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Bankers beware. Lenders are under stricter scrutiny regarding who they conduct business with and what they know about their debtors, particularly when a debtor subsequently files for bankruptcy. While lenders often monitor their debtors to ensure that the debtors have the ability to repay the lender and to protect their collateral, often they are wary of assuming too much control over the debtor’s operations for fear of lender liability lawsuits. That fear is well-founded. Recently, cases have analyzed whether to permit claims to proceed against lenders on theories of aiding and abetting, equitable subordination, deepening insolvency and fraudulent conveyance in situations where the lenders have taken little action beyond ordinary lending or due diligence. Courts have analyzed the threshold of lender participation that must be alleged to state a lender liability claim. Two recent cases illustrate the risk of potential liability that lenders expose themselves to when they deal with high-risk debtors, obtain knowledge about a debtor’s dealings through due diligence or statutorily mandated investigations, or exercise control over the debtors. However, one recent decision bucks this trend and provides some comfort to lenders who want to monitor their debtors without exposing themselves to lender liability. Lenders also must be wary of liability for potential torts and of potentially losing their priority standing when a debtor files for bankruptcy. Fortunately for lenders, it has been recognized that under 11 U.S.C. 541, a trustee assumes not only a debtor’s claims, but is also subject to the defenses that may be asserted against the debtor — including the application of the equitable defense of in pari delicto. In In re First Alliance Mortgage Co., No. 01-971, 2002 U.S. Dist. LEXIS 5858 (C.D. Cal. Jan. 11, 2002), the court permitted an aiding and abetting claim and an equitable subordination claim against a lender to proceed and effectively minimized the pleadings requirements for certain elements of each claim. Underwriters Lehman Commercial Paper Inc. provided services to defendant mortgage companies — collectively First Alliance — that were in the business of subprime mortgage lending. The loans, many of which were refinancings by homeowners who had significant equity in their homes, typically were secured by the borrowers’ homes. The plaintiffs claimed that First Alliance, which filed a voluntary petition under Chapter 11, engaged in deceptive and illegal practices in violation of consumer protection laws. The plaintiffs claimed that Lehman was liable for aiding and abetting and equitable subordination because it provided First Alliance with underwriting services and a credit facility with which First Alliance could make its loans. PARTICIPATION IN THE UNDERLYING TORT Lehman brought a motion to dismiss the aiding and abetting claim. Lehman contended that plaintiffs did not plead the element of a primary wrong for an aiding and abetting claim. Typically, liability may be imposed on one who aids and abets the commission of an intentional tort if the person knows the other’s conduct constitutes a breach of duty and gives substantial assistance or encouragement to the other’s act. The court found that the plaintiffs’ detailed description of First Alliance’s allegedly fraudulent lending practice sufficiently met the pleading requirement for the element of a primary wrong. The court rejected Lehman’s argument that the plaintiffs must plead that a defendant actually made a misrepresentation or somehow played a role in the alleged fraudulent inducement or misrepresentation. Instead, the court applied the rationale of Lomita Land & Water Co. v. Robinson, 97 P. 10 (Cal. 1908), which involved promoters of a corporation that purchased land from the defendant and who then took a secret profit by representing to the subscribers that the purchase price was higher than what they paid the defendant. The court held the defendant liable as an aider and abetter even though the misrepresentation occurred before he knew of the scheme. Likewise, in First Alliance, the court stated that aiding and abetting implies “an intentional participation with knowledge of the object to be attained.” Lehman did not make any false representations itself, and did not do anything to market the scheme to the defrauded creditors. Instead, Lehman was alleged to have had knowledge of the scheme through its due diligence and regulatory actions against First Alliance and to have aided the scheme by providing a credit facility to First Alliance from which the fraudulent loans were made. The court noted that Lehman’s conduct “may be more egregious, since it aided First Alliance not just in fulfilling the past misrepresentations, but also before new misrepresentations were made” and that Lehman profited from the credit that it extended to First Alliance. Because Lehman’s credit facility made the borrower’s fraudulent practices possible, this satisfied the element of “substantial assistance” for an aiding and abetting claim. Thus, when a lender merely extends the credit that makes a debtor’s fraud possible, that may be sufficient to state an aiding and abetting claim. EQUITABLE SUBORDINATION To set forth an equitable subordination claim under � 510(c), a plaintiff must plead: (a) the defendant engaged in some type of inequitable conduct; (b) the misconduct injured creditors or conferred unfair advantage on the defendant; and (c) equitable subordination must not be inconsistent with the Bankruptcy Code. A claim of equitable subordination typically arises from three factual situations: (1) when a fiduciary of the debtor misuses his position to the disadvantage of other creditors; (2) when a third party controls the debtor to the disadvantage of other creditors; and (3) when a third party actually defrauds other