JOEL H. SLOMSKY, District Judge.
This dispute begins with Covenant Partners, L.P. ("Covenant"), a Delaware limited partnership investment fund founded and run by Defendants William B. Fretz, Jr. and John P. Freeman. Defendants founded Covenant in 1996 to invest the money of friends, family, and others close to them in privately-held startup and growth-stage companies. From cradle to grave, Defendants exercised complete control over Covenant, making all decisions regarding its business affairs, including the management, investment, disbursement, and use of its assets. Between 1999 and 2013, Covenant acquired nearly 8 million shares of a small, private online pet supply retailer called Pet Food Direct, later known as Pet360, Inc. ("Pet360"). The actions Defendants took (and failed to take) in managing Covenant, and particularly in managing the Pet360 shares Covenant had acquired, are the subject of this litigation.
After founding Covenant in 1996, Defendants started Keystone Equities Group, L.P. ("Keystone") in 2003 as a registered broker-dealer.
Covenant's business and affairs were governed by a Limited Partnership Agreement ("LPA"). Under the LPA, Defendants were permitted to, among other things, borrow money on behalf of Covenant and secure loans with a pledge of Covenant's assets. They also were permitted to self-deal and have conflicts of interest. Finally, under the LPA, Defendants were entitled to receive a Performance Fee each year if certain conditions were met. The Performance Fee constituted 20% of the excess profits of Covenant for that year. In 2009 and 2010, Performance Fees were paid to Defendants even though Covenant had losses from prior years that had not been recouped.
In 2009, the Attorney General of Pennsylvania filed a lawsuit against Defendants, Covenant, and others in the Commonwealth Court of Pennsylvania, alleging wrongdoing related to a $2.5 million investment that Covenant had accepted in 2002 from a nonprofit entity known as Citizens Alliance for Better Neighborhoods ("Citizens"). As a result, in 2011, having incurred legal bills during this litigation, Defendants approached Peter Frorer, a business associate, to borrow money. Frorer agreed to lend Defendants money and, through his company, Frorer Partners, L.P., he made three loans: (1) a $450,000 personal loan to Fretz; (2) a $50,000 personal loan to Freeman; and (3) a $300,000 loan to Covenant, each with a maturity date of November 30, 2011. Although the loans may have been funded on different dates, each loan was secured by a separate pledge of Pet360 common shares, and executed on or about March 8, 2011. At that time each pledge of shares remained in the name of each borrower. The value of the Pet360 shares, however, was unknown.
In approximately August 2012, none of the loans had been repaid, and Frorer began demanding better collateral from Defendants and Covenant on the three loans due to concerns raised by Frorer Partners's auditors. Frorer wanted the shares retitled into the name of Frorer Partners. This request began an approximately yearlong battle between Defendants and Frorer and his auditors regarding retitling the shares. As a result of Frorer's continued demands to have Defendants retitle Covenant's Pet360 shares into the name of Frorer Partners, on March 26, 2013, a total of 2,978,989 shares were retitled, and on September 15, 2013, another 2,000,000 shares were retitled all into the name of Frorer Partners. Defendants and Frorer understood that when the loan was repaid, the shares would return to Covenant. At the time of both transfers, the value of the Pet360 shares remained variable and virtually unknown.
After the March and September 2013 retitlings, Frorer continued to demand more of Covenant's Pet360 common shares, but Defendants would not acquiesce. At the end of 2013, Frorer refused to return Covenant's Pet360 shares in exchange for other collateral. At this point, Frorer was the largest common shareholder of Pet360. On February 21, 2014, Frorer met with Brock M. Weatherup, Pet360's Chief Executive Officer ("CEO"), who informed him that Pet360 was receiving interest from various organizations about a potential acquisition. On June 11, 2014, Frorer sent an email to Defendants' attorney purporting to "foreclose" on the Pet360 shares that had been retitled in March and September 2013. Thereafter, on July 9, 2014, Frorer met with Weatherup, who informed him of PetSmart, Inc.'s ("PetSmart") intent to purchase all of Pet360's common stock for an expected price of slightly under $1 per common share.
