PA Federal Business Decisions Volume 19, No. 1

Henry M. Sneath, Business Decisions Editors (Originally published in the Winter 2015 edition of the Pennsylvania Bar Association’s Civil Litigation Update)

Third Circuit Applies Pennsylvania’s Discovery Rule in D&O Suit

In a recently published, precedential decision, the Third Circuit Court of Appeals reversed the dismissal of a shareholder individual and derivative action after applying Pennsylvania’s discovery rule to the plaintiff shareholder’s breach of fiduciary duty and corporate waste claim arising out of the alleged fraudulent sale of a corporation’s assets. The case, Schmidt v. Skolas, 770 F.3d 241 (3d Cir. Oct. 17, 2014), involved an allegation by the plaintiff shareholder that the defendants, including, among others, the liquidating trust and various directors and officers, had sold the corporation’s assets to insiders for substantially less than fair market value. Although the plaintiff shareholder did not dispute that the suit had not been filed within two years of the sale of the assets, he argued that he was not in a position to know the fraudulent nature of the sale until details of the sale emerged and subsequent market events confirmed the true value of the assets. The court agreed.

In so concluding, the court held that the district court had improperly taken judicial notice of various documents, including websites and press releases, that were neither “integral” to the complaint nor relied upon by the plaintiff shareholder in drafting the complaint. The court concluded, instead, that the statute of limitations should be resolved solely on the allegations in the complaint, SEC filings, and documents relied upon by the plaintiff shareholder in drafting the complaint.

Following this approach, the court determined that the statute of limitations facially had not run with respect to one of the challenged asset sales since the complaint did not specify a date of the sale. With respect to the other asset sales that the plaintiff shareholder challenged, the court found that there was insufficient information to suggest that the plaintiff shareholder should have discovered the sales earlier through “reasonable diligence.” Specifically, in the absence of any allegations or evidence to suggest that the plaintiff shareholder knew the identities of the buyers of the assets, it could not be said that the plaintiff shareholder should have looked at the buyers’ SEC filings for purposes of learning the sale price of the assets. This, coupled with the fact that a fiduciary relationship existed between the plaintiff shareholder and several of the defendants, weighed against denying the plaintiff shareholder the benefit of the discovery rule with respect to the other asset sales.

Third Circuit Examines the Scope of Confidential Relationships in Insider Trading Cases

In United States v. McGee, 763 F.3d 304 (3d Cir. 2014), the Third Circuit examined the type of confidential relationship required to trigger a violation of SEC Rule 10b-5, which establishes a standard for duty of trust in insider trading cases. The factual background of McGee raises an interesting dilemma: at what point does a personal relationship become sufficient to render the recipient of insider information forbidden to act upon that information without disclosure?

Timothy McGee met Christopher Maguire in 1999 at an Alcoholics Anonymous (“AA”) meeting. The two became friends and McGee informally mentored Maguire in the ways of AA. Id. at 308-9. “Given the sensitive nature of their communications, McGee assured Maguire that their conversations were going to remain private.” Id. at 309. Though most of their conversations focused on alcohol recovery related topics, the men also became friends as they shared similar interests. McGee was an investment advisor, while Maguire was a businessman who worked at Philadelphia Consolidated Holding Corp. (“PHLY”), a publically traded company.

In 2008, Maguire was involved with the pending sale of PHLY. During this time, Maguire began to suffer alcohol relapses. During a conversation in which Maguire was seeking help and advice from McGee, Maguire provided insider information about the pending sale – which would be for three times the company’s book value. Id. Acting on this information, McGee borrowed money and purchased 10,750 shares of PHLY. After the sale went public, McGee sold his shares for a nearly $300,000 profit.

Ultimately, McGee was charged under Rule 10b-5 and was convicted at trial. McGee appealed the decision, arguing that Rule 10b-5 requires the breach a fiduciary duty for conviction and that there was no such fiduciary relationship in this matter. Specifically, McGee argued that the trial court’s interpretation of Rule 10b-5(b)(2) exceeded the rulemaking authority of the SEC. The Third Circuit performed a Chevron test and held that the trial court’s application of Rule 10b-5(b)(2) was proper. Further, the Third Circuit held that a true fiduciary relationship is not required to prove a violation of 10b-5: “Under Rule 10b-5(b)(2), a duty to disclose [that a source of insider information] exists when there is a ‘history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know’ that the person communicating the information expects it to be confidential.” Id. at 317.

Thus, the Third Circuit found that the confidential relationship between McGee and Maguire was sufficient to trigger the disclosure requirements of Rule 10b-5 – even though the “confidential relationship” between McGee and Maguire was not a classic version of a confidential or fiduciary relationship. In other words, 10b-5 may be triggered if the parties have an expectation of confidentiality.

