September 01, 2003
In the instant case, Breeden appealed an order of the Honorable John E. Sprizzo, of the Southern District of New York, which granted summary judgment dismissing complaints asserted against BFG’s former outside lawyers (Kirkpatrick & Lockhart LLP, Robinson, St. John & Wayne LLP and Storch & Brenner LLP) (the “Law Firm Defendants”), and one of its former outside auditors (Arthur Andersen LLP (f/k/a Arthur Andersen & Co.) (“AA”)).4 The primary issues on appeal were whether the Trustee had standing to assert the claims, and whether, in deciding to hold an evidentiary hearing to resolve the issue of standing, the district court deprived the Trustee of his asserted right to a trial by jury.5
Breeden was the trustee of BFG, a company that was used as a vehicle for what was characterized as the largest Ponzi scheme in U.S. history.7 BFG, a closely-held family business, raised capital for its operations from private investors and institutions.8 The Ponzi scheme consisted of the sale and resale or pledging of the same office equipment leases.9 Bud and Kathleen Bennett were the sole shareholders of BFG. Bud Bennett was Chairman and CEO; Kathleen Bennett was BFG’s President; one son, Patrick Bennett, was the CFO; their other son, Michael, was Deputy CEO.10 Together, as a practical matter, they had control over every decision made at BFG. Every Bennett family member was on the BFG board of directors, and there were no outside directors. Bud and Kathleen not only participated in management, but exercised complete control. Nothing occurred without Bud’s and Kathleen’s knowledge, participation and acquiescence. In fact, in a report submitted by the Trustee himself pursuant to 11 U.S.C. § 1106 (the “1106 Report”), the Trustee conceded that BFG was a Bennett family “dictatorship.”11
Although there were other directors on the BFG board, the Bennett family always held at least 50% of the seats; each non-Bennett family director was handpicked by Bud; and each was a BFG employee.14 Board meetings were scripted in advance, and each board member was provided with speaking parts before the meeting.15 The Bennett family (in particular Bud and Patrick Bennett) did not tolerate any questioning from the board or from BFG employees that could have uncovered the fraud.16 For example, BFG’s Comptroller from 1990 to 1994 was fired by the Bennetts after he repeatedly sought information and documentation concerning suspicious transactions that the Bennetts directed him to record in the company books.17
The summary judgment record established that Bud and Kathleen Bennett knew of and benefited from the fraud, as evidenced by numerous “smoking guns” that came to light during discovery. In 1990, for example, BFG’s Chief Accounting Officer and Controller jointly sent a memo to Bud stating that the company’s financial statements did not reflect the true financial condition of the company, identifying specific questionable financial transactions and warning that AA, BFG’s outside auditor at the time, was being misled at the direction of Patrick.19 No one told the auditors; no one removed Patrick as CFO. Rather, a week later, Patrick and Kathleen gave AA a false “management rep” letter and Patrick stayed in control.
AA Was Deceived
AA audited, and issued unqualified or “clean” opinions, with respect to the financial statements of BFG for the years ended 1989 and 1990. In 1992, however, AA refused to issue a report on BFG’s 1991 financial statements until certain accounting, commercial and securities law issues that AA had identified (not the existence of a fraud or Ponzi scheme) were resolved to its satisfaction.20 In response, and without any Board input, Bud personally fired AA.21 By letter to the board, AA promptly confirmed its termination, withdrew its 1990 report and detailed the specific issues that had precluded it from issuing an opinion on BFG’s 1991 financial statements. The Board neither discussed nor investigated the reasons behind AA’s discharge or AA’s withdrawal letter.22
In October 1995, two groups of employees, including high-level BFG personnel – in-house lawyers and corporate officers – discovered that BFG had pledged to banks more than fifty million dollars in leases that already had been sold to investors.24 Once again, the Bennetts did nothing, and Patrick remained in control.25 In the same year, after several BFG employeesthreatened to resign over the discrepancies that had come to light, BFG hired a New York law firm to investigate the double-pledging (i.e., the creation of fictitious leases and the multiple sale and pledging of the same leases).26 Thereafter, Bud and Patrick agreed to an oversight committee.27 But this “ad hoc” committee was powerless; it had no authority to fire Patrick or to carry out any of its recommendations.28
Breeden, standing in the shoes of BFG, commenced adversary proceedings on March 27, 1998 against Kirkpatrick & Lockhart LLP, Robinson, St. John & Wayne, and Arthur Andersen & Co., and on January 29, 1999, against Storch & Brenner, LLP.
