United States: Claims Limited for Aiding Breach of Fiduciary Duties

The U.S. Court of Appeals for the Second Circuit's opinion in In re Sharp Int'l Corp., 403 F3d 43 (2d Cir. 2005), gave lenders comfort that in extricating themselves from relationships with borrowers they believe to be engaged in fraudulent activity they will not be held liable for failing to blow the whistle and expose the fraud.

However, the Second Circuit's recent decision in Lerner v. Fleet Bank, N.A., et al., 2006 WL 2260822 (2d Cir. 2006), highlights the potential liability banking institutions may face if they fail to actively monitor trust accounts maintained at their banks. The difference in the outcome of Sharp and Lerner can simply be described as the difference between the absence and existence of a duty.

In re Sharp Int'l Corp., 403 F3d 43 (2d Cir. 2005), involved a lending relationship between Sharp and State Street Bank. The relationship began in 1996, when State Street granted Sharp a $20 million demand line of credit secured by Sharp's assets. Approximately two years later, State Street became concerned that Sharp was growing at an alarmingly rapid pace and consuming a large amount of cash. State Street retained a forensic accountant to investigate Sharp. State Street's investigation confirmed its suspicion that there was rampant fraud at Sharp.

However, rather than blow the whistle and expose the fraud, State Street agreed to forebear from exercising its rights under the credit documents and "arranged quietly for the [principals] to repay the State Street loan from the proceeds of new loans from unsuspecting lenders" and ignored inquiries from noteholders regarding Sharp's financial condition. Sharp, 403 F3d at 47. Sharp used the time provided by State Street to arrange to borrow an additional $25 million in financing ($10 million more than Sharp owed State Street) from a group of unsuspecting investors and, in 1999, these investors purchased $25 million in subordinated notes from Sharp. Id. at 48. Approximately $12.25 million of the proceeds from the note issuance was used to pay off State Street and Sharp's principals gave personal promissory notes for the remaining $2.75 million of debt. Shortly after State Street was repaid, the noteholders commenced an involuntary bankruptcy against Sharp.

Sharp's trustee in bankruptcy commenced an adversary action against State Street for allegedly aiding and abetting Sharp's breach of fiduciary duty and for fraudulent transfer, and sought recovery of funds looted after the date that State Street learned of the fraud as well as to avoid repayment of the loans. The district court affirmed an order of the bankruptcy court dismissing the complaint against State Street. The trustee appealed the district court's order to the Second Circuit.

In considering the trustee's claims against State Street, the Second Circuit stated that under New York law, a party must establish the following three elements to successfully plead a claim for aiding and abetting a breach of fiduciary duty: (i) a breach by a fiduciary of obligations to another; (ii) that the defendant knowingly induced or participated in the breach; and (iii) that the plaintiff suffered damages as a result of the breach. See id. at 49-50 (citations omitted).

Because the trustee did not allege that State Street owed an independent duty, the circuit's inquiry focused on the second element, i.e., whether State Street knowingly induced or committed affirmative acts that furthered the principals' breach of duty. See id. at 51. The trustee alleged that the following acts committed by State Street constituted inducement sufficient to impose liability: (i) after learning about the fraud, demanded that Sharp obtain new sources of financing to retire the State Street debt; (ii) deliberately concealing its knowledge of the fraud; (iii) electing not to foreclose on the loan; (iv) avoiding the noteholders' repeated attempts to reach State Street to discuss the Sharp credit; and (v) providing State Street's contractually required consent to the new loans. The court held that, at most, these omissions constituted failures to act and, as such, did not constitute "substantial assistance." The court concluded that State Street had come by information through diligent inquiry that any other lender could have made. The court stated that "the complaint [said] no more than that State Street relied on its own wits and resources to extricate itself from peril, without warning persons it had no duty to warn" and that that State Street had no duty under New York law to inform Sharp, its existing creditors, or its prospective creditors' of the fraud because:

the legal relationship between a borrower and a bank is a contractual one of debtor and creditor and does not create a fiduciary relationship between the bank and its borrower. Id. at 51-52 (citations omitted).

However, unlike Sharp, the Second Circuit in Lerner found that certain plaintiffs had asserted viable claims against the lenders for allegedly aiding and abetting a breach of fiduciary duty. The facts in Lerner arise out of a massive Ponzi scheme operated by an attorney, David Schick. Mr. Schick's fraudulent plan operated as follows: He would bid on distressed mortgage pools at auctions by the Federal Deposit Insurance Co. (FDIC) and other banking institutions. Upon being awarded the bid, he would immediately try to re-sell the mortgage pool to another buyer for a profit. However, in order to bid on the properties, he had to prove to the FDIC that he had the funds to complete the purchase and was required to put down large deposits, which were provided by his investors. In order to convince the investors to send him money for the deposits, Mr. Schick stated that he would deposit the entrusted funds in escrow accounts covered by restrictive provisions. Relying on the fact that Mr. Schick was a licensed attorney in New York and that he agreed to deposit the funds in restricted accounts, investors sent him tens of millions of dollars. However, Mr. Schick managed to raid the "restricted" escrow accounts and steal approximately $82 million dollars before his fraud was discovered. See Lerner 2006 WL 2260822 at * 2.

