Case Study: Delaware Bankruptcy Court Denies Trustee's Breach of Fiduciary Duty Suit

In March 2011, Frorer Partners, L.P., owned by Peter Frorer (Frorer), lent Fretz $450,000, Freeman $50,000 and Covenant $300,000 (Covenant Loan) (together, Loan(s)).  Each Loan had a note (the, Note(s)) and was secured by a pledge (the Pledge(s)) of Pet360 common shares by each borrower. The Notes and Pledges required repayment of principal, interest and return of the shares upon repayment. The Loans matured Nov. 30, 2011.

By December 2011, the Loans defaulted. In 2012-2013, Frorer Partners' auditor questioned their value and suggested write downs. The auditor didn't believe the 2011 Pledges protected the Loans.  Frorer threatened to sue if better collateral wasn't provided.  After over a year of negotiations, in March and September 2013, Covenant retitled 4.9 million Pet360 common shares into Frorer Partners' name to better collateralize the Covenant Loan. Frorer also gave a personal guaranty.

In 2013, Pet360 became a takeover target, including for PetSmart.  Frorer was Pet360's largest common shareholder.  On Feb. 21, 2014, Pet360's CEO told Frorer that Pet360 was in discussions about a sale to PetSmart. On June 11, 2014, Frorer “foreclosed” on the Pet360 shares held to secure the Covenant Loan. On July 9, 2014, Pet360's CEO told Frorer the terms of PetSmart's purchase, notably the per share price.

On July 30, 2014, for $400,000, Frorer purchased a $2.5 million judgment held against Covenant.  Frorer formed, Tripartite, LLC to make the purchase. Frorer then had Tripartite execute and obtain another 2.7 million Pet360 shares.

When the PetSmart sale was announced in August 2014, Defendants reported Frorer's activities to the SEC, which recommended a Chapter 7 filing by Covenant and a claw back action.  On Sept. 19, 2014, Defendants filed Covenant's Chapter 7 petition. The PetSmart deal closed on Sept. 29, 2014.

Defendants assisted the Trustee in suing Frorer for fraud and other claims, resulting in a recovery of all proceeds from Pet360's sale to PetSmart.  The Trustee then sued Defendants for breach of fiduciary duty, alleging the following wrongs: 1) the Loan Advances to Keystone; 2) Performance Fees paid in 2009 and 2010; 3) retitling Pet360 common shares in 2013; 4) “obligating” Covenant for personal Loans; and 5) improper accounting of assets. Seitz at 62.

Court's Analysis and Opinion

Because Covenant was a Delaware entity, Delaware substantive law applied. Because the case was in Pennsylvania, its statute of limitations applied. Seitz at 63 n. 25, 68-78.

The court decided three motions in limine by Defendants. One, which sought exclusion of evidence of negotiations between the Trustee and the SEC under Fed. R. Evid. 408, and as hearsay under Fed. R. Evid. 801, 802, was granted, while Defendants' motion to exclude the SEC settlement agreement was denied as moot, because the Trustee no longer sought its admission. A third motion in limine that sought exclusion of Frorer's hearsay statements, was denied because the statements were so extensive it was not possible for the court to make hearsay determinations. Rather, the court weighed the statements and decided they were unreliable, lacked probative value and did not consider them. Id. at 63-68.

Two Parts of the Trustee's Claim Were Time-Barred

The court applied Pennsylvania choice of law rules. Klaxon Co. v. Stentor Electric Manufacturing, 313 U.S. 487 (1941). Its borrowing statute applies the out-of-state limitations period or the Pennsylvania period “whichever first bars the claim.” Applying Pennsylvania's two-year period, not Delaware's three-year limitations period, the court concluded that the Trustee's claims for the Loan Advances and the Performance Fees, were barred because they had occurred over two years before the petition date. The court also concluded that there was no tolling. Seitz at 67-69.

In identifying fiduciary duties owed, the court reviewed §15-404(b) of the Delaware Revised Uniform Partnership Act (the Partnership Act), which can apply to Delaware limited partnerships. It states the statutory “default” fiduciary duties of loyalty and care, the former requiring fiduciaries to account to the partnership, not misappropriate partnership opportunities and refrain from competing. 6 Del. Code Ann. §15-404(b).

