lender liability and equitable subordination

8/3/2019 Lender Liability and Equitable Subordination

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American Bankruptcy Institute

18TH

ANNUAL SOUTHWEST BANKRUPTCY CONFERENCE

SEPTEMBER 23, 2010

BREAKING THE BANK:

LENDER LIABILITY AND

EQUITABLE SUBORDINATION

A PANEL PRESENTATION BY:

Martin R. Barash

Klee, Tuchin, Bogdanoff & Stern LLP

Scott F. Gautier

Peitzman, Weg & Kempinsky LLP

Stephen J. King

Bank of America Business Capital

Geoffrey A. Richards

William Blair & Company

*Attached written materials provided by Klee, Tuchin, Bogdanoff & Stern LLP


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18th AnnuAlSouthweSt BAnkruptcyconference

A Review Of Lender Liability Principles Prior To TOUSA and Yellowstone

Developments in Lender Liability:

Four Causes of Action, a Theory of Damages, and a Defense

Materials Prepared By:

Prof. Kenneth N. Klee

And

Matthew C. Heyn1

1 2007, All Rights Reserved. Prof. Klee is a partner with Klee, Tuchin, Bogdanoff & Stern LL P and aProfessor at the UCLA School of Law. Mr. Heyn is an attorney with Klee, Tuchin, Bogdanoff & SternLLP. Laine Z. Mervis and Brent C. Butler contributed to previous versions of these materials. The viewsexperessed herein reflect solely those of the essay authors and do not represent the views of the UCLASchool of Law or Klee, Tuchin, Bogdanoff & Stern LLP, or any of their respective clients or members.


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TABLE OF CONTENTS

I. OVERVIEW. ................................................................................................1

II. EQUITABLE SUBORDINATION .................................................................1

A. Basics ................................................................................................1

B. Supreme Court Requires Specific Findings for Subordination ..........4

C. Transferee Liability for Bad Acts of Transferor ..................................9

III. RECHARACTERIZATION. ........................................................................10

A. Recharacterization of a Loan as an Equity Contribution .................11

B. Recharacterization of a Sales Transaction as Secured Loan .........161. Intent of the Parties................................................................19

2. Language of Agreement. .......................................................20

3. Allocation of Risk and Benefits. .............................................20

IV. AIDING AND ABETTING BREACH OF FIDUCIARY DUTY. .................... 23

A. The Existence of a Fiduciary Duty and Breach of the Duty ............. 25

B. Knowing Participation in the Breach of the Fiduciary Duty.............. 26

C. Causation and Damages .................................................................29

V. DEEPENING INSOLVENCY. ....................................................................30

A. The Development of an Independent Cause of Action.................... 32

B. Deepening Insolvency as a Theory of Damages.............................36

VI. IN PARI DELICTODEFENSE. .................................................................37

A. The Adverese Interest Exception ....................................................39

B. The Innocent Decision Maker Exception....................................... 40

C. The Successor in Interest Exception ...............................................42


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TABLE OF AUTHORITIES

FEDERAL CASES

In re 80 Nassau Assocs.,

169 B.R. 834 (Bankr. S.D.N.Y. 1994)........................................................... 2, 5

Aaron Ferer & Sons Ltd. v. Chase Manhattan Bank,731 F.2d 112 (2d Cir. 1984) ........................................................................... 23

Abbott v. Equity Group, Inc.,2 F.3d 613 (5th Cir. 1993)............................................................................... 29

Adena, Inc. v. Cohn,162 F. Supp. 2d 351 (E.D. Pa. 2001) ............................................................. 25

Aetna Casualty & Surety Co. v. Leahey Construction Co.,219 F.3d 519 (6th Cir. 2000) .......................................................................... 28

Akro Investicni Spolecnost v. A.B. Watley,No. 01 Civ. 7693 (LAP), 2003 U.S. Dist. LEXIS 3478 (S.D.N.Y. Mar. 12,2003)............................................................................................................... 42

Allard v. Arthur Andersen & Co.,924 F. Supp. 488 (S.D.N.Y. 1996)............................................................ 31, 37

In re Aluminum Mills Corp.,132 B.R. 869 (N.D. Ill. 1991) ............................................................................ 5

Am. United Mut. Life Ins. Co. v. City of Avon Park,311 U.S. 138, 61 S. Ct. 157, 85 L. Ed. 91 (1940)............................................. 2

Anchor Resolution Corp. v. State Street Bank & Trust Co. (In re AnchorResolution Corp.),221 B.R. 330 (Bankr. D. Del. 1998).................................................................. 6

Aquino v. Black (In re Atlantic Rancher, Inc.),279 B.R. 411 (Bankr. D. Mass. 2002)....................................................... 12, 14

Bala v. Kaler (In re Racing Servs.),340 B.R. 73 (8th Cir. B.A.P. 2006) ................................................................... 3


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Bankruptcy Servs. v. Ernst & Young, Ernst & Young, LLP (In re CBIHolding Co.),247 B.R. 341 (Bankr. S.D.N.Y. 2000)............................................................. 42

Bateman Eichler, Hill Richards, Inc. v. Berner,

472 U.S. 299, 105 S. Ct. 2622, 86 L. Ed. 2d 215 (1985)................................ 38

Bayer Corp. v. Mascotech, Inc. (In re Autostyle Plastics, Inc.),269 F.3d 726 (6th Cir. 2001) ................................................................. 7, 8, 12,

14, 15

Bear v. Coben (In re Golden Plan of California, Inc.),829 F.2d 705 (9th Cir. 1986) .......................................................................... 20

In re Beverages Int'l Ltd.,

50 B.R. 273 (Bankr. D. Mass. 1988)................................................................. 3

Bondi v. Bank of America Corp. (In re Parmalat Securities Litigation),383 F. Supp. 2d 587 (S.D.N.Y. 2005)............................................................. 25

Bookland v. Baker, Newman & Noyes, LLC,271 F. Supp. 2d 324 (D. Me. 2003) .......................................................... 35, 37

Branch Banking & Trust Co. v. Lighthouse Fin.,No. 04 CVS 1523, 2005 WL 1995410 (N.C. Super. Ct. July 13, 2005).......... 24

Breeden v. Kirkpatrick & Lockhart,268 B.R. 704 (S.D.N.Y. 2001) .................................................................. 41, 42

Burden v. United States,917 F.2d 115 (3d Cir. 1990) ............................................................................. 5

In re CBI Holding Co.,311 B.R. 350 (S.D.N.Y. 2004) ........................................................................ 43

Cohen v. Adventist Health Sys./West (In re Diamond Benefits Life Ins.Co.),No. MDL 93-0972-PHX-RGS, 2006 U.S. Dist. LEXIS 10074 (D. Ariz.March 10, 2006).............................................................................................. 29

CSC Holdings, Inc. v. Redisi,309 F.3d 988 (7th Cir. 2002) .......................................................................... 14


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Capitol Bank. & Trust Co. v. 604 Columbus Avenue Realty Trust (In re 604Columbus Avenue Realty Trust),968 F.2d 1332 (1st Cir. 1992)........................................................................... 3

Carter-Waters Okla., Inc. v. Bank One Trust Co., N.A. (In re Eufala Indus.

Auth.),266 B.R. 483 (10th Cir. B.A.P. 2001) ............................................................... 4

Cenco Inc. v. Seidman & Seidman,686 F.2d 449 (7th Cir. 1982) .......................................................................... 42

Chance World Trading v. Heritage Bank of Commerce,438 F. Supp. 2d 1081 (N.D. Cal. 2005) .......................................................... 27

Citicorp Venture Capital, Ltd. v. Comm. of Creditors Holding Unsecured

Claims (In re Papercraft Corp.),324 F.3d 197 (3d Cir. 2003) ............................................................................. 4

Citicorp Venture Capital v. Comm. of Creditors Holding Unsecured Claims,160 F.3d 982 (3d Cir. 1998) ............................................................................. 3

In re Citigroup, Inc. Sec. Litig.,330 F. Supp. 2d 367 (S.D.N.Y. 2004)............................................................. 28

In re Clamp-All Corp.,

223 B.R. 198 (Bankr. D. Mass. 1999)............................................................... 2

Cohen v. KB Mezzanine Fund II, LP (In re SubMicron Sys. Corp.),432 F.3d 448 (3d Cir. 2006) ............................................................................. 8

In re Cold Harbor Assocs.,204 B.R. 904 (Bankr. E.D. Va. 1997) ................................................. 11, 14, 16

Collins v. Kohlberg & Co. (In re Southwest Supermarkets, L.L.C.),315 B.R. 565 (Bankr. D. Ariz. 2004) ............................................................... 32

Official Comm. of the Unsecured Creditors of Color Tile, Inc. v. BlackstoneFamily Inv. Pshp. (In re Color Tile),

2000 U.S. Dist. LEXIS 1303 (D. Del. Feb. 9, 2000)........................................ 16

In re Commercial Loan Corp.,316 B.R. 690 (Bankr. N.D. Ill. 2004) ............................................................... 19


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Commodity Futures Trading Corp. v. Sidoti,178 F.3d 1132 (11th Cir. 1999) ...................................................................... 29

Conte v. US Alliance Fed. Credit Union,303 F. Supp. 2d 220 (D. Conn. 2004) ............................................................ 23

In re County of Orange,203 B.R. 983 (Bankr. C.D. Cal. 1996), affd sub nom.,County of Orange v. McGraw-Hill Co. (In re County of Orange),245 B.R. 138 (C.D. Cal. 1997)........................................................................ 25

Daniel Boone Area School Dist. v. Lehman Bros., Inc.,187 F. Supp. 2d 400 (W.D. Pa. 2002) ............................................................ 25

Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.),

333 B.R. 205 (Bankr. S.D.N.Y. 2005)..................................................... 4, 9, 10

Enron Corp. v. New Power Co. (In re New Power Co.),438 F.3d 1113 (11th Cir. 2006) ........................................................................ 7

In re Envid, Inc.,345 B.R. 426 (Bankr. D. Mass. 2006)............................................................. 35

In re Exide Techs., Inc.,299 B.R. 732 (Bankr. D. Del. 2003).......................................................... 15, 32

FDIC v. First Interstate Bank of Des Moines, N.A.,885 F.2d 423 (8th Cir. 1989) .......................................................................... 28

FDIC v. Nathan,804 F. Supp. 888 (S.D. Tex. 1992)................................................................. 39

FDIC v. O'Melveny & Myers,61 F.3d 17 (9th Cir. 1995)............................................................................... 43

In re Fabricators, Inc.,926 F.2d 1458 (5th Cir. 1991) .......................................................................... 4

Fairchild Dornier GmbH v. Official Comm. of Unsecured Creditors (In reDornier Aviation (N. Am.), Inc.),453 F.3d 225 (4th Cir. 2006) ........................................................................ 7, 8


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Fassett v. Delta Kappa Epsilon,807 F.2d 1150 (3d Cir. 1986) ......................................................................... 27

Feltman v. Prudential Bache Sec.,122 B.R. 466 (S.D. Fla. 1990) ........................................................................ 31

Filler v. Hanvit Bank,No. 01 Civ. 9510 (MGC), 2003 U.S. Dist. LEXIS 15950 (S.D.N.Y. Sept.12, 2003)......................................................................................................... 29

Filler v. Hanvit Bank,339 F. Supp. 2d 553 (S.D.N.Y. 2004)....................................................... 26, 28

Fireman's Fund Insurance Co. v. Grover (In re Woodson Co.),813 F.2d 266 (9th Cir. 1987) .......................................................................... 20

In re First Truck Lines, Inc.,190 B.R. 827 (S.D. Ohio 1993)......................................................................... 5

Fla. Dep't of Ins. v. Chase Bank of Tex. Nat'l Ass'n,274 F.3d 924 (5th Cir. 2001) .......................................................................... 36

In re Flagship Healthcare,(Bankr. S.D. Fla. 2001) ................................................................................... 37

Flood v. Makowski,2004 U.S. Dist. LEXIS 16957, 2004 WL 1908221 (M.D. Pa. 2004) ............... 25

Ford v. Feldman (In re Florida Bay Trading Co.),177 B.R. 374 (Bankr. D. Fla. 1994) .................................................................. 2

Glinka v. Dartmouth Banking Co. (In re Kelton Motors, Inc.),121 B.R. 166 (Bankr. D. Vt. 1990).................................................................... 5

In re Gouiran Holdings, Inc.,

165 B.R. 104 (E.D.N.Y. 1994) ........................................................................ 31

Gouveia v. Tazbir,37 F.3d 295 (7th Cir. 1994) ............................................................................ 13

Granite Partners, L.P. v. Bear, Stearns & Co.,17 F. Supp. 2d 275 (S.D.N.Y. 1998)............................................................... 38


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Grupo Mexicano De Desarrollo v. Alliance Bond Fund,527 U.S. 308 (1999) ................................................................................. 13, 14

HBE Leasing Corp. v. Frank,48 F.3d 623 (2d Cir. 1995) ............................................................................... 2

Hannover Corp. of Am. v. Beckner,211 B.R. 849 (M.D. La. 1997)................................................................... 31, 37

Hashimoto v. Clark,264 B.R. 585 (D. Ariz. 2001)........................................................................... 28

In re Hedged Investments Assocs., Inc.,380 F.3d 1292 (10th Cir. 2004) ............................................................ 8, 12, 16

In re Herby's Foods, Inc.,2 F.3d 128 (5th Cir. 1993)....................................................................... 3, 8, 12

Higgins v. McCrea,116 U.S. 671, 6 S. Ct. 557, 29 L. Ed. 764 (1886)........................................... 38

Holman v. Johnson,1 Cowp. 341, 343, 98 Eng. Rep. 1120, 1121 (K.B. 1775) .............................. 38

In re Hyperion Enters.,

158 B.R. 555, 561 (D.R.I. 1993) ....................................................................... 8

In re IKON Office Solutions, Inc.,277 F.3d 658 (3d Cir. 2002) ........................................................................... 29

Internal Rev. Serv. v. Noland,48 F.3d 210 (6th Cir. 1995) .............................................................................. 6

In re Investors Funding Corp. of N.Y. Sec. Litig.,523 F. Supp. 533 (S.D.N.Y. 1980)............................................................ 31, 39

Jaguar Cars, Inc. v. Royal Oaks Motor Car Co.,46 F.3d 258 (3d Cir. 1995) ............................................................................. 28

Javitch v. First Montauk Fin. Corp.,279 F. Supp. 2d 931 (N.D. Ohio 2003)........................................................... 28


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K & S Partnership v. Continental Bank, N.A.,952 F.2d 971 (8th Cir. 1991) .......................................................................... 25

Kaye v. Dupree (In re Avado Brands, Inc.),No. 05-3823, 2006 Bankr. LEXIS (Bankr. N.D. Tex. Dec. 28, 2006).............. 35

Kittay v. Atlantic Bank (In re Global Service Group LLC),316 B.R. 451 (Bankr. S.D.N.Y. 2004)....................................................... 33, 34

Kolbeck v. Lit America, Inc.,939 F. Supp. 240 (S.D.N.Y. 1996), aff'd, 152 F.3d 918 (2d Cir. 1998)..... 27, 29

In re LTV Steel Co.,274 B.R. 278 (Bankr. N.D. Ohio 2001) ......................................................21-23

In re LTV Steel Co.,333 B.R. 397 (Bankr. D. Ohio 2005)............................................................... 32

In re Lane,742 F.2d 1311 (11th Cir. 1984) ...................................................................... 16

Lehman Bros. Commer. Corp. v. Minmetals Int'l Non-Ferrous MetalsTrading Co.,179 F. Supp. 2d 118 (S.D.N.Y. 2000)............................................................. 29

Levine v. Diamanthusel, Inc.,950 F.2d 1478 (9th Cir. 1991) ........................................................................ 28

Lichtenstein v. Stockton Bates, LLP (In re Computer Personalities Sys.,Inc.),No. 01-14231, 2003 Bankr. LEXIS 1572 (Bankr. E.D. Pa. Nov. 18,2003)............................................................................................................... 32

In re Lifschultz Fast Freight,132 F.3d 339 (7th Cir. 1997) ........................................................................ 3, 7

Limor v. Buerger (In re Del-Met Corp.),322 B.R. 781 (Bankr. M.D. Tenn. 2005) ................................................... 32, 37

Lippe v. Bairnco Corp.,218 B.R. 294 (Bankr. S.D.N.Y. 1998)............................................................. 41


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Logan v. JKV Real Estate (In re Bogdan),414 F.3d 507 (4th Cir. 2005) .......................................................................... 45

Machinery Rental Inc. v. Herpel (In re Multiponics, Inc.),622 F.2d 709 (5th Cir. 1980) ............................................................................ 4

In re Major Funding Corp.,82 B.R. 443 (Bankr. S.D. Tex. 1987).............................................................. 21

Majors Furniture Mart, Inc. v. Castle Credit Corp.,602 F.2d 538 (3d Cir. 1979) ........................................................................... 20

Manufacturers Hanover Trust Co. v. Yanakas,7 F.3d 310 (2d Cir. 1993) ............................................................................... 23

Marrama v. Citizens Bank,___U.S. ___, 127 S. Ct. 1105, __ L. Ed. 2d __ (2007).................................. 10

McNamara v. PFS (In re Personal & Bus. Ins. Agency),334 F.3d 239 (3d Cir. 2003) ........................................................................... 44

Mediators, Inc. v. Manney (In re Mediators Inc.),105 F.3d 822 (2d Cir. 1997) ........................................................................... 40

Merrimac Paper Co. v. Harrison (In re Merrimac Paper Co.),

420 F.3d 53 (1st Cir. 2005)............................................................................... 6

Meyers v. Moody,475 F. Supp. 232 (N.D. Tex. 1979), affd, 693 F.2d 1196, 1214 (5th Cir.1982)............................................................................................................... 30

In re Micro-Precision Techs., Inc.,303 B.R. 238 (Bankr. D. N.H. 2003) ............................................................... 15

In re Missionary Baptist Church Foundation of America, Inc.,

818 F.2d 1135 (5th Cir. 1987) .......................................................................... 4

Estate of Mixon v. United States,464 F.2d 394 (5th Cir. 1972) .......................................................................... 16

In re Mobile Steel Co.,563 F.2d 692 (5th Cir. 1977) .........................................................................2-5


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In re Monahan Ford Corp.,340 B.R. 1 (Bankr. E.D.N.Y. 2006)................................................................. 36

Munroe v. Harriman,85 F.2d 493 (2d Cir. 1936) ............................................................................. 40

In re N & D Properties, Inc.,799 F.2d 726 (11th Cir. 1986) .......................................................................... 4

Neilson v. Union Bank of Cal., N.A.,290 F. Supp. 2d 1101 (C.D. Cal. 2003) .............................................. 25, 27, 29

In re New Era Packaging, Inc.,186 B.R. 329 (Bankr. D. Mass. 1995)............................................................... 5

Norwest Bank Worthington v. Ahlers,485 U.S. 197 (1988) ....................................................................................... 13

OMelveny & Myers v. FDIC,512 U.S. 79, 114 S. Ct. 2048, 129 L. Ed. 2d 67 (1994).................................. 38

OSRecovery, Inc. v. One Groupe Intl, Inc.,354 F. Supp. 2d 357 (S.D.N.Y. 2005)............................................................. 26

