Enron Versus Wall Street

In addition to the SPEs, Enron also structured transactions called “prepays.” These are transactions in the commodities markets in which parties arrange for the upfront prepayment of commodities to be delivered at a later date. It is alleged that Enron used prepay transactions designed by the bank defendants to disguise loans to Enron, and to inflate operating cash flow. The complaint reveals that these transactions generally occurred at the end of fiscal reporting periods. It alleges that the prepay transactions employed a structure that eliminated market risk from the transactions, to take advantage of favorable accounting rules. Had the defendants simply loaned the money, Enron would have had to report the loans as debt on the balance sheet. Moreover, by characterizing these transactions as prepay, the insiders booked the obligations as “price risk management” liabilities, thus avoiding the radar screens of various rating agencies, which monitored Enron's debt and related financial ratios. The complaint alleges that the defendants knew the insiders were manipulating the balance sheet and executing the prepay transactions to improperly bolster operating cash flow, and to hide debt from the rating agencies and others.

The plaintiffs allege that in each of the subject transactions, the defendants participated with “actual knowledge” that the transaction was designed to, or would, benefit the insiders, at the company's expense. In return, the defendants received large fees. The complaint alleges that as a result of the defendants actions, the company was injured in one of the following ways: 1) its debt was wrongfully expanded out of all proportion to its ability to repay and it became insolvent and thereafter deeply insolvent; 2) it was forced to file bankruptcy and incurred and continues to incur substantial legal and administrative costs, as well as the costs of governmental investigations; 3) its relationships with its customers, suppliers and employees were undermined; and 4) its assets were dissipated. Complaint at ' 797.

Aiding and Abetting Breach of Fiduciary Duty

It has been stated that: “Where a person in a fiduciary relation to another violates his duty as a fiduciary, a third person who participates in the violation of duty is liable to the beneficiary.” 5 Scott on Trusts, ' 506 at 3568 (3d ed. 1967).

The long-held standard for aiding and abetting breach of fiduciary duty generally requires the plaintiff to prove the following elements: 1) a breach by a fiduciary of obligations to another; 2) that the defendant knowingly induced or participated in the breach; and 3) that the plaintiff suffered damages as a result of the breach. See, Whitney v. Citibank, N.A., 782 F.2d 1106 (2nd Cir. 1986). See also, In re Exide Technologies Inc., 299 B.R. 732 (Bankr. D. Del. 2003) (denying motion to dismiss aiding and abetting count against syndicate of lenders where, inter alia, lenders allegedly participated in insiders' breaches of duties by, inter alia, inducing the debtors to consummate an acquisition when the debtors were insolvent, granting additional collateral against debtors, using financial leverage by preventing debtors from timely filing Chapter 11, to avoid 90-day preference period).

Knowingly Inducing or Participating in the Breach

The second prong of the aiding and abetting cause of action requires the defendant to have either a) knowingly induced or b) participated in, the breach of fidiciary duty. To satisfy the “knowing inducement” element, is actual or constructive knowledge required? Is intent to harm required? These questions appear very relevant to the Enron action.

In the recent case of In re Sharp International Corp. 281 B.R. 506 (Bankr. E.D.N.Y. 2002) the court concluded that, under New York law, the plaintiff is not required to prove intent to harm, but rather that the aider and abetter had actual knowledge of the breach and “induced or participated in it.” Id. at 514 (citations omitted). Importantly, the court ruled that “constructive knowledge is legally insufficient to impose aiding and abetting liability.” Id. (citations omitted) In the Sharp case, the plaintiff's complaint did not allege that the lender had actual knowledge of the insiders diversion of funds, but merely that the lender had suspicions of fraudulent activity, which were ultimately confirmed. The court held that “suspicion and surmise do not constitute actual knowledge,” Id., and dismissed the aiding and abetting claim against the lender.

Participation in the Breach

A defendant may also be held liable for participating in another's breach of fiduciary duty if the defendant provided “substantial assistance.” S&K Sales Co. v. Nike, Inc. 816 F.2d 843, 848 (2nd Cir. 1987). Under New York law, “substantial assistance” requires a showing that the aider and abetter affirmatively assists, helps conceal, or by virtue of failing to act when required to do so, enables the breach of duty to proceed. Sharp, supra, at 516. It has been held that the inaction of an aider and abetter constitutes “substantial assistance” only if the defendant owes an independent fiduciary duty to plaintiff. Id.