The court also cited to §15-404(c) of the Partnership Act for the Delaware default fiduciary duty of care, which “is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law.” Id., stating that “a court will only apply the Delaware Act's default fiduciary duties if the partners 'have not expressly made provisions in their partnership agreement.” Id. at 79-80 citing Gerber v. EPE Holdings, LLC, 2013 Del Ch. LEXIS 8 (Del. Ch. Jan. 18, 2013).

The court emphasized that “[t]he policy of the Delaware Act is 'to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements.” Seitz at 80 (citing 6 Del. Code Ann. §17-1101(b); Wenske v. Blue Bell Creameries, Inc., 2018 Del. Ch. LEXIS 221, 2018 WL 3337531, at 12 (Del. Ch., Jul. 6, 2018). The LPA may “disclaim fiduciary duties, and replace them with contractual duties.” Id. (citing Brinkerhoff v. Enbridge Energy Co., 159 A. 3d 242, 252 (Del. 2017) (citing §17-1101(d)). “Principles of contract law preempt fiduciary principles where the parties to a limited partnership have made their intentions to do so plain.” Id. (citing Brickell Partners v. Wise, 794 A. 2d 1, 3-4 (Del. CH. 2001) (quoting Sonet v. Timber Co., 722 A. 2d 319, 322 (Del Ch. 1998)).

Applying these rules to the facts, the court found that Covenant's LPA granted “full, exclusive and complete authority” to the General Partner to manage and control the business of Covenant and to cause it to borrow money and to pledge its assets as security. Seitz at 83-84. It also found that language §§7 and 8 of the LPA authorized Defendants to self-deal and have conflicts. Id.

Thus, the fiduciary duty of loyalty was disclaimed by Covenant's LPA. Id. Gotham Partners, L.P., 2000 Del. Ch. LEXIS 146, 2000 WL 1476663 at 10 (“Where the Partnership Agreement provides the standard that will govern the duty owed by a General Partner to its partners in self-dealing transactions, it is the contractual standard and not the default fiduciary duty of loyalty's fairness standard that exclusively controls.”) On the duty of care, the court took a different view, stating:

As to the duty of care, the closest the LPA comes to addressing this duty is in §12.1, which states that “[t]he General Partner shall exercise the authority granted herein to the best of its abilities and shall use its best efforts to carry out the business of the Partnership.” (Id. LPA §12.1).  By this language, the LPA has not made its intentions to disclaim a duty of care “plain.” Brickell Partners, 794 A. 2d at 3-4 (quoting Sonet, 722 A. 2d at 322).

Id. at 86.

The court then described the duty of care as follows:

[L]iability for breaching the duty of care 'is predicated upon concepts of gross negligence. Id. (quoting Aronson, 473 A. 2d at 812.) To find gross negligence, 'the decision has to be so grossly off-the-mark as to amount to reckless indifference or a gross abuse of discretion.' In re Zale Stockholders Litig., Civ. A. No. 9388, 2015 Del. Ch. LEXIS 274, 2015 WL 6551418, at 4 (Del. Ch. Oct. 29, 2015) (quoting Solash v. Telex Corp., 1988 Del. Ch. LEXIS 7, 1988 WL 3587, at 9 (Del. Ch. Jan. 19, 1988). Put another way, gross negligence has a 'stringent meaning' under Delaware partnership law, 'which involves a devil-may-care attitude or indifference to duty amounting to recklessness.'  (citations omitted). To prevail on a breach of duty of care claim, a plaintiff must prove 'that the defendant was “recklessly uniformed” or acted “outside the bounds of reason.” (citations omitted.)'

Id. at 87-89.

No Breach of Fiduciary Duty

The court noted that the LPA permitted the General Partner to enter into the Covenant Loan and to use Covenant's property as collateral. Id. It also noted that the Covenant Loan documents required the shares to be returned on repayment. The Trustee presented no evidence to show that Defendants' actions were grossly negligent. Id.

As for retitling the Pet360 shares, the court noted that the Covenant Loan had defaulted, Frorer and his auditors were demanding more collateral and were threatening to sue if better collateral was not provided.  “For approximately one year, Defendants battled with Frorer and his auditors over the retitling.” Id. at 90.