In re Oakwook Homes Corp.,

340 B.R. 510 (Bankr. D. Del. 2006)................................................................ 36

In re Octagon Roofing,157 B.R. 852 (N.D. Ill. 1993) ............................................................................ 8

Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co.,267 F.3d 340 (3d Cir. 2001) ......................................................... 31, 32, 38, 44

Official Comm. of Unsecured Creditors VarTec Telecom, Inc. v. Rural Tel.Fin. Coop. (In re VarTec Telecom, Inc.),

335 B.R. 631 (Bankr. N.D. Tex. 2005)............................................................ 35

Ortho-Med, Inc. v. Micro-Aire Surgical Instruments, Inc.,No. CV 93-7621(JGD),1995 U.S. Dist. LEXIS 22217 (C.D. Cal. April

10, 1995)................................................................................................... 29, 30

PM Denver, Inc. v. Porter (In re Porter McLeod, Inc.),231 B.R. 786 (D. Colo. 1999) ......................................................................... 45


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S & K Sales Co. v. Nike, Inc.,816 F.2d 843 (2d Cir. 1987) ........................................................................... 23

SPC Plastics Corp. v. Griffith (In re Structurlite Plastics Corp.),224 B.R. 27 (6th Cir. B.A.P. 1998) ................................................................... 6

In re SW Fla. Heart Group,346 B.R. 897 (Bankr. M.D. Fla. 2006) ............................................................ 35

Sampsell v. Imperial Paper & Color Corp.,313 U.S. 215, 61 S. Ct. 904, 85 L. Ed. 1293 (1941)......................................... 2

Schact v. Brown,711 F.2d 1343 (7th Cir. 1983) .................................................................. 31, 32

Schnelling v. Thomas (In re AgriBiotech, Inc.),319 B.R. 216 (D. Nev. 2004) .......................................................................... 32

Scholes v. Lehmann,56 F.3d 750 (7th Cir. 1995) ............................................................................ 43

Scognamillo v. Credit Suisse First Boston LLC,No. C03-2061 (TEH), 2005 U.S. Dist. LEXIS 20221 (N.D. Cal. Aug. 25,2005)............................................................................................................... 26

Scott v. Dime Sav. Bank of New York, FSB,886 F. Supp. 1073 (S.D.N.Y. 1995), affd, 101 F.3d 107 (2d Cir. 1996) ........ 23

Secs. Investor Prot. Corp. v. BDO Seidman, LLP,49 F. Supp. 2d 644 (S.D.N.Y. 1999)..........................................................40-42

Seitz v. Detweiler, Hershey & Assocs. P.C. (In re CitX Corp.),448 F.3d 672 (3d Cir. 2006) ..................................................................... 36, 37

In re Sharp Intl. Corp.,

302 B.R. 760 (E.D.N.Y. 2003) ........................................................................ 24

Shearson, Lehman, Hutton, Inc. v. Wagoner,944 F.2d 114 (2d Cir. 1991) ..................................................................... 37, 38

Simione v. Nationsbank of Del., N.A. (In re Simione),229 B.R. 329 (Bankr. W.D. Pa. 1999) .............................................................. 7


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Smith v. Andersen L.L.P.,175 F. Supp. 2d 1180 (D. Ariz. 2001)....................................................... 39, 41

Smith v. Arthur Anderson LLP (In re Boston Chicken),421 F.3d 995 (9th Cir. 2005) .......................................................................... 36

State St. Bank & Trust Co. v. Inversiones Errazuriz Limitada,246 F. Supp. 2d 231 (S.D.N.Y. 2002)............................................................. 23

Stone St. Servs. v. Daniels,Civ. A. No. 00-1904, 2000 U.S. Dist. LEXIS 18904, 2000 WL 1909373(E.D. Pa. Dec. 29, 2000)................................................................................. 25

Strong v. France,474 F.2d 747 (9th Cir. 1973) .......................................................................... 27

In re Student Fin. Corp.,335 B.R. 539 (D. Del. 2005) ........................................................................... 37

In re SubMicron Sys. Corp.,291 B.R. 314 (Bankr. D. Del. 2003)..................................................... 8, 12, 14,

16In re U.S. Abatement Corp.,

39 F.3d 556 (5th Cir. 1994) .............................................................................. 4

U.S. Bank, N.A. v. Stalnaker (In re Rosen Auto Leasing, Inc.),No. BK02-81781, 2004 Bankr. LEXIS 1399 (Bankr. D. Neb. Sept. 17,2004)............................................................................................................... 15

In re UVAS Farming Corp.,91 B.R. 575 (Bankr. D.N.M. 1988).................................................................... 4

United States ex rel. Rahman v. Oncology Assocs., P.C.,198 F.3d 489 (4th Cir. 1999) .......................................................................... 14

United States v. Noland,517 U.S. 535, 116 S. Ct. 1524, 134 L. Ed. 2d 748 (1996)....................... 3, 5, 6,

7United States v. Pepperman,

976 F.2d 123 (3d Cir. 1992) ........................................................................... 13

United States v. Reorganized CF&I Fabricators of Utah, Inc.,518 U.S. 213, 116 S. Ct. 2106, 135 L. Ed. 2d 506 (1996)................................ 6


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In re Vanguard Airlines, Inc.,302 B.R. 292 (Bankr. W.D. Mo. 2003)............................................................ 15

In re Verestar, Inc.,343 B.R. 444 (Bankr. S.D.N.Y. 2006)............................................................. 35

In re Virtual Network Servs. Corp.,902 F.2d 1246 (7th Cir. 1990) .......................................................................... 5

In re Vitreous Steel Prods. Co.,911 F.2d 1223 (7th Cir. 1990) .......................................................................... 5

In re WCI Cable, Inc.,282 B.R. 457 (Bankr. D. Or. 2002) ................................................................. 13

In re W.T. Grant Co.,4 B.R. 53, 74 (Bankr. S.D.N.Y. 1980)............................................................... 7

Wechsler v. Squadron, Ellenoff, Plesent & Sheinfeld, L.L.P.,212 B.R. 34 (S.D.N.Y. 1997) .......................................................................... 41

In re Werth,37 B.R. 979 (Bankr. D. Colo. 1984).................................................................. 2

Whitney v. Citibank, N.A.,

782 F.2d 1106 (2d Cir. 1986) ................................................................... 25, 29

Wight v. Bankamerica Corp.,219 F.3d 79 (2d Cir. 2000) ....................................................................... 39, 42

Williams v. Bank Leumi Trust Co.,No. 96 Civ. 6695 (LMM), 1997 U.S. Dist. LEXIS 7538 (S.D.N.Y. May30, 1997)......................................................................................................... 28

Woodward v. Metro Bank,

522 F.2d 84 (5th Cir. 1975) ............................................................................ 28

In re Zenith Electronics Corp.,241 B.R. 92 (Bankr. Del. 1999) ........................................................................ 8


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STATE CASES

A.W. Crisp, Jr. v. Southwest Bancshares Leasing Company,586 S.W.2d 610 (1979) .................................................................................. 39

Anstine v. Alexander,128 P.3d 249 (Colo. Ct. App. 2005) ............................................................... 26

Austins Admx v. Winstons Exx,11 Va. 33 (1806) ............................................................................................. 38

Bondi v. Citigroup, Inc.,No. BER-L-10902-04, 2005 WL 975856 (N.J. Super. Ct. Law Div. Feb.28, 2005)......................................................................................................... 24

Cacciola v. Nellhaus,733 N.E.2d 133 (Mass. Ct. App. 2000)........................................................... 24

Camerer v. California Sav. & Comml Bank,4 Cal. 2d 159, 170-71, 48 P.2d 39 (1935) ...................................................... 43

Carson Fischer, PLC v. Standard Fed. Bank.,No. 248125, 2005 WL. 292343 (Mich. Ct. App. Feb. 8, 2005), revd inpart, 2006 WL 1303137 (Mich. May 12, 2006) ............................................... 24

Casey v. U.S. Bank Assoc.,26 Cal. Rptr. 3d 401. 405-06 (Cal. Ct. App. 2005) ......................................... 24

Casey v. U.S. Bank Nat. Assn.,127 Cal. App. 4th 1138 (2005) ................................................................. 25, 26

Center v. Hampton Affiliates, Inc.,66 N.Y.2d 782 (N.Y. 1985) ............................................................................. 39

Chem-Age Indus., Inc. v. Glover,

652 N.W.2d 756 (S.D. 2002) .......................................................................... 24

Corcoran v. Frank B. Hall & Co.,149 A.D.2d 165, 545 N.Y.S.2d 278 (N.Y. App. Div. 1st Dept 1989).............. 32

Coroles v. Sabey,79 P.3d 974 (Utah Ct. App. 2003) .................................................................. 37


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DePinto v. Ashley Scott, Inc.,222 A.D.2d 288, 635 N.Y.S.2d 215 (1st Dept 1995)...................................... 29

Desert Palm Properties, N.V. v. McFarlane,No. 01-92-00967-CV, 1994 Tex. App. LEXIS 2951 (Tex. App. 1994)............ 40

Fate v. Owens,27 P.3d 990 (N.M. Ct. App. 2001), cert. denied, 27 P.3d 476 (N.M.2001)............................................................................................................... 24

Future Group II v. Nationsbank,478 S.E.2d 45 (S.C. 1996) ............................................................................. 24

Halifax Corp. v. Wachovia Bank,604 S.E.2d 403 (Va. 2004) ............................................................................. 24

Herbert H. Post & Co. v. Sidney Bitterman, Inc.,219 A.D.2d 214, 639 N.Y.S.2d 329 (N.Y. App. Div. 1st Dept 1996).............. 32

Holmes v. Young,885 P.2d 305 (Colo. Ct. App. 1994) ............................................................... 24

King v. George Schonberg & Company,233 A.D.2d 242, 650 N.Y.S.2d 107 (1st Dept 1996)...................................... 27

Kuhlman Elec Corp. v. Chappell,No. 2003-CA-001232-MR, 2005 WL 3243498 (Ky. Ct. App. Dec. 2,2005)............................................................................................................... 24

Lenticular Europe, LLC ex rel Van Leeuwen v. Cunnally,693 N.W.2d 302 (Wis. Ct. App. 2005) ............................................................ 24

Malpiede v. Townson,780 A.2d 1075 (Del. 2001) ............................................................................. 24

Monroe v. Board of Regents,602 S.E.2d 219 (Ga. Ct. App. 2004)............................................................... 24

Nerbonne, N.V v. Lake Bryant Intl Properties,689 So. 2d 322 (Fla. Dist. Ct. App. 1997)....................................................... 24

Putnam v. Chase,106 Ore. 440 (1923) ....................................................................................... 43


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Matthew Nozemack, Note, Making Sense Out of Bankruptcy CourtsRecharacterization of Claims: Why Not Use 510(c) EquitableSubordination?,56 Washington & Lee Law Review 689 (1999) ................................................ 7


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I. OVERVIEW.