In Whitney v. Citibank, N.A., supra, one limited partner of a partnership sued the partnership's lender based upon two co-partners' breach of duty, and the lenders' knowing participation in the breach. The partnership in Whitney was set up to develop a residential apartment project, under an option to purchase the property from its owner. The lender thereafter became the owner of the subject property, as a result of a foreclosure. Rather than sell the property to the partnership with whom it contracted, the bank decided to sell the property to a third party for a higher price. To effectuate the sale, the lender needed the consent of the partnership. Two of the three partners gave the lender their consent, in return for which, the lender paid them $200,000. This was done without plaintiff's knowledge or consent. After making inquiries to the lender, plaintiff was never advised by the lender of the agreement to pay the plaintiffs partners $200,000 for obtaining the partnership consent.

The court upheld an award of both compensatory and punitive damages against the bank. The Court of Appeals observed that “there were red flags flying all over the place. Once [defendant] was put on notice of questions concerning the authority of [the two partners] to bind the partnership without [plaintiff's] consent, it owed a duty to reveal the facts to [plaintiff] … ” Id. at 1116.

Conclusion

Whether the allegations made in the Enron complaint, if proven true, will be sufficient to establish that the defendants aided and abetted the insiders' breach of duty will be of interest to bankruptcy practitioners and loan officers alike. The lawsuit may further develop the growing doctrine of aiding and abetting breach of fiduciary duties, particularly as against banks and lending institutions.

In late September 2003, Enron Corp. and Enron North America Corp. sued more than 40 banks and financial institution defendants for knowingly participating with insiders of Enron in a “multi-year scheme to manipulate and misstate Enron's financial condition.” Complaint at '1.

A Brief Summary

While the filed complaint (279 pages with 53 separate counts against multiple defendants) raises many complex facts, to summarize, generally: Enron entered into business relationships with “special purpose” partnerships, in which insiders were managers and investors. These partnerships were generally set up as special purpose entities (SPEs) designed to give Enron the appearance of a healthier financial condition, by removing from Enron's balance sheet assets that lost or were at risk of losing value. SPEs are commonly used financial structures, and serve legitimate goals of enhancing liquidity and reducing credit risk. However, in the Enron litigation, the debtors allege that the SPEs were created to misstate Enron's true financial health. The debtors also allege that while the bank defendants appeared to make “at risk” investments in the SPEs, as required by applicable accounting regulations, insiders gave “secret assurances” to the defendants that these investments would be repaid. In fact, is alleged that the bank defendants often “insisted” these investments be repaid, thereby violating accounting rules for SPEs. The complaint alleges that, with knowledge by the defendants, insiders of Enron treated the proceeds received under the SPE transactions as operating cash flow, rather than as financing activities. Given such improper accounting and false and misleading financial disclosures surrounding these off balance sheet partnerships, the SPEs were tainted, credit rating agencies were duped, and the rest, as they say, is history.

In addition to the SPEs, Enron also structured transactions called “prepays.” These are transactions in the commodities markets in which parties arrange for the upfront prepayment of commodities to be delivered at a later date. It is alleged that Enron used prepay transactions designed by the bank defendants to disguise loans to Enron, and to inflate operating cash flow. The complaint reveals that these transactions generally occurred at the end of fiscal reporting periods. It alleges that the prepay transactions employed a structure that eliminated market risk from the transactions, to take advantage of favorable accounting rules. Had the defendants simply loaned the money, Enron would have had to report the loans as debt on the balance sheet. Moreover, by characterizing these transactions as prepay, the insiders booked the obligations as “price risk management” liabilities, thus avoiding the radar screens of various rating agencies, which monitored Enron's debt and related financial ratios. The complaint alleges that the defendants knew the insiders were manipulating the balance sheet and executing the prepay transactions to improperly bolster operating cash flow, and to hide debt from the rating agencies and others.

The plaintiffs allege that in each of the subject transactions, the defendants participated with “actual knowledge” that the transaction was designed to, or would, benefit the insiders, at the company's expense. In return, the defendants received large fees. The complaint alleges that as a result of the defendants actions, the company was injured in one of the following ways: 1) its debt was wrongfully expanded out of all proportion to its ability to repay and it became insolvent and thereafter deeply insolvent; 2) it was forced to file bankruptcy and incurred and continues to incur substantial legal and administrative costs, as well as the costs of governmental investigations; 3) its relationships with its customers, suppliers and employees were undermined; and 4) its assets were dissipated. Complaint at ' 797.

