The Wagoner Doctrine Keeps Rolling

This common-sense doctrine is best and most recently embodied in Breeden v. Kirkpatrick & Lockhart LLP (In re Bennett Funding Group, Inc.), 336 F.3d 94 (2d Cir. 2003). Bennett Funding may go down in legal and business history as the greatest Ponzi scheme of the 1990s, if not the entire 20th century. Strictly ruled by a handful of closely related members of the Bennett family, the firm perpetrated massive fraud by selling and then reselling the same office equipment leases over and over again, defrauding lenders and investors alike.

This was made possible because the Bennett family comprised the company's sole shareholders, chairman, CEO and CFO, and a group exercised dictatorial control over the enterprise. The Bennetts likewise dominated the board of directors, with handpicked associates, who dared not question the inner family circle. Any non-family directors were powerless, a fact that proved critical later on.

Trustee Brings Claims

After the company fell into bankruptcy, trustee Richard Breeden brought claims against the debtors' outside attorneys for malpractice. The law firms' defense was a claim that the trustee lacked standing to sue them, for reason that the wrongdoing of the Bennett family had to be imputed to the corporate entity cum debtor and its trustee. Thereby tainted, only the outside creditors, and not the trustee as the successor in interest to the debtor, could maintain suit. On a motion for summary judgment, District Judge John Sprizzo of New York's Southern District ruled against the trustee, and dismissed the complaint. See 268 B.R. 704 (S.D.N.Y. 2001). The trustee appealed on the grounds that his lawsuit would only be barred if all the decision makers at the debtor were implicated in the company's wrongful conduct.

The Wagoner Doctrine

Writing for the Second Circuit, District Judge Harold Baer opened with the succinct declaration that a bankruptcy trustee generally has no standing to sue third parties on behalf of creditors, but may only assert claims held by the debtor itself. Therefore, where a defunct corporation has joined with a third party to commit fraud, the trustee cannot maintain suit. The taint of the debtor's misdeeds effectively denies a trustee standing to sue, a rule well settled by the Second Circuit in Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, 118 (2d Cir. 1991), and hence widely quoted as the Wagoner doctrine.

District Judge Baer noted Wagoner's maxim that “[w]here a corporation's management and a third party collaborated in the fraudulent scheme, the trustee can sue only if it can establish that there has been damage to the corporation apart from the damage to third-party creditors. Yet even if the company is damaged, the trustee is prohibited from recovery if the corporation's “sole shareholder and decision maker” was a culpable wrongdoer.

The rationale of Wagoner, declared the tribunal, is rooted in fundamental principles of agency law, specifically that the misconduct of managers within the scope of their employment will normally be imputed to the corporation. By definition, this excludes wrongful acts of an agent that are in reality for the benefit of the agent and not the corporate entity. Significantly, however, this exception only saves the business from imputation of the agent's fraud when the malfeasor had totally abandoned the interests of the corporation.

Lastly, where there is an identity between the corporation and the agent, the subprinciple holds in imputing the agent's knowledge of wrongdoing to the corporation, regardless of who the benefit accrues to, because the oneness of the culprit and the corporation makes the knowledge of the fraud inescapable. This is also called the “sole actor” exception, noted the court.

The Second Circuit had taken pains to point out these axioms and their variations for the following reason: It was agreed that Bennett family members were the central actors in fraud. It is well established that an agent's conduct is imputed to the corporation it serves, when the business accepts and benefits those acts, even wrongful ones. Here, the tribunal found that the debtors' financial affairs were dominated by the ruling family, and there was “uncontroverted evidence” that the domineering family exploited this advantage by diverting company funds to themselves. Moreover, they took steps to assure their unfettered control by bullying board members into submission, even those directors who were ostensibly independent. Applying the Wagoner rule, the panel concluded that knowledge of the fraud committed by company's ruling class must be imputed to the corporation itself, thus barring the trustee's suit.

The trustee next argued that the imputation of fraud as called for by Wagoner cannot be accomplished unless all relevant shareholders and/or decision makers are involved in the fraud. Wagoner does not apply if there are so called “innocent directors” in the management mix. The Second Circuit allowed that an exception to Wagoner exists if at least one decision maker in a management role or amongst the shareholders be untainted by the fraud, and, more importantly, be in a position to stop it.