creditors. Lehman contended that the equitable subordination claim was inconsistent with the Bankruptcy Code. Specifically, Lehman contended that the class plaintiffs did not have standing to bring the equitable subordination claim but, instead, the borrowers committee, which filed a separate lawsuit for equitable subordination on behalf of the bankruptcy estate, was the only proper party to bring the claim. In most cases, such a claim is the property of the bankruptcy estate and must be brought by the bankruptcy trustee. However, an individual creditor who was “particularly harmed” by the defendant has standing to assert its own claim for equitable subordination. Because the plaintiffs pled that Lehman was vicariously liable for the fraudulent lending, they set forth a cognizable equitable subordination claim that was not inconsistent with the Bankruptcy Code. Thus, courts will permit individuals, rather than just bankruptcy trustees, to proceed with claims against lenders. IN RE EXIDE TECHNOLOGIES As in First Alliance, in In re Exide Technologies, Inc., 299 B.R. 732 (Bankr. D. Del. 2003), the court permitted claims for aiding and abetting and equitable subordination and recognized a tort claim for deepening insolvency against a lender — based on plaintiff’s theory that the lender’s loan permitted the debtor to fraudulently continue its business for nearly two years in ever-increasing insolvency. Lenders established a $650 million credit facility for debtor, the Exide Group. Subsequently, a further loan of $250 million was used to finance the acquisition of a competitor. In exchange for the financing, the debtor granted the lenders significant additional collateral and guarantees. The plaintiffs — a committee of unsecured creditors and an entity — alleged in this adversary proceeding that the effect of this transaction was to increase significantly the lenders’ control over the debtor. The lenders and the debtor entered into amendments to the loan agreements, and in the interim, the debtor became insolvent. The plaintiffs further asserted that the lenders caused the debtor to suffer massive losses and to become less solvent, costing creditors substantial value. The lenders filed a motion to dismiss. As in First Alliance, the lenders contended that the elements of an underlying breach of fiduciary duty and of knowing participation were missing from the complaint’s aiding and abetting claim. The court found that the complaint set forth facts showing the element of an underlying breach by asserting that the debtor’s directors repeatedly favored the lenders to the detriment of the debtor’s unsecured creditors. For example, the directors granted the lenders collateral pledges far in excess of the value of any new credit provided and authorized payment of significant fees to the lenders’ professionals. The court found that the complaint set forth facts showing the element of knowing participation by asserting that the lenders knowingly participated in these breaches by inducing the acquisition of the debtor’s competitor and providing investment banking services and financing in connection therewith and by preventing the debtors from filing insolvency petitions. INEQUITABLE CONDUCT OF AN INSIDER Where First Alliance analyzed whether an individual’s equitable subordination claim was inconsistent with the Bankruptcy Code, Exide analyzed the effect of a lender’s status as an insider on an equitable subordination claim. Under � 510, when a defendant is an insider, the standard of finding inequitable conduct is less exacting. Inequitable conduct for an insider generally arises from: (1) fraud, illegality and breach of fiduciary duties; (2) undercapitalization; or (3) defendant’s use of the debtor as a mere instrumentality or alter ego. To qualify as inequitable conduct, the insider must have actually used its power to control the debtor or its position of trust with the debtor to its own advantage or to the other creditors’ detriment. For the purposes of bankruptcy, the important distinction is the distinction between the existence of control and the exercise of that control to direct the activities of the debtor. Here, the court found that the complaint set forth facts supporting the elements of inequitable conduct and of resulting injury by asserting that the lenders had access to the debtor’s financial records and, thus, the opportunity to determine the debtor’s financial condition, and that the lenders induced the debtor to acquire its competitor to gain influence and leverage over the debtor, which was used to control the debtor and to obtain additional collateral and guarantees. DEEPENING A DEBTOR’S INSOLVENCY Lenders need to be concerned about more than liability for aiding and abetting; they also have potential liability for other torts. The plaintiffs alleged that the lenders caused the debtor to acquire its competitor so that they could obtain the control necessary to force the debtor to continue its business for nearly two years at ever-increasing levels of insolvency. The lenders’ conduct allegedly caused the debtor to suffer massive losses and to become more deeply insolvent, costing creditors substantial value. In response, lenders contended that this claim was not an actionable tort and that the claim is defeated by the in pari delicto doctrine. The court noted that the 3rd U.S. Circuit Court of Appeals, in Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340 (3d Cir. 2001), described the tort of deepening insolvency as “an injury to the debtor’s corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life.” Ultimately, the Exide court held that the Delaware Supreme Court would recognize a claim for deepening insolvency when there has been damage to corporate property. The court further held that the tort of deepening insolvency has been pled sufficiently by the plaintiffs. Lenders are not without defenses to such