In July 2014, Frorer entered into an Assignment Agreement with the Commonwealth of Pennsylvania under which he would purchase the $2.5 million judgment that had been entered against Covenant as a result of the Attorney General's lawsuit related to the investment from Citizens. Frorer formed an entity called Tripartite, LLC ("Tripartite") for the purpose of acquiring this judgment and caused the Prothonotary of the Court of Common Pleas of Montgomery County, Pennsylvania ("Prothonotary") to issue a writ of execution on the judgment. The writ of execution resulted in a writ of attachment being directed to Pet360 as garnishee, requiring it to attach property in its possession belonging to Covenant, including any Pet360 shares, and to surrender to the custody of the Prothonotary its Pet360 common shares. On September 11, 2014, Covenant surrendered approximately 2.7 million Pet360 shares to the Prothonotary. On approximately September 29, 2014, Pet360 merged with PetSmart, and Covenant's 4,978,989 Pet360 shares that had been retitled to Frorer Partners were redeemed for cash consideration of $0.793 per share, totaling $3,948,338.28.
On September 19, 2014, Defendants caused Covenant to file a Chapter 7 petition for bankruptcy
On July 18, 2016, the Trustee filed this action as an adversary proceeding in the bankruptcy court against Defendants for breach of fiduciary duty owed to Covenant. Though the Complaint alleges a single count of breach of fiduciary duty, the Trustee advances five theories of how Defendants breached their duty. First, the Trustee alleges that Defendants caused Covenant to make unauthorized loan advancements to Keystone from 2008 to 2010. Second, he asserts that Defendants caused Covenant to issue unearned Performance Fees to themselves through its General Partner in 2009 and 2010. Third, the Trustee contends that Defendants caused Covenant to improperly transfer its Pet360 common shares as collateral for Covenant's loan in March and September 2013. Fourth, he argues that Defendants obligated Covenant for their own personal debts to Frorer Partners. And fifth, the Trustee alleges that Defendants failed to maintain proper records and account for various assets of Covenant.
On March 31, 2017, Defendants moved to withdraw the bankruptcy reference of this adversary proceeding under 28 U.S.C. § 157(d), seeking a bench trial in this Court.
From January 22 to 25, 2018, a four-day bench trial was held before this Court. Thereafter, the parties submitted proposed findings of fact and conclusions of law. (Doc. Nos. 36, 37.) On May 18, 2018, closing arguments were held. Pursuant to Federal Rule of Civil Procedure 52(a),
In 1996, Defendants William B. Fretz, Jr. and John P. Freeman founded Covenant as a private Delaware limited partnership. (Doc. No. 15 at 1.)
Covenant's general partner was Covenant Capital Management Partners, L.P. ("CCMP" or "General Partner"), and CCMP's general partner was Covenant Capital Management, Inc. ("CCMI"). (Doc. No. 15 at 1-2.) Defendants owned CCMI. (Ex. P-48.) CCMI owned 1% and Defendants each owned 49.5% of CCMP, the General Partner. (Doc. No. 15 at 2.)
On February 25, 2003, Defendants started Keystone, a registered broker-dealer that raised money for private companies and some public companies. (Ex. D-24; Fretz Tr. at 21:13-17, Jan. 22, 2018; at 74:21-22, Jan. 23, 2018.) As a broker-dealer, Keystone was registered with FINRA. (Fretz Tr. at 21:18-19, Jan. 22, 2018.) From the time it was formed, Keystone was Covenant's broker-dealer and was located in Oaks, Pennsylvania, where it shared office space with Covenant. (Doc. No. 15 at 2; Fretz Tr. at 79:8-14, Jan. 23, 2018.) As Covenant's broker-dealer, Keystone covered all of its expenses. (Fretz Tr. at 81:15-19, Jan. 23, 2018.) Defendants each owned up to 16% of Keystone. (Doc. No. 15 at 2.) Fretz was President and Freeman was Managing Director of Keystone. (Fretz Tr. at 20:17-21, Jan. 22, 2018; Freeman Tr. at 199:6-10, Jan. 23, 2018.)
From 1996 until Covenant's bankruptcy in September 2014, Defendants were the principals in charge of Covenant, making all decisions regarding its business affairs, including the management and investment, disbursement, and use of its assets. (Fretz Tr. at 18:25-19:9, Jan. 22, 2018.) Freeman was President and Fretz was Managing Director of Covenant. (Fretz Tr. at 119:22-120:6, Jan. 23, 2018; Freeman Tr. at 195:7-8, Jan. 23, 2018.) Defendants exercised complete control over Covenant. (Freeman Tr. at 198:15-17, Jan. 23, 2018.) Fretz's role at Covenant was to bring in funds and communicate with investors. (Fretz Tr. at 78:20-23, Jan. 23, 2018.) Freeman's role at Covenant was to look for deals that were attractive to invest in, but he was not involved in the day-to-day operations. (Freeman Tr. at 25:17-25, Jan. 24, 2018.) Defendants never were paid a salary. (Fretz Tr. at 78:24-79:2, Jan. 23, 2018.)