There are myriad potential sources of lender liability when a debtor files forbankruptcy. In the past, creditors committees and trustees have sued banks for,among other things, breach of contract (both oral and written), breach of the

implied duty of good faith, fraud, misrepresentation, aiding and abetting fraud,and breach of fiduciary duty.2 To discuss any one of these sources of lenderliability fully would take more space than we have been allotted. Instead, thesematerials provide the basics and some cutting-edge issues for four lender liabilitycauses of action that have been developing recently: equitable subordination,recharacterization, aiding and abetting breach of fiduciary duty, and deepeninginsolvency. We also discuss deepening insolvency as a measure of damagesand one defense that has been rapidly developing: in pari delicto.

II. EQUITABLE SUBORDINATION.

A. Basics.

Bankruptcy Code 510(c) permits a bankruptcy court to subordinate all orpart of a lenders allowed claim or interest, or to transfer any lien securing asubordinated claim to the bankruptcy estate. It provides that a court, after noticeand hearing, may:

(1) under principles of equitable subordination, subordinate forpurposes of distribution all or part of an allowed claim to all or part of

another allowed claim or all or part of an allowed interest to all orpart of another allowed interest; or

(2) order that any lien securing such a subordinated claim betransferred to the estate.3

Unless a creditors claim is subordinated through a plan of reorganization, aclaim for equitable subordination must be brought by an adversary proceeding. 4

The authority of the bankruptcy courts to alter the payment priorities of the

Bankruptcy Code based on equitable grounds is well established.

5

The

2 See generally, Gerald L. Blanchard, Lender Liability: Law, Practice and Prevention (2003).3 11 U.S.C. 510(c).4 Fed R. Bankr. P. 7001(8).5 See, e.g., Pepper v. Litton, 308 U.S. 295, 305, 605 S. Ct. 238 (1939) (ruling that the

bankruptcy court has exclusive jurisdiction over subordination, allowance, and disallowanceFOOTNOTE CONTINUED ON NEXT PAGE


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Supreme Court has held that [t]he power of the bankruptcy court to subordinateclaims or to adjudicate equities arising out of the relationship between the severalcreditors is complete.6 The bankruptcy courts equitable authority is notdependent on express statutory provisions. It inheres in the jurisdiction of a courtin bankruptcy.7 In the exercise of its equitable jurisdiction the bankruptcy court

has the power to sift the circumstances surrounding any claim to see thatinjustice or unfairness is not done in administration of the bankrupt estate.8

In general, the equitable subordination doctrine is limited to reorderingdistribution priorities and does not permit total disallowance of a claim.9 Inaddition to altering the distribution priorities on account of a claim, where asubordinated claim is secured, Bankruptcy Code 510(c)(2) permits courts totransfer any lien securing a subordinated claim to the estate to effectuate theintended remedy.10

of claims, and that the court may reject a claim in whole or in part according to the equitiesof each case); HBE Leasing Corp. v. Frank, 48 F.3d 623, 633 (2d Cir. 1995) ([e]quitablesubordination is distinctly a power of federal bankruptcy courts, as courts of equity, tosubordinate the claims of one creditor to those of others); In re Clamp-All Corp., 223 B.R.198, 211 (Bankr. D. Mass. 1999) (holding that the court could, sua sponte, subordinate theclaims of creditors who had engaged in inequitable conduct to all other non-insider claimsunder section 510(c)); In re Poughkeepsie Hotel Assoc. Joint Venture, 132 B.R. 287, 292(Bankr. S.D.N.Y. 1991) (The notion of equitable subordination, as embodied in 510(c), ispeculiar to bankruptcy law and an issue which can only be decided in a bankruptcy setting).

6 Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215, 219, 61 S. Ct. 904, 85 L. Ed. 1293(1941) (recognizing equitable power of substantive consolidation).

7 Am. United Mut. Life Ins. Co. v. City of Avon Park, 311 U.S. 138, 146, 61 S. Ct. 157, 85 L.Ed. 91 (1940) (holding that equitable considerations must play a role in deciding whether toconfirm a plan).

8 Pepper, 308 U.S. at 308-09 (subjecting the allowance of an insiders claim to strict scrutiny).9 See In re Mobile Steel Co., 563 F.2d 692, 699 (5th Cir. 1977); In re 80 Nassau Assocs., 169

B.R. 834, 837 (Bankr. S.D.N.Y. 1994). However, if the conduct of the creditor is soegregious that it affects the validity of the claim under applicable principles of law, thebankruptcy court can disallow the claim as part of the claims allowance process, as wasdone in Pepper v. Litton. See 308 U.S. at 309. Section 502(j) preserves from Chandler actthe same language used in Pepper to disallow the claim of an insider under principles of

equitable subordination. Compare 11 U.S.C. 502(j) to 308 U.S. at 305, n.12; see also In reWerth, 37 B.R. 979, 991 (Bankr. D. Colo. 1984) (the claim will be disallowed to the extent[the debtor] establishes damages under Colorado law, resulting from the Banks breach [ofan oral contract to lend money]).

10 Ford v. Feldman (In re Florida Bay Trading Co.), 177 B.R. 374, 386 (Bankr. D. Fla. 1994).Note that instead of allowing the trustee to avoid the security interest, which is preserved forthe bankruptcy estate under Bankruptcy Code 551, only if the court so orders will thesecurity interest be transferred to the estate for the benefit of the creditors. Id.


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doctrine also has been utilized to address inequitable conduct by insiders tradingin a bankrupt debtors claims as well as inequitable pre-petition conduct.14

B. Supreme Court Requires Specific Findings forSubordination.

By the broad language of Bankruptcy Code 510(c), Congress left thedevelopment of the law of equitable subordination to the courts. Bankruptcycourts generally equitably subordinate a lender when the lender steps beyondthe traditional role of a lender and participates in the debtors business orengages in other egregious conduct that justifies the use of the courts equitablepowers.15

Because equitable subordination is remedial, not penal, the claim generallywill be subordinated only to the extent necessary to offset the specific harm that

the debtor and its creditors suffered on account of the alleged inequitableconduct.16 However, the misconduct need not be related to the creation of theclaim for the claim to be subordinated.17

Over the years, the courts developed various standards or tests todetermine whether the conduct (or misconduct) of a particular creditor shouldresult in equitable subordination of the creditors claim, some of which deviated

1360 (1st Cir. 1992) (Whether the creditor is an insider or fiduciary of the debtor isfundamentally important to the level of scrutiny that courts apply to allegations of misconductagainst a creditor); In re Fabricators, Inc., 926 F.2d 1458, 1465 (5th Cir. 1991) (ruling that ifthe claimant is not an insider, then evidence of more egregious misconduct . . . isnecessary); In re Missionary Baptist Church Foundation of America, Inc., 818 F.2d 1135,1144 n.8 (5th Cir. 1987); In re N & D Properties, Inc., 799 F.2d 726, 731 (11th Cir. 1986).

14 See Citicorp Venture Capital, Ltd. v. Comm. of Creditors Holding Unsecured Claims (In rePapercraft Corp.), 324 F.3d 197 (3d Cir. 2003) (holding that claimants covert purchase ofclaims at discounted amount while acting as fiduciary to debtor was sufficiently egregious towarrant subordination of amount paid for claims and damage inflicted on non-sellingcreditors -- including litigation expenses); In re UVAS Farming Corp., 91 B.R. 575 (Bankr.D.N.M. 1988).

15 In re U.S. Abatement Corp., 39 F.3d 556, 561 (5th Cir. 1994).16

Id.; Mobile Steel, 563 F.2d at 701; Carter-Waters Okla., Inc. v. Bank One Trust Co., N.A. (Inre Eufala Indus. Auth.), 266 B.R. 483 (10th Cir. B.A.P. 2001).

17 Machinery Rental Inc. v. Herpel (In re Multiponics, Inc.), 622 F.2d 709 (5th Cir. 1980);Benjamin v. Diamond (In re Mobile Steel Corp.), 563 F.2d 692 (5th Cir. 1977); Enron Corp.v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 333 B.R. 205 (Bankr. S.D.N.Y.2005) (Fundamentally, the analysis focuses on the alleged inequitable conduct, and anyassociated harm therefrom, not on any particular claim or group of claims.); In re Reed, 11B.R. 258 (Bankr. D. Utah 1981).


