Opinion
Case No. 96-61376 Chapter 11; Adv. Pro. No. 97-70049A
August 9, 2000
Thomas J. McCormack, Esq., CHADBOURNE PARKE LLP, New York, New York, for Defendants Sherwood Insurance Services, Inc. and Ivan Richard Small.
Conrad K. Harper, Esq., SIMPSON THACHER BARTLETT, New York, New York, for § 1104 Trustee.
Guy A. Van Baalen, Esq., Utica, New York, Assistant U.S. Trustee.
MEMORANDUM-DECISION, PROPOSED FINDINGS OF FACT, CONCLUSIONS OF LAW AND RECOMMENDATIONS
Presently before the Court is a motion filed on December 27, 1999, on behalf of Sherwood Insurance Services, Inc. ("Sherwood") and Ivan Richard Small ("Small"), seeking dismissal of Counts V and VI of the Third Amended Adversary Complaint filed by Richard C. Breeden as Chapter 11 trustee ("Trustee") of the consolidated case of The Bennett Funding Group, Inc. ("BFG"). Opposition to the motion was filed by the Trustee on January 10, 2000, to which Sherwood and Small filed a reply on January 14, 2000.
The motion was scheduled to be heard on January 13, 2000, in Utica, New York. The court advised the parties that it would issue a written decision based upon the parties' pleadings and memoranda without the necessity of oral argument.
JURISDICTIONAL STATEMENT
The Court has "related to" jurisdiction pursuant to 28 U.S.C. § 157 (c) to the extent that the causes of action found in the Trustee's Third Amended Adversary Complaint for which Sherwood and Small seek dismissal are based on aiding and abetting fraud and aiding and abetting a breach of fiduciary duty to BFG by its former Chief Financial Officer, Patrick Bennett.
FACTUAL BACKGROUND
The Debtors in this Chapter 11 case are eight interrelated companies that comprised a network of financial service companies formerly controlled by the Bennett family of Syracuse, New York. Following accusations of massive criminal securities fraud in March 1996 by the Securities Exchange Commission, petitions were filed by the Debtors pursuant to Chapter 11 of the Bankruptcy Code (11 U.S.C. § 101-1330) ("Code"). On April 18, 1996, the Trustee was appointed in what was later to become a substantively consolidated case by Order of this Court, dated July 25, 1997. Since that time, numerous adversary proceedings have been commenced by the Trustee in this Court which seek damages from the Debtors, certain of their officers, and numerous third parties who allegedly abetted the fraud.
Most recently, on September 9, 1999, the Trustee filed a motion in this adversary proceeding for permission to serve and file his Third Amended Adversary Complaint seeking to add Sherwood and Small as defendants. The adversary proceeding initially was commenced on February 24, 1997, and according to the Third Amended Adversary Complaint, the Trustee is seeking the entry of a judgment:
(a) awarding Plaintiff compensatory damages for breach of a reinsurance cover note (the "Reinsurance Cover Note") brokered and drafted by Lloyd Thompson Limited ("Lloyd Thompson") and issued by Sphere Drake Insurance plc ("Sphere Drake") and Sphere Drake Underwriting management (Bermuda) Limited ("Sphere Drake Underwriting," collectively the "Sphere Drake Defendants") with respect to an insurance policy issued to The Bennett Funding Group, Inc. ("BFG") by Capital Insurance Company, Ltd. ("Capital Insurance"), formerly known as Bennett Insurance Company ("BIC"), a captive insurer managed by Triangle Insurance Management Limited ("Triangle"); (b) declaring that Plaintiff has the sole interest in, and right to, the proceeds of the Reinsurance Cover Note and that the Sphere Drake Defendants are obligated to pay all deficiencies between the obligation to pay and the lease payments received; (c) avoiding, as preferential transfers, the designation of defendants Dollar Capital Corporation ("Dollar Capital") and The Commercial Bank ("Commercial Bank") as loss payees under the insurance policy issued by Capital Insurance as loss payees under the insurance policy issued by Capital Insurance to BFG, and ordering the turnover of the transferred property to the Trustee; (d) awarding Plaintiff compensatory damages as a result of the actions of Lloyd Thompson, Triangle, the Sphere Drake Defendants, Sherwood and Small in aiding and abetting the fraud perpetrated on BFG by Patrick R. Bennett ("Patrick Bennett") and others; (e) awarding Plaintiff compensatory damages as a result of the actions of Lloyd Thompson, Triangle, the Sphere Drake Defendants, Sherwood and Small in aiding and abetting the breach of the fiduciary duty owed by Patrick Bennett to BFG; (f) awarding Plaintiff compensatory damages as a result of the Sphere Drake Defendants' negligence in failing, during their audits and inspections of BFG's books and records, to detect the fraud and other wrongdoing committed by Patrick Bennett and his aiders and abettors, and/or in concealing their knowledge of the fraudulent activities; and (g) granting such other and further relief as the Court deems just.