The plaintiffs in Lerner were the investors who were defrauded by Mr. Schick and the defendants were various banks at which Mr. Schick maintained his attorney trust accounts containing the funds received from investors. The plaintiffs sued the banks alleging that the banks assisted Mr. Schick by failing to report his overdrafts on attorney fiduciary accounts to the state bar for disciplinary action and by evading their reporting requirements by misleadingly marking some checks drawn against accounts with insufficient funds as "Refer to Maker". See id. at * 1. "Refer to Maker" is a generic term used in the banking industry which essentially means that a bank has determined that a check cannot be honored, but the bank does not offer an explanation for the dishonor. It is frequently used when a bank suspects fraud, but cannot affirmatively establish it. In addition, one plaintiff alleged it was affirmatively misled by one of the defendants when, after receiving a returned check marked "Refer to Maker," it called the bank to confirm whether there were sufficient funds on deposit to cover the check and was told that Mr. Schick did have sufficient funds to cover the check. Further, Mr. Schick had also transferred funds from attorney trust accounts to his personal accounts.

The causes of action asserted against the banks included, among others, negligence, fraud, aiding and abetting fraud, and aiding and abetting breach of fiduciary duty. See id. For the reasons discussed below, the court dismissed all plaintiffs' aiding and abetting fraud claims and held that only those plaintiffs who actually had funds on deposit with one of the defendant banks (hereinafter, "Plaintiffs with Privity") had stated viable claims for negligence and aiding and abetting breach of fiduciary duty and affirmed the district court's dismissal of claims against any defendant in which the plaintiff did not have funds on deposit.

In reviewing plaintiff's negligence claim, the court first noted the general rule that "a depository bank has no duty to monitor fiduciary accounts maintained at its branches in order to safeguard funds in those accounts from fiduciary misappropriation" and stated that this rule applies to attorney trust accounts. See id. at * 10 (citations omitted). The court continued, however, that "a bank may be liable for participation in such a diversion, either by itself acquiring a benefit, or by notice or knowledge that a diversion is intended or being executed" and that adequate notice may come from chronic insufficiency of funds. Id. Moreover, under state law, banks are required to report overdrafts on attorney trust accounts to the Lawyers' Fund for Client Protection because "over drafts are particularly probative in signaling misappropriation." Id. at * 11. Thus, the court held: "Once [Mr.] Schick began repeatedly to overdraw on his attorney trust accounts at a defendant bank, that bank had a duty . . . to make reasonable inquiries and to safeguard attorney trust funds from [Mr.] Schick's misappropriation." See id. at * 12. Accordingly, the circuit reversed the district court's order dismissing the negligence claims of the Plaintiffs with Privity.

As to the fraud count, the court dismissed the claims of all plaintiffs, except the claim of the one plaintiff who was told by a defendant that there were sufficient funds on deposit to cover a returned check when in fact there were not, because the other plaintiffs could not point to any misrepresentation by any defendant that was relied on.

The court similarly dismissed the aiding and abetting fraud claims. To establish liability for aiding and abetting fraud, a plaintiff must show: (1) the existence of a fraud; (2) defendant's knowledge of the fraud; and (3) that the defendant provided substantial assistance to advance the fraud's commission. See id. at *15. The court held that the plaintiffs did not establish that the banks had actual knowledge of Mr. Schick's fraud. Specifically, the court stated that although the banks knew that he engaged in improper conduct that would warrant discipline, the alleged facts did not give rise to the "strong inference," required by FedRCivPro 9(b), of actual knowledge of his outright looting of client funds. See id. Accordingly, the court affirmed the district court's dismissal of plaintiffs' aiding and abetting fraud claims.

Turning to plaintiffs' aiding and abetting breach of fiduciary duty claim, the court held such claim had been sufficiently pled only by those Plaintiffs with Privity. The court distinguished this claim from the aiding and abetting fraud claim because, although the banks' knowledge that Mr. Schick was commingling funds and overdrawing trust accounts may not have been sufficient to show that the banks had actual knowledge of his theft of client funds, overdrawing trust accounts constituted a breach of fiduciary duty. Thus, the court focused on the second element, i.e., whether the banks knowingly induced or participated in Mr. Schick's breach of fiduciary duty.

In order to have knowingly participated, it must be shown that one provided "substantial assistance," which, according to the Court, occurs when " . . . a defendant affirmatively assists, helps conceal or fails to act when required to do so, thereby enabling the breach to occur. However, the mere inaction of an alleged aider and abettor constitutes substantial assistance only if the defendant owes a fiduciary duty directly to the plaintiff." Id. at * 17 (emphasis added). Because the court had already ruled that under applicable law the banks had a duty to make a reasonable inquiry, take steps to safeguard the trust funds and report the overdrafts on Mr. Schick's attorney trust accounts to the Lawyers' Fund, but failed to do so, the court held that the banks provided substantial assistance to Mr. Schick and could be liable to those Plaintiffs with Privity for aiding and abetting his breach of fiduciary duty. As succinctly stated by the court, "When put on notice of a misappropriation of trust funds, the banks in this case were obligated to take reasonable steps to prevent the misappropriation that an investigation would uncover." Id. at * 18. Accordingly, the court held that the banks' actual knowledge of Mr. Schick's breach of duty could provide the basis for an aiding and abetting claim by those Plaintiffs with Privity.

William S. Katchen is a partner and Michael F. Hahn is an associate with Duane Morris. The views expressed in this article are solely those of the authors and do not necessarily reflect the opinions of Duane Morris, its associates, or clients.

This article originally appeared in the New York Law Journal and is republished here with permission from law.com

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