But this was not the case here, as the allegedly independent directors were “impotent to actually do anything.” Regardless of intentions, the dictatorial control of the Bennett family rendered the outside directors as mere figureheads. In a sharp rebuke, the tribunal rejected what it characterized the trustee's “would-a, could-a, should-a test” as “simply not the law.” A theoretical power to arrest the fraud is never enough to forestall application of Wagoner, said the appellate court, and in the instant case the family's “control of every aspect of every activity within the [Bennett Funding] empire … from the get-go” doomed the trustee's argument to failure.

In conclusion, pursuant to the Wagoner rule, the corporation, and thus the trustee, had no right to sue Bennett Funding's law firms, given that the corporation was itself a perpetrator of the fraud. The taint of that fraud adhered to the trustee, and denied him standing to bring suit.

Conclusion

Overlooking Bennett Funding, its ultimate result should surprise no one. The Wagoner doctrine forecloses suit by a debtor or trustee when the root cause of the fraud can be found within the corporation's own executive suite. It would defy rationality to permit suits against third parties when the debtor's own perfidy gave rise to malfeasance within the business. Bennett Funding properly picks up the Wagoner, and delimits the standing of debtors or trustees to sue when the problems begin in their own backyards.

Moreover, Bennett Funding amplifies the importance of the “sole actor” and “innocent director” exceptions to the overall rule of Wagoner. First, the “sole actor” proviso salvages the right of the debtor or trustee to sue when the defrauding agent acts solely to benefit itself. That is only right, because the corporation should not be foreclosed from suit, when it was only injured and achieved no benefit. In the instant case, that did not happen, and the distinction serves as a critical contrast for future cases.

Second, the important corollary of the “innocent director” exception has limited availability. In order to work to save the corporation from the misdeeds of controlling persons on the inside, the debtor or trustee must demonstrate that not only did innocent directors or managers exist, they had the actual power to do something. As Bennett Funding so aptly teaches, the salvation of the “innocent director” only comes into play if those free of involvement had real power to do something positive to stop the fraud. To hold otherwise would vitiate Wagoner, and hand a convenient out to the undeserving.

In the final analysis, Bennett Funding reinforces well-reasoned rules of standing to sue, and ably assists those who might sue or be sued in bankruptcy cases influenced by corporate misdeeds. To further analyze the ramifications upon specific parties, we turn to the sidebar discussion below. Given the continued vitality of the Wagoner doctrine and its progeny Bennett Funding, we believe these principles will continue to dominate for a long time coming.

(see below)

Bennett Funding – A Checklist Of Who Loses, Who Benefits

Can the legal principles of Bennett Funding be easily distilled into a basic checklist of who wins, who loses, and why? Yes, it can, and here are the results.

“Honest” Debtors and Trustees. We leave the definition of “honest” to you. But it can be said with confidence that when a corporation is very much the victim of fraud by others, and neither obtains nor retains any benefit for itself, then the way is clear for the resulting debtor or trustee to sue third parties complicit in the wrongdoing.

“Not-So-Honest'” Debtors and Trustees. To be sure, trustees only inherit less-than-scrupulous situations, so no barbs intended here. Nonetheless, the imputation of fraud is unavoidable when the debtor is a willing participant in scandal or even just its beneficiary. As demonstrated, when key decision makers and owners participate in or condone fraud, they foreclose subsequent legal action by the debtor or trustee. Even mere acquiescence might be enough to prohibit suit.

Creditors. Without a doubt, creditors who were the eventual victims of corporate fraud are the biggest beneficiaries of Bennett Funding and its predecessors. They alone have unquestioned standing to sue for wrongs that injured them, and with the field cleared of the debtor or trustee, their course of action is simplified.

Potential Defendants. Rightly or wrongly, those third parties accused of aiding and abetting the fraud that leads to a debtor's downfall now have one less enemy to fight. The debtor and trustee of a complicit corporation is removed from the scene. Nonetheless, the injured creditors are still a force to be reckoned with, and rightly so. For the innocent, this eases the burden of defense, by having only one clear-cut set of adversaries. For the guilty, the ire of angry creditors will be solely focused on them, without the distraction of a competing debtor or trustee. Justice will be served swiftly and more certainly as a result of Bennett Funding.

A truism of bankruptcy is that assets available to pay creditors are few and far between. Among them are causes of action, and thus both debtors and trustees rightly hoard the right to sue third parties. Does the debtor or trustee have standing to sue when the entity brought the harm upon itself? Generally, the answer is no, and thus in this present environment of corporate misdeeds and scandals, litigation against outsiders is foreclosed by the debtor's own misfeasance.

