankr. S.D.N.Y.). <a href="#6a">Return to
article</a>

<a name="7">7</a> In re Enron Corp.,
Case No. 01-16034 (Bankr. S.D.N.Y). See, also, Friedman, "Enron
Versus Wall Street," 21 No. 2 Bankr. Strategist Fox. <a href="#7a">Return to article</a>

<a name="8">8</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 parties ultimately settled).

<a href="#8a">Return to article</a>

<a name="9">9</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="#9a">Return to article</a>

<a name="10">10</a> F.R.C.P. 9(b);
Sharp, 302 B.R. at 770. See, also, expanded discussion of
"heightened specificity" required for F.R.C.P. 9(b) and aiding and
abetting claims; Neilson v. Union Bank of California N.A., 290
F.Supp.2d 1101, 1129-30 n. 81 (C.D. Cal. 2003). <a href="#10a">Return to
article</a>

<a name="11">11</a> See supra note
2. <a href="#11a">Return to article</a>

<a name="12">12</a> Id. *2-3. <a href="#12a">Return to article</a>

<a name="13">13</a> Id. at *3-5. <a href="#13a">Return to article</a>

<a name="14">14</a> Id. <a href="#14a">Return to article</a>

<a name="15">15</a> Id. at *6-7. <a href="#15a">Return to article</a>

<a name="16">16</a> Id. at *6-7. <a href="#16a">Return to article</a>

<a name="17">17</a> Id. <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> Id. See Albion
Alliance Mezzanine Fund L.P. v. State Street Bank & Trust Co.,

2003 N.Y. Misc. LEXIS 1557, *7, No. 602711/01 (N.Y. Sup. Ct. Apr. 14,
2003) aff'd., 2 A.D.3d 162, 767 N.Y.S.2d 619 (1st Dep't. 2003).
<a href="#19a">Return to article</a>

<a name="20">20</a> Id. at *8-10.
In re Sharp Int'l. Corp., 281 B.R. 506, 515-17 (Bankr. E.D.N.Y.
2002). <a href="#20a">Return to article</a>

<a name="21">21</a> In re Sharp Int'l.
Corp., 302 B.R. 760 (E.D.N.Y. 2003). <a href="#21a">Return to
article</a>

<a name="22">22</a> Id. While the
appeal was pending, the New York court dismissed the complaint against
State Street on a motion for summary judgment finding that nothing in
discovery revealed any conduct by State Street that was more serious
than that conduct alleged in the adversary proceeding. Albion,
2003 N.Y. Misc. LEXIS 1557 at *17-18, aff'd., 2 A.D.3d 162, 767
N.Y.S.2d 619 (1st Dep't. 2003). <a href="#22a">Return to article</a>

<a name="23">23</a> 2005 U.S. App. LEXIS.
<a href="#23a">Return to article</a>

<a name="24">24</a> Id. at *12-16.
<a href="#24a">Return to article</a>

<a name="25">25</a> Id. See 281 B.R.
at 515. <a href="#25a">Return to article</a>

<a name="26">26</a> Id. See 302 B.R.
at 771. <a href="#26a">Return to article</a>

<a name="27">27</a> Id. at *15-16.
<a href="#27a">Return to article</a>

<a name="28">28</a> Id. at *15
(other citations omitted). <a href="#28a">Return to article</a>

<a name="29">29</a> Id. at *15-16.
<a href="#29a">Return to article</a>

<a name="30">30</a> Id. at *16
(other citations omitted) (emphasis added). <a href="#30a">Return to
article</a>

<a name="31">31</a> Id. at *17-18.
<a href="#31a">Return to article</a>

<a name="32">32</a> Id. at *20,
citing Bank Leumi Trust Co. v. Block 3102 Corp., 180 A.D.2d 588,
589, 580 N.Y.S.2d 299, 301 (1st Dep't. 1992). <a href="#32a">Return to
article</a>

<a name="33">33</a> Id. <a href="#33a">Return to article</a>

<a name="34">34</a> Id. at 21-22. <a href="#34a">Return to article</a>

<a name="35">35</a> See Prof. Dan
Schechter, 2005 COMFINNL 31 (April 18, 2005). <a href="#35a">Return to
article</a>

<a name="36">36</a> Prof. Schechter states
that the court in Neilson v. Union Bank of California N.A., 290
F.Supp.2d 1101 (C.D. Cal. 2003), reached a different conclusion on the
same facts. Id. I would disagree in that the Neilson court
was presented with facts analyzed under California law—where
substantial assistance doesn't require the "affirmative" act required
under New York law, but rather that the actions of the aider/abettor
proximately caused the harm on which the primary liability is
predicated. Neilson 290 F.Supp at 1129-30 (other citations
omitted). Accordingly, the court in Neilson found that the bank's
provision of cash upon which the Ponzi scheme of fraud was funded met
the standard of proximate cause. Further, in that case, there were
allegations that defendants made affirmative statements misrepresenting
the financial situation of the company and the classification of its
assets to investors as well—as vouching for the person committing
the primary violation. Id. at 1130-31. State Street may have
walked the line by refusing to respond to inquiries, but in

Sharp, no affirmative misrepresentations were alleged. <a href="#36a">Return to article</a>

Journal Authors

Jo Ann J. Brighton

Journal Date

Wednesday, June 1, 2005 - 12:00

Bankruptcy Rule

2005

none