From 1999 to 2012, Covenant's accountant was Mark S. Carrow, Certified Public Accountant ("CPA"). (Carrow Tr. at 55:8-21, Jan. 25, 2018.) From 1999 to 2009, Carrow was Covenant's accountant through his own firm, Carrow, Doyle & Associates, and from 2009 to 2012, he was Covenant's accountant through the accounting firm of Citrin Cooperman, LLP ("Citrin"). (
In 1999, Covenant began investing in Pet360, which was a private online retailer of pet food and supplies that had no publicly-traded stock. (Doc. No. 15 at 3; Fretz Tr. at 99:8-10, Jan. 23, 2018.) Pet360 had, however, three types of privately-traded stock: Series A Preferred, Series B Preferred, and common shares. (Freeman Tr. at 33:1-6, Jan. 24, 2018; Weatherup Dep. at 39:14-24.) Series A Preferred and Series B Preferred shares had a liquidation preference and a right of first refusal.
Between 1999 and 2013, Covenant acquired 7,795,000 common shares of Pet360. (Fretz Tr. at 39:25-40:10, Jan. 22, 2018.) The investment in Pet360 was one of Covenant's largest. (
Freeman served on Pet360's Board of Directors from approximately 2000 until February 2014, when he was removed by a vote of Pet360's common shareholders. (Doc. No. 15 at 3; Freeman Tr. at 202:13-24, Jan. 23, 2018.) From May 2009 until its acquisition by PetSmart in late September 2014, Brock M. Weatherup was CEO of Pet360. (Doc. No. 15 at 3; Freeman Tr. at 31:15-32:2, Jan. 24, 2018; Weatherup Dep. at 12:8-12.) When Weatherup became CEO of Pet360, Freeman had a good relationship with him, but after a period of time, their relationship changed. (Freeman Tr. at 32:3-7, Jan. 24, 2018.) Freeman said that the relationship declined because Weatherup did not like the way that Freeman was challenging him at board meetings regarding the performance of the company and was denying him bonuses. (
In addition to Covenant, Frorer Partners, a private limited partnership investment fund owned and controlled by an individual named Peter Frorer, also invested in Pet360 and held common shares beginning in 1999. (Fretz Tr. at 102:7-20, Jan. 23, 2018; Weatherup Dep. at 40:24-41:5.) Defendants met Frorer in approximately 1994 when he worked with them at Pennsylvania Merchant Group, a broker-dealer. (Fretz Tr. at 104: 3-5, Jan. 23, 2018.)
As provided in Covenant's LPA, Defendants ran Covenant through the General Partner, CCMP. Covenant's business and affairs were governed by the LPA, which granted the General Partner authority to engage in the activities set forth in the LPA. (Doc. No. 15 at 1.) The LPA provides that Covenant is a limited partnership under the Delaware Revised Limited Partnership Act ("Delaware Act") and that the Delaware Act governs the rights and liabilities of the partners, except as otherwise provided in the LPA. (Ex. P-39, LPA §§ 1.2, 5.1.)
The LPA is dated June 15, 1999 and has been amended four times. (Doc. No. 15 at 2; Fretz Tr. at 45:9-13, Jan. 23, 2018.) The first amendment is dated November 26, 1996. (Ex. P-39 at 6.) The second amendment is dated July 30, 1999. (
The LPA grants the General Partner broad and exclusive management authority over Covenant's business, including the authority to borrow money in Covenant's name and to secure such borrowing with Covenant's property. (Ex. P-39, LPA §§ 6, 12.1.) Section 6 of the LPA governs the General Partner's investment activities, while § 12.1 governs the General Partner's Management of Covenant. (
(Ex. P-39, LPA § 6.) Section 6(b) authorizes the General Partner to borrow money on behalf of Covenant and to secure loans with a pledge of Covenant's assets. (Fretz Tr. at 84:12-18, Jan. 23, 2018; Seitz Tr. at 153:8-154:2, Jan. 24, 2018.)
Section 12.1 of the LPA sets forth the powers of the General Partner in managing Covenant. (Doc. No. 15 at 1.) Section 12.1 provides in relevant part as follows:
(Ex. P-39, LPA § 12.1.) Section 12.1 then lists the "powers of the General Partner on behalf and at the expense of the Partnership." (
(Ex. P-39, LPA § 12.1(d), (g).) In sum, under §§ 6 and 12.1 of the LPA, the General Partner was authorized to enter into loans on behalf of Covenant and to use Covenant's assets (including a pledge of Covenant's stocks) to secure those loans. (Fretz Tr. at 96:18-97:2, Jan. 23, 2018.)