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from the Mobile Steel standard.18 In the 1990s, for example, some courtspermitted equitable subordination without any proof of inequitable conduct.19

In United States v. Noland,20 however, the Supreme Court announcedsignificant limits on the judicial power to subordinate claims. In that case, the

debtor filed for relief under chapter 11 and, in attempting to operate its business,incurred certain federal tax liabilities. After the case was converted to chapter 7,the IRS filed claims for taxes, interest and penalties, and administrative expensesentitled to priority under Bankruptcy Code 503(b), 507(a), and 726(a)(1). Thebankruptcy court allowed the tax claims as administrative expenses, butsubordinated the portions of the tax claims that were penalties pursuant to 510(c). The bankruptcy court weighed the equities and found that theBankruptcy Codes preference for repaying actual losses trumped the statutorypriority granted to the governments tax penalties.21 The decision was affirmedby the Sixth Circuit Court of Appeals, which held:

Because of the nature of the postpetition, nonpecuniary loss taxpenalty claims in a chapter 7 case, we believe such claims are

18 Rodolakis v. Chertoff (In re 1236 Dev. Corp.), 188 B.R. 75, 82 (Bankr. D. Mass. 1995)(holding that the trustee has the burden of producing sufficient evidence of a prima faciecase of equitable subordination of a creditors claim, after which the burden shifts to theclaimant to prove the fairness and good faith of the challenged transaction); In re 80 NassauAssocs., 169 B.R. at 840 (holding that the claim of a non-insider fiduciary in a commercialcase can only be subordinated based on inequitable conduct if the claimant has

substantially breached a duty arising under contract, tort or other area of law); In reAluminum Mills Corp., 132 B.R. 869, 894 (N.D. Ill. 1991) (The quality of conduct consideredto be inequitable under 510(c) depends on the nature of the legal relationship betweenthe creditor and the debtor).

19 See, e.g., Burden v. United States, 917 F.2d 115, 120 (3d Cir. 1990) (holding that proof ofinequitable conduct need not be found for the general creditors to be entitled to equitablesubordination); In re Virtual Network Servs. Corp., 902 F.2d 1246 (7th Cir. 1990) (holdingthat the subordination of nonpecuniary tax law claims of the IRS was warranted even thoughIRSs actions were within the law); In re Vitreous Steel Prods. Co., 911 F.2d 1223 (7th Cir.1990) (holding that bankruptcy court need not find that mortgagee engaged in misconduct,and that inquiry should focus on fairness to the other creditors); In re New Era Packaging,Inc., 186 B.R. 329, 335 (Bankr. D. Mass. 1995) (no fault equitable subordination looks tothe nature or origin of the claim . . . While the legislative history states that a bankruptcycourt is authorized to subordinate a claim by reason of the claimants misconduct . . . it alsosuggests that a bankruptcy courts power to subordinate a claim on equitable grounds ismore extensive); Glinka v. Dartmouth Banking Co. (In re Kelton Motors, Inc.), 121 B.R. 166,190 (Bankr. D. Vt. 1990).

20 517 U.S. 535, 116 S. Ct. 1524, 134 L. Ed. 2d 748 (1996).21 In re First Truck Lines, Inc., 190 B.R. 827 (S.D. Ohio 1993).


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In response to this Supreme Court authority, bankruptcy practitionerssometimes have recast their equitable subordination arguments as arguments forthe recharacterization of debt into equity, which is discussed below. Thepropriety of recharacterization largely depends on whether recharacterization is

distinct from Bankruptcy Code 510(c)s power to equitably subordinate claims.Certainly, the effect of both recharacterization and equitable subordination issimilar in that in both cases, the claim is subordinated below that of othercreditors.28 However, there are important differences.29 In an equitablesubordination analysis, the court is reviewing whether a legitimate creditorengaged in inequitable conduct, in which case the remedy is subordination of thecreditors claim to that of another creditor only to the extent necessary to offsetinjury or damage suffered by the creditor in whose favor the equitable doctrinemay be effective.30 On the other hand, where a claim is recharacterized, theadvance is not a claim to begin with, and the creditor is not a legitimate one [and

therefore] equitable subordination never comes into play.31 Accordingly, a court

approach, the court in Virtual Network determined proof of inequitable conduct was notnecessary for subordination of nonpecuniary loss tax penalty claims. In my view...TenthCircuit jurisprudence...[does not] preclude[] application of the flexible test under appropriatecircumstances....); cf. Simione v. Nationsbank of Del., N.A. (In re Simione), 229 B.R. 329,336 (Bankr. W.D. Pa. 1999) (noting that since Noland, the Court of Appeals for the ThirdCircuit has not decided whether misconduct is always a prerequisite to equitablesubordination).

28 Bayer Corp. v. Mascotech, Inc. (In re Autostyle Plastics, Inc.), 269 F.3d 726, 748 (6th Cir.2001).

29 Some of the confusion between the doctrines [of equitable subordination andrecharacterization] is caused by the fact that undercapitalization is a factor in the equitablesubordination analysis and often is a factor in a recharacterization analysis, leading somecourts to equitably subordinate claims that other courts would recharacterize as equitycontributions. Id. at 749 (quoting Matthew Nozemack, Note, Making Sense Out ofBankruptcy Courts Recharacterization of Claims: Why Not Use 510(c) EquitableSubordination?, 56 Wash. & Lee L. Rev. 689, 717 (1999)).

30

Id. (quoting In re W.T. Grant Co., 4 B.R. 53, 74 (Bankr. S.D.N.Y. 1980)); Fairchild DornierGmbH v. Official Comm. of Unsecured Creditors (In re Dornier Aviation (N. Am.), Inc.), 453F.3d 225 (4th Cir. 2006)(holding that recharacterization is separate from the claim allowanceprocess); Enron Corp. v. New Power Co. (In re New Power Co.), 438 F.3d 1113, (11th Cir.2006) (recharacterization inquiry by a court-appointed Examiner was allowed to proceedbeyond both the claim allowance proceedings and Plan Confirmation itself).

31 In re Autostyle Plastics, Inc., 269 F.3d at 749 (internal citations and quotation marksomitted).


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may recharacterize debt as equity regardless of satisfaction of the otherrequirements of equitable subordination.32

Notwithstanding the arguments above, courts adhering to the minority viewhave held that recharacterization requires, as one element, some manner of

inequitable conduct.33 Under this minority view, if the bankruptcy court decidesthat the lenders claim should not be subordinated or disallowed because it doesnot meet the criteria set forth in 510(c) or as determined by applicable caselaw, the debtor/mortgagor generally will not be permitted to seek to have thelenders claim recharacterized under other sections of the Bankruptcy Code.Section 502 of the Bankruptcy Code, which sets forth various claim objections,does not include an objection based on recharacterization.34 For example, thebankruptcy court in In re SubMicron Sys. Corp. held that in order torecharacterize a loan as an equity contribution there must be evidence of . . .inequitable conduct. This is because any other analysis would discourage loans

from insiders to companies facing financial difficulty and that would beunfortunate because it is the shareholders who are most likely to have themotivation to salvage a floundering company.35

32 Id., 269 F.3d at 749 (quoting In re Hyperion Enters., 158 B.R. 555, 561 (D.R.I. 1993))(internal quotations omitted); see also Fairchild Dornier, 453 F.3d at 225, Cohen v. KBMezzanine Fund II, LP (In re SubMicron Sys. Corp.), 432 F.3d 448 (3d Cir. 2006); In re:

Autoplastics, Inc., 269 F.3d 726 (6th Cir. 2001); In re Hedged Investments Assocs., Inc., 380F.3d 1292 (10th Cir. 2004); In re Herbys Foods, Inc., 2 F.3d at 133 (a court is authorized torecharacterize a loan as an equity contribution even when circumstances do not warrantequitable subordination.).

33 See, e.g., In re Zenith Electronics Corp., 241 B.R. 92, 107 (Bankr. Del. 1999) (torecharacterize debt as equity or to equitably subordinate a claim, the creditor must havedone something inequitable.).

34 See, e.g., Pacific Express Holding, Inc. v. Pioneer Commercial Funding Corp. (In re PacificExpress, Inc.), 69 B.R 112, 115 (9th Cir. B.A.P. 1986) (ruling that while the bankruptcy courtmay determine the amount and disallowance of claims under 502(a) of the BankruptcyCode, those provisions do not provide for the characterization of claims as equity or debt

because such a determination is governed specifically and exclusively by 510(c)); PinetreePartners, Ltd. v. Retirement Sys. (In re Pinetree Partners, Ltd.), 87 B.R. 481, 491 (Bankr.N.D. Ohio 1988) (The equitable powers of the court derive from the Bankruptcy Code andconsequently reach no further than its provisions. Accordingly, the claims of [the debtor] arenot subject to recharacterization from debt to equity absent controlling provisions of [510(c)]).

35 In re SubMicron Sys. Corp., 291 B.R. 314, 325 (Bankr. D. Del. 2003) (quoting In re OctagonRoofing, 157 B.R. 852, 858 (N.D. Ill. 1993) (internal quotations omitted)).


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Enron argued that the transferred claims should be subject tosubordination on the ground that the transferred claims that would have beensubject to subordination as of the Petition Date should remain subject tosubordination thereafter because Fleet cannot transfer greater rights than ithad.39 To the extent the purchasers of the claims are not indemnified, they

should have protected themselves by demanding indemnification, which is in thestandardized claims trading contract, rather than by seeking to limit a debtorsrights. In addition, Enron contended that a judicial holding that the transferredclaims could not be subordinated based on the transferors conduct woulddramatically undermine the congressional purpose behind 510(c). Such aholding would encourage wrongdoers to wash their claims in order to escapefrom subordination, contrary to public policy and congressional intent under theBankruptcy Code.

The bankruptcy court found that the transferred claims were still subject to

equitable subordination under 510(c) of the Bankruptcy Code. In so ruling, thecourt effectively held that the remedy of equitable subordination remains with theclaims; the transfer of those claims does not immunize them from subordinationin the hands of the transferee. It further held that the good faith defense is notavailable to the transferee. The bankruptcy court agreed with Enrons policyargument that shielding transferred claims from subordination would encouragecreditors who have engaged in inequitable conduct to wash their claims free ofthe possibility of subordination merely by transferring them.