But the rule has been severely tested of late, as a plethora of bankrupts brought down by fraud seek to recover from third parties that might have participated in the wrongdoing. Indeed, as this writing went to press, debtor Enron had just launched a $3 billion dollar lawsuit against its banks, claiming the financiers participated in fraudulent schemes against the company. See Hays, “Enron Suit Strikes Back,” The Houston Chronicle (Thursday, September 25, 2003). Nevertheless, the principle remains largely intact, and for good reason.

The Greatest Ponzi Scheme of the 90s

This common-sense doctrine is best and most recently embodied in Breeden v. Kirkpatrick & Lockhart LLP (In re Bennett Funding Group, Inc.), 336 F.3d 94 (2d Cir. 2003). Bennett Funding may go down in legal and business history as the greatest Ponzi scheme of the 1990s, if not the entire 20th century. Strictly ruled by a handful of closely related members of the Bennett family, the firm perpetrated massive fraud by selling and then reselling the same office equipment leases over and over again, defrauding lenders and investors alike.

This was made possible because the Bennett family comprised the company's sole shareholders, chairman, CEO and CFO, and a group exercised dictatorial control over the enterprise. The Bennetts likewise dominated the board of directors, with handpicked associates, who dared not question the inner family circle. Any non-family directors were powerless, a fact that proved critical later on.

Trustee Brings Claims

After the company fell into bankruptcy, trustee Richard Breeden brought claims against the debtors' outside attorneys for malpractice. The law firms' defense was a claim that the trustee lacked standing to sue them, for reason that the wrongdoing of the Bennett family had to be imputed to the corporate entity cum debtor and its trustee. Thereby tainted, only the outside creditors, and not the trustee as the successor in interest to the debtor, could maintain suit. On a motion for summary judgment, District Judge John Sprizzo of New York's Southern District ruled against the trustee, and dismissed the complaint. See 268 B.R. 704 (S.D.N.Y. 2001). The trustee appealed on the grounds that his lawsuit would only be barred if all the decision makers at the debtor were implicated in the company's wrongful conduct.

The Wagoner Doctrine

Writing for the Second Circuit, District Judge Harold Baer opened with the succinct declaration that a bankruptcy trustee generally has no standing to sue third parties on behalf of creditors, but may only assert claims held by the debtor itself. Therefore, where a defunct corporation has joined with a third party to commit fraud, the trustee cannot maintain suit. The taint of the debtor's misdeeds effectively denies a trustee standing to sue, a rule well settled by the Second Circuit in Shearson Lehman Hutton, Inc. v. Wagoner , 944 F.2d 114, 118 (2d Cir. 1991), and hence widely quoted as the Wagoner doctrine.

District Judge Baer noted Wagoner's maxim that “[w]here a corporation's management and a third party collaborated in the fraudulent scheme, the trustee can sue only if it can establish that there has been damage to the corporation apart from the damage to third-party creditors. Yet even if the company is damaged, the trustee is prohibited from recovery if the corporation's “sole shareholder and decision maker” was a culpable wrongdoer.

The rationale of Wagoner, declared the tribunal, is rooted in fundamental principles of agency law, specifically that the misconduct of managers within the scope of their employment will normally be imputed to the corporation. By definition, this excludes wrongful acts of an agent that are in reality for the benefit of the agent and not the corporate entity. Significantly, however, this exception only saves the business from imputation of the agent's fraud when the malfeasor had totally abandoned the interests of the corporation.

Lastly, where there is an identity between the corporation and the agent, the subprinciple holds in imputing the agent's knowledge of wrongdoing to the corporation, regardless of who the benefit accrues to, because the oneness of the culprit and the corporation makes the knowledge of the fraud inescapable. This is also called the “sole actor” exception, noted the court.

The Second Circuit had taken pains to point out these axioms and their variations for the following reason: It was agreed that Bennett family members were the central actors in fraud. It is well established that an agent's conduct is imputed to the corporation it serves, when the business accepts and benefits those acts, even wrongful ones. Here, the tribunal found that the debtors' financial affairs were dominated by the ruling family, and there was “uncontroverted evidence” that the domineering family exploited this advantage by diverting company funds to themselves. Moreover, they took steps to assure their unfettered control by bullying board members into submission, even those directors who were ostensibly independent. Applying the Wagoner rule, the panel concluded that knowledge of the fraud committed by company's ruling class must be imputed to the corporation itself, thus barring the trustee's suit.