See Trustee's Third Amended Adversary Complaint at ¶ 1.
The Trustee's motion was unopposed and on October 29, 1999, the Court issued an Order granting the Trustee's request.
The following statement of facts is drawn from the pleadings of the Trustee, unless otherwise indicated. The Court presents these allegations merely for the purpose of providing background. They do not constitute findings of fact by the Court which would be binding on the parties in any subsequent proceedings.
1. The Debtors
The Trustee's adversary complaint was filed on behalf of two of the debtor entities, specifically, BFG, whose principal business consisted of originating and assigning equipment lease contracts to investors, and The Processing Center, Inc. ("TPC"), which would service the leases generated by BFG. Although BFG had been a legitimate, reputable finance company for the first decade of its existence, the nature of its business underwent a fundamental change in or about 1988. Under the direction of Patrick Bennett, its Chief Financial Officer, BFG began to assign leases which, unbeknownst to the investors who paid for them, had already been assigned to other persons. This deception was made possible, in part, by the intricacies of BFG's lease servicing program, under which TPC would continue to make collections from the lessees on behalf of the investors who had purchased the future lease payments. While each multiple-pledged lease would provide a short-term benefit to BFG, this fraud had the long-term effect of deepening BFG's insolvency since each investor would eventually demand to be paid back in an amount greater than his or her original investment. However, Patrick Bennett was able to escape the immediate consequences of this deception by resorting to the classic expedient of the "Ponzi" scheme — in effect, paying off these old investors not with the fruits of their investment, but rather with funds misappropriated from new investors. This device could succeed only as long as BFG was able to attract an ever-growing circle of investors, which in turn drove Patrick Bennett to apply his fraud on an increasingly widening scale.
As a result of these practices, by the middle 1990s, BFG had grown into what the Trustee has elsewhere described as "the largest Ponzi scheme ever carried out against individual investors and financial institutions in U.S. history." Breeden v. Bennett (In re The Bennett Funding Group, Inc.), 220 B.R. 743, 747 (Bankr.N.D.N.Y. 1997). The most immediate victims of this fraud were, of course, the thousands of BFG investors and creditors who were left holding millions of dollars in unpaid obligations when the bubble finally burst in early 1996. The Ponzi scheme also inflicted serious damage on BFG itself, whose business reputation was all but destroyed by the exposure of the fraud. Moreover, by masking the true state of BFG's finances, the Ponzi scheme allowed BFG to continue in the lease financing business long after it had stopped being profitable, thus artificially deepening its insolvency prior to bankruptcy. Additionally, the Ponzi scheme created a financial screen behind which Patrick Bennett was able to secretly divert tens of millions of dollars of BFG funds to his personal use. These embezzled funds were then used by Patrick Bennett to purchase, inter alia, interests in various unsuccessful gambling and entertainment ventures.
While the Trustee's complaint states that Patrick Bennett was "aided and abetted by others" in his orchestration of this fraud, it does not specify whether these "others" included his parents, Edmund and Kathleen Bennett, who were the sole shareholders of BFG. However, in several other adversary proceedings that are currently pending in this case, the Trustee has affirmatively alleged that the Bennett parents were aware that certain leases had been double-pledged, and further characterizes them as "knowing participants" in the Ponzi scheme. See First Amended Complaint in Breeden v. Patrick R. Bennett et al., Adv. No. 96-70154 at ¶¶ 63-66; Complaint in Breeden v. OnBank Trust Co. et al., Adv. No. 98-70629 at ¶ 20.
The complaint's only other allegation about the inner workings of BFG is a statement that, at all relevant times, Patrick Bennett "was not the sole director and/or officer of BFG." (¶ 86) The identities and functions of these other officers and directors are not stated in the complaint. It is also not stated whether these other officers knew of the fraud, or whether they could have done anything to prevent it.
