• Recent Case Increases Directors Exposure to Bankruptcy Litigation
  • September 21, 2005 | Author: David E. Lemke
  • Law Firm: Waller Lansden Dortch & Davis, LLP - Nashville Office
  • A recent decision by the United States Court of Appeals for the Third Circuit may make it easier for bankruptcy trustees and/or creditors committees of failed companies to sue board members for breach of fiduciary duty and get their cases to trial.

    On August 3, 2005, the Court of Appeals reversed the decision of the District Court in the case of Stanziale v. Nachtomi (In re Tower Air, Inc.). The Court of Appeals determined that the bankruptcy trustee for the estate of Tower Air, Inc., had sufficiently pled claims for breach of the duties of care, loyalty, and bad faith under Delaware law. The trustee alleged that a number of Tower Air's former officers and directors drove the company into insolvency by indifference, egregious decision-making and inaction over a period of four years.

    The Court found that the trustee's complaint alleged facts sufficient to overcome the business judgment rule. Under the business judgment rule, board actions approved by a majority of truly independent and disinterested directors are presumed to be taken in good faith, on an informed basis and in the best interests of the company. The presumption creates a very high burden for any plaintiff to overcome at trial.

    The presumption has also been used by courts, especially Delaware courts, to create a high hurdle for a plaintiff to overcome at the very beginning of the lawsuit when the plaintiff files his complaint setting forth his claims. Under Delaware law, a plaintiff must, in the very first document he files with the Court, allege facts in support his claims with sufficient specificity that the facts, if taken as true, rebut the presumption of the business judgment rule. If the plaintiff is unable to state such facts with the required specificity, then the Court can dismiss the complaint without allowing the plaintiff to proceed with the case. Many Delaware decisions (and, until Stanziale, federal decisions applying Delaware law) have dismissed claims brought against directors at the very beginning of the case because the plaintiff did not allege specific facts to avoid the presumption of the business judgment rule.

    The Court of Appeals, however, held that in federal court -- where most trustees or committees will bring such actions -- the plaintiff need not state facts in the complaint with specificity in order to proceed with the lawsuit. Rather, the plaintiff must simply establish a claim upon which relief can be granted. In other words, so long as the complaint sets out claims of irrationality or inattention and gives the directors fair notice of the grounds for those claims, the plaintiff will be permitted to move to the discovery stage in an effort to establish facts at trial which support the claims.

    For directors, as a practical matter, the Stanziale case means that a bankruptcy trustee or creditors committee may now be more willing to file suit against former directors of a bankrupt company without first having to engage in expensive and extensive pre-suit discovery. Moreover, if such a suit is filed, it is more likely that the complaint will get past the initial stage and the lawsuit will at least advance to the discovery stage. Therefore, directors are likely to be disappointed if they are hoping for a quick exit from such a lawsuit on the grounds that sufficient facts have not been provided. Rather, the suit is now more likely to proceed through discovery and need to be defended on the merits of the case -- increasing both the cost of defense for the directors and the risk of an adverse ruling against them.

    The recently decided Disney case involving the Board's actions relating to Michael Ovitz's termination compensation stands for the same principle. While the directors were ultimately found not to have violated their fiduciary duties, their allegedly negligent conduct gave the plaintiff facts sufficient to allow the case to proceed to trial -- at significant cost.

    What can directors do? The first answer, of course, is making sure that the Board always acts independently, in good faith, on an informed basis, and in the best interests of the company. In addition, directors should make sure the company has adequate D&O insurance and that the liability coverage will not be eroded by the costs of legal defense.