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A federal judge’s refusal to grant a jury trial to director defendants and officers accused by a bankruptcy trustee of breaching their fiduciary duties has been reversed by the 2nd U.S. Circuit Court of Appeals. Overturning a multimillion-dollar verdict issued by Southern District Judge Robert W. Sweet, the circuit instructed the judge to hold a jury trial after finding that the action was not equitable in nature because it constituted a suit “at law” within the meaning of the Seventh Amendment. The ruling, written by 2nd Circuit Judge Joseph M. McLaughlin, means that director and officer defendants in Pereira v. Farace, 03-5053, will have a second chance to prevail in defending claims that they mismanaged assets of Trace International Holdings. Trace was a privately held corporation whose assets consisted of stock in three companies, Foamex International Inc., United Auto Group Inc., and CHF Industries. Its majority shareholder and chief executive officer, Marshall Cogan, was accused of exhausting Trace’s capital through a series of transactions that included large salaries for himself retroactively approved by the board, a loan to himself to cover a buy-back of stock from Dow Chemical Corp. (part of $13 million in loans he took from the company), and a $1 million 60th birthday party for himself at the Museum of Modern Art. The company filed for Chapter 11 reorganization in 1999 and, in 2000, the bankruptcy court converted the case into a Chapter 7 liquidation. John Pereira was appointed trustee and replaced the company’s creditors as plaintiff in an action against Trace’s directors and officers — board members Andrea Farace and Frederick Marcus, Trace officer and attorney Philip Smith and Trace officer and certified public accountant Karl Winters. Pereira charged that all of Trace’s officers and directors breached their fiduciary duties and the directors had violated Delaware Corporation Law provisions prohibiting the payment of dividends while insolvent or where the payments create insolvency or the redemption of stock when a corporation’s capital is impaired or will be impaired. The defendants demanded a jury trial, but Judge Sweet found that the allegations against them did not constitute actions “at law” because actions for breach of fiduciary duty were historically equitable and Pereira was seeking restitution. Sweet then conducted a 12-day trial that ended with a finding that the defendants were liable for mismanaging the company because they disregarded corporate governance procedures and turned a “blind eye” to Cogan’s actions — all of which amounted to a breach of fiduciary duties. He also found them liable for improper issuance of dividends and for allowing Dow to redeem stock. He held Marcus liable for $37.4 million, Farace liable for $27.3 million, Smith liable for $21.4 million and Winters liable for $21.4 million. Only Winters settled with the trustee prior to the appeal. Among the “sandstorm of claims on appeal,” Judge McLaughlin said, was that “the underlying action was legal and the remedy sought was compensatory damages, not equitable restitution.” “Although Rule 2 of the Federal Rules of Civil Procedure grandly proclaims that ‘there shall be one form of action to be known as ‘civil action’ thereby causing the merger of law and equity, the distinction ‘retains its viability’ today,” McLaughlin said. “By preserving the right to a jury trial only in ‘suits at common law,’ the Seventh Amendment of the United States Constitution perpetuates the law/equity dichotomy.” TWO-PART TEST To determine whether a case is a suit at law, he said, the court is instructed to apply a two-part test under Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989) — first asking whether the action would have been equitable in 18th-century England and, second, whether the remedy sought is legal or equitable in nature. Judge McLaughlin said the case would have been considered equitable in the 18th century. But on the second question, he said the court agreed with the defendants that “because they never possessed the funds in question and thus were not unjustly enriched, the remedy sought against them could not be considered equitable,” and they therefore had a right to a jury trial. The district court, McLaughlin said, “improperly characterized the Trustee’s damages as restitution.” McLaughlin added that the court was conceding its decision in Strom v. Goldman Sachs & Co., 202 F.3d 138 (1999), “points to a contrary result.” In Strom, he said, “we characterized as equitable the monetary relief sought by plaintiff for defendant’s alleged breach of fiduciary duty even though the defendant did not actually possess the funds in question.” But two years later, the U.S. Supreme Court in Great-West Life & Annuity Insurance Co. v. Knudson, 534 U.S. 204 (2002), “reconfigured the landscape of restitution,” he said, ruling that “for restitution to lie in equity, the action generally must seek not to impose personal liability on the defendant, but to restore to the plaintiff particular funds or property in the defendant’s possession.” This reasoning, McLaughlin said, “cuts across the grain of Strom.“ Judge Rosemary Pooler joined in the opinion. Judge Jon O. Newman issued a concurring opinion in which he said that “whether a jury is available for a claim for money damages for breach of fiduciary duties is, for me, a close question.” “Despite the sweep of language from the Restatement (Second, of Trusts) supporting actions in equity against fiduciaries for breach of their duties and the rarity of decisions requiring a jury for such claims, I am persuaded that the Supreme Court’s dictum in Great West, sends a signal that should not be ignored,” Newman said. Theodore J. Fischkin, John P. Campo and John S. Kinzey of LeBoeuf, Lamb, Greene, & MacRae represented Pereira. Guy Petrillo of Dechert represented Farace. Brian E. Mass and Wendy Stryker of Frankfurt Kurnit Klein & Selz represented Marcus. Robert A. Meister, John J. Clarke Jr. and Joshua S. Sohn of Piper Rudnick Gray Cary represented Smith and Winters.

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