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In an era rife with corporate scandals, a decision this week by the 3rd U.S. Circuit Court of Appeals is likely to stir up the atmosphere in board rooms and executive offices nationwide by making it significantly easier for bankruptcy trustees to file suit against corporate directors and officers for alleged breaches of their fiduciary duties. In Stanziale v. Nachtomi, a unanimous three-judge panel revived a suit against the former officers and directors of the defunct charter airline Tower Air Inc. in which the trustee claims they drove the company into insolvency by indifference and egregious decisionmaking. The appellate panel concluded that U.S. District Judge Kent A. Jordan of the District of Delaware erred by applying Delaware’s stricter Chancery Rule 8 pleading standard and instead should have applied the more lenient federal “notice pleading” standard. Although Chancery Rule 8 appears at first glance to mirror Rule 8 of the Federal Rules of Civil Procedure, the appeals court found that, in practice, the rules are significantly different. “The problem is that Delaware courts interpret Chancery Rule 8 to require pleading facts with specificity. That is not the federal notice pleading standard,” U.S. Circuit Judge D. Brooks Smith wrote. “By requiring [trustee Charles] Stanziale to allege specific facts, the district court erroneously pre-empted discovery on certain claims by imposing a heightened pleading standard not required by Federal Rule of Civil Procedure 8,” Smith wrote in an opinion joined by Circuit Judges Richard L. Nygaard and D. Michael Fisher. Under the federal rule, Smith said, “supporting facts should be alleged, but only those necessary to provide the defendant fair notice of the plaintiff’s claim and the grounds upon which it rests.” To hold otherwise, Smith said, “would be effectively to transform Rule 12(b)(6) dismissal motions into multi-purpose summary judgment vehicles. That we will not do.” By requiring fact pleading, Jordan found that the trustee’s suit failed to satisfy the requirements of Delaware’s “business judgment rule.” The business judgment rule, Jordan said, creates a “presumption that directors making a business decision, not involving self-interest, act on an informed basis, in good faith and in the honest belief that their actions are in the corporation’s best interest.” To overcome that presumption, a plaintiff must allege self-dealing or plead “with particularity” facts showing that the challenged decision was not the result of a valid business judgment. The suit failed, Jordan found, because Stanziale had not alleged specific facts showing that the directors’ and officers’ actions “bespoke irrationality or inattention” sufficient to rebut the presumption of valid business judgment. Now the 3rd Circuit has ruled that Jordan was correct in applying the business judgment rule but erred by requiring fact pleading. When analyzed under the more lenient federal notice pleading standard, the court said, many of Stanziale’s claims satisfy the business judgment rule. The ruling is a victory for attorneys John L. Reed, Matt Neiderman, John J. Soroko and Diane E. Vuocolo of Duane Morris. In the suit, Stanziale accuses Tower Air’s former directors and officers of “gross negligence and mismanagement.” The suit outlines Tower Air’s growth in the 1980s and early 90s, culminating in a period when it employed more than 1,400 workers and operated 14 Boeing 747s, and its descent in the late 1990s when its revenues plummeted and most of its fleet was grounded due to mechanical problems. Stanziale’s allegations lay much of the blame at the feet of Tower Air’s founder, Morris Nachtomi, who served as chairman of the board and CEO from 1989 until 2000 and was the company’s president between 1986 and 2000. According to court papers, Nachtomi and his family owned a substantial majority of outstanding common stock and a controlling interest in the airlines, and, as a result, the other directors and officers “served at Nachtomi’s pleasure, and Nachtomi controlled the firm’s management and operations.” Founded in 1982 as an international charter airline, Tower Air soon expanded into domestic and international scheduled passenger service. By 1988, its signature route, which accounted for roughly one-quarter of its revenue, was scheduled passenger service from New York to Tel Aviv. The first signs of serious financial problems arose in 1996 when the company lost $20 million. But Stanziale contends that Nachtomi continued to expand, adding an Athens route in 1997 and, the next year, a route to Santo Domingo in the Dominican Republic. The Santo Domingo route was added, the suit alleges, only because Nachtomi’s daughter expressed personal interest in it, and despite never turning a profit, it was continued until 2000. The suit also alleges that