III. RECHARACTERIZATION.

Recharacterization refers to an equitable power exercised by bankruptcycourts to treat a purported claim or transaction according to its true economicnature and substance, notwithstanding its form or name. The Bankruptcy Codedoes not expressly grant any such power, but many courts have nonethelessfound an implied power to recharacterize based on their general powers ascourts of equity.40 In the context of lender liability, two types of recharacterizationhave recently had significant implications for banks: recharacterization of loansas equity contributions and recharacterization of sales as secured loans.

39 Id. at 215.40 In Marrama v. Citizens Bank, ___U.S. ___, 127 S. Ct. 1105, __ L. Ed. 2d __ (2007), the

Supreme Court recently held that an individual debtors right to convert their case fromchapter 7 to chapter 13, under the Bankruptcy Code section 706(a) was subject to theinherent power of every federal court to sanction abusive litigation practices.


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A. Recharacterization of a Loan as an Equity Contribution.

The following scenario helps illustrate the recharacterization of a loan asan equity contribution:

Corporation is grossly undercapitalized. It must raise $6million in order to meet payroll and other immediate and criticalworking capital needs. Unfortunately, Corporation cannot locate anylender willing to extend financing. Among other things, Corporationcan barely service its current debt, it has no unencumbered assetsto offer as security for an additional loan, and it does not havesufficient cash flow to service interest or principal on any additionalloan. Two Investors sit on Corporations board of directors, each ofwhom has already invested millions of dollars in equity inCorporation at its inception and in subsequent financing rounds.

Investors agree that they will each loan $3 million to Corporation inexchange for notes bearing interest at 10 percent. The notes arenegatively amortized: they do not require any payment of principal orinterest during their term but must be satisfied in their entirety by aballoon payment at maturity after three years. The loan proceedsare used immediately to fund Corporations working capital needs.However, Corporations financial condition continues to deteriorate; itcannot service its other debt; and it eventually files for bankruptcyrelief. Investors file proofs of claim on account of their notes. At thispoint, Corporations other unsecured creditors request that the

bankruptcy court recharacterize the purported financing notes asequity contributions. They argue that the amounts advanced byInvestors, although cast in the form of loans, were actually equityinfusions.

Presented with such a request, under the majority view, the bankruptcycourt is not required to accept the label of debt or equity placed by the debtorupon a particular transaction, but must inquire into the actual nature of thetransaction to determine how best to characterize it.41 In other words, the courtis required to scrutinize the transaction according to an objective test of

economic reality to determine its true economic nature.

42

If the transaction,although cast in the form of a loan[,]nevertheless has the substance and

41 In re Cold Harbor Assocs., 204 B.R. 904, 915 (Bankr. E.D. Va. 1997).42 Cohen v. KB Mezzanine Fund II, L.P. (In re Submicron Sys. Corp.), 291 B.R. 314, 323

(Bankr. D. Del. 2003) (citations omitted).


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11. the ability of the corporation to obtain loans from outside lendinginstitutions.

12. the extent to which the advance was used to acquire capital assets.13. failure of the debtor to repay on the due date or seek

postponement.64

Finally, lower courts in the Third Circuit also have adopted the followingseven factor test, which incorporates various factors from the preceding tests:

1) the name given to the instrument.2) the intent of the parties.3) the presence of a fixed maturity date.4) the right to enforce payment of principal and interest.5) the presence or absence of voting rights.6) the status of the contribution in relation to regular corporate

contributors.7) the certainty of payment in the event of the corporations insolvency

or liquidation.65

As a result of these recharacterization decisions, lenders and investorsshould clearly specify whether their transactions are intended to give rise to debtor equity. Otherwise, lenders/investors risk having a bankruptcy court make sucha determination for them. For a transaction to be characterized as a loan, thedocumentation should specify repayment terms, a loan maturity date and interestrate, and provide typical indicia of indebtedness. The transaction should also be

administered as a loan.

B. Recharacterization of Sale Transactions as a SecuredLoan.

Recharacterization also has surfaced in relation to the treatment of a saleof financial assets, i.e., a securitization. The sale of a financial asset to a thirdparty is an attractive option to many businesses because it can enable the

64 Estate of Mixon v. United States, 464 F.2d 394 (5th Cir. 1972) (Fifth Circuit tax case); In reHedged-Investments Assocs., Inc., 380 F.3d at 1298 (Tenth Circuit bankruptcy case); In reLane, 742 F.2d at 1314-15 (Eleventh Circuit bankruptcy case)); In re Cold Harbor Assocs.,204 B.R. at 915 (lower court within Second Circuit).

65 See In re Submicron Sys. Corp., 291 B.R. at 323 (citing In re Color Tile, Inc., 2000 U.S. Dist.LEXIS 1303, at *14 (D. Del. Feb. 9, 2000)).


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business to generate cash quickly and relatively inexpensively. This is describedas follows:66

[F]or businesses seeking to realize quickly the value oftheir receivables, the financial markets have developed

elaborate mechanisms to finance the purchase of suchreceivables. These mechanisms involve bankruptcy remotespecial purpose corporations which acquire inexpensive fundsby selling securities in the public or private debt securitiesmarkets, and use the funds to purchase receivables from theoriginators. This process is known as securitization of thereceivables.

Debt service on the securities issued to finance thepurchase of the receivables is typically supported by a bank

letter of credit or loan facility. In such a structure the bank,rather than the securities holder, assumes the most significantcredit risk associated with the receivables. In deciding toparticipate in such transactions, banks (and other parties to thetransaction as well) rely on the continued existence of a more-or-less predictable and uninterrupted stream of cash flow fromthe receivables. More specifically, the parties to thesetransactions want to feel assured, to the extent possible, that ifthe business originating the receivables enters bankruptcy, thereceivables would not become part of the bankruptcy estate.

The typical receivables securitization is structured as apurchase of the receivables from the originator, i.e., a truesale, in order to provide the party such assurance. Receivableswhich have truly been sold by the originator should be propertyof the purchaser, not of the originator (or the originatorsbankruptcy estate).

From time to time, courts are called on to determine whether a transactioncan be characterized either as a true sale or a disguised secured loan.Consider the following scenario:

Corporation sells its existing receivables to a third party,possibly a wholly owned subsidiary created by Corporationspecifically for this purpose. Corporation receives the purchase

66 Robert D. Aicher & William J. Fellerhoff, Characterization of a Transfer of Receivables as aSale or a Secured Loan Upon Bankruptcy of the Transferor, 65 Am. Bankr. L.J. 181, 181(1991).


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price, and receivables are transferred to the third party. Pursuant tothe sale agreement, as the receivables are collected, they aredistributed in part to the third party and in part to Corporation.Corporation files for bankruptcy relief. Third party claims thatCorporation has no interest in the sold receivables, which never form

part of Corporations bankruptcy estate under 541 and are notavailable for distribution to creditors.

Now consider the following additional details:

Under the sale agreement, Corporation continues to collectreceivables, although they have been sold to third party. Alsounder the sale agreement, third party receives a fixed amount everymonth from Corporation, regardless of the amounts collected, andeven if no amounts are collected. Corporation receives only the

balance, if any. In fact, all risk of collection rests on Corporation,with no risk allocated to third party.

Following Corporations bankruptcy filing, Corporationscreditors request that the bankruptcy court look past the label of thetransaction and find that no sale took place. Certainly, Corporationreceived funds from the third party. But Corporations creditorsargue that these were loan proceeds, not a purchase price. AndCorporation did not sell to third party ownership of the receivables.Rather, it transferred a security interest in the receivables.

Corporation then paid a fixed amount to third party in repayment ofthe loan. As such, the receivables now form part of Corporationsbankruptcy estate. Third party has claim against estate, in line withother creditors. Assuming third party has perfected its securityinterest, third partys claim will be secured by the receivables.Whatever the outcome, third partys recovery on the assets would bedelayed by the bankruptcy process.

Some commentators have defined a true sale as a transfer of financialassets in which the parties state that they intend a sale, and in which all of thebenefits and risks commonly associated with ownership are transferred for fair

value in an arms-length transaction.67 Courts have struggled, however, incrafting a standard for determining whether the sale of a financial asset shouldbe characterized as a true sale or a secured loan. The recent opinion In reCommercial Loan Corp. described this as follows:

67 Peter V. Pantaleo et al., Rethinking the Role of Recourse in the Sale of Financial Assets,52 Bus. Law. 159, 159 (1996).


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Whether to deem a transaction a sale or a loan when afinancial asset a right to payment has changed hands is anold legal problem for which there has never been an easysolution.

The extensive case law is almost no help. Confrontedwith loan/true sale questions, courts typically adopt somethingresembling a totality of the circumstances test, declaring thatthe sale determination depends on the intent of the parties andrequires an examination of the parties relationship.

Under that amorphous rubric, however, different courtsconsider different factors and give those factors different weight.So, for example, the language of the parties contract hasmattered little to some courts. To others, it is has been more orless dispositive. Some courts find critical the purchasersretention of some recourse against the seller. Others deem itmerely relevant, or choose to ignore it altogether[.]

With no discernible rule of law or analytical approachevident from the decisions, a court could flip a coin and findsupport in the case law for a decision either way. The absenceof any set legal analysis, along with the annoying tendency ofdecisions to turn on their facts, makes predicting the outcome ofa loan/true sale dispute nearly impossible. 68

As noted, courts have relied on numerous, varying, and sometimesopposing factors in order to determine whether a transfer of assets should betreated as a true sale or as a disguised secured loan. Some of these factorsare briefly described below.