The Trustee alleged, among other things, that AA was negligent in (1) issuing “clean” opinions for BFG’s 1989 and 1990 financial statements and (2) failing to notify appropriate personnel at BFG or law enforcement authorities when it (a) discovered problems with BFG’s 1991 statements and potential non-compliance with the securities laws, (b) refused to issue an opinion on BFG’s 1991 financial statements, and (c) withdrew its opinion on BFG’s 1990 financial statements because the unresolved issues raised during the 1991 audit might have been present, albeit on a much smaller scale, in 1990. The Trustee’s complaints against the Law Firm Defendants alleged, among other things, that they submitted a letter to the SEC concerning BFG’s business that was false and designed to delay or hinder the SEC investigation of BFG.
In June 2000, the Law Firm Defendants served summary judgment motions. After the district court ordered an evidentiary hearing in the law firm cases as to the issue of standing, AA requested leave to participate in the hearing due to the substantial overlap of the legal issues and facts. The district court directed that AA should participate in the hearing, and AA then moved for summary judgment as to standing.
The district court held a four-day evidentiary hearing during which the court heard witnesses and received into evidence a number of documents and deposition transcripts, which supplemented the summary judgment papers.29 On August 21, 2001, Judge Sprizzo found that there were no genuine issues of material fact and granted summary judgment dismissing the actions against the Law Firm Defendants and AA on the ground that the Trustee, on behalf of the debtor, lacked standing to sue third parties (its lawyers and its outside auditors) where the fraud was perpetrated by the debtor itself.30
The Standing Issue
The Bennett Opinion reaffirms the Second Circuit’s decisions in Mediators, Hirsch and Wagoner (the “Wagoner trilogy”), which stand for the proposition that a bankruptcy trustee (or other party standing in the shoes of the debtor) lacks standing to assert malpractice claims on behalf of the debtor against professionals or other third parties for injuries occasioned by the debtor’s own misconduct.31 Because management’s misconduct is imputed to the corporation, and because a trustee stands in the shoes of the corporation, the Wagoner rule bars a trustee from suing to recover for a wrong that he himself essentially took part in.32
According to the Bennett Court, the rationale for the Wagoner rule is “the fundamental principle of agency that the misconduct of managers within the scope of their employment will normally be imputed to the corporation.”35 An exception to this general principle is the “adverse interest exception,” which provides that the acts of the agent will not be charged to the corporation if the agent “is really committing a fraud for his own benefit.”36 However, this “adverse interest exception” applies “only when the agent has ‘totally abandoned’ the principal’s interests.”37
The Bennett Court suggested a possible question as to the applicability of the “sole actor” rule, noting that it did not “readily apply here” because the agent perpetuating the fraud, Patrick, was not one of the principal owners of the enterprise (his parents were), but it was unnecessary to pursue this particular issue.41 The Bennett Court held that “other well-established principles of agency law” required the dismissal of the Trustee’s suit for lack of standing:
The Trustee’s argument on appeal rested in large measure on Wechsler v. Squadron, Ellenoff, Plesent & Sheinfeld, L.L.P.,43 which he interpreted as meaning that to impute fraud to the debtor, and thus bar the trustee from bringing suit, “all relevant shareholders and/or decisionmakers [must be] involved in the fraud.”44
The Bennett Court characterized the Trustee’s Wechsler-based argument as a “would-a, could-a, should-a test”: i.e., if there exists an innocent shareholder or decision-maker who would have sought to put a stop to the fraud, a trustee will have standing to assert the claim.45 The evidence the Trustee proffered to support this argument were affidavits (and then testimony at the hearing) from three former officers of BFG, each speculating that if told of the fraud, he would have sought in some undefined way to bring an end to it.