Aiding and Abetting Breach of Fiduciary Duty

It has been stated that: “Where a person in a fiduciary relation to another violates his duty as a fiduciary, a third person who participates in the violation of duty is liable to the beneficiary.” 5 Scott on Trusts, ' 506 at 3568 (3d ed. 1967).

The long-held standard for aiding and abetting breach of fiduciary duty generally requires the plaintiff to prove the following elements: 1) a breach by a fiduciary of obligations to another; 2) that the defendant knowingly induced or participated in the breach; and 3) that the plaintiff suffered damages as a result of the breach. See, Whitney v. Citibank, N.A. , 782 F.2d 1106 (2nd Cir. 1986). See also, In re Exide Technologies Inc., 299 B.R. 732 (Bankr. D. Del. 2003) (denying motion to dismiss aiding and abetting count against syndicate of lenders where, inter alia, lenders allegedly participated in insiders' breaches of duties by, inter alia, inducing the debtors to consummate an acquisition when the debtors were insolvent, granting additional collateral against debtors, using financial leverage by preventing debtors from timely filing Chapter 11, to avoid 90-day preference period).

Knowingly Inducing or Participating in the Breach

The second prong of the aiding and abetting cause of action requires the defendant to have either a) knowingly induced or b) participated in, the breach of fidiciary duty. To satisfy the “knowing inducement” element, is actual or constructive knowledge required? Is intent to harm required? These questions appear very relevant to the Enron action.

In the recent case of In re Sharp International Corp. 281 B.R. 506 (Bankr. E.D.N.Y. 2002) the court concluded that, under New York law, the plaintiff is not required to prove intent to harm, but rather that the aider and abetter had actual knowledge of the breach and “induced or participated in it.” Id. at 514 (citations omitted). Importantly, the court ruled that “constructive knowledge is legally insufficient to impose aiding and abetting liability.” Id. (citations omitted) In the Sharp case, the plaintiff's complaint did not allege that the lender had actual knowledge of the insiders diversion of funds, but merely that the lender had suspicions of fraudulent activity, which were ultimately confirmed. The court held that “suspicion and surmise do not constitute actual knowledge,” Id., and dismissed the aiding and abetting claim against the lender.

Participation in the Breach

A defendant may also be held liable for participating in another's breach of fiduciary duty if the defendant provided “substantial assistance.” S&K Sales Co. v. Nike, Inc. 816 F.2d 843, 848 (2nd Cir. 1987). Under New York law, “substantial assistance” requires a showing that the aider and abetter affirmatively assists, helps conceal, or by virtue of failing to act when required to do so, enables the breach of duty to proceed. Sharp, supra, at 516. It has been held that the inaction of an aider and abetter constitutes “substantial assistance” only if the defendant owes an independent fiduciary duty to plaintiff. Id.

In Whitney v. Citibank, N.A., supra, one limited partner of a partnership sued the partnership's lender based upon two co-partners' breach of duty, and the lenders' knowing participation in the breach. The partnership in Whitney was set up to develop a residential apartment project, under an option to purchase the property from its owner. The lender thereafter became the owner of the subject property, as a result of a foreclosure. Rather than sell the property to the partnership with whom it contracted, the bank decided to sell the property to a third party for a higher price. To effectuate the sale, the lender needed the consent of the partnership. Two of the three partners gave the lender their consent, in return for which, the lender paid them $200,000. This was done without plaintiff's knowledge or consent. After making inquiries to the lender, plaintiff was never advised by the lender of the agreement to pay the plaintiffs partners $200,000 for obtaining the partnership consent.

The court upheld an award of both compensatory and punitive damages against the bank. The Court of Appeals observed that “there were red flags flying all over the place. Once [defendant] was put on notice of questions concerning the authority of [the two partners] to bind the partnership without [plaintiff's] consent, it owed a duty to reveal the facts to [plaintiff] … ” Id. at 1116.

Conclusion

Whether the allegations made in the Enron complaint, if proven true, will be sufficient to establish that the defendants aided and abetted the insiders' breach of duty will be of interest to bankruptcy practitioners and loan officers alike. The lawsuit may further develop the growing doctrine of aiding and abetting breach of fiduciary duties, particularly as against banks and lending institutions.