The LPA allows the General Partner and Defendants to self-deal and to have conflicts of interest with Covenant regarding investment and business activities. Section 7 of the LPA allows the General Partner and Defendants to engage in investment activities that may be the same or affiliated with Covenant. (Fretz Tr. at 85:15-19, Jan. 23, 2018.) That is, § 7 allows Defendants to self-deal with respect to investments on their own account even when a conflict of interest is created by that activity. (
(Ex. P-39, LPA § 7.) Correspondingly, § 8 of the LPA generally provides that conflicts of interest will not prohibit Covenant from engaging in a transaction. Section 8 reads as follows:
(
The LPA provides that the General Partner may be entitled to receive a Management Fee and a Profit Allocation ("Performance Fee"),
(Ex. P-39, LPA § 10.7.)
Thus, under § 10.7, the General Partner would receive a Performance Fee if Covenant's quarterly profit that otherwise would be allocated to a Limited Partner exceeded that Limited Partner's unrecouped losses. (
Although § 10.7 addresses what occurs if a Limited Partner's profits exceed that Limited Partner's Unrecouped Losses,
In annually calculating the Performance Fee, Carrow relied on § 10.7 of the LPA. (Carrow Tr. at 60:5-15, 61:9-15, Jan. 25, 2018.) If Covenant took a loss for the year, the Performance Fee would not be paid. (
In 2009 and 2010, Performance Fees were paid to the General Partner. (Doc. No. 15 at 2-3.) The General Partner received a Performance Fee of $409,373 in 2009 and a Performance Fee of $102,248 in 2010.
On March 1, 2012, the fourth amendment to the LPA was made following its approval by 86% of the Limited Partners. (Ex. P-40; Fretz Tr. at 47:19-48:3, Jan. 23, 2018.) The purpose of the fourth amendment was to clarify and ratify the method for calculating the Performance Fee, and specifically that Covenant did not have to recoup losses from prior years before the Performance Fee could be paid. (Fretz Tr. at 46:8-18, 96:5-17, Jan. 23, 2018.) That is, the fourth amendment to the LPA specified that unrecouped losses would not be carried forward to the next year. (
(Ex. P-40.) Defendants were paid Performance Fees prior to the effective date of the fourth amended LPA, when Covenant had unrecouped losses from prior years. (Fretz Tr. at 49:1-3, Jan. 23, 2018.)
From 2008 to 2010, Covenant's broker-dealer, Keystone, which also was partially owned by Defendants, experienced significant financial difficulty, was not profitable, and had net losses of approximately $600,000 per year. (Fretz Tr. at 23:10-16, Jan. 22, 2018.) Freeman testified that during this time, the entire industry was experiencing financial problems. (Freeman Tr. at 199:13-23, Jan. 23, 2018.) In 2010, Keystone's audited financial statements contained a "going concern" clause. (Doc. No. 15 at 2.)
Between April 28, 2008 and June 1, 2010, Covenant made loans to Keystone totaling $1,203,058. (Doc. No. 15 at 2; Ex. D-10; Fretz Tr. at 25:23-25, Jan. 22, 2018.) In 2008 and 2009, there were no loan documents to support these loans, but the loans were disclosed each year in the financial statements and tax returns of Keystone and in the tax returns of Covenant. (Fretz Tr. at 26:9-27:15, Jan. 22, 2018; Carrow Tr. at 72:20-73:11, Jan. 25, 2018.) Defendants did not disclose in writing to Covenant's Limited Partners that Covenant was loaning money to Keystone, but Fretz testified that he talked to them and told most of them what Defendants were doing. (Fretz Tr. at 36:24-37:17, Jan. 22, 2018.)
On June 1, 2010, Covenant made its final loan to Keystone for $15,000. (Ex. D-10; Fretz Tr. at 141:21-25, Jan. 23, 2018.) After the loans were made, Defendants executed, on behalf of Keystone, an unsecured promissory note to Covenant dated December 31, 2010 for $1,410,573, which represented the principal and accrued interest on the loans ("Keystone Note"). (Doc. No. 15 at 2; Ex. P-38; Fretz Tr. at 27:16-28:8, Jan. 22, 2018.) The Keystone Note was signed by Fretz on behalf of Keystone and by Freeman on behalf of Covenant. (Ex. P-38; Fretz Tr. at 29:9-12, Jan. 22, 2018.) According to the terms of the Keystone Note, Keystone promised to repay the loans from Covenant within two years. (Freeman Tr. at 231:13-15, Jan. 23, 2018.) The loans were unsecured, that is, no collateral was provided to Covenant for them, and Keystone never repaid any of the principal or the interest on them. (Fretz Tr. at 28:9-21, Jan. 22, 2018; 143:1-4, Jan. 23, 2018.)