2. Sphere Drake
The ability of BFG to draw new victims into its Ponzi scheme depended in large part on BFG's ability to market its securities as conservative, low-risk investments. To this end, Patrick Bennett sought to obtain financial guarantees that would give the Bennett leases the appearance — though not the effect — of being insured. Beginning in 1990, Patrick Bennett obtained insurance for various Bennett investments from Assicurazioni Generali S.p.A. ("Generali"), whose relationship with BFG was terminated by 1994. At that time, Generali was replaced by Sphere Drake, a British corporation and one the world's leading reinsurance companies, as well as Sphere Drake Underwriting, its Bermuda affiliate. Also in the summer of 1994, Patrick Bennett created a "captive" Bermuda insurance company known as Bennett Insurance Co., Ltd. ("BIC"), the name of which was later changed to Capital Insurance. In October 1994, BIC issued its Master Commercial Lines Policy #0001 to BFG, which purported to insure BFG against shortfalls in its lease collections. BIC, in turn, was reinsured by Sphere Drake. Because BIC had only minimal capital reserves, Sphere Drake functioned for all practical purposes as BFG's primary insurer, and further agreed to a "claims paying agent agreement" pursuant to which claims could be made to it directly in place of BIC. Among other provisions, this agreement contained a choice of law clause which provided that any dispute arising under it would be governed according to the laws of Bermuda.
While it thus might have appeared that the investments sold by BFG had the backing of a large and reputable reinsurance company, a number of hidden clauses in the insurance contracts combined to make Sphere Drake's reinsurance almost wholly illusory. Among these was a "double trigger" clause which set out two conditions that must be met before BIC (and, by extension, Sphere) would become obligated to pay BFG: there would have to be a shortfall in the payments made by the equipment lessees to BFG, and BFG would have to default on its own obligations to its investors. This was significant because, in a typical Ponzi scheme, the Ponzi operator never misses a payment to his investors until the moment when the entire scheme collapses. As a result, in this case, the double trigger ensured that no insurable event would take place prior to BFG's bankruptcy, no matter how badly the leases performed. Secondly, a "fraudulent acts" clause required BFG to reimburse its insurers for any payments made on account of its own fraud. Thirdly, under a "hold harmless" agreement that was added to the claims paying agent agreement in 1995, BFG was obligated to reimburse Sphere Drake for any and all claims paid out under BIC's reinsurance policy. Because BFG was itself the named insured under the BIC policies, the resulting payment obligations were entirely circular: in the event of an insured shortfall, BFG would make a claim against BIC, which would look for payment to Sphere Drake, which would in turn have a right of reimbursement against BFG. This last agreement was kept secret from many of BFG's key officers, including William Crowley, its Chief Accounting Officer.
Sphere Drake was aware of the unconventional nature of this insurance mechanism. In particular, the fraudulent acts clause was the subject of considerable discussion by high-ranking Sphere Drake officials, including Eric Keen, the Vice President of Underwriting at Sphere Drake Underwriting. Keen expressed his belief that this clause was unenforceable, and worried that the inclusion of the clause suggested that illegal activity was occurring at BFG. In spite of these concerns, however, Keen authorized the inclusion of the fraudulent acts language.
Needless to say, the true nature of this insurance was kept hidden from the purchasers of Bennett investments. On November 2, 1994, Sphere Drake drafted a "Confirmation of Reinsurance," which stated that it had issued reinsurance to BIC. Copies of this were distributed to investors along with putative "Certificates of Insurance" issued by BIC. Although the investors who received these Certificates were led to believe that they were the actual beneficiaries of these policies, in all but a few instances, the named loss payee under the policy was TPC. The Certificates did not contain industry-standard language stating that they conveyed no legal rights; nevertheless, they were highly effective in attracting investors to BFG.
3. Lloyd Thompson and Triangle
Lloyd Thompson is a British corporation which brokered the transactions between BFG, BIC, and Sphere Drake. During the course of the negotiations, Lloyd Thompson drafted or reviewed all the contract provisions discussed above, and at one point represented to Sphere Drake that, on account of the hold harmless agreement, the insurance program was a mere "cosmetic exercise" with no real risk to the insurer. It is not alleged that Lloyd Thompson assumed any of the risk (real or imagined) of this insurance program for itself, nor is it alleged that Lloyd Thompson received anything other than a regular brokerage commission for its work.