1. Intent of the Parties.First, courts typically will ignore the labels used by the parties and instead

investigate the true nature of the transaction and the intent of the parties inentering into the transaction. The courts examine all of the relevant factual

circumstances surrounding the transaction, including the parties practices,objectives, business activities, and relationships. Thus, in Majors Furniture Mart,Inc. v. Castle Credit Corp., the United States Court of Appeals for the ThirdCircuit rejected the argument that an agreements explicit reference to sales andpurchases proved that the parties intended a true sale of accounts and not a

68 316 B.R. 690, 700-01 (Bankr. N.D. Ill. 2004).


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security transfer. 69 The court rejected this argument and instead analyzed theparties business activities, objectives and relationship.

2. Language of Agreement.On the other hand, a minority of courts has focused on the agreements

language as determinative. For example, in Bear v. Coben (In re Golden Plan ofCalifornia, Inc.), the Ninth Circuit found substantive indicia of a sale where theparties agreement contained phrases such as assigns, sets over and transfersall rights, title and interest, and concluded that the parties intended a true salenot a disguised loan. 70

3. Allocation of Risk and Benefits.By far, the most important factor in determining whether a sale of a

financial asset should be characterized as a true sale or as a secured loan is theextent to which the risks and benefits associated with ownership have either

been retained by the [seller] or transferred to the [purchaser].71

One of the risks of ownership that is always examined is whether thetransferee bears the risk of loss with respect to the transferred assets. If thetransferor fails to retain any of the risks or obligations of ownership, a court islikely to consider the transaction a secured loan.72 The presence of recourse isthe most important aspect of risk allocation; it suggests that the parties intendeda loan and not a sale. If the parties had intended a sale, then the buyer wouldhave retained the risk of default, not the seller. The greater the recourse thetransferee has against the debtor (through, for example, chargebacks or

adjustments to the purchase price), the more the transfer resembles a disguisedloan rather than a sale. Courts differ on the weight they attach to the presence of

69 602 F.2d 538, 543 (3d Cir. 1979) (rejecting argument that an agreements explicit referenceto sales and purchases proved that the parties intended a true sale of accounts and nota security transfer).

70 Bear v. Coben (In re Golden Plan of California, Inc.), 829 F.2d 705 (9th Cir. 1986)(concluding that transaction was a true sale where agreement contained phrases such asassigns, sets over and transfers all rights, title and interest.).

71 Kenneth N. Klee & Brendt C. Butler, Asset-Backed Securitization, Special Purpose Vehiclesand Other Securitization Issues, 35 U.C.C.L.J. 23, 49 (2002). Extensive portions of this

article are excerpted here.72 Majors Furniture Mart, Inc. v. Castle Credit Corp., 602 F.2d 538, 543 (3d Cir. 1979) (holding

that a shifting of all risk indicates a security interest). See also, Firemans Fund InsuranceCo. v. Grover (In re Woodson Co.), 813 F.2d 266, 271-72 (9th Cir. 1987) (holding thattransaction was loan because the seller bought an insurance contract in order to guaranteea fixed return to investors; in a true sale the loan pool investors would share in the risk ofdefault and would have to rely on the creditworthiness of the borrowers [mortgagors] andthe collateral.).


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recourse provisions. Some courts view the presence of such a provision asnearly conclusive of the parties intent to create a security interest, while othersview recourse as only one of several factors.

Related to transference of risk of loss to the transferee is the retention of

the benefits of ownership by the debtor. The issue here is whether the debtorhas the right to repurchase the assets transferred or to substitute other propertyfor the assets transferred. If the debtor were permitted to do this, it could captureany increase in the value of the transferred assets and thus would have retaineda significant benefit of ownership. If there is an obligation on the part of the SPVto transfer to the Originator surplus in excess of the purchase price paid for theassets (or in excess of the purchase price plus a reasonable interest rate or rateof return), or an ability of the Originator to repurchase the assets, then thebenefits of ownership appear to have been retained by the Originator, and thistransaction resembles a secured financing rather than a true sale. Once the

debtor has received the purchase price for the assets, it should not have controlover the assets.73

The decision in In re LTV Steel Co.74 received significant attention from thesecuritization industry. LTV had entered into two separate securitizationtransactions with separate bank groups prepetition, one backed by receivablesand the other by inventory. Each transaction involved a transfer of identifiedassets to a SPV, and in each case a major law firm provided an opinion to thebanks to the effect that the asset transfer from LTV to the SPV was a true sale.

Once in bankruptcy, LTV (as debtor in possession) sought torecharacterize the two asset securitization transactions arguing that thetransactions did not involve true sales; rather, they constituted financingdesigned to deprive unsecured creditors of the ability to realize any meaningfulrecovery from the lenders enormous equity cushion, and to enable the lenders toexercise remedies without any accountability to the bankruptcy court or any otherparties in interest. LTV focused on the five indicia that it believed established asecurity financing instead of a true sale of inventory and receivables:

73 In re Major Funding Corp., 82 B.R. 443, 449 (Bankr. S.D. Tex. 1987) (characterizing a

transaction as a loan based on the fact that the assignor did not segregate specificreceivables to pay its investors, but rather paid each investor a specified return from itsgeneral pool of mortgage receivables); Petron Trading Co. v. Hydrocarbon Trading &Transport Co., 663 F. Supp. 1153, 1159 (E.D. Pa. 1986) (declining to uphold a true salewhen an assignor continued to prepare invoices for contract payments, did not notify itsaccount debtor that its debt had been assigned, and retained rights under the assignmentcontract to petition the account debtor for price adjustment).

74 274 B.R. 278 (Bankr. N.D. Ohio 2001).


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sufficient to support the entry of the interim cash collateralorder.76

IV. AIDING AND ABETTING BREACH OF FIDUCIARY DUTY.

In general, a bank does not have a fiduciary duty to its borrowers.77 Thereare recognized exceptions to this whereby courts will find that a fiduciary dutywas created where a banks conduct exceeds the usual creditor-debtorrelationship,78 such as where there is either a confidence reposed which investsthe person trusted with an advantage in treating the person so confiding, or anassumption of control and responsibility.79 However, these circumstances arebeyond the scope of these materials, which focus on when lenders will be liablefor aiding and abetting a breach of fiduciary duty.

A claim for aiding and abetting the breach of a fiduciary duty generallyrequires that the plaintiff show:

(1) the plaintiff was in a fiduciary relationship with a third party,(2) there was a breach of the fiduciarys duty by the third party,(3) there was a knowing participation in the breach by a defendant who is

not a fiduciary and(4) there are damages proximately caused by the breach.80

76 Id. at 285. Abbey subsequently filed an appeal but the matter was settled prior to a decisionthereon when the parties agreed upon a debtor in possession financing arrangement. Eventhough the courts decision was not a final decision on the merits of the true sale issues, itcontinues to create concern in the finance industry.

77 State St. Bank & Trust Co. v. Inversiones Errazuriz Limitada, 246 F. Supp. 2d 231, 256-257(S.D.N.Y. 2002). See also, Aaron Ferer & Sons Ltd. v. Chase Manhattan Bank, 731 F.2d112, 122 (2d Cir. 1984) (under New York law, usual relationship of bank and customer isthat of debtor and creditor and a bank owes no fiduciary duty to borrower).

78 Conte v. US Alliance Fed. Credit Union, 303 F. Supp. 2d 220, 227 (D. Conn. 2004) (inspecial circumstances... a fiduciary relationship will arise between a bank and a customer ifthere is a confidence placed in the bank that gives it an advantage in dealing with thecustomer who is placing his trust in the bank.); Scott v. Dime Sav. Bank of New York, FSB,886 F. Supp. 1073 (S.D.N.Y. 1995) affd, 101 F.3d 107 (2d Cir. 1996).

79 Manufacturers Hanover Trust Co. v. Yanakas, 7 F.3d 310, 318 (2d Cir. 1993) (internalquotation marks and citations omitted).

80 See S & K Sales Co. v. Nike, Inc., 816 F.2d 843, 851 (2d Cir. 1987); Blanchard, supranote 2 5.10; cf. Restatement (Second) Torts 876(b).


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To the extent the underlying breaches of fiduciary duty are based on fraudulentconduct, the complaint must meet the requirement of Rule 9(b) of the FederalRules of Civil Procedure, which mandates that all allegations of fraud must bepled with particularity.81

Financial institutions are among those entities most frequently sued for aidingand abetting:

Because modern banks provide an array of valuable, and frequentlyinnovative, financing services, banks often are regarded as havingbeen a partner in crime with a company the bank may haveconsidered merely a borrower or customer. The factual elementsfrequently recurring in bank fraud cases include, most notably:(i) financing, through a series of transactions, of a fraudulententerprise over an extended duration; (ii) the banks use of actual or

alleged atypical banking practices, and; (iii) an ultimate bankruptcy(or absconding with funds) by a borrower or client of the bank.82

One of the most significant issues in the area of aiding and abetting breachof fiduciary duty is whether the cause of action exists in all states and, if not,where does it not exist. Eighteen states have recognized a cause of action foraiding and abetting breach of fiduciary duty.83 At least one case indicates federal

81 In re Sharp Intl. Corp., 302 B.R. 760, 770 (E.D.N.Y. 2003).82 Richard C. Mason, Civil Liability for Aiding and Abetting, 61 Bus. Law. 1135, 1166 (May

2006).83 Id. at 1159 (citing Casey v. U.S. Bank Assoc., 26 Cal. Rptr. 3d 401. 405-06 (Cal. Ct. App.