claims. The court stated that the doctrine of in pari delicto is an affirmative defense to a deepening insolvency claim. As explained by the 3rd Circuit in Lafferty, the doctrine of in pari delicto states that a plaintiff may not assert a claim against a defendant if the plaintiff bears fault for the claim, and the party is barred from recovering damages if his losses are substantially caused by activities the law forbade him to engage in. Because actions brought by bankruptcy trustees and creditors committees are analyzed as of the date of the commencement of bankruptcy, the causes of action and defenses are measured as of the bankruptcy commencement date. Accordingly, lenders would be able to defend against a bankruptcy trustee’s claims by asserting the in pari delicto doctrine if the underlying debtor bears fault for the claim. In Lafferty, two lease financing corporations — which allegedly operated a “Ponzi scheme” — filed for bankruptcy. The creditors committee brought claims on behalf of the two debtors alleging that third parties helped engineer the scheme and fraudulently induced the debtors to issue debt securities, thereby deepening their insolvency and forcing them into bankruptcy. The 3rd Circuit concluded that deepening insolvency constituted a valid cause of action under Pennsylvania law and that because the committee, standing in the shoes of the debtors, was in pari delicto with the third parties it was suing, its claims were properly dismissed. The court explained that the doctrine of in pari delicto provides that “a plaintiff may not assert a claim against a defendant if the plaintiff bears fault for the claim” and that a party is “barred from recovering damages if his losses are substantially caused by activities the law forbade him to engage in.” The doctrine incorporates a number of different defenses, depending on whether contract, tort or another claim is asserted. As a remedy of equity, courts may disallow the defense when it would otherwise produce an inequitable result. The Lafferty court noted that “application of the in pari delicto doctrine is affected by the rules governing bankruptcies.” The explicit language of � 541 directs courts to evaluate defenses as they existed “as of the commencement of the case.” The trustee “stands in the shoes of the debtor” and “take[s] no greater rights than the debtor himself had.” Therefore, to the extent that the trustee must rely on � 541 for standing, he may not use his status as trustee to insulate a debtor from wrongdoing. Thus, a trustee is subject to the defenses which could be asserted against the debtor. In Lafferty, the 3rd Circuit analyzed whether an officers’ conduct should be imputed to the debtors so that the doctrine of in pari delicto bars the committee’s claims. Under the law of imputation, courts impute the fraud of an officer to a corporation when the officer commits the fraud: (1) in the course of his employment and (2) for the benefit of the corporation. The second part of the imputation test — whether fraudulent conduct was perpetrated for the benefit of the debtor corporation — is often analyzed under the “adverse interest exception.” Where the corporate agent is found to act adversely to the interest of the corporation or not for the benefit of the corporation, then there can be no imputation. The adverse interest exception is, itself, qualified by the “sole actor” exception, which provides that “if the agent is the sole representative of a principal, then that agent’s fraudulent conduct is imputable to the principal regardless of whether the agent’s conduct was adverse to the principal’s interests.” See Lafferty. The sole agent “has no one to whom he can impart his knowledge, or from whom he can conceal it, and that the corporation must bear the responsibility for allowing an agent to act without accountability.” Courts have applied the sole actor exception where the agent dominated the corporation. In PNC Bank v. Hous. Mortgage Corp., 899 F. Supp. 1399 (W.D. Pa. 1994), the court dismissed a corporation’s claims against accountants because sole shareholders and officers of corporation participated in alleged fraud. When analyzing the application of the sole actor exception in Lafferty, the 3rd Circuit noted that “[t]he possible existence of any innocent independent directors does not alter the fact that” the directors dominated the debtor. Ultimately, in Lafferty, the 3rd Circuit rejected the committee’s argument that the sole actor exception should not apply where innocent independent directors may have acted only negligently. This case supports the assertion of the equitable doctrine of in pari delicto by lenders against trustees or other claimants. The application of this doctrine is established in the bankruptcy context, and it is expected that the assertion of this defense will greatly increase. IN RE SHARP INT’L CORP. In In re Sharp Int’l Corp., No. 02CV-5306, 2003 WL 2996744 (E.D.N.Y. Dec. 5, 2003), the court analyzed the level of sufficiency required to support a claim that a lender aided and abetted fraud, and whether a lender’s acceptance of funds in repayment of pre-existing loans gives rise to a fraudulent transfer claim. Sharp was a closely-held corporation in which its former owners, the Spitzes, owned all of the common stock. This adversary proceeding arose out of a massive fraud against Sharp and its creditors by the Spitzes in which they fraudulently inflated the company’s reported sales and revenues and used these falsified documents to raise large amounts of money from lenders. The former owners also stole money from the company, diverting the funds to numerous companies, most of which were affiliated with the former owners, and which provided no consideration to the company in exchange for the transfers. Before the former owners committed these acts, its lender, State Street, approved a line of credit secured