But at the time the Keystone Note was signed, Freeman believed that the loans were a good use of Covenant's investors' funds. (
Keystone eventually became the subject of an investigation by FINRA, which resulted in a fine of approximately $25,000 or $30,000 and the revocation of Keystone's license. (Fretz Tr. at 23:3-4, 23:22-24, Jan. 22, 2018; Freeman Tr. at 200:8-12, Jan. 23, 2018.) It also resulted in an order barring Defendants for life from associating with any FINRA member firm in any capacity. (Fretz Tr. at 3:16-23, Jan. 23, 2018; Freeman Tr. at 15-17, Jan. 23, 2018.)
At some point after the FINRA investigation began, Keystone closed and ceased doing business. Although the parties stipulated that Keystone closed in 2010 (Doc. No. 15 at 2), Defendants both testified at trial that Keystone continued to operate after 2010.
In 2009, the Attorney General of Pennsylvania filed a lawsuit against Defendants, Covenant, and others in the Commonwealth Court of Pennsylvania, alleging wrongdoing related to a 2002 investment of $2.5 million that Covenant had accepted from a nonprofit entity known as Citizens Alliance for Better Neighborhoods,
In or around March 2011, Frorer Partners, controlled by Peter Frorer, made three separate loans to Fretz, Freeman, and Covenant. (Doc. No. 15 at 3; Fretz Tr. at 55:21-56:3, Jan. 22, 2018.) Frorer Partners lent Fretz $450,000 ("Fretz Loan"), lent Freeman $50,000 ("Freeman Loan"), and lent Covenant $300,000 ("Covenant Loan"). (These three loans will be referred to hereafter as the "Frorer Partners Loans"). (Doc. No. 15 at 3.)
Each loan was secured by separate collateral and verified by an individual promissory note and an individual stock pledge agreement that pledged shares of Pet360 common stock to secure the loan and provided for a maturity date of November 20, 2011. (Exs. D-2, D-3, D-4, D-5; Fretz Tr. at 56:24-57:7, Jan. 22, 2018; 103:15-22, 104:16-20, Jan. 23, 2018; Freeman Tr. at 207:12-208:11, Jan. 23, 2018.) The Fretz Loan was secured by a pledge of 339,365 shares of Pet360 stock, as well as land he owned in Costa Rica. (Ex. D-2; Fretz Tr. at 105:18-107:8, 109:3-17, Jan. 23, 2018.) The Freeman Loan was secured by a pledge of 400,000 shares of Pet360 stock. (Ex. D-4; Freeman Tr. at 36:13-37:2, Jan. 24, 2018.) And the Covenant Loan was secured by a pledge of 3,000,000 shares of Pet360 stock. (Ex. D-5; Fretz Tr. at 112:16-114:8, Jan. 23, 2018.) Although the loans may have been funded on different dates, the notes and pledges of shares for all three loans were executed on or about March 8, 2011 at Frorer's home in Bryn Mawr, Pennsylvania. (Fretz Tr. at 106:24-107:20; Freeman Tr. at 215:11-22, Jan. 23, 2018; 36:13-37:5, Jan. 24, 2018.)
When the pledges of Pet360 shares were given to Frorer, as representative of Frorer Partners, they remained certificated in the name of the owner of the shares and were not retitled into the name of Frorer Partners at that time. (Exs. D-3, D-4, D-5; Fretz Tr. at 28:7-25, 124:20-8, Jan. 23, 2018; Freeman Tr. at 217:19-21, Jan. 23, 2018.) The Pledge of Shares of Stock for each loan provides the following language:
(Exs. D-2, D-3, D-4, D-5.) Thus, by these paragraphs, if the Covenant Loan was paid off, the shares pledged as collateral for that loan would return to the owner of the shares. (Fretz Tr. at 108:14-20, 109:18-114:8, Jan. 23, 2018.) If the Covenant Loan defaulted, Frorer Partners would be entitled to receive the value of the principal of the loan plus interest. (Fretz Tr. at 117:2-5, Jan. 23, 2018; Freeman Tr. at 41:14-19, Jan. 24, 2018.)
