In re Scott Acquisition Corp.

• Decision Date: 23 June 2006
• Docket Number: Bankruptcy No. 04-12594(PJW).,Adversary No. 05-30112(PJW).
• Citation: 344 B.R. 283
• Parties: In re SCOTT ACQUISITION CORP., et al., Debtors. Montague S. Claybrook, as Chapter 7 Trustee for Debtors Scott Acquisition Corp. and its subsidiary Scotty's, Inc., Plaintiff, v. Thomas E. Morris, an individual, David Bost, an individual, Robert Pacos, an individual, Paul Dulfer, an individual, David James, an individual, Joe Patten, an individual, Douglas N. Bowne, an individual, and John Kelly, an individual, Defendants.
• Court: U.S. Bankruptcy Court — District of Delaware

344 B.R. 283

In re SCOTT ACQUISITION CORP., et al., Debtors Montague S. Claybrook, as Chapter 7 Trustee for Debtors Scott Acquisition Corp. and its subsidiary Scotty's, Inc., Plaintiff, v. Thomas E. Morris, an individual, David Bost, an individual, Robert Pacos, an individual, Paul Dulfer, an individual, David James, an individual, Joe Patten, an individual, Douglas N. Bowne, an individual, and John Kelly, an individual, Defendants.

Bankruptcy No. 04-12594(PJW).

Adversary No. 05-30112(PJW).

United States Bankruptcy Court, D. Delaware.

June 23, 2006.

Laura Davis Jones, Bruce Grohsgal, Pachulski, Stang, Ziehl, Young, Jones & Weintraub P.C., Wilmington, DE, Jeremy V. Richards, James K.T. Hunter, Jonathan J. Kim, Pachulski, Stang, Ziehl, Young, Jones & Weintraub P.C., Los Angeles, CA, for Defendants.

Christopher P. Simon, Erica N. Finnegan, Cross & Simon, LLC, Wilmington, DE, Craig P. Rieders, Brett M. Amron, Genovese Joblove & Battista, PA, Miami, FL, for Plaintiff.

MEMORANDUM OPINION

PETER J. WALSH, Bankruptcy Judge.

This opinion is with respect to the defendants' Thomas E. Morris, David Bost, Robert Pacos, Paul Dulfer, David James, Joe Patten, Douglas N. Bowne, and John Kelly's motion (Adv.Doc. # 17) to dismiss the Chapter 7 trustee's complaint against them. For the reasons discussed below, the Court will deny the motion.

BACKGROUND

Scotty's, Inc. is the wholly-owned subsidiary of Scott Acquisition Corp. (Adv. Doc. # 1,¶4). Prior to their bankruptcy, Scotty's, Inc. and Scott Acquisition Corp. (collectively, the "Debtors") were retailers of building materials and home improvement products for the "do it yourself" home improvement market (Adv.Doc. # 1, ¶ 18). The defendants, Morris, Bost, Pacos, Dulfer, James, Patten, Bowne, and Kelly, were the individual officers and directors of Scotty's, Inc. ("Scotty's") (Adv. Doc. # 1, ¶¶ 8-15).

The complaint alleges the defendants' misconduct as follows. In 1998, Scotty's entered into a Loan and Security Agreement with Congress Financial Corporation (Florida) ("Congress") (Adv.Doc. # 1, ¶ 23). Under that agreement, Congress loaned Scotty's certain sums of money and took a security interest in substantially all of the Debtors' property (Adv.Doc. # 1, ¶ 23). Scotty's, however, was unable to make the required loan payments (Adv. Doc. # 1, ¶ 27). As a result, Scotty's and Congress made various amendments to the loan agreement (Adv.Doc. # 1, ¶ 27).

During negotiations relating to the loan, Congress expressed its desire to have Scotty's divest itself of its real estate holdings and pay down the amounts owed to Congress (Adv.Doc. # 1, ¶ 26). This would not only reduce the amount owed to Congress but would also allow inventory to be the sole focus of Congress' security interest (Adv.Doc. # 1, ¶ 26). Having inventory as the only collateral would allow Congress with a quick exit strategy — payment on a potential Scotty's liquidation (Adv.Doc. # 1, ¶ 26).

As such, Scotty's began divesting itself of its real estate holdings on a sale-andleaseback basis (Adv.Doc. # 1, ¶ 28). Some properties were sold to independent third parties (Adv.Doc. # 1, ¶ 28). Others, however, were sold to entities controlled by certain of the defendants (Adv.Doc. # 1, ¶ 28). These insider defendants, through the controlled entities, paid less than fair market value for Scotty's choice real estate (Adv.Doc. # 1, ¶¶ 28-29). In return, Scotty's received no more favorable treatment on the terms of the leases than it would have with `third parties (Adv.Doc. # 1, ¶ 69(c)).

Throughout, Scotty's failed to solicit and consider third party offers for the purchase of its choice real estate (Adv.Doc. # 1, ¶ 69(b)). Further, Scotty's failed to seek any independent consideration or review of these insider sale-and-leaseback transactions (Adv.Doc. # 1, ¶ 69(d)). Accordingly, the complaint alleges that the defendants, the officers and directors of Scotty's, breached their fiduciary duties of care and loyalty in several respects (Adv. Doc. # 1, ¶ 69). The complaint also alleges that the defendants had knowledge and rendered substantial assistance with regard to one another's breaches of fiduciary duties (Adv.Doc. # 1, ¶ 77).