[Wechsler] does not stand for the proposition . . . that the presence of any innocent officers, directors, or shareholders avoids the imputation of fraudulent acts by management to the corporation. Indeed, to the extent the Wechsler Court refers to “all relevant shareholders and/or decision[-] makers” it concedes the well-accepted proposition that some members of management are irrelevant for the purposes of applying the Wagoner rule. Only management that exercises total control over the corporation – or that exercises total control over the type of transactions involved in the particular fraudulent activity at issue – are relevant.46
The Bennett Opinion, in contrast, clearly rejected the Trustee’s “would-a, could-a, should-a test,” holding that “this is simply not the law.”47 The Second Circuit observed that:
Here whether one or more so-called independent directors, the people relied upon by the trustee to avoid Wagoner, might have in some metaphysical sense stopped the fraud, it is beyond peradventure that under all the circumstances, it was only their heart that might have been in the right place. Indeed, each so-called independent director was impotent to actually do anything.48
The Evidentiary Hearing
As the district court stated in its opinion, the written record alone was sufficient to grant summary judgment.51 However, the district court decided to hold the evidentiary hearing out of an “abundance of caution” and “in order to allow the trustee an additional opportunity to bring forth evidence in support of his standing.”52 The evidentiary hearing thus afforded the Trustee the further opportunity to establish the existence of a genuine issue of material fact.
The Trustee nevertheless argued on appeal that the district court erred: (1) by dismissing under Rule 56 on standing grounds after denying Rule 12(b)(6) motions on the same grounds; and (2) by holding an evidentiary hearing and by resolving issues of credibility, thus depriving him of a jury trial in contravention of the U.S. Constitution.53 The Bennett Court found no error and approved the district court’s approach.
The Trustee argued that the hearing was inappropriate because the facts necessary to determine whether standing existed are the same facts that would have been decided by the jury with respect to defendants’ in pari delicto defense.56 The Second Circuit rejected this argument, noting that “[i]t is precisely these [summary judgment] standards that the court below sought to meet with an evidentiary hearing . . . . The hearing did not decide questions of fact but was rather an effort to flesh them out.”57
As demonstrated above, the Bennett Opinion is particularly noteworthy for two reasons. First, with respect to the issue of standing, the Bennett Opinion reaffirms the Second Circuit Wagoner trilogy (as well as similar decisions from other circuits) that bar a trustee from suing third parties to recover for a wrong that the company essentially took part in. Additionally, the Bennett Opinion makes clear that a “would-a, could-a, should-a” argument, based on the presence of one or more allegedly innocent officers or directors, will not evade the Wagoner rule. Thus, in order to have standing to sue third parties on behalf of the company, a bankruptcy trustee needs to show more than a decision-maker who “would-a, could-a, should-a” put an end to the fraud, but rather, needs one who the evidence shows was both willing and, as a practical matter, able to do so.
1. Breeden v. Kirkpatrick & Lockhart LLP, 336 F.3d 94 (2d Cir. 2003) (“Bennett Opinion”). The unanimous decision was written by the Honorable Harold Baer, Jr., United States District Judge for the Southern District of New York, sitting by designation.
2. U.S. Const. art. III, §2, cl. 1.
3. Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, 1091 (2d Cir. 1995). See also Breeden, 336 F.3d at 99.
4. The authors were counsel to AA throughout the lower court and appellate proceedings. Mr. Warren argued before the Second Circuit on behalf of AA.
6. See, e.g., Shearson Lehman Hutton, Inc. v Wagoner, 944 F.2d 114 (2d Cir. 1991); Hirsch v. Arthur Andersen & Co., 72 F.3d 1085 (2d Cir. 1995); Mediators, Inc. v. Manney (In re Mediators, Inc.), 105 F.3d 822 (2d Cir. 1997). See also Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 354 (3d Cir. 2001); FDIC v. Ernst & Young, 967 F.2d 166 (5th Cir. 1992).