Triangle is a Bermuda corporation, 49% of which was owned by Lloyd Thompson at the time of its association with BFG. During this period, Triangle served as manager for BIC, in the course of which it prepared and issued the Certificates of Insurance to the investors. In addition, various BFG documents were maintained by Janice Witkowski ("Witkowski"), an employee of Triangle. These documents are alleged to have contained evidence of BFG's double-pledging of leases, and thus of its Ponzi scheme. As with Lloyd Thompson, however, it is not alleged that Triangle received any compensation for its work other than a standard professional fee.
4. Sherwood and Small
Sherwood is a corporation engaged in wholesale insurance brokerage. Small is an insurance broker employed by Sherwood. It is alleged that in May 1994 Small was contacted to assist in locating alternative insurance markets for BFG. Small solicited Lloyd Thompson's assistance in brokering insurance to replace that provided by Generali, furnishing Lloyd Thompson with information about BFG's business, the proposed structure of the insurance sought and the structure of the insurance that had been provided by Generali. See ¶¶ 15-16 of the Third Amended Adversary Complaint. Small and Sherwood, along with Lloyd Thompson, divided the brokerage commission among themselves following the placement of BFG's account with Capital Insurance, reinsured by Sphere Drake. See id. at ¶ 17.
Small participated in discussions with BFG, Lloyd Thompson and Triangle concerning the Generali insurance program, including the "double trigger," the fraudulent acts provision and the hold harmless agreement. See id. at ¶¶ 16, 29, 87. Sherwood and Small participated with Lloyd Thompson, Triangle and Sphere Drake in negotiating the BFG policy, reviewing and commenting on drafts of the policy. See id. at ¶¶ 18-23. Sherwood and Small, along with the other parties involved with the negotiations, knew that BFG's investors would rely on the fraudulent acts provision. See id. at ¶¶ 33. Sherwood and Small also knew that as long as the Ponzi scheme remained afloat, the Sphere Drake Defendants would be protected by the "double trigger." See id. at ¶ 91.
Sherwood and Small helped to negotiate and draft the hold harmless agreement found in the BFG policy and knew that BFG was self-insured and that Sphere Drake was essentially a front for BFG. See id. at ¶ 95. Sherwood and Small also knew that the hold harmless agreement was unknown to investors and was known only to Patrick Bennett and certain Bennett family members. See id. at ¶ 71. Sherwood and Small also knew that its existence was not known to BFG's Chief Accounting Officer and never informed him of it. See id. at ¶ 72.
Sherwood and Small participated in negotiations concerning the terms of the reinsurance. See id. at ¶ 35. They knew that the existence of the Reinsurance Cover Note contributed to the marketing and sale of BFG's investment products. See id. at 92, 130.
Sherwood and Small have been joined as defendants to Counts V and VI of the Third Amended Adversary Complaint. The Trustee alleges that Sherwood and Small knew that Patrick Bennett and others were committing or planning to commit fraud. See id. at ¶¶ 88 and 132. It is the Trustee's position that Sherwood and Small aided and abetted the fraud on BFG by failing to convey their knowledge of it to BFG or a related entity. See ¶ 133. The Trustee alleges that Sherwood and Small provided assistance and encouragement in the Ponzi scheme by placing and negotiating the BFG policy and Reinsurance Cover Note. See id. at ¶ 134. Similar allegations serve as the basis for the Trustee's allegation that Sherwood and Small aided and abetted Patrick Bennett's breach of his fiduciary duty owed to BFG. See id. at ¶¶ 144-145.
ARGUMENTS
Sherwood and Small seek dismissal of Counts V and VI of the Trustee's Third Amended Adversary Complaint based on the argument that (1) the Trustee lacks standing to assert claims of aiding and abetting fraud and breach of fiduciary duty and (2) it fails to state a claim against Sherwood and/or Small pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure ("Fed.R.Civ.P."), as incorporated by reference in Rule 7012 of the Federal Rules of Bankruptcy Procedure ("Fed.R.Bankr.P."). They also seek dismissal of Counts V and VI on the grounds that the Trustee has not pleaded fraud with particularity pursuant to Fed.R.Civ.P. 9(b), as incorporated by reference in Fed.R.Bankr.P. 7009. In particular, Sherwood and Small argue that the Trustee has made no specific allegations identifying actions taken by Sherwood and Small. Instead, they contend that the Trustee's allegations are asserted against a group of defendants. Sherwood and Small also argue that they owed no duty of disclosure to either the investors or BFG.
