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Geoff Trachtenberg
Geoff Trachtenberg
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Directors Not Liable for the Misrepresentations of Their Agents Absent a Showing They Had "Knowledge" of the Misrepresentations

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Judge Kessler of Division One just handed down another one of his massive opinions (this is not a criticism, just an observation). He seems to be a prolific writer and, my guess, a prolific reader as well.

The case, Dawson v. Withycombe, marks another important milestone in the development of Arizona’s corporate law. It follows in the footsteps of Wells Fargo Bank v. Arizona Laborers, Teamsters and Cement Masons Local No. 395 Pension Trust Fund, 201 Ariz. 474, 38 P.3d 12 (2002) and Standard Chartered PLC v. Price Waterhouse, 190 Ariz. 6, 945 P.2d 317 (App. 1996) and, similar to those opinions, the Dawson opinion spans almost seventy pages and addresses and an astonishing number of issues on appeal. Naturally, some are more important than others, but the following represents the highpoints.

The nature of the case concerns a complicated series of loan transactions and is essentially about whether individual directors of a corporation could be liable for fraudulent misrepresentations made by an alleged agent. In short, the plaintiff loaned money to a troubled company and, when the loan went bad, sued two of the company’s directors due to various misrepresentations made by an alleged agent in connection with securing the loan.

The case went to a jury on two independent theories – aiding and abetting fraudulent misrepresentation and constructive fraud. The jury found for the Plaintiff, fixing his damages at $5,000,000 and assessing 35% fault against the Defendants for fraudulent misrepresentation and 40% against the Defendants for constructive fraud.

For some people, this outcome might seem confusing because it seems like the Plaintiff is getting inconsistent awards (and obviously is not going to be able to collect on both awards separately). While this has never happened to me, this is the proper way to present the matter to the jury and, in such event, a the plaintiff must then subsequently “elect his remedy” (i.e., absent some additional factor, such as the statutory or contractual right to request attorneys fees, he would obviously select the outcome with the greater recovery).

Anyway, since my office handles these kinds of cases, the part that concerns me, is the standards being imposed to establish “knowledge” – the sine qua non of director liability – and the complete judicial evisceration of any “duty” in connection with supervising employees.

A good chunk of the opinion deals with whether there was sufficient evidence to show that the directors knew of the misrepresentations by the alleged agents. The Court noted that “[d]irectors are not liable for misrepresentations made by their agent, if the agent, in fact, made them without their knowledge or instruction, and in reality deceived them as well as the shareholders.” Thus, the Court held that, “[u]nder Arizona law, a director cannot be liable without some kind of personal participation in the tort or at least acquiescence by knowledge of the tort combined with a failure to act.” The Court found that, in the present case, there was not sufficient evidence to show such knowledge to subject the directors to agency liability for misrepresentations.

So far, this seems to be generally in line with what we would expect in connection with director liability for misrepresentations of agents, but then the Court addressed whether there was sufficient evidence to support liability for misrepresentations based upon a theory of “aiding and abetting.” Again, the knowledge issue was crucial, but this is where the opinion seems to go awry in my view.

Aiding and abetting is not just another species or derivative liability – it is a stand alone tort. It is not clear to me from the opinion, but it seems as though the trial court treated aiding and abetting as a kind of vicarious liability theory – like agency or respondeat superior - and that seems erroneous. The Court of Appeals, however, seemed to do the same thing.

Yet the Court recognized that in the aiding and abetting context knowledge may be “inferred from the circumstances presented” and, significant to aiding and abetting cases, “[a]ctual and complete knowledge of the details of the primary tort may not be necessary in all cases; the knowledge requirement may be satisfied by showing general awareness of the primary tortfeasor’s fraudulent scheme.”

This is where aiding and abetting liability diverges from agency liability. In the agency context, the case law and authorities seem to require actual knowledge for director liability. As the Court acknowledged, aiding and abetting only requires a general awarenessi.e., an express rejection of the “actual knowledge” standard. It suffices to say, the Court disagrees with me on this, however. See, Note 16. The jury was instructed that “[i]t is enough if you conclude that a defendant has general awareness of the fraud and knew that a fraud was being committed,” but according to the Court, “[t]hat instruction still requires ‘actual knowledge’ of a fraud.” Id. Does this make sense to anyone?

Anyway, such thinking on the Court’s part explains the reason why they held, yet again, that the standard was not met. The Court explained:

[Plaintiff’s] primary argument that [Defendants] had general awareness of the fraud is that they knew Goett [i.e., the alleged agent] was dishonest and that [the Company] was in poor financial condition and they nonetheless sent Goett out to procure a loan. Even assuming the truth of this statement, however, it is not sufficient to support liability on [Defendant’s] part for aiding and abetting. That [Defendants] were aware of [the Company’s] financial condition and of Goett’s dishonest character, and were aware that he was soliciting funds from [Plaintiff], indicates poor judgment and risky business practices. It does not, however, rise to the level of scienter required for aiding and abetting, specifically that they were aware that Goett did or would in fact use fraudulent statements as a means of procuring the loan.

