We previously discussed Bankruptcy Judge Martin Glenn’s analysis of the Wagoner Rule in the Feltman v. Kossoff & Kossoff LLP (In re TS Empl., Inc.) case.[1]  The bankruptcy trustee (the “Trustee”) had asserted a fraud claim against the debtor’s outside accountant and its principal (the “Defendants”).  The Defendants moved to dismiss the complaint, citing the Wagoner Rule.  Judge Glenn held that the Trustee’s assertion of the adverse interest exception to the Wagoner Rule did not apply, but allowed the Trustee to amend the complaint to strengthen allegations concerning the insider exception.  In a recent decision, Judge Glenn denied the Defendants’ motion to dismiss the amended complaint, concluding that the Trustee alleged sufficient facts concerning application of the insider exception.[2] 

As discussed in our previous post, the Wagoner Rule prohibits a bankrupt corporation – or an entity that stands in the corporation’s shoes – from asserting claims against third parties for defrauding the corporation where the third parties assisted corporate managers in committing the alleged fraud.  In re Platinum-Beechwood Litig., No. 18-CV-10936, 2019 U.S. Dist. LEXIS 104562, at *2 (S.D.N.Y. June 21, 2019).  There are two exceptions to this rule: 1) the insider exception, and 2) the adverse interest exception.  Under the insider exception, the Wagoner Rule does not bar an action against “fiduciaries who are insiders in the sense that they either are on the board or in management, or in some other way control the corporation.”  In re Refco Inc. Sec. Litig., No. 04-MD-1902, 2010 U.S. Dist. LEXIS 132778, at *16 (S.D.N.Y. Dec. 6, 2010).  Under the adverse interest exception, the Wagoner Rule does not apply “where the corporation is actually the victim of a scheme undertaken by the agent to benefit himself or a third party personally.”  Feltman v. Kossoff & Kossoff LLP (In re TS Empl. Inc.), 597 B.R. 543, 553 (Bankr. S.D.N.Y. 2019). 

In the amended complaint, the Trustee asserted that the Defendants were “non-statutory” insiders because the Defendants were not in one of the categories listed as an “insider” under the Bankruptcy Code.[3]  Judge Glenn noted that courts often consider a non-exclusive list of factors when analyzing allegations of insider status:  1) the close relationship between the debtor and the Defendants; 2) the degree of the Defendants’ involvement in the debtor’s affairs; 3) whether the Defendants had opportunities to self-deal; and 4) whether the Defendants hold or held a controlling interest in the debtor.  Feltman, 2019 Bankr. LEXIS 2079, at *14-15 (citing In re PHS Grp. Inc., 581 B.R. 16, 33 (Bankr. E.D.N.Y. 2018)).

In his previous decision, Judge Glenn concluded that the first factor – the Defendants and the debtor had a close relationship – weighed in favor of a finding of insider status.  Feltman, 597 B.R. at 551. But, Judge Glenn also said, that factor alone was insufficient for the insider exception to apply.  Id.

In his recent decision, Judge Glenn ruled that the amended complaint’s allegations concerning the second factor – the degree of the Defendants’ involvement in the debtor’s affairs – were sufficient to permit the Trustee to proceed with the lawsuit.  Judge Glenn noted that the Defendants were alleged to have exercised virtually exclusive control over the debtor’s financial reporting systems and internal accounting.  And while the Defendants were the debtor’s outside accountant, the Defendants’ alleged “control over the [d]ebtor, rather than formal title,” is what mattered in the analysis.  Moreover, the amended complaint also alleged that the Defendants underreported the debtor’s payroll tax liabilities to the IRS, thus indicating that the Defendants essentially served as the debtor’s management.  Feltman, 2019 Bankr. LEXIS 2079, at *20.  Judge Glenn concluded that these allegations and others “provide case-specific context for the Court to reasonably infer the plausibility of the other allegations for which the Defendants stand accused.”  Id., *22.