In response to Sherwood and Small's assertion that the Trustee lacks standing to assert claims of aiding and abetting fraud and breach of fiduciary duty, the Trustee cites to a decision of this Court rendered the day after Sherwood and Small's motion was filed on December 27, 1999. See Breeden v. Sphere Drake Insurance PLC, et al., Case No. 96-61376, Adv.Pro. No. 97-70049 (Bankr.N.D.N Y Dec. 28, 1999) ("December 1999 Decision"). In the December 1999 Decision the Court denied Lloyd Thompson and Triangle's motion for reconsideration of a decision rendered on August 6, 1999 ("August 1999 Decision) in connection with this adversary proceeding which recommended to the U.S. District Court for the Northern District of New York that Lloyd Thompson and Triangle's motion for dismissal of Counts V and VI of the Trustee's Second Amended Adversary Complaint based on the Trustee's lack of standing be denied.
On January 25, 2000, the Court signed an Order indicating that "the reasoning of the Court's August 6, 1999 Memorandum-Decision and December 28, 1999 Memorandum-Decision applies with equal force to these defendants' [Lloyd Thompson and Triangle, as well as Sphere Drake Defendants] motion to dismiss Counts V and VI of the Third Amended Adversary Complaint."
The Trustee asserts that the allegations made against Sherwood and Small are based on the discovery to date. The Trustee contends that the Third Amended Adversary Complaint sets forth details concerning Sherwood and Small's participation in the structuring of the BFG insurance program, which are sufficient to support an inference of their knowing participation in the alleged fraud. The Trustee takes issue with the argument made by Sherwood and Small that the Third Amended Adversary Complaint fails to distinguish the two of them from the remainder of the defendants. The Trustee directs the Court to various allegations in the Third Amended Adversary Complaint applied to Sherwood and Small, pointing out that the two defendants are not included in every paragraph in which Lloyd Thompson,, Triangle and the Sphere Drake Defendants are mentioned.
In this case, Sherwood and Small allege that the Trustee conducted a deposition of Small over the course of 8 days.
DISCUSSION
The Trustee argues that "the same considerations that prompted the Court to grant the Trustee's motion to amend this Complaint to assert causes of action against Defendants now dictate that the Defendants' motion to dismiss the Complaint should be denied." See Trustee's Memorandum of Law, filed January 10, 2000, at 7-8. Indeed, it is true that if a proposed amendment would be subject to dismissal pursuant to Fed.R.Civ.P. 12(b)(6), the courts have indicated that "the proper course is to deny the motion to amend." See Smith v. O'Connor, 901 F. Supp. 644, 650 (S.D.N.Y. 1995) (citations omitted). At the same time, Fed.R.Civ.P. 15(a) provides that leave to amend "shall be freely given when justice so requires." As noted by the United States Court of Appeals for the Second Circuit, "[a] motion to amend should be denied only for such reasons as `undue delay, bad faith, futility of the amendment, and perhaps most important, the resulting prejudice to the opposing party.'" Richardson Greenshields Securities, Inc. v. Lau, 825 F.2d 647, 653 n. 6 (2d Cir. 1987). None of those reasons were raised in opposition to the Trustee's motion to amend his Complaint to add Sherwood and Small as defendants. Accordingly, the Court granted the motion as unopposed. It is within that context that the Court finds it appropriate to address the arguments now being raised by Sherwood and Small.