Further, the complaint states that the defendants caused Scotty's to enter into certain loan agreements with the insider defendants, whereby the insider defendants loaned several million dollars to Scotty's at an interest rate of 11% or greater (Adv.Doc. # 1, ¶ 53). Scotty's paid back these loans in full, with interest (Adv. Doc. # 1, ¶ 69(e)). According to the complaint, such loans were unnecessary from the outset and were entered into at a time when the Debtors were insolvent (Adv. Doc. # 1, ¶ 69(e)).

On September 10, 2004, the Debtors filed voluntary petitions for relief under Chapter 11, Title 11 of the United States Code (the "Bankruptcy Code") (Adv.Doc. # 1, ¶ 3). After the petition date, the defendants reduced the limit of liability on the directors and officers liability insurance to $2,000,000 from its previous limit of $5,000,000 (Adv.Doc. # 1, ¶ 64). On June 23, 2005, this Court entered an order converting the' Chapter 11 cases to Chapter 7 cases (Adv.Doc. # 1, ¶ 6). On June 28, 2005, Montague S. Claybrook was appointed the Chapter 7 trustee (the `Trustee") (Adv.Doc. # 1, ¶ 7).

The Trustee commenced this action on November 2, 2005 (Adv.Doc. # 1), alleging that the defendants breached their fiduciary duties, aided and abetted breaches of fiduciary duties, and breached their employment contracts with respect to the insider sale-and-leaseback transactions, the insider financing, and the reduction of Scotty's directors and officers insurance. The defendants now move to dismiss the complaint asserting that the Trustee has failed to state a claim upon which relief can be granted and that the Trustee lacks standing.

DISCUSSION

A motion to dismiss for failure to state a claim upon which relief can be granted serves to test the sufficiency of the complaint. Kost v. Kozakiewicz, 1 F.3d 176, 183 (3d Cir.1993). When deciding such a motion, a court accepts as true all allegations in the complaint and draws all reasonable inferences from it which the court considers in a light most favorable to the plaintiff. Rocks v. City of Philadelphia, 868 F.2d 644, 645 (3d Cir.1989). A court should not grant a motion to dismiss "unless it appears beyond doubt that the plaintiff can prove no set of facts in support of [its] claim which would entitle [it] to relief." Conley v. Gibson, 355 U.S. 41, 45-46, 78 S.Ct. 99, 2 L.Ed.2d 80 (1957). "The issue is not whether a plaintiff will ultimately prevail but whether the claimant is entitled to offer evidence to support the claims." Maio v. Aetna, Inc., 221 F.3d 472, 482 (3d Cir.2000) (quotations and citation omitted).

The complaint contains three counts: Count I alleges that the defendants breached their fiduciary duties, Count II alleges that the defendants aided and abetted one another's breach of fiduciary duties, and Count III alleges that the defendants breached their employment agreements. The defendants have moved to dismiss the three counts of the complaint. According to the defendants, the complaint as a whole fails because the Trustee lacks standing to bring such actions. Alternatively, the defendants argue that Count I fails, at least in part, because the directors of a wholly-owned subsidiary owe no duty to the subsidiary corporation, and that Count II fails because the complaint does not allege the necessary elements of an aiding and abetting claim. These arguments are not persuasive.

Count I

Count I of the complaint alleges a typical breach of fiduciary duty claim against the directors and officers of a whollyowned subsidiary. The Trustee argues that he may bring this action on behalf of at least three different potential plaintiffs: 1) Scott Acquisition Corp., the parent corporation, 2) Scotty's, the wholly-owned subsidiary, or 3) the creditor's of Scotty's. The defendants argue that this Court should dismiss Count I, to the extent it is brought on behalf of the subsidiary corporation, because the directors and officers do not owe a duty to any entity other than the parent corporation.

The defendants concede that the Trustee may sue in the name of the parent corporation but nevertheless refuse to acknowledge that the Trustee may, alternatively, sue in the name of Scotty's. Also, the defendants appear to acknowledge that the directors owe a fiduciary duty to Scotty's creditors but nevertheless argue that the Trustee does not have standing to bring such a claim. As a result, the issue presented by the defendants' motion to dismiss Count I is only whether the directors and officers of a wholly-owned insolvent subsidiary owe a fiduciary duty to that subsidiary.

The defendants argue that the directors do not owe any duties to the subsidiary itself. In support of this, the defendants rely principally on Southwest Holdings, L.L.C. v. Kohlberg & Co. (In re Southwest Supermarkets, L.L.C.), 315 B.R. 565 (Bankr.D.Ariz.2004), in which the court interpreted Delaware corporate law to the effect that "Delaware law appears to hold that when a subsidiary is wholly owned, its officers and directors owe their fiduciary duties solely to the single shareholder, and not to the subsidiary corporation itself' and that "there is nothing to suggest this law changes when the corporation becomes insolvent." Id. at 575-76. I respectfully do not agree with that interpretation, however. In my view, Delaware law would recognize that the directors and officers of an insolvent wholly-owned subsidiary owe fiduciary duties to the subsidiary and its creditors. This view is supported by a number of courts that have addressed the issue.

The Southwest court relied on the Delaware Supreme Court's decision in Anadarko Petroleum Corp. v. Panhandle Eastern Corp., 545 A.2d 1171 (Del.1988) for the proposition that the directors of a whollyowned insolvent subsidiary owe fiduciary...