To me, and apparently to the jury, this is just wrong. How does one square the more flexible “general awareness” standard with having to show that the Defendants “did or would in fact” commit a tort?

Anyway, then the Court turned its attention to yet another alternate theory, namely, that the directors were liable for the misstatements based upon a civil conspiracy theory. Such a claim, however, has a higher burden of proof (clear and convincing evidence) and requires a showing of an agreement “to accomplish an unlawful purpose or a lawful purpose by unlawful means, and accomplish the underlying tort, which in turn caused damages.” As you can imagine, if there was not enough evidence to establish knowledge of the misrepresentations, there would not be enough evidence to establish such an “agreement,” and indeed, that was the result.

One bit of dicta on this issue that is worrisome is the Court’s footnote that “we observe without deciding that [the] alleged conspiracy between [Defendants] may have been legally impossible as an intra-enterprise conspiracy.” Then the Court cites sources concluding that “employees of corporation cannot conspire as matter of law unless serving independent personal stake.” I am not sure why the Court felt it was necessary to address this point, especially in such a manner that tends to suggest that such a conspiracy would not be legally cognizable, but there you have it.

Then the Court turned its attention to the constructive fraud claim. Constructive fraud is “a breach of legal or equitable duty which, without regard to moral guilt or intent of the person charged, the law declares fraudulent because the breach tends to deceive others, violates public or private confidences, or injures public interests.” “While it does not require a showing of intent to deceive or dishonesty of purpose, it does require a fiduciary or confidential relationship.” In addition, “the breach of duty by the person in the confidential or fiduciary relationship must induce justifiable reliance by the other to his detriment.”

The essence of the Plaintiff’s argument in this regard was that, when the Company entered the “zone of insolvency,” Defendants failed to ‘”storm the corporate office,” take over the operation and make sure its finances were beneficially expended for creditors. In essence, Plaintiff relied upon the fact that, “when a firm is insolvent, creditors are included in the class of persons to whom a board of directors owes a fiduciary duty.”

The Court, however, concluded that the Plaintiff failed to show how he “reasonably relied” upon the Defendants’ omissions in failing to take on traditional Board functions to his detriment. The Court observed that “[t]he bulk of [Plaintiff’s] argument vis-à-vis reasonable reliance on [Defendant’s] alleged omissions is that he did not halt the line of credit because he was not alerted that there was not adequate financing to repay the loan by the due date.” The Court held that, “because the fiduciary duty was not personal to [Plaintiff], the Board’s duty to [the Company’s] creditors did not encompass a personal duty to [Plaintiff] to inform him of the status of his loan.”

The Court then turned to the issues on cross-appeal.

The Court started with the issue of whether the trial court erroneously granted summary judgment as to Plaintiff’s negligence claim. In sum, Plaintiff argued that the directors were liable for negligently supervising their agent in connection with the loan transactions. The Court of Appeals affirmed the trial court. The Court explained that, while there are some circumstances that give rise to a duty imposed upon directors to creditors (discussed above), “for personal liability to attach, the involvement of the directors must be more direct and not simply based on failure to properly supervise corporate employees.” In other words, the Court held that, as a matter of law, directors have no duty to properly supervise employees.

Am I missing something? Is the Court mixing apples and oranges? How can the standards for derivative agency liability wrongs committed by an agent be related to whether a director has a duty to supervise its employees? One thing has nothing to do with the other, and the Court has essentially created a judicial exemption for directors – shielding them from any exposure to negligence in connection with supervising employees! What is going on?

Anyway, the Court then addressed punitive damages. Since the Plaintiff’s case was essentially gutted above, it is not surprising that the Court held there was insufficient evidence to establish the “evil hand” / “evil mind” standard.

The Court next addressed a question on the calculation of interest. In that regard, the Court held, in “cases in which no demand [for payment] has been made on the defendants, the prejudgment interest is calculated from the time the complaint was filed.” The Court explained that “[t]he weight of Arizona law supports the proposition that, absent a demand letter, prejudgment interest should accrue from the date the complaint was filed.”

And finally the Court addressed an issue as to the effect of an intermediary settlement with one of the parties and the effect on the calculation of interest. In this regard, the Court held that “a proper calculation of prejudgment interest would reflect accrual of interest on the total judgment from the time the complaint was filed until the time of the settlement, and then on the amount of the judgment less the amount of the settlement after the date of the settlement.”