A. Trustee's Standing
The basis for Sherwood and Small's argument that the Trustee lacks standing to assert claims of aiding and abetting fraud and breach of fiduciary duty is that they are "irreconcilable with the Trustee's prior assertion that the Bennett parents participated in the diversion of assets from BFG, and, therefore, were participants in the underlying fraud and breaches of fiduciary duty." See Memorandum of Law, filed on Dec. 27, 1999, on behalf of Sherwood and Small, at 4. Indeed, this Court previously found that the Bennett parents, Edmund T. Bennett and Kathleen M. Bennett, were the sole shareholders of BFG, and as such the Trustee's standing "will depend on proof of a number of specific facts which are not affirmatively alleged in his pleadings, such as the innocence of one or both Bennett parents and the existence of an officer or shareholder with the ability to prevent the fraud of Patrick Bennett." See August 1999 Decision at 30. Of several adversary proceedings in which the Trustee alleged that the Bennett parents were aware of the fraud, to date the Court has rendered a judgment against them in Cordoba Corp., Bennett Funding Group Inc. and Bennett Management and Development Corp. v. Edmund T. Bennett and Kathleen M. Bennett (In re Cordoba Corp.), Case No. 96-62330, Adv. Proc. 96-70132 (Bankr.N.D.N.Y. Aug. 5, 1998) and also rendered a judgment in a second adversary in which there were allegations made against them in connection with what the Trustee asserted was a Ponzi scheme, see Richard C. Breeden Trustee v. Patrick R. Bennett, et al. (In re The Bennett Funding Group, Inc.), 220 B.R. 743 (Bankr.N.D.N.Y. 1997). In the December 1999 Decision the Court concluded that "[n]either judgment/order entered in the above-referenced adversary proceedings was `based on the Trustee's allegations that the Bennett parents knew of the Ponzi scheme.' Therefore, neither judgment/order precludes the Trustee from asserting on behalf of BFG claims of aiding and abetting fraud and breach of fiduciary duty . . . ." December 1999 Decision at 6.
Without the benefit of the Court's December 1999 Decision, Sherwood and Small present similar arguments in seeking the dismissal of the Third Amended Adversary Complaint based on the Trustee's lack of standing. The Court finds no basis for altering its prior conclusion and accordingly, will deny Sherwood and Small's motion seeking dismissal of Counts V and VI based on the Trustee's lack of standing.
B. Fed.R.Civ.P. 9(b) and 12(b)(6)
In ruling on a motion to dismiss pursuant to Fed.R.Civ.P. 12(b) for failure to state a claim upon which relief may be granted, the Court is to accept the material facts alleged in the Trustee's Complaint as true. See Cohen v. Koenig, 25 F.3d 1168, 1171-72 (2d Cir. 1994) (citation omitted). "[U]nless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief," dismissal is inappropriate. Conley v. Gibson, 355 U.S. 41, 45-46, 78 S.Ct. 99, 102, 2 L.Ed.2d 80 (1957).
To state a claim for aiding and abetting fraud, the underlying fraud must be pleaded with particularity pursuant to Fed.R.Civ.P. 9(b). See Primavera Familienstiftung v. Askin, 173 F.R.D. 115, 123 (S.D.N.Y. 1997). An underlying breach of fiduciary duty claim sounding in fraud must also meet the requirements of Rule 9(b). See Strougo on Behalf of Brazil Fund, Inc. v. Scudder, Stevens Clark, Inc., 964 F. Supp. 783, 804 (S.D.N.Y. 1997). Where multiple defendants are involved, it is necessary that the pleading give notice to each defendant of the fraudulent conduct with which it individually stands charged. See ABF Capital Management v. Askin Capital Management, L.P., 957 F. Supp. 1308, 1318 (S.D.N.Y. 1997); see also Primavera, 173 F.R.D. at 126 (stating that "[a] fraud claim may not rely upon vague allegations of conduct that clump individuals together." (citation omitted)). As such, "a claim may not rely upon blanket reference as to acts or omissions by all defendants." Id. This comports with the purposes of Rule (9)(b) of (1) providing fair notice of a plaintiff's claim to enable a defendant to prepare a defense; (2) protecting a defendant from harm to his reputation or good will, and (3) reducing the number of strike suits. See DiVittorio v. Equidyne Extractive Industries, Inc., 822 F.2d 1242,1247 (2d Cir. 1987); Primavera. 173 F.R.D. at 128.
When it is a trustee that is pleading fraud in a bankruptcy context, the courts have relaxed the particularity standard because of the fact that a trustee's allegations are based on secondhand knowledge. See Devaney v. Chester, 813 F.2d 566, 569 (2d Cir. 1987); see also Breeden v. Bennett, 220 B.R. at 753 (noting that "'[c]ourts generally evaluate averments of fraud in the bankruptcy context more liberally than in other civil actions charging fraud.'" (quoting Wieboldt Stores, Inc. v. Schottenstein, 94 B.R. 488, 498 (N.D.Ill. 1988)). At the same time, it is to be expected that the degree of particularity required will be higher in the situation where the trustee has had an opportunity to take discovery of those with knowledge of the pertinent facts. See Devaney, 813 F.2d at 569; Primavera, 173 F.R.D. at 128.
