“You win some, you lose some. But you live, you live to fight another day…” – Mr. Jones, Friday

Just what must be alleged for claims for breach of fiduciary duty to proceed past initial pleadings and into meaningful fact development? In a recent decision, the United States Bankruptcy Court for the Eastern District of Pennsylvania walks through several important considerations inherent in challenging (or surviving) breach of fiduciary duty claims at the initial pleading stage.

In Seitz v. Fretz et al (In re Covenant Partners, L.P.), the chapter 7 trustee for a limited partnership brought breach of fiduciary duty claims against two individuals who had allegedly controlled the debtor through its general partner.  In exercising that control, they allegedly diverted investor funds to another company that they controlled, even when the limited partnership was ailing.  The trustee further alleged that the two defendants had paid themselves performance bonuses even though the partnership had failed to meet the stated benchmarks for such payments.  After initial pleadings, the defendants then moved for a judgment on the pleadings on six grounds:

• Failure to state a claim for breach of fiduciary duty because the defendants owed no such duty to the debtor;
• Failure to state a claim because the estate had already been made whole for the claims stated;
• The claims are time-barred;
• The claims are barred by in pari delicto;
• The claim for attorneys’ fees is precluded by the “American Rule” against fee-shifting; and
• Claims for breach of fiduciary duty do not give rise to punitive damages under Delaware law.

In judging the Rule 12(c) motion by the same standards that would apply to a Rule 12(b)(6) motion to dismiss (i.e., that the facts presented in the pleadings and the inferences to be drawn therefrom should be viewed in the light most favorable to the nonmoving party), the bankruptcy court rejected all six of these arguments.  Importantly, certain of these arguments failed as a matter of law, while others were simply unsubstantiated on the record before the court.

The court’s analysis is instructive, and each issue is briefly summarized below.

Existence of Fiduciary Duty and Breaches Thereof

First, the court rejected the defendants’ argument that they did not owe fiduciary duties to the limited partnership.  The two defendants owned and controlled Covenant Capital Management, Inc., which was, in turn, the general partner of Covenant Capital Management LP, itself the general partner of the Debtor.  Looking to the applicable Delaware case law, the court acknowledged that the individuals who control general partners owe fiduciary duties to those limited partners.  In other words, the liability does not stop with the corporate formality of the general partner entity – and the fiduciary duties owed to limited partners extend to those who actually control the general partner, or, in this case, those who control the general partner that controls the general partner.

After concluding that the defendants did, in fact, owe fiduciary duties to the debtor, the court observed that the allegations in the pleadings supported an inference that those duties of care and loyalty were breached when the defendants diverted corporate funds from the debtor and directed improper incentive bonuses to themselves.  Dismissal of such claims was therefore unwarranted.

Double Recovery

The defendants then argued that the Trustee’s prior settlement of claims for improper stock transfers precluded recovery in this action, as that settlement resulted in full compensation for the debtor’s injuries and the Trustee could not obtain a “double recovery.”  The court summarily rejected this argument, noting that the Trustee had alleged claims separate and distinct from those that had already been settled (i.e., separate claims for improper stock transfers) and that the claims against the defendants could proceed without limitation.

Statute of Limitations

The court similarly rejected the defendants’ argument that the Trustee’s claims were somehow barred by a statute of limitations.  The allegedly wrongful performance bonuses were paid in 2009-2010, while the allegedly improper diversion of investment funds occurred from 2008 through 2012.  Consequently, the defendants argued that Delaware’s three-year statute of limitations for breach of fiduciary duty actions barred the Trustee’s claims, which were not asserted until July 2016.

The court rejected these arguments.  With respect to the improper diversion of funds, the court observed that section 108 of the Bankruptcy Code automatically provides the trustee with an additional two years after the petition date to commence any actions that could have been commenced on that date.  Because the bankruptcy case was commenced in September 2014, those additional two years were automatically triggered for the Trustee’s breach of fiduciary duty claims on account of actions that occurred in or after September 2012.  But more broadly, the court observed that the facts as alleged supported the possibility of equitable tolling (at least when viewed through the Rule 12(c) lens).  The court pointed to Delaware law regarding the “discovery rule” that equitably tolls statutes of limitations where the injury was inherently unknowable and the injured party was “blamelessly ignorant” of the wrongful acts.  The time to file suit, therefore, would not begin to run until such acts and injuries were discovered.  Because the record was inconclusive as to whether or not the defendants had actually deceived the debtor to the extent that equitable tolling would be warranted, the court concluded that the claims should not be dismissed on the basis of timeliness – at least not at this stage in the proceedings.

In Pari Delicto

The defendants also advanced an argument that the Trustee, as successor to the debtor, is vicariously liable for the debtor’s wrongful acts and is therefore barred from asserting claims against the defendants due to the doctrine of in pari delicto, which bars plaintiffs from asserting claims against defendants if the plaintiff itself bears fault for the claim. Further discussion of in pari delicto is available here.

However, the in pari delicto defense simply does not apply to claims for breach of fiduciary duty.  (Which makes senses, when you stop to think about it.  If the debtor had been controlled by the defendants and wound up committing wrongful acts as a result, why should the debtor’s decision-makers – who brought about such wrong-doing – be absolved from all liability in connection therewith?) The court therefore summarily rejected this argument.

Fee Shifting

The court next rejected defendants’ argument that the “American Rule” precludes an award of attorneys’ fees in the event that the Trustee prevails in his action against the defendants.  Under Delaware law (which was applicable to the breach of fiduciary duty action), there exist certain exceptions to the American Rule, pursuant to which awards of attorneys’ fees are justified.  Because the pleadings did not conclusively demonstrate that no exception applied, the court refused to dismiss the request for attorneys’ fees.

Punitive Damages

The court finally acknowledged that it was similarly premature to reject requests for punitive damages.  The court observed that, even though the Delaware Chancery Court does not award punitive damages, other courts in Delaware do allow for punitive damages in situations where the defendant’s conduct has been “particularly reprehensible” or “exhibit[ed] a wanton or willful disregard for the rights of the plaintiff.”  This “conscious indifference” to a plaintiff’s legal rights could give rise to punitive damages.  The court concluded that, if the facts alleged in the Trustee’s complaint were proven to be true, a fact finder could conclude that such conduct rose to a level that would give rise to an award of punitive damages.  Therefore, the court refused to reject the request for punitive damages.

Conclusion

It is important to note that the bankruptcy court’s rejection of all six of the defendants’ arguments was premised on a standard of review that skews significantly in favor of the plaintiff.  And it is entirely possible that the defendants could prevail on one or more of these theories at a later stage in the proceedings.  However, the court’s decision points to some of the critical hurdles that defendants must clear in order to defeat claims for breach of fiduciary duty before a factual record is sufficiently developed and before the parties are able to put evidence before the court.  Although plaintiffs must satisfy the applicable pleading standards and put on the requisite prima facie case, significant presumptions continue to weigh in favor of a robust factual record and preservation of all legitimate arguments for sufficient briefing and fact-finding.