Officer/Director Breach of Duty: If Things Get Bad Enough, There May Be Recourse

Official Comm. of Unsecured Creditors v. Baldwin (In re Lemington Home for the Aged), 777 F.3d 620 (3rd Cir. 2015) –

The debtor was a nonprofit corporation that operated a nursing home.  The chapter 11 unsecured creditors committee brought proceedings against former officers and directors.  Eventually a judgment was entered finding the defendants liable for breach of fiduciary duties and deepening insolvency, and imposing punitive damages against the officers and some of the directors.  The defendants appealed to the 3rd Circuit.

The nursing home was established in 1883, and “was the oldest, non-profit, unaffiliated nursing home in the United States dedicated to the care of African-America[n] seniors.”  The CEO had been hired as administrator of the nursing home in 1997.  Another defendant became CFO in 2002, and reported to the CEO.  An additional 13 defendants were members of the board of directors and had “direct supervisory control, authority and responsibility” over the CEO.

The nursing home experienced financial difficulties for decades, but had always managed to survive.  However, things became worse under the CEO and CFO during the early 2000s.  The home was cited for regulatory deficiencies at a rate that was almost three times the average for nursing homes in the state.

The CEO began working part time in 2004, even though state law required that all nursing homes have a full-time administrator.  During the course of investigating two suspicious deaths at the home, a state agency concluded that patient recordkeeping and billing “were in a state of disarray.”

In early 2005, the board voted to close the home, although the bankruptcy petition was not filed for another three months.  Once in bankruptcy reporting did not improve.  Operating reports filed almost four months late would have shown that the home received ~$1.4 million in payments, which would have made the business more attractive to a buyer.

Under applicable state law:

[A]n officer shall perform his duties as an officer in good faith, in a manner he reasonably believes to be in the best interests of the corporation and with such care, including reasonable inquiry, skill and diligence, as a person of ordinary prudence would use under similar circumstances.

And the duty of royalty required officers to “devote themselves to the corporate affairs with a view to promote the common interests and not their own.”

The jury heard that the CEO’s responsibilities included insuring that contracts were in place, the bills were paid, the nursing staff was adequate, and the facility was operated in compliance with laws.  The 3rd Circuit found that there was more than enough evidence to show that the CEO breached her duty of care.  During her tenure, the nursing home was cited repeatedly for failing to keep clinical records, and an investigation in 2004 concluded that the CEO “lacks the qualifications, the knowledge of the PC regulations and the ability to direct staff to perform personal care services as required.”  This finding was made at a point when the CEO had been the administrator for more than six years.

Testimony also established that the CEO was not working full time, even though state law required a full-time administrator.  Initially the CEO contended that she actually was working full time.  However, she admitted that this was not the case when confronted with her application for long-term disability benefits filed with the state in which she represented that she was working only 20 to 24 hours per week.  The court characterized her “self-interested decision” to remain as administrator as a breach of her duty of loyalty – by collecting a full-time salary while not fulfilling her duties.

As for the CFO, a nursing home consultant assessing the home on behalf of the major creditor testified that he repeatedly requested various records, including Medicare and Medicaid cost reports, and accounts receivable and payable, financial statements, etc.  In evading his requests, the CFO went so far as to lock himself in his office.  When the consultant finally talked to the CFO, the CFO admitted that there really weren’t any records, saying “well, I’ve got, you know, a little Excel spreadsheet I use, only I try to keep a bank balance.”  The consultant also discovered that the CFO had failed to bill Medicare for at least $500,000 of services.

Other evidence included an email from the CFO to a potential purchaser proposing that they buy the nursing home and appoint him as president and CEO.

Failing to maintain a general ledger and forgoing collection of $500,000 due from Medicare, among other things, was sufficient to show that the CFO “fell far short of fulfilling his duty of care.”  The decision to remain CFO despite his incompetence and the self-interested proposal to the potential purchaser were sufficient to show a breach of loyalty.

The directors were subject to a fiduciary duty defined using a standard similar to that for officers.  The directors knew that the nursing home had an unusually high number of deficiencies, and that a 2001 independent review of the home recommended that the CEO be replaced with a seasoned administrator – noting that the home would not be able to improve without a competent administrator.  Although the board obtained a $178,000 grant to search for a new administrator, the funds were never used.

The board became aware at some point in time that the administrator was working part time, even though state law required a full-time administrator.  They also elevated the CFO even though they knew he had not been maintaining proper financial records while he was CFO.

As the court summarized it, this is not a case where directors acted in good faith in reliance on employers or experts to make a decision to continue employing an administrator who was arguably less than ideal.  Rather there were several independent reports urging that the CEO be replaced.  Thus, the directors had actual knowledge “yet stuck their heads in the sand in the face of repeated signs that residents were receiving care that was severely deficient.”

On the deepening insolvency count, the court relied on the fact that the directors concealed the decision to close the home for three months.  The court construed this as consciously defrauding the nursing home’s creditors.  Further, during bankruptcy the board failed to establish a normal sale process and failed to disclose the $1.4 million tax payments that could have increased the ability to find a borrower.  The officers’ mismanagement also damaged the insolvent nursing home’s value.

Turning to punitive damages, a threshold question was whether establishing the wealth of the defendant was a prerequisite for punitive damages.  Case law suggested that punitive damages should be set to deter, and so should be set based on wealth of the defendant, as opposed to corresponding to compensatory damages.  No evidence on wealth was admitted at trial, so the question was whether punitive damages were precluded.

The 3rd Circuit sided with the cases that found evidence of wealth was not required as a condition of assessing punitive damages.  Rather the “pole star” is the “outrageous conduct of the defendants, not evidence of a defendant’s wealth.”  Case law refers to outrageous conduct as the result of the defendant’s “evil motive or his reckless indifference to the rights of others.”  There must be a showing of acts of “malice, vindictiveness and a wholly wanton disregard of the rights of others.”

Applying this standard, the 3rd Circuit concluded that the officers were properly subject to punitive damages.  However the lower court finding that five of the board members should also be assessed punitive damages based on the fact they received more information than the other directors was not sufficient.  They did not act out of self-interest and the district court directed a verdict in their favor on the claim that they violated the duty of loyalty.  Consequently, the 3rd Circuit reversed the award of punitive damages against the directors.

Reading this opinion, an initial thought might be that officers and directors should keep in mind that rules governing conduct and liability for a Delaware corporation may not be the same as those governing corporations organized in other jurisdictions.  However, by the end of the opinion, a better lesson learned would be that officers and directors do have responsibilities, and just because affairs have been allowed to deteriorate for a number of years does not mean that they won’t be held accountable someday.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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