Under New York law, it is necessary that three elements be asserted to state an aiding and abetting claim: (1) the existence of the primary wrongful conduct; (2) the aider and abettor's knowledge of the wrongful conduct, and (3) substantial assistance by the aider and abettor. See Fromer v. Yogel, 50 F. Supp.2d 227, 247 (S.D.N.Y. 1999); Kolbeck v. LIT America, Inc., 939 F. Supp. 240, 245 (S.D.N.Y. 1996) (citation omitted), aff'd 152 F.3d 918 (2d Cir. 1998); ABF Capital, 957 F. Supp. at 1328.
There does not appear to be any dispute concerning the existence of wrongful conduct on the part of Patrick Bennett. Therefore, the Court will focus its discussion on the other two elements.
1. Sherwood and Small's Alleged Knowledge of Patrick Bennett's Wrongful Conduct
Allegations of constructive knowledge are insufficient when stating a claim for aiding and abetting fraud or breach of fiduciary duty. See Kolbeck, 939 F. Supp. at 246. Instead, the Trustee must allege actual knowledge. See id. (citations omitted). It is sufficient that the Trustee set forth facts which give rise to a strong inference of fraudulent intent on the part of the alleged aider and abettor. See San Leandro Emergency Medical Group Profit Sharing Plan v. Philip Morris Cos., Inc., 75 F.3d 801, 809 (2d Cir. 1996); Fromer, 50 F. Supp.2d at 248-49.
A plaintiff may establish a "strong inference" of fraudulent intent "(a) by alleging facts showing a motive for committing fraud and a clear opportunity for doing so, or (b) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior by defendant." Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1128 (2d Cir. 1994) (citations omitted); ABF Capital, 957 F. Supp. at 1331; see also DiLeo v. Ernst Young, 901 F.2d 624, 629 (7th Cir. 1990) (noting that a plaintiff "may not rest on a bare inference that the defendant `must have had' knowledge of the facts. The plaintiff must support the inference with some reason to conclude that the defendant has thrown in his lot with the primary violators.").
With respect to establishing motive, courts in this Circuit apply an "informed economic self-interest" test to evaluate whether it has been sufficiently alleged. See In re Health Management, Inc. Securities Litigation, 970 F. Supp. 192, 202 (E.D.N.Y. 1997); Shields, 25 F.3d at 1130. It is not enough simply to establish an ordinary financial incentive "because financial incentive is an inherent feature of legitimate commerce." San Leandro Emergency Medical Group Profit Sharing Plan, 75 F.3d at 814; see also Primavera, 173 F.R.D. at 124 (indicating that "allegations that a defendant stands to gain economically from fraud do not satisfy the heightened pleading requirements of Rule 9(b)).
In this case, the Trustee alleges that Sherwood and Small, along with Lloyd Thompson, divided the brokerage commission among themselves. Nowhere in the Complaint does the Trustee allege that the commission was extraordinary or was based on the continued viability of the fraud. In Breeden v. Generali U.S. Branch, Case No. 96-61376, Adv. Pro. No. 96-70195 (Bankr.N.D.N.Y. Dec. 19, 1997, this Court found that the Trustee had pled sufficient facts from which to draw an inference "that Generali sought to profit by receiving insurance premiums from BFG . . ." while the fraud continued. See id. at 28. So too in ABF Capital, plaintiffs alleged that the brokers had received "extremely high fees, including special commissions . . ." and had an incentive to see the fraud continue. See ABF Capital, 957 F. Supp. at 1331.
In his Memorandum of Law filed in opposition to Sherwood and Small's motion, the Trustee suggests that their motive "is obvious from the pleadings: to structure a risk-free program and obtain substantial funds." See Trustee's Memorandum of Law at 21. The Trustee also contends that Sherwood and Small sought "much more than `ordinary' financial gain." See id. However, there is nothing in the Third Amended Adversary Complaint to support the arguments the Trustee now makes, in opposition to Sherwood and Small's motion, that the commission was substantial or out of the ordinary. To suggest that Sherwood and Small had a motive in seeking to partake in "premiums without risk" also flies in the face of the allegations in the Complaint that Sherwood and Small were brokers, not insurers providing BFG with coverage on the lease portfolios, who normally received a commission for their services, not premiums. Nowhere in the Trustee's Complaint is there any allegation that Sherwood and Small had an economic interest in the premiums to be generated while the fraud continued.