2005); Holmes v. Young, 885 P.2d 305, 308 (Colo. Ct. App. 1994); Malpiede v. Townson,780 A.2d 1075, 1097 (Del. 2001); Nerbonne, N.V v. Lake Bryant Intl Properties, 689 So. 2d322, 325 (Fla. Dist. Ct. App. 1997); Thornwood, Inc. v. Jenner & Block, 799 N.E.2d 7.56,768-69 (Ill. App. Ct. 2003), appeal denied, 807 N.E.2d 982 (Ill. 2004); Kuhlman Elec Corp. v.Chappell, No. 2003-CA-001232-MR, 2005 WL 3243498, at *8 (Ky. Ct. App. Dec. 2, 2005);Cacciola v. Nellhaus, 733 N.E.2d 133, 139 (Mass. Ct. App. 2000); Carson Fischer, PLC v.Standard Fed. Bank., No. 248125, 2005 WL 292343, at *6 (Mich. Ct. App. Feb. 8, 2005),revd in part, 2006 WL 1303137 (Mich. May 12, 2006); Witzman v. Lehrman, Lehrman &Flom, 601 N.W2d 179, 186-87 (Minn. 1999); Branch Banking & Trust Co. v. Lighthouse Fin.,

No. 04 CVS 1523, 2005 WL 1995410, at *7 (N.C. Super. Ct. July 13, 2005); Bondi v.Citigroup, Inc., No. BER-L-10902-04, 2005 WL 975856, at *18 (N.J. Super. Ct. Law Div.Feb. 28, 2005); Fate v. Owens, 27 P.3d 990, 997-98 (N.M. Ct. App. 2001), cert. denied, 27P.3d 476 (N.M. 2001); Shearson Lehman Bros. Inc. v. Bagley, 614 N.Y.S.2d 5 (N.Y. App.Div. 1994); Future Group II v. Nationsbank, 478 S.E.2d 45, 50 (S.C. 1996); Chem-AgeIndus., Inc. v. Glover, 652 N.W.2d 756, 773-76 (S.D. 2002); Toles v. Toles, 113 S.W.3d 899,917 (Tx. Ct. App. 2003); Halifax Corp. v. Wachovia Bank, 604 S.E.2d 403, 412-14 (Va.2004); and Lenticular Europe, LLC ex rel Van Leeuwen v. Cunnally, 693 N.W2d 302, 309(Wis. Ct. App. 2005)).


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common law provides a cause of action aiding and abetting breach of a fiduciaryduty.84 On the other hand, Georgia does not recognize a claim for aiding andabetting a breach of fiduciary duty85 and there are conflicting federal decisionsconcerning predictions of Pennsylvania law.86

A. The Existence of a Fiduciary Duty and Breach of the Duty.

Proving aiding and abetting breach of fiduciary duty requires proving thatthere existed a fiduciary to the plaintiff of a third party. Typically, the plaintiffdoes not need to prove that the defendant had an independent fiduciary duty tothe plaintiff, 87 though (as noted below) if the defendant owes plaintiff a fiduciaryduty, this will change the analysis.88

The recent case of Bondi v. Bank of America Corp. (In re ParmalatSecurities Litigation) is typical of suits against banks. In that case, the plaintiff,

suing on behalf of Parmalat (the debtor), alleged that Bank of America assistedParmalat managers in structuring and executing a series of complex, mostly off-balance sheet, financial transactions that were deliberately designed to concealParmalats insolvency.89 These complex transactions allegedly included loanswith undisclosed side-letter agreements, use of special purpose entities to hidethe use of debt as equity, and swaps that had no currency or interest rateexchanges and offered the counterparties no ability to hedge.90

84 K & S Partnership v. Continental Bank, N.A., 952 F.2d 971, 980 (8th Cir. 1991) (Knowingparticipation in a breach of fiduciary duty is analogous to a cause of action . . . for aiding

and abetting a securities fraud, where the primary violation involves a breach of fiduciaryduty.) cf. Whitney v. Citibank, N.A., 782 F.2d 1106, 1115 (2d Cir. 1986)).85 Monroe v. Board of Regents, 602 S.E.2d 219, 224 (Ga. Ct. App. 2004).86 Compare Adena, Inc. v. Cohn, 162 F. Supp. 2d 351, 357 (E.D. Pa. 2001) (predicting

Pennsylvania would recognize a claim for aiding-abetting breach of fiduciary duty) andStone St. Servs. v. Daniels, Civ. A. No. 00-1904, 2000 U.S. Dist. LEXIS 18904, 2000 WL1909373, at *3 (E.D. Pa. Dec. 29, 2000) with Daniel Boone Area School Dist. v. LehmanBros., Inc., 187 F Supp. 2d 400, 413 (W.D. Pa. 2002) and Flood v. Makowski, 2004 U.S.Dist. LEXIS 16957, No. 03-1803, 2004 WL 1908221 at *36 (M.D. Pa. 2004).

87 Neilson v. Union Bank of Cal., N.A., 290 F. Supp. 2d 1101, 1133 (C.D. Cal. 2003); Casey v.U.S. Bank Nat. Assn., 127 Cal. App. 4th 1138, 1145 (2005) (we reject the banks attempt to

overlay the civil conspiracy independent duty requirement onto an aiding and abettingclaim.). But see In re County of Orange, 203 B.R. 983 (Bankr. C.D. Cal. 1996), affd in part,revd in part on other grounds sub nom, County of Orange v. McGraw-Hill Co. (In re Countyof Orange), 245 B.R. 138 (C.D. Cal. 1997).

88 See infra, note 97 and accompanying text.89 383 F. Supp. 2d 587, 590 (S.D.N.Y. 2005).90 Id. at 592.


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substantial assistance if the alleged aider/abettor has a fiduciary duty to theinjured party.98

The Third Circuit Court of Appeals, in applying Pennsylvania law, hasnoted that Restatement (Second) of Torts 876 suggests the following six

factors to determine whether a defendant rendered substantial assistance forpurposes of accomplice liability:

a. the nature of the act encouraged;

b. the amount of assistance given by the defendant;

c. the defendants presence or absence at the time of the tort;

d. the defendants relation to the other tortfeasor;

e. the defendants state of mind; and

f. the foreseeability of the harm that occurred.99

Knowledge of the fiduciarys breach of duty is required for liability for aidingand abetting that breach.100 The knowledge of wrongdoing requirementgenerally means the aider/abettor must have known the act was a breach offiduciary duty.

98 Strong v. France, 474 F.2d 747, 752 (9th Cir. 1973).99 Fassett v. Delta Kappa Epsilon, 807 F.2d 1150, 1163 (3d Cir. 1986) (quoting Restatement

(Second) of Torts, 876(b), comment d).100 Chance World Trading v. Heritage Bank of Commerce, 438 F. Supp. 2d 1081, 1086-1087

(N.D. Cal. 2005) (the inference that Heritage Bank knew of Ms. Yadav-Ranjans fraudcannot be drawn from evidence that Heritage Bank did not follow its own internal rules, andthe only other evidence Chance World has produced that could show knowledge byHeritage Bank is an e-mail, which, according to uncontradicted testimony, was not sent to avalid address for the bank.); Neilson, 290 F. Supp. 2d at 1120 (C.D. Cal. 2003) (Thecomplaint asserts that the Banks knew Slatkin was committing fraud and was breaching hisfiduciary duties to class members. It also alleges that each bank actively participated inSlatkins Ponzi scheme with knowledge of his crimes. . . . It alleges, in particular, that theBanks utilized atypical banking procedures to service Slatkins accounts, raising aninference that they knew of the Ponzi scheme and sought to accommodate it by alteringtheir normal ways of doing business. This supports the general allegations of knowledge.);Kolbeck v. Lit America, Inc., 939 F.Supp. 240, 247 (S.D.N.Y. 1996), affd, 152 F.3d 918 (2dCir. 1998) (Inaction, or a failure to investigate, constitutes actionable participation onlywhen a defendant owes a fiduciary duty directly to the plaintiff; that the primary violator owesa fiduciary duty to the plaintiff is not enough.); King v. George Schonberg & Company, 233A.D.2d 242, 243, 650 N.Y.S.2d 107 (1st Dept 1996).


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In Hashimoto v. Clark the court found that plaintiff had not adequately allegedknowledge where:

As far as these officers were concerned, the disposal of the metalspresented no cause for alarm. Sheffield was a metals dealer who,

Safrabank assumed, regularly traded metals. Furthermore,Safrabank had no reason to believe that Sheffield had not otherwisecovered its positions. These officers deny that Safrabank had anyknowledge of Sheffields overall metals positions or of its futurestrading.101

Generally, Knowledge is hard to prove. However, in bank fraud cases,defendants use of atypical banking procedures is a judicially recognized basisfor an inference of knowledge the bank is aiding anothers misconduct.102

Familiarity over an extended period with the course of conduct relating to the

scheme at issue also may support an inference of knowledge.103

Most court have even gone beyond the actual knowledge standard.Where facts are known to the defendant from which the conclusion objectivelyfollows that a fraud is being perpetrated (and assisted by defendant), aider-abettor liability may exist even if the defendant lacked actual knowledge.104

Those courts have held that, unlike a cause of action for conspiracy, theknowledge requirement for aiding and abetting liability may be satisfied by proofthat a defendant acted with reckless disregard.105 Reckless disregard is not,

101 Hashimoto v. Clark, 264 B.R. 585, 598-99 (D. Ariz. 2001).102 Aetna Casualty & Surety Co. v. Leahey Construction Co., 219 F.3d 519, 536 (6th Cir. 2000);

Camp v. Dema, 948 F.2d 455, 459 (8th Cir. 1991); Woodward v. Metro Bank, 522 F.2d 84,97 (5th Cir. 1975).

103 Jaguar Cars, Inc. v. Royal Oaks Motor Car Co., 46 F.3d 258, 270 (3d Cir. 1995) (holdingthat experience and active participation in the . . . dealership, combined with the extent ofthe fraud presented a sufficient basis for imposition of aiding-abetting liability). In that case,the eviden

lender liability and equitable subordination

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