The trustee next argued that the imputation of fraud as called for by Wagoner cannot be accomplished unless all relevant shareholders and/or decision makers are involved in the fraud. Wagoner does not apply if there are so called “innocent directors” in the management mix. The Second Circuit allowed that an exception to Wagoner exists if at least one decision maker in a management role or amongst the shareholders be untainted by the fraud, and, more importantly, be in a position to stop it.

But this was not the case here, as the allegedly independent directors were “impotent to actually do anything.” Regardless of intentions, the dictatorial control of the Bennett family rendered the outside directors as mere figureheads. In a sharp rebuke, the tribunal rejected what it characterized the trustee's “would-a, could-a, should-a test” as “simply not the law.” A theoretical power to arrest the fraud is never enough to forestall application of Wagoner, said the appellate court, and in the instant case the family's “control of every aspect of every activity within the [Bennett Funding] empire … from the get-go” doomed the trustee's argument to failure.

In conclusion, pursuant to the Wagoner rule, the corporation, and thus the trustee, had no right to sue Bennett Funding's law firms, given that the corporation was itself a perpetrator of the fraud. The taint of that fraud adhered to the trustee, and denied him standing to bring suit.

Conclusion

Overlooking Bennett Funding, its ultimate result should surprise no one. The Wagoner doctrine forecloses suit by a debtor or trustee when the root cause of the fraud can be found within the corporation's own executive suite. It would defy rationality to permit suits against third parties when the debtor's own perfidy gave rise to malfeasance within the business. Bennett Funding properly picks up the Wagoner, and delimits the standing of debtors or trustees to sue when the problems begin in their own backyards.

Moreover, Bennett Funding amplifies the importance of the “sole actor” and “innocent director” exceptions to the overall rule of Wagoner. First, the “sole actor” proviso salvages the right of the debtor or trustee to sue when the defrauding agent acts solely to benefit itself. That is only right, because the corporation should not be foreclosed from suit, when it was only injured and achieved no benefit. In the instant case, that did not happen, and the distinction serves as a critical contrast for future cases.

Second, the important corollary of the “innocent director” exception has limited availability. In order to work to save the corporation from the misdeeds of controlling persons on the inside, the debtor or trustee must demonstrate that not only did innocent directors or managers exist, they had the actual power to do something. As Bennett Funding so aptly teaches, the salvation of the “innocent director” only comes into play if those free of involvement had real power to do something positive to stop the fraud. To hold otherwise would vitiate Wagoner, and hand a convenient out to the undeserving.

In the final analysis, Bennett Funding reinforces well-reasoned rules of standing to sue, and ably assists those who might sue or be sued in bankruptcy cases influenced by corporate misdeeds. To further analyze the ramifications upon specific parties, we turn to the sidebar discussion below. Given the continued vitality of the Wagoner doctrine and its progeny Bennett Funding, we believe these principles will continue to dominate for a long time coming.

(see below)

Bennett Funding – A Checklist Of Who Loses, Who Benefits

Can the legal principles of Bennett Funding be easily distilled into a basic checklist of who wins, who loses, and why? Yes, it can, and here are the results.

“Honest” Debtors and Trustees. We leave the definition of “honest” to you. But it can be said with confidence that when a corporation is very much the victim of fraud by others, and neither obtains nor retains any benefit for itself, then the way is clear for the resulting debtor or trustee to sue third parties complicit in the wrongdoing.

“Not-So-Honest'” Debtors and Trustees. To be sure, trustees only inherit less-than-scrupulous situations, so no barbs intended here. Nonetheless, the imputation of fraud is unavoidable when the debtor is a willing participant in scandal or even just its beneficiary. As demonstrated, when key decision makers and owners participate in or condone fraud, they foreclose subsequent legal action by the debtor or trustee. Even mere acquiescence might be enough to prohibit suit.

Creditors. Without a doubt, creditors who were the eventual victims of corporate fraud are the biggest beneficiaries of Bennett Funding and its predecessors. They alone have unquestioned standing to sue for wrongs that injured them, and with the field cleared of the debtor or trustee, their course of action is simplified.

Potential Defendants. Rightly or wrongly, those third parties accused of aiding and abetting the fraud that leads to a debtor's downfall now have one less enemy to fight. The debtor and trustee of a complicit corporation is removed from the scene. Nonetheless, the injured creditors are still a force to be reckoned with, and rightly so. For the innocent, this eases the burden of defense, by having only one clear-cut set of adversaries. For the guilty, the ire of angry creditors will be solely focused on them, without the distraction of a competing debtor or trustee. Justice will be served swiftly and more certainly as a result of Bennett Funding.