Company in Financial Trouble? Officers Beware

In these increasingly financially troubled times, it is important to remember that Bankruptcy Courts, trustees and creditors' committees may investigate the pre-bankruptcy acts and omissions of officers and directors. A recent decision by the U.S. Bankruptcy Court for the District of Delaware highlights the need for all corporate officers, including general counsel, to remain vigilant as to the conduct of their fellow officers.

In Miller v. McDonald, et al. (In re World Health Alternatives, Inc.), Bankr. Case No. 06-10166, Adv. Pro. No. 07-51350, the Chapter 7 Trustee brought an adversary proceeding against various individuals who had served as officers of World Health Alternatives, including Brian T. Licastro, who had served as Vice President of Operations and General Counsel. The Trustee alleged that the defendants had, among other things, breached their fiduciary duties, aided and abetted the breach of fiduciary duties, wasted corporate assets, aided and abetted the corporate waste, committed fraud, aided and abetted the fraud, and made negligent misrepresentations. Additionally, the Trustee brought a claim against Licastro for professional negligence in his role as general counsel. The Trustee's allegations were based on false representations made to lenders, false representations in financial statements submitted to the S.E.C., the diversion of funds intended to pay taxes, and lavish spending on corporate jets and luxury cars at a time when the company was reporting negative income.

Licastro moved to dismiss all counts in the complaint. The Bankruptcy Court granted the motion as to the fraudulent transfer and equitable subordination counts. However, Judge Walsh rejected Licastro's arguments as to the causes of action for alleged bad acts. Contrary to Licastro's argument, the Bankruptcy Court determined that under Delaware case law "the fiduciary duties of officers have been assumed to be identical to those of directors." See Miller v. McDonald, Adv. Pro. No. 07-51350, Memorandum Opinion [ECF 139], www.deb.uscourts.gov, citing In re Walt Disney Co. Derivative Litigation, No. Civ. A. 15452, 2004 WL 2050138, at *3 (Del. Ch. Sept. 10, 2004); see also In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959, 969 (Del. Ch. 1996). In rejecting Licastro's argument that there were no allegations that he personally gained or otherwise had knowledge or affirmatively participated in any wrongdoing, the court held that Licastro's failure to "implement an adequate monitoring system and/or the failure to utilize such system to safeguard against corporate wrongdoing" constituted a breach of his fiduciary duty. Id. Moreover, the court determined that 17 C.F.R. Part 205 (Jan. 29, 2007), adopted by the S.E.C. pursuant to § 307 of the Sarbanes-Oxley Act, created a fiduciary duty owed by a general counsel to inspect the truthfulness of financial statements submitted to the S.E.C. and to report up the chain of command if he or she suspects wrongdoing. Id. In sum, the court found that Licastro, by virtue of his being a member of senior management, knew or should have known of the corporate wrongdoing taking place around him yet failed to do anything to prevent it.

With respect to the allegations of professional negligence, the Bankruptcy Court found that the complaint sufficiently stated a claim of professional negligence by alleging that Licastro "breached the applicable standard of care … by not providing oversight and failing to provide advice that would have prevented [World Health Alternatives] from submitting S.E.C. filings that included material misrepresentations." Id., citing Miller v. McDonald, Adv. Pro. No. 07-51350, First Amended Complaint [ECF 89], http://www.deb.uscourts.gov/.

Although the court's ruling does not expand the scope of potential liability for officers and directors, the opinion is a fresh reminder that members of senior management owe fiduciary duties to the corporation and, when those duties are breached, those individuals face the possibility of personal liability for their actions.