by the company’s assets. The lender became concerned that Sharp was growing at an alarmingly rapid pace and consuming a large amount of cash. The lender also took action that demonstrated its concern regarding the company’s loan, including requesting work papers from the company’s outside auditors and retaining a company that specialized in investigating financial fraud to formally investigate Sharp. The lender then halted its investigation, deciding not to confront the company’s principals or to alert anyone else to the clear evidence of fraud. The lender then obtained Sharp’s agreement to secure new financing — presumably from investors unaware of the fraud — and to use that financing to pay off the debt to the lender. The noteholders purchased an additional $25 million in subordinated notes from Sharp. Subsequently the noteholders commenced an involuntary Chapter 11 bankruptcy proceeding against Sharp. While the Sharp court identified the elements of a common law aiding and abetting claim in nearly an identical manner as in First Alliance and Exide, it found that no aiding and abetting claim was stated against the lender. The court noted that a plaintiff must plead: (1) a breach of fiduciary obligations to another; (2) that the defendant knowingly induced or participated in the breach; and (3) that the plaintiff suffered damages as a result of the breach. Regarding the third element, the court noted that there is no requirement that the alleged aider and abettor have an intent to harm. The court noted that to the extent the underlying breach was based on fraudulent conduct, the complaint must meet the Rule 9(b) heightened pleading requirement. However, Rule 9(b)’s requirements do not apply to “conditions of the mind,” including knowledge that may be averred generally. To satisfy the knowledge prong, the alleged aider and abettor “must have actual knowledge of the primary violator’s underlying breach of fiduciary duty.” Constructive knowledge is “legally insufficient to impose aiding and abetting liability.” The court noted that assertions that an alleged aider and abetter harbored well-founded but unconfirmed suspicions of the primary violator’s wrongdoing are not sufficient to plead actual knowledge simply because those suspicions turned out to be correct. Where an alleged aider and abetter investigates a primary wrongdoer’s conduct, a factual inquiry must be conducted to determine the precise point at which evidence giving rise to suspicions of fraud reached a cumulative critical mass sufficient to support an inference of actual knowledge. When reviewing the Bankruptcy Court’s prior dismissal of this claim and analyzing the facts contained in the complaint, the court stated that there were “sufficient facts which if proven could lead a reasonable jury to infer that State Street, a sophisticated commercial bank, actually knew” of the fraudulent reporting of the company’s accounts receivable in order to raise money to fund the looting of the corporation by the corrupt management. However, the court held that the complaint failed to identify any affirmative act of the lender’s participation in the Spitzes’ breach of their fiduciary duties to Sharp and, therefore, dismissed the complaint for failure to state a claim. THE TRANSFER SUPPORTS THE CLAIM The gravamen of Sharp’s constructive fraudulent conveyance claim is that the lender did not receive payment in good faith because, at the time of the payment, the lender was aware of the fraud and the payment was intended as a quid pro quo for Sharp’s assistance in the fraud on the noteholders. When analyzing the term “good faith,” the court noted that a finding that good faith is lacking based solely on the transferee’s awareness that the transferor lacks the resources to satisfy all his debts would run afoul of the fundamental principle that a preference — a payment by an insolvent debtor satisfying debts to one creditor at the expense of others — is not a fraudulent conveyance. A conveyance that satisfied an antecedent debt made while the debtor is insolvent is neither fraudulent nor otherwise improper, even if its effect is to prefer one creditor over another. Here, the lender was a bona fide creditor that advanced funds to Sharp in good faith. The court noted that the fraud was not in the transfer to the lender but, instead, in the manner in which the funds transferred to repay the debt were raised. It is not the purpose of the fraudulent conveyance law, however, to remedy the wrong regarding the fraudulent manner in which the funds were transferred. A trustee is specifically authorized under the Bankruptcy Code to pursue fraudulent transfer claims on behalf of the debtor’s unsecured creditors, and is not empowered to pursue the claims of the debtor’s secured creditors. Indeed, the court advised that the noteholders themselves could seek relief under other legal theories, such as restitution. Ultimately, the fraudulent conveyance claim failed. The analysis of where the fraud exists — either in the transfer itself or in the manner in which the funds are transferred — is critical to setting forth a cognizable fraudulent transfer claim. Yet, lenders may be subject to suits by the fraud victims, particularly based on the court’s acknowledgement that the fraud victims may seek recovery from the lender through restitution or otherwise. Courts are permitting claims to proceed against lenders and, at times, straining to read a complaint as including all elements of a lender liability claim. We anticipate that in light of the governance statutes and the corporate climate, actions by bankruptcy trustees and others against lenders will increase. William S. Katchen is a partner and Sheila Raftery Wiggins is an associate at Duane Morris (www.duanemorris.com) of Newark, N.J. If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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