Thus having found that the Trustee failed to allege facts sufficient to establish a motive for committing fraud, the Court must focus on whether the Trustee has alleged facts that constitute strong circumstantial evidence of conscious misbehavior on the part of Sherwood and Small. See Primavera, 173 F.R.D. at 123 (noting that "[w]hen relying on circumstances indicating conscious misbehavior, the strength of the circumstantial evidence generally must be greater." (citation omitted)). In this regard, the Trustee asserts that Sherwood and Small brokered "an illusory insurance program on behalf of BFG and Sphere Drake" by helping negotiate and draft the BFG policy, the Reinsurance Cover Note, and the hold harmless agreement. See Trustee's Memorandum of Law at 24. A review of the Trustee's Complaint reveals allegations that Sherwood and Small's participation in the negotiations of the BFG policy consisted of reviewing and commenting on the drafts of the policy. Nowhere are there any allegations that Sherwood and Small drafted the BFG policy. Unlike the Sphere Drake Defendants and Lloyd Thompson and Triangle, there are no allegations that Sherwood and Small drafted the Reinsurance Cover Note or the Certificates of Insurance . The only document that Sherwood and Small appears to have drafted was the hold harmless agreement, which Trustee alleges was unknown to the investors or BFG's Chief Accounting Officer. Those allegations, in and of themselves, do not constitute strong circumstantial evidence, which if proven, would be sufficient to establish conscious misbehavior on the part of Sherwood and Small to justify a strong inference of fraudulent intent and actual knowledge of Patrick Bennett's fraud and breach of his fiduciary duty.
2. Alleged Substantial Assistance of Sherwood and Small
Even if the Court were to find that the Trustee has alleged sufficient facts to establish actual knowledge on the part of Sherwood and Small, the Court finds that the Trustee has not pled sufficient facts to support his allegations of substantial assistance. The allegations that they participated in negotiations with the other defendants knowing full well that the investors would rely on the insurance being marketed by Patrick Bennett and/or BFG support a finding that they rendered assistance. At the same time, there are no allegations that they had any control over the materials alleged to have misled the investors or in any way participated in their distribution. See Morin v. Trupin, 823 F. Supp. 201, 207 (S.D.N.Y. 1993). This factor alone would not preclude a finding of substantial assistance if the Trustee had alleged a "heightened economic motivation." See ABF Capital, 957 F. Supp. at 1328 (noting that "where there are particularly strong allegations of motivation and scienter, the allegations of substantial assistance need not be as directly tied to the production and dissemination of the misleading documents themselves." (citation omitted)); see also Primavera, 173 F.R.D. at 124 (citations omitted). The Trustee's allegations with respect to Sherwood and Small's assistance in the reinsurance program do not appear to rise to the level of "substantial" in the opinion of the Court.
Accordingly, the Court concludes that the Trustee has failed to allege facts sufficient to meet the level of particularity set forth in Fed.R.Civ.P. 9(b) with respect to Sherwood and Small. Therefore, the Court will grant Sherwood and Small's motion to dismiss Counts V and VI of the Third Amended Adversary Complaint for failure to state a claim for fraud with particularity. However, the Court also deems it appropriate pursuant to Fed.R.Civ.P. 15(a) to allow the Trustee thirty (30) days from the date of a final order of the District Court in which to replead fraud with greater specificity. See Devaney, 813 F.2d at 569; Primavera Familienstiftung v. Askin, 1996 WL 494904, slip op. at *22 (S.D.N.Y. 1996).
Based on the foregoing, it is hereby
RECOMMENDED to the United States District of New York that Sherwood and Small's motion for dismissal of Counts V and VI of the Third Amended Adversary Complaint based on the Trustee's lack of standing be denied; it is further
RECOMMENDED to the United States District Court of the Northern District of New York that Sherwood and Small's motion for dismissal of Counts V and VI of the Third Amended Adversary Complaint pursuant to Fed.R.Civ.P. 9(b) and 12(b)(6) be granted; and it is further
RECOMMENDED to the United States District Court of the Northern District of New York that the Trustee be granted thirty (30) days from the date of a final order to replead those claims dismissed for failure to plead fraud with particularity, namely, the claims against Sherwood and Small for aiding and abetting the fraud on BFG.