After protracted negotiations, Frorer's repeated threats and after speaking with Carrow, the retilting occurred in March and September 2013. Id. at 91.  On the Trustee's allegation that Defendants over-collateralized the Covenant Loan, the court referenced Pet360's CEO, who said that the shares had no known value and that their price was “highly variable, and very hard to value and that “[d]uring the time of the events challenged by the Trustee, Pet360 was a small, private startup company with no publicly traded stock and had never turned a profit.  (Doc. No. 15 at 3.)  Furthermore, no expert valuation of the Pet360 shares was done in the case.”  Id. at 93. The court concluded:

In pledging and then retitling the Pet360 shares into the name of Frorer Partners as collateral for the defaulted Covenant Loan, Defendants acted in an informed manner, considering the possibility that if they did not take action, Frorer Partners could in fact foreclose on the Pet360 shares.  Accordingly, their conduct in this case was not 'grossly off-the-mark'.

Id. at 93.

The Delaware Business Judgment Rule

The Delaware business judgment rule  “generally protects the actions of general partners, affording them a presumption that they acted on an informed basis and in the honest belief that they acted in the best interest of the partnership and the limited partners.  In re Boston Celtics Ltd. Partnership Shareholders Litigation, 1999 Del. Ch. LEXIS 166 (Del. Ch. Aug. 6, 1999) (citations omitted); Unocal Corp. v. Mesa Petroleum Co., 493 A. 2d 946, 954 (Del. 1985).”  Seitz at 93-95.  “In applying the business judgment rule, a court 'will not substitute its judgment for that of the board if the latter's decision can be 'attributed to any rational business purpose.'”  Id. (quoting Sinclair Oil Corp. v. Levien, 280 A. 2d 720 (Del. 1971).

“Instead, a court 'will presume' that partners 'take care to be informed in good faith'.  (citation omitted) If a partner, 'acting with due diligence and good faith, pursues a business strategy that [he] believes will increase the corporation's value, but that also involves the incurrence of additional debt, [he] does not become a guarantor of that strategy's success.'” Seitz at 94 (citing Trenwick Am. Litigation Trust v. Ernst & Young, L.L.P., 906 A. 2d 168, 205 (Del. Ch. 2006)).

The court concluded that the fact that over one year after the share retitlings, Pet360 was purchased by PetSmart for $1.00 per share, did not permit the court to “substitute its judgment for that of the Defendants. Defendants were not the guarantors of Covenant's success.  Defendants acted on an informed basis with the honest belief that, considering all of the circumstances, they were acting in Covenant's best interest. That the Pet360 shares turned out to be worth more than what Defendants thought at the time does not show that they breached their duty of care. Their actions are attributable to a rational business purpose and are protected by the business judgment rule. For these reasons, the Court finds that the Defendants did not breach their duty of care. And although no breach of contract cause of action was pled by the Trustee, Defendants acted within the authority given to them by Covenant's LPA.” Seitz at 94-96.

No Award for Damages

The court rejected the Trustee's “Loan consolidation” argument, concluding that he did not prove Defendants caused Covenant to become obligated for their personal Loans.  Nor had the Trustee shown that Defendants failed to account for various assets. Id. at 97-99. In addition, because the court was not able to find any breach of fiduciary duty by the Defendants, the Trustee was not entitled to damages. Id. at 99.

Practice Points

Consider withdrawing the reference:  If your client did not file a claim in the bankruptcy and is a defendant in an adversary, consider moving to withdraw the bankruptcy reference under 28 U.S.C. §157(d) for trial in district court. It can be a better forum for non-debtor parties.  See, Forte, Earl M., The Fraudulent Transfer Handbook (2017 Ed.), Ch. 22 “Bankruptcy courts vs. other courts – Withdrawal of the bankruptcy reference.”

The governing partnership agreement is critical:  Especially in Delaware, if a fiduciary duty claim arises in the limited partnership context, the limited partnership agreement is critical for determining what duties are owed.

The Delaware default duty of care has a very high misconduct threshold:  The default duty of care in Delaware has a gross negligence standard that requires almost total reckless indifference to impose liability.  The business judgment rule is also very protective.

Consider a breach of contract claim:  Delaware permits claims for breach of contract in partnership disputes, so a claim for breach of the partnership agreement should be considered. Seitz at 98. This might, for example, provide a longer limitations period.

Review the trustee's prior actions:  Review the Trustee's prior actions in the bankruptcy case and use those prior actions to your benefit if possible.

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Earl M. Forte is a Philadelphia-based attorney with the law firm of Eckert Seamans Cherin & Mellott, LLC. He advises clients in commercial disputes and bankruptcy cases, and has substantial experience with business torts and involving fraudulent transfer and breach of fiduciary duty.  The author represented defendants, William B. Fretz, Jr. and John P. Freeman in the Seitz case discussed in this article.