7. Breeden, 336 F.3d at 96, 97.
9. Id. at 97.
15. Id. at 98.
18. Breeden, 268 B.R. at 710-11, 713.
19. Id. at 711.
20. Breeden, 336 F.3d at 98.
23. Id. at 98.
29. The district court decided to hold the evidentiary hearing out of an “abundance of caution” and “in orderto allow the trustee an additional opportunity to bring forth evidence in support of his standing.” Breeden, 268 B.R. at 708.
30. Breeden v. Kirkpatrick & Lockhart LLP, 268 B.R. 704 (S.D.N.Y. 2001). In granting summary judgment, the district found that the facts elicited through discovery and in testimony given at the hearing established “beyond a peradventure of doubt” that Bud, Kathleen, Patrick and Michael Bennett were the only four relevant decision-makers at BFG and no member of the Bennett family was innocent with respect to the Ponzi scheme. Specifically, the district court noted, among other things, that: (i) BFG’s Assistant Controller from 1985 to 1990 testified that “nobody outside the Bennett family had final decision-making authority at BFG”; and (ii) a BFG director and executive committee member from 1993 to 1996 testified that the Bennetts “ran everything.” Id. at 710-11.
32. Wight v. Bankamerica Corp., 219 F.3d 79, 86 (2d Cir. 2000).
33. Breeden, 336 F.3d at 99.
35. Id. at 100.
36. Id. (citing Wight, 219 F.3d at 86-87).
37. Id. (citing Wight, 219 F.3d at 87).
38. Id. See also Munroe v. Harriman, 85 F.2d 493, 495 (2d Cir. 1936).
39. See Wagoner, 944 F.2d at 120; In re Mediators, 105 F.3d at 827.
40. See Munroe v. Harriman, 85 F.2d at 496. Munroe is the Second Circuit’s seminal case on the sole actor rule. The issue in Munroe was whether a bank should be charged with knowledge of the wrongdoing by its chief executive officer, Harriman, who was not the sole shareholder. The Court deemed Harriman to be the sole actor on behalf of the bank because the other officers and directors “were completely dominated by Harriman and habitually did whatever he requested.” Id. at 494. The Second Circuit in Mediators and Breeden has relied on Munroe. See Mediators, 105 F.3d at 827 (parenthetically describing Munroe as holding that the “knowledge of [a] self-dealing dominant officer [is] imputed to bank”); Breeden, 336 F.3d at 100 (citing Munroe for the proposition that “acts of agent imputed to principal ‘if the principal adopts the unauthorized act of his agent in order to retain a benefit for himself’”).
42. Id. at 100-101 (emphasis added).
43. 212 B.R. 34 (S.D.N.Y. 1997).
44. Breeden, 336 F.3d at 101 (emphasis added).
46. Breeden, 268 B.R. at 710.
47. Breeden, 336 F.3d at 101.
49. Breeden, 268 B.R. at 710.
50. Breeden, 336 F.3d at 101.
51. Breeden, 268 B.R. at 708.
53. Breeden, 336 F.3d at 102.
54. Id. (citing Lujan v. Defenders of Wildlife, 504 U.S. 555, 561 (1992), and Matsushita Elec. Indus. Co. v. Zenith Radio Corp., 475 U.S. 574 (1983)).
55. Id. (citing Filetech S.A. v. France Telecom, S.A., 157 F.3d 922, 932 (2d Cir. 1998) and Argus Inc. v. Eastman Kodak Co., 612 F. Supp. 904, 908 (S.D.N.Y. 1985), aff’d, 801 F.2d 38 (2d Cir. 1986)). Additional authority for the use of an evidentiary hearing to resolve standing issues include: In re United States Catholic Conference, 824 F.2d 156, 162 (2d Cir. 1987), rev’d on other grounds, 487 U.S. 72 (1988); Guadagno v. Wallack Ader Leithan Assocs., 932 F. Supp. 94, 95 (S.D.N.Y. 1996); Duke Power Co. v. Carolina Envtl. Study Gro up, Inc., 438 U.S. 59, 72 (1978).