Tower Air’s Tel Aviv office kept separate financial records and its own bank account, making it virtually impossible for the company’s officers in New York to audit the Tel Aviv books. Eventually, the Tel Aviv office accumulated significant debt, and creditors forced Tower Air’s Israeli operations into liquidation. Stanziale claims that when the airline needed cash in the late 1990s, Nachtomi cut ticket prices so low that the company would not profit on certain flights even if its planes were full. The company also lost more than $1 million in revenue by failing to ensure that tickets were processed for payment from credit card companies, the suit says. After Tower Air filed for bankruptcy, a large cache of unprocessed tickets were found in the company’s U.S. offices. In the meantime, the suit alleges, Tower Air’s jet engines were deteriorating. At first, the company cannibalized its own engines to generate spare parts. Instead of repairing the engines, the suit says, the directors followed Nachtomi’s advice to borrow $58 million to purchase new engines because doing so would be cheaper than repairing old engines. Stanziale claims in the suit that the board breached its fiduciary duty because it never discussed the need for new engines, the state of the old engines, or the financial ramifications of buying and leasing versus repairing. By 2000, the suit says, 11 of Tower Air’s 19 planes were out of service. By contrast, 17 out of 20 planes were in service in 1998, the suit says. Tower Air’s fiscal descent culminated in a voluntary petition for Chapter 11 relief in 2000. Stanziale was appointed trustee and remained trustee when the bankruptcy was converted from Chapter 11 to Chapter 7 in late-2000. In June 2001, Stanziale sued Nachtomi and six other officers and directors. Now the 3rd Circuit has revived four of the seven counts alleged in the suit. Smith found that under Delaware law, “overcoming the presumptions of the business judgment rule on the merits is a near-Herculean task.” Delaware courts, he said, have held that it may be accomplished “by showing either irrationality or inattention.” Under that test, Smith said, the first count in Stanziale’s complaint failed because it alleged only that Tower Air’s directors breached their duty to act in good faith by declining to repair Tower Air’s jet engines and instead replacing them with new engines. “We consider that an allegation of a classic exercise of business judgment because a reasonable business person could have reached that decision in good faith,” Smith wrote. “It seems to us that a complaint is self-defeating when it states an ostensibly legitimate business purpose for an allegedly egregious decision.” But Smith found that the suit’s second count stated a valid claim by alleging that Tower Air’s officers did nothing when they were told by the corporate director of safety about quality assurance problems with aircraft maintenance and of failures to record maintenance and repair work. “Whether the officers’ behavior is construed as an egregious decision or as unconsidered inaction, that allegation is troubling,” Smith wrote. “Under no circumstances should aircraft maintenance problems be ignored. Lives are on the line.” Jordan had dismissed the claim after finding that Stanziale alleged “no facts that would characterize [the officers'] actions as egregious.” Smith disagreed, saying, “We can imagine few things more egregious. The officers’ alleged passivity in the face of negative maintenance reports seems so far beyond the bounds of reasonable business judgment that its only explanation is bad faith.” In the third count, Stanziale alleged two forms of inattention — first, that the directors employed an irrational decisionmaking process in approving multimillion-dollar leases of jet engines; and, second, that the board failed in good faith to install a legal compliance and business performance monitoring system. Smith found the claim was a valid one because “the directors’ alleged rubber-stamping of major capital expenditures is consistent with bad faith.” The fourth count was also valid, Smith found, because it alleged that the officers failed to process used airline tickets worth $1 million. “If proved, that might constitute gross negligence,” Smith wrote. Smith also found that the allegation that Tower Air’s Santo Domingo Route was established and maintained “purely to please” Nachtomi’s family appears to be “explicable only by bad faith. In the appeal, the directors and officers were represented by attorneys from four firms — Bruce E. Jameson of Prickett Jones & Elliot in Wilmington (who argued the case for all of the defendants); Robert M. Kaplan of Robson Ferber Frost Chan & Essner in New York; Rodney M. Zerbe of Dechert’s New York office; and P. Gregory Schwed of Loeb & Loeb in New York.

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