Adelphia
In an 85-page decision with implications for (i) the fiduciary duties of lenders and investment banks, (ii) the doctrine of in pari delicto (by which a court denies relief it would otherwise grant because of wrongdoing on the plaintiff's part) and (iii) claims for equitable disallowance-In re Adelphia Commc'ns Corp., No. 02-41729, 2007 Bankr. LEXIS 1942 (Bankr. S.D.N.Y. June 11, 2007)-the United States Bankruptcy Court for the Southern District of New York recently held that no fiduciary duty exists between an investment bank and its client where the applicable contract so states, even if such duty otherwise would be found under applicable law. The Bankruptcy Court also held that (i) section 541 of the Bankruptcy Code and the doctrine of in pari delicto do not necessarily bar recovery by a creditors' committee on behalf of the debtors' estates where the debtors' personnel have acted wrongfully and (ii) the doctrine of equitable disallowance survived the enactment of section 510(c) of the Bankruptcy Code, which provides for equitable subordination.
The Creditors' Committee's Complaint
On behalf of the estates of Adelphia Communications Corporation and its subsidiaries (collectively, "Adelphia"), the Official Committee of Unsecured Creditors (the "Committee") brought an adversary proceeding against Adelphia's bank lenders and investment banks (the "Defendants"). The Committee's 256-complaint charged the Defendants with wrongdoing in their dealings with Adelphia's former management, John, Timothy, Michael and James Rigas (the "Rigases"), against whom Adelphia had brought suit for looting the company. The Committee's numerous claims against the Defendants included (i) claims for aiding and abetting the Rigases' breaches of fiduciary duty in connection with "co-borrowing" facilities under which Adelphia became liable to repay the banks for billions of dollars that benefited the Rigases, (ii) claims for breach of fiduciary duty (asserting that the bank lenders and investment banks themselves had fiduciary duties to the estate), (iii) claims for fraudulent transfers and preferences related to incurring and/or paying down the debt on borrowing facilities that benefited the Rigases, (iv) claims to equitably subordinate and/or disallow, and to recharacterize, bank lenders' claims and (v) violations of the Bank Holding Company Act.1
Breach of Fiduciary Duty Claims
In addition to alleging that the Defendants aided and abetted the Rigases' breaches of fiduciary duty, the Committee asserted that the Defendants themselves breached fiduciary duties to Adelphia. The Bankruptcy Court dismissed these claims as to lender banks, noting that, under Pennsylvania law, a lender is not ordinarily the fiduciary of a borrower unless the lender gains substantial control over the borrower's business affairs. The Bankruptcy Court held that the Committee's allegations, however, were that these banks provided material assistance to the Rigases in the Rigases' control over Adelphia, which would support a claim of aiding and abetting a breach of fiduciary duty, but not a direct breach.
As to most of the investment bank Defendants, however, the Bankruptcy Court denied the Defendants' motion to dismiss, noting that the investment banks did not have "the benefit of the substantial body of caselaw speaking to the nonexistence of fiduciary relations as between lenders and borrowers."2 Although the status of the investment banks as underwriters for Adelphia did not automatically give rise to a fiduciary duty, the Committee alleged that the investment banks also served as advisors to Adelphia in structuring and conducting transactions. Because such a role could support the existence of a fiduciary duty, the Bankruptcy Court would not dispose of most of these claims on a motion to dismiss.
Notably, for both the lender and investment banks, the Bankruptcy Court held that no fiduciary duty existed where the Defendants had contracts that specifically stated that the Defendant had no fiduciary relationship with or duty to Adelphia. As to these Defendants, the Bankruptcy Court dismissed the Committee's claims of breaches of fiduciary duty.
Section 541 of the Bankruptcy Code Has No Bearing on the Defense of In Pari Delicto
In response to the Committee's claims that certain agent bank and investment bank Defendants aided and abetted the Rigases' breaches of fiduciary duty, the Defendants argued, inter alia, that, under principles of in pari delicto, or the "unclean hands" doctrine, the Adelphia bankruptcy estate could not recover on its claims, even if the Defendants acted wrongfully, because the conduct of the debtor's personnel is imputed to the Committee.
The Bankruptcy Court disagreed with courts that had held that, under section 541 of the Bankruptcy Code,3 a trustee (or an official committee) was subject to the same defenses as the debtor would be at the commencement of a bankruptcy case. Judge Gerber reasoned that, while section 541 is relevant to granting ownership of causes of action to the insolvent estate representative, section 541 places no federal limits on the application of state law in determining defenses that might be good against the estate, including that of in pari delicto.
The Bankruptcy Court also determined that the Pennsylvania Supreme Court, in analyzing in pari delicto defenses, has taken into account whether the application of in pari delicto is equitable under the circumstances, including the extent to which the debtor's "unclean hands" should be used to penalize innocent creditors. Therefore, the Bankruptcy Court's evaluation of the Defendants' in pari delicto defense would involve a factual determination of whether the Committee was an innocent successor (and thus would not be decided on a motion to dismiss).
Equitable Disallowance Survives the Enactment of Section 510(c)
The Committee, in addition to seeking equitably to subordinate the Defendants' claims (i.e. to demote their claims to a junior status based on their alleged wrongdoing), sought equitable disallowance of such claims. The Bankruptcy Court ruled that equitable disallowance, whereby a court can completely disallow a creditor's claims based on its inequitable conduct, remains viable despite the enactment of section 510(c), which authorizes equitable subordination. The Bankruptcy Court's ruling was based on the legislative history of section 510(c) and applicable rules of statutory construction.
Future Implications
The Adelphia decision has several important future implications:
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Banks not wishing to take on fiduciary responsibilities and risks should include language in their standard form agreements stating that no fiduciary relationship exists.
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Section 541 may not automatically make defenses that a defendant could have used against the debtor applicable to trustees or official committees, limiting the availability of the in pari delicto defense. Further, the Bankruptcy Court's view of in pari delicto indicates that defendants should proceed with caution when employing this defense.
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Secured or senior lenders' concerns regarding a potential equitable subordination claim by other creditors in a bankruptcy proceeding should be extended to encompass the possibility of the complete disallowance of the lenders' claims.
If you would like a copy of the Adelphia decision or if you have any questions regarding this decision and its implications, or about the legal issues discussed herein generally, please do not hesitate to contact us.
1 This Insolvency and Restructuring Update addresses only a few of the Committee's claims. The Court ruled that many other claims, including claims of or for fraudulent transfers, preferences, equitable subordination and disallowance, aiding and abetting the Rigases' breaches of fiduciary duty and violations of the Bank Holding Company Act, had been plead with sufficient particularity to survive a motion to dismiss. The Adelphia decision is a reminder of how little substance is necessary to sustain litigation, even where the court itself explicitly expresses doubt as to the likelihood of the plaintiffs' ultimate success on the merits.
2 See In re Adelphia Commc'ns Corp., 2007 Bankr. LEXIS 1942, at *104.
3 Section 541 of the Bankruptcy Code provides, in relevant part, that property of the bankruptcy estate includes "all legal or equitable interests of the debtor in property as of the commencement of the case." 11 U.S.C. § 541(a) (emphasis added).