In 2011, when Defendants and Covenant pledged Pet360 common shares as collateral for the Frorer Partners Loans, the shares had no known value. As noted, Pet360 was a small, private startup company with no publicly traded stock and had never turned a profit. (Doc. No. 15 at 3; Fretz Tr. at 99:23-100:1, Jan. 23, 2018.)
Even Brock M. Weatherup, CEO of Pet360 from 2009 until its acquisition by PetSmart in late September 2014, was unable to place a value on the common shares of Pet360 in 2011. He said that in 2011, there was no public market for the stock of Pet360. (Weatherup Dep. at 50:16-51:14.) He further stated that the only time Pet360 would value its common shares would be for a stock option grant of one form or another, and the valuation would be done to determine the exercise price of the option. (
Although the Trustee contends that 76 cents was an accurate valuation at the time for Pet360 common shares, no evidence supports this figure. In fact, when asked whether 76 cents was the correct value for Pet360 common shares in August 2012, Weatherup said he did not know what the reference point for 76 cents would be. (
When asked whether, before the PetSmart merger, the value of Pet360 common shares was anyone's guess, Weatherup said, "Correct. Well, it's always negotiated. It's always highly debatable. I mean you try and have valuation firms that, you know, do things, but they can always be wildly different." (Weatherup Dep. at 74:7-16.) Importantly, no expert valuation of the Pet360 shares was done in this case. (Seitz Tr. at 157:13-25, Jan. 24, 2018.) Based on the evidence of record, the value of Pet360 common shares in 2011, when the shares were pledged as collateral for the Frorer Partners Loan, was virtually unknown.
None of the three Frorer Partners Loans were repaid by their maturity date of November 30, 2011, and each went into default at the end of 2011. (Fretz Tr. at 104:21-25, 114:12-16, Jan. 23, 2018; Freeman Tr. at 8:24-9:3, Jan. 24, 2018.) Consequently, in approximately August 2012, Peter Frorer contacted Fretz and informed him that since the loans were in default, the outside accounting firm, Rothstein Kass, was conducting an audit of Frorer Partners and was expressing concern about the value of the Frorer Partners Loans. (Doc. No. 15 at 3-4; Fretz Tr. at 61:22-25, 65:20-66:3, Jan. 22, 2018.) Because the loans were in default, they would have to be classified as "impaired"
Frorer Partners's audit originally was handled by Rothestein Kass, but in 2012, Frorer Partners switched accounting firms to Citrin, who completed the audit. (Doc. No. 15 at 4; Carrow Tr. at 104:13-105:7, Jan. 25, 2018.) Carrow was the Managing Partner at Citrin and the relationship partner responsible for Frorer Partners's audit. (Doc. No. 15 at 4; Carrow Tr. at 55:22-23, Jan. 25, 2018.) As noted, Carrow also was Covenant's longstanding outside CPA. (Doc. No. 15 at 4.)
Although the Covenant Loan already was supported by the collateral of the pledge of Pet360 shares, when the loan went into default, Frorer wanted better collateral to satisfy his auditors. (Fretz Tr. at 65:13-15, 67:23-68:1, 70:14-71:31, Jan. 22, 2018; 31:8-19, Jan. 23, 2018.) Frorer wanted the Pet360 shares to be retitled from the name of Covenant to the name of Frorer Partners. (Fretz Tr. at 31:8-19, 124:20-23, Jan. 23, 2018.) Fretz testified that he believed Frorer's auditors wanted the shares retitled because if they remained in the names of the borrowers, they would not be negotiable enough for Frorer to execute on them. (
During the summer of 2012 began what would become an approximately yearlong battle between Defendants and Frorer and his auditors over retitling the Pet360 shares into the name of Frorer Partners. (
Frorer continued to demand that the pledged Pet360 shares be retitled into the name of Frorer Partners. Sometime at the end of February 2013, Fretz contacted Carrow regarding the creation of an option, or buyback, agreement between Covenant and Frorer Partners to protect the interest of the Pet360 shares given to Frorer Partners in the event of foreclosure of the shares. (Carrow Tr. at 82:11-83:15, 114:16-23, Jan. 25, 2018.) Carrow testified that in doing so, Fretz was trying to satisfy Frorer Partners to stop any foreclosure on the shares and was looking for a way to have an agreement by which Frorer would have control over the shares without the shares being lost or impaired by Covenant. (
On February 20, 2013, Carrow sent an email to Peter Frorer, stating as follows: "I spoke to