Court Affirms Judgment for Race Car Team Against T-Mobile in Breach of Contract Action

In VICI Racing, LLC v. T-Mobile USA, Inc., 763 F.3d 273 (3d Cir. 2014), Defendant T-Mobile USA, Inc. entered into a three-year agreement on March 30, 2009 to sponsor Plaintiff VICI Racing, LLC’s American Le Mans Series race car team. As part of the agreement, VICI Racing would receive a series of yearly payments from T-Mobile in return for displaying T-Mobile’s logo and trademark on its race cars, trailers, uniforms, and other promotional items. In addition, T-Mobile was to become the exclusive wireless carrier for Porsche, Audi, and VW telematics programs.

During the first year of the contract, VICI Racing’s only race car was in a serious accident on July 18, 2009. VICI Racing notified T-Mobile of the problem shortly after the accident and indicated that it believed it would take 45-60 days to repair the car. VICI Racing was unable to compete in four races until it repaired the car and resumed racing in October 2009. In addition to the problems with the race car, T-Mobile was unable to secure the telematics business from Porsche, Audi, or VW.

On January 5, 2010, after T-Mobile failed to make a $7 million payment that was due on January 1, 2010, VICI Racing sent T-Mobile a notice of default. T-Mobile responded by claiming that VICI Racing was in breach of the contract due to the failure to secure the telematics business for T-Mobile and the failure to enter a race car in a race during the period when VICI Racing’s car was being repaired.

After a bench trial, the district court found that T-Mobile had breached the contract, the telematics provision of the contract was ambiguous and therefore unenforceable, and VICI Racing was excused from entering a series of races while its car was being repaired under the force majeure provision of the contract. The district court entered judgment in favor of VICI Racing and awarded $7 million in damages, which corresponded to the amount due under the agreement for 2010 but not the additional $7 million due for 2011 that VICI Racing requested.

Both T-Mobile and VICI Racing appealed. T-Mobile challenged the district court’s determination of liability, and VICI Racing challenged the damage award.

With respect to the telematics provision of the contract, the district court found that the language in the single provision in the contract that dealt with this issue was ambiguous. It then turned to parol evidence in an attempt to determine the parties’ intent, but was unsuccessful in resolving the ambiguity. Because the contract contained a severability clause, the district court struck this provision from the contract.

The Third Circuit upheld the district court’s decision. It agreed that the telematics provision of the contract was ambiguous and that severance of the provision was proper. The court rejected T-Mobile’s argument that the provision could not be severed because it was the basis for T-Mobile signing the agreement. The telematics provision was a very small portion of the contract, the recitals in the contract did not indicate that this provision was central to the agreement, and there was an overall lack of emphasis or description about telematics in the agreement. Taken together, the Third Circuit agreed that there was insufficient evidence to support T-Mobile’s argument.

The Third Circuit also upheld the finding that the force majeure provision of the contract excused VICI Racing’s failure to race in a number of races. Pursuant to the terms of the contract, the force majeure provision could be invoked if (1) the prevented obligation was nonmonetary and out of the party’s control, (2) prompt notice was given, and (3) the obligation was resumed as soon as the interference was removed. The court concluded that all three conditions had been met with respect to the damaged race car and the missed races.

T-Mobile argued that the provision did not apply because the interference was monetary in nature. It claimed that VICI Racing could have spent more money to resolve the problem sooner. The court disagreed. It concluded that the interference was the damage sustained to the race car, which was a nonmonetary event. The fact that VICI Racing might have been able to spend additional money to fix the car sooner did not make it a monetary interference. The court similarly rejected T-Mobile’s attempt to impose a requirement that the force majeure provision could only be invoked if the interference was unforeseeable because (1) it failed to raise that issue below, (2) the contract did not impose such a requirement, and (3) Delaware law would not impute a foreseeability requirement in these circumstances.

Finally, the district court only awarded damages to VICI Racing for the 2010 term of the agreement. It concluded that VICI Racing had a duty to mitigate its damages for 2011, which had not been done, and that awarding an additional $7 million would be a windfall.

The Third Circuit affirmed the $7 million damage award for 2010 but vacated the decision not to award another $7 million in damages for 2011. It concluded that mitigation of damages is an affirmative defense that T-Mobile had waived. It also concluded that it was error to find the additional $7 million would be a windfall. A windfall means that the damage amount would have been greater than a party’s expectation interest. In this case, there was no evidence to support such a determination. Thus, the Third Circuit vacated the ruling that VICI Racing was not entitled to damages for 2011 and remanded for further consideration.

Involuntary Petition for Bankruptcy that Met Statutory Requirements Dismissed Because Petition Was Filed in Bad Faith

In Forever Green Ath. Fields, Inc. v. Dawson, No. 14-641, 2014 U.S. Dist. LEXIS 112751 (E.D. Pa. Aug. 13, 2014) (opinion by J. Dalzell), the U.S. District Court for the Eastern District of Pennsylvania affirmed a Bankruptcy Court’s dismissal of an involuntary petition for bankruptcy on grounds that the petition was filed as a bad faith litigation tactic, even though the involuntary petition conformed to statutory requirements.

On April 20, 2012, Charles Dawson, his wife Kelli Dawson, and the law firm Cohen, Segalis Pallas, Greenhall & Furman, PC (collectively, the “Petitioning Creditors”) filed an involuntary petition under Chapter 11 of the Bankruptcy Code against Forever Green Athletic Fields, Inc. (“Forever Green”), a company that marketed artificial turf for athletic fields. Prior to that filing, the Petitioning Creditors and Forever Green had a lengthy litigation history, resulting from Charles Dawson leaving Forever Green to become a member of a competitor, ProGreen Sports Surfaces, LLC (“ProGreen”). In 2005, Forever Green filed suit in the Bucks County Court of Common Pleas against Mr. Dawson, ProGreen and others seeking in excess of $5,000,000 arising from the alleged diversion of corporate assets, which was later removed to federal court. At about the same time, the Dawsons filed suit against Forever Green in Louisiana seeking unpaid commissions and wages allegedly owed to the Dawsons. A Consent Judgment was eventually entered in the Louisiana action against Forever Green and in favor of the Dawsons for $306,006.24. During that time, the Pennsylvania action was suspended in favor of arbitration. ProGreen then sought to terminate the arbitration because Forever Green was insolvent. The motion listed tax liens and judgments recorded against Forever Green, including a $206,126.00 judgment of Cohen, Segalis and the Dawsons’ Consent Judgment. Thereafter, the Dawsons took steps seek to garnish any Forever Green funds in the arbitrator’s possession, which created a conflict of interest and resulted in the suspension of the arbitration. Forever Green responded by filing a suit in the Court of Common Pleas of Philadelphia County against the Dawsons and others, seeking a declaratory judgment and other equitable relief relating to whether funds in the possession of the arbitrator were immune from claims by the Dawsons. While the Philadelphia action was pending, the Petitioning Creditors filed the involuntary petition for bankruptcy and simultaneously filed a suggestion of bankruptcy in the Philadelphia action.

Forever Green filed a motion to dismiss the involuntary petition. After conducting a two-day hearing, Judge Magdeline D. Coleman of the U. S. Bankruptcy Court for the Eastern District of Pennsylvania found by a preponderance of the evidence that Charles Dawson filed the involuntary petition “in furtherance of an improper bankruptcy purpose.” Specifically, she found that Dawson filed the petition as part of a scheme to frustrate the prosecution of the pending arbitration against Dawson and to force Forever Green to pay Dawson’s claims ahead of Forever Green’s other creditors. In doing so, she found that the fact that Dawson was a bona fide creditor did not establish that he filed the petition for a proper bankruptcy purpose. As a result, the court granted Forever Green’s motion to dismiss on grounds that the involuntary petition was a bad faith filing and an abuse of the bankruptcy court system.

On appeal to the U.S. District Court, the Petitioning Creditors contended that the Bankruptcy Court erred in dismissing the involuntary petition based upon its finding that the Petition Creditors acted in bad faith, when the petitioning creditors met the statutory criteria for filing an involuntary petition, i.e., three bona fide judgment creditors with a non-contingent claim and their aggregate claims exceeded the statutory threshold. The District Court rejected the Petitioning Creditors’ argument, finding that an involuntary bankruptcy petition is subject to dismissal if filed in bad faith, irrespective of whether the statutory requirements for an involuntary petition under 11 U.S.C. § 303(b) were met. The court found that a Bankruptcy Court must look to the totality of the circumstances to determine bad faith, including the nature of the debt, the timing of the petition, how the debt arose, the debtor’s motive in filing the petition, how the debtor’s actions affected creditors, the debtor’s treatment of creditors both before and after the petition was filed, and whether the debtor has been forthcoming with the bankruptcy court and the creditors. The District Court concluded that Judge Coleman properly considered these factors and did not abuse her discretion in finding that the petition was filed in bad faith. Accordingly, the District Court affirmed dismissal of the petition.

— Contributed by R. Brandon McCullough, Esq. , Houston Harbaugh, Pittsburgh, Pennsylvania;

Applying Pearson v. Component Tech. Corp., Eastern District of Pennsylvania Upholds Bankruptcy Court’s Finding that Plaintiffs Failed to Pierce Corporate Veil

In Black v. Gigliotti, Nos. 14-2733 and 14-2734, 2014 U.S. Dist. LEXIS 107980 (E.D. Pa. Aug. 6, 2014) (opinion by J. Baylson), the U.S. District Court for the Eastern District of Pennsylvania held that Plaintiffs failed to show evidence supporting its claims for piercing the corporate veil under the factors set forth in Pearson v. Component Tech. Corp., 247 F.3d 471 (3d Cir. 2001). As a result, the court affirmed the bankruptcy court’s order granting Defendants’ motion for summary judgment and denying Plaintiffs’ motion for summary judgment.

Prior to the present case, Plaintiffs had filed a lawsuit against Gigliotti Avignon Associates LLP (“Gigliotti Avignon”) seeking to recover a deposit paid to Gigliotti Avignon for the construction of a home. Gigliotti Avignon was owned by three brothers, Christopher Gigliotti and Defendants Ronald Gigliotti and John Gigliotti. Following a judgment in favor of Plaintiffs in that case, Defendants advised that Gigliotti Avignon was insolvent. A few months later, Defendants filed for Chapter 7 bankruptcy. Following the filing of amended adversary complaints in Defendants’ bankruptcies, which included only claims for piercing the corporate veil and nondischargeability of debt under 11 U.S.C. § 523(a)(2) and (4), Defendants moved for summary judgment and Plaintiffs cross-moved. The bankruptcy court granted Defendants’ motion for summary judgment and denied Plaintiffs’ motion.

On appeal, Plaintiffs contended that the two-part test of Craig v. Lake Asbestos of Quebec, Ltd., 843 F.2d 145 (3d Cir. 1988), should have been applied by the bankruptcy court instead of the test set forth in Pearson to evaluate whether Defendants created a corporate entity as a sham to evade personal liability. According to Plaintiffs under Craig, this exists “where ‘(1) the parent so dominated the subsidiary that it had no separate existence but was merely a conduit for the parent and (2) the parent abused the privilege of incorporation by using the subsidiary to perpetrate a fraud or injustice, or otherwise to circumvent the law.’” However, the Eastern District Court pointed out that the Third Circuit still considered the same factors laid out in Pearson in deciding Craig. Those factors considered “to determine whether a corporate entity is merely an alter ego of the controlling shareholder” are as follows: “gross undercapitalization, failure to observe corporate formalities, nonpayment of dividends, insolvency of debtor corporation by the dominant stockholder, nonfunctioning of officers and directors, absence of corporate records, and whether the corporation is merely a façade for the operations of the dominant stockholder.” In the present case, the court warned of the “notoriously difficult” burden for plaintiffs to show that the “the debtor corporation is little more than a legal fiction.”

Applying the above, the court determined that Plaintiffs failed to show any evidence that Gigliotti Avignon was a sham enterprise or that Defendants abused the corporate form. The bankruptcy court previously determined that there was no evidence that Gigliotti Avignon was undercapitalized. Plaintiffs also failed to show that Defendants withdrew funds for personal use or comingled assets with personal funds. Thus, the court upheld the bankruptcy court finding that Plaintiffs could not establish their claim to pierce the corporate veil.

Plaintiffs also could not establish their claim of nondischargeability of debt. In order to show a debt is nondischargeable, Plaintiffs had to show that (1) a valid debts exists and (2) that the debt meets the requirements of the enumerated exceptions to dischargeability. If there is no enforceable obligation, however, there is no debt that can be non-dischargeable. Plaintiffs must show that they “hold an enforceable obligation under non-bankruptcy law” to establish a valid debt. Plaintiffs’ judgment was against Gigliotti Avignon, not the Defendants and, since Plaintiffs were unable to pierce the corporate veil, the debt was attributable only to Gigliotti Avignon with no enforceable obligation against Defendants.

Finally, Plaintiffs failed to establish a claim against Defendants under the participation theory. Under Pennsylvania law, “a corporate officer ‘who takes part in the commission of a tort by the corporation is personally liable therefor; but an officer of a corporation who takes no part in the commission of the tort committed by the corporation is not personally liable to third persons for such a tort.” The court agreed with the bankruptcy court’s previous findings that Plaintiff failed to plead claims of tortious conduct in the complaint, Plaintiffs failed to present evidence of tortious conduct and Plaintiffs’ claims for the underlying torts were previously dismissed as untimely.

The Eastern District Court of Pennsylvania concluded that the bankruptcy court correctly determined Plaintiffs lacked evidence supporting their claim to pierce the corporate veil or establishing liability based on the participation theory. As a result, the court affirmed the bankruptcy court’s order.

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