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Bankruptcy Court Partially Dismisses Liquidating Trustee's Complaint against Debtor's Minority Shareholder and its Principal

Monday, August 1, 2011

The United States Bankruptcy Court for the District of Delaware partially dismissed a complaint filed by a liquidating trustee against a private equity firm and its principal for breach of fiduciary duty and fraud. Specifically, the bankruptcy court dismissed the breach of fiduciary duty claim against the private equity firm for failure to demonstrate that, as a minority shareholder, it exercised “actual control” over the debtor and also dismissed the trustee’s fraud claims for failure to prove that alleged representations by the principal that the private equity firm “was likely to” provide additional financing constituted fraud. At the same time, however, the bankruptcy court declined to dismiss the breach of loyalty claim against the private equity firm’s principal, who served on Debtor’s board, based on the allegation that he had secretly met with the debtor’s largest competitor. The bankruptcy court’s decision illustrates the difficulties associated with seeking redress against a debtor’s former shareholders and principals, as well as the potential liability for such parties if such a breach of duty can be established.

GA and Kelly’s Relationship with Debtor

In March 2002, prior to the bankruptcy filing of ProxyMed, Inc. (“Debtor”), General Atlantic LLC (“GA”), a private equity firm, entered into a stock and warrant purchase agreement (“Purchase Agreement”) with Debtor, under which it acquired unregistered shares of Debtor’s common stock and warrants to purchase additional shares after April 5, 2003. In accordance with the Purchase Agreement, GA appointed Braden Kelly (“Kelly”), a managing member of GA, to Debtor’s board of directors. As of March 28, 2003, GA’s shares represented 2.9 percent of the voting interests of Debtor. Thereafter, following an acquisition by Debtor of a third party company, GA exercised its original warrants under the Purchase Agreement, thereby increasing its ownership in Debtor to 26.8 percent. Notably, while serving on Debtor’s board of directors, Kelly had significant involvement in the governance of Debtor, including searching for Debtor’s new CEO, John Lettko (“Lettko), who subsequently consulted with Kelly regularly regarding the daily operation of Debtor.

GA’s Representations Regarding its Continued Financing of Debtor

In the course of his interview process and thereafter, Kelly allegedly repeatedly indicated to Lettko that GA would continue to provide financing to Debtor. Additionally, in May 2006, Kelly indicated that GA would either “lead or follow the financing” for Debtor to begin acquiring more preferred provider organization networks (“PPOs”). Similarly, on September 7, 2006, a managing director of GA invited Lettko to New York to discuss the possibility of GA providing further financing and, on September 14, 2006, Kelly again represented to Lettko that GA was probably interested in participating in financing on a pro rata basis. During this same time period, however, GA began to pursue an investment in Emdeon Business Services (“EBS”), a significant competitor of Debtor, with Kelly allegedly making assurances to EBS that GA’s ownership stake in Debtor would not constitute an impediment to consummating a deal (“Kelly/EBS Meeting”). Significantly, on or about September 18, 2006, the GA managing director overseeing the EBS deal sent an email to another GA managing director stating that Kelly thought that EBS represented a better investment opportunity than did Debtor. Shortly thereafter, on September 26, 2006, EBS announced GA’s investment of $325 million in cash and a $925 million loan in EBS and, later that same day, William Ford ("Ford") informed Lettko that GA would not provide any additional financing to Debtor. Debtor then tried, without success, to obtain additional financing and, on July 23, 2008, filed a voluntary petition for chapter 11 bankruptcy.

Liquidating Trustee’s Complaint against GA and Kelly

Pursuant to Debtor’s confirmed plan, a liquidating trustee (“Trustee”) assumed control over Debtor’s remaining assets, including any causes of action. In this role, the Trustee filed a complaint against GA and Kelly for breach of their fiduciary duties and for fraud. Specifically, the Trustee alleged that Kelly had concealed his conflict of interest resulting from GA’s pursuit of an investment in EBS, had misrepresented GA’s interest in making an additional investment in Debtor, and had failed to inform Debtor that it should not rely on GA to provide any additional financing. In response, GA and Kelly moved to dismiss the complaint (“Motion to Dismiss”), arguing that the fiduciary duty claims were governed by Florida law, as the state of Debtor’s incorporation. GA additionally asserted that, as a minority shareholder, it did not owe a fiduciary duty to Debtor and that it did not exercise control of Debtor so as to fit within a narrow exception that creates a fiduciary duty under such circumstances. Finally, Kelly argued that the Complaint had failed to establish a breach of his duty of loyalty, and GA asserted that the Trustee’s fraud claims had failed under Delaware law.

Bankruptcy Court Dismisses Breach of Fiduciary Duty Claim against GA Only

Rendering its decision on the Motion to Dismiss, the bankruptcy court began its analysis by considering the law applicable to the Trustee’s fiduciary duty claims and determined that although Florida law, as the state of incorporation, was applicable, Delaware law was also relevant because the Florida courts typically look to Delaware law to establish their own corporate doctrines. See In re World Health Alternatives, Inc., 385 B.R. 576, 590 (Bankr. D. Del. 2008). Applying Florida law, the bankruptcy court concluded that although Florida recognizes a cause of action against majority shareholders who “utilize their control of the corporation to their advantage as against the minority shareholder,” see Tillis v. United Parts, Inc., 395 So.2d 618, 619 (Fla. Dist. Ct. App. 1981), the Trustee had failed to allege facts supporting the contention that GA exercised such “actual control” over Debtor. Concluding, in contrast, that the Trustee’s breach of fiduciary duty claim against Kelly had been sufficiently pled, the bankruptcy court noted that, under both Florida and Delaware law, officers and directors owe fiduciary duties to the corporation and its shareholders, and that good faith is embedded with this duty. See Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006). Applying this standard, the bankruptcy court decided that the Complaint sufficiently alleged that Kelly had violated his duty of good faith by partaking in the Kelly/EBS Meeting in order to ensure that GA’s investment in Debtor would not interfere with GA’s investment in EBS. Accordingly, the bankruptcy court granted the Motion to Dismiss with respect to the breach of fiduciary duty claim against GA, but declined to dismiss the breach of loyalty claim against Kelly.

Bankruptcy Court Dismisses Liquidating Trustee’s Fraud Claims

Focusing next on the Trustee’s fraud claim, the bankruptcy court resolved that, contrary to the parties’ assertion, it was unnecessary to conduct a choice of law analysis because the claim failed under either New York or Delaware law. Pointing out that the Trustee based his fraud claim on the detrimental reliance that Debtor placed on alleged misrepresentations that Kelly had made regarding providing additional financing, the bankruptcy court found that no action for fraud arises under Delaware law if a speaker makes a promise, which is intended to be performed, yet later reneges on such promise. Similarly, the bankruptcy court determined that although New York law permits an action for fraud based on statements of opinion where a confidential relationship exists, no such relationship existed in the instant case. Hutchins v. Utica Mut. Ins. Co., 107 A.D.2d 871, 872 (N.Y. App. Div. 1985). Moreover, while recognizing that specific affirmations are actionable under New York law under some circumstances, the bankruptcy court concluded that predictions of future actions, such as those made by Kelly indicating that GA “was likely to” or “interested in” providing further financing to Debtor, are too uncertain to sustain a cause of action for fraud. See Burgundy Basin Inn, Ltd. v. Watkins Glen Grand Prix Corp., 51 A.D.2d 140, 144-45 (N.Y. App. Div. 1976). Finally, the bankruptcy court noted that there was no plausible allegation in the Complaint that the speakers knew their statements to be false. Accordingly, the bankruptcy court ruled that the Trustee’s fraud allegations were insufficient to withstand the stringent pleading requirements under Federal Rule of Civil Procedure 9(b) and should thus be dismissed.

Bankruptcy Court Partially Dismisses Liquidating Trustee’s Complaint

Ultimately, the bankruptcy court granted the Motion to Dismiss with respect to the Liquidating Trustee’s breach of fiduciary duty claims against GA and fraud claim, but denied the motion as to the breach of loyalty claim against Kelly. As a result, the Trustee’s recovery on the Complaint will depend on the ability to prove at trial that Kelly breached his duty of loyalty to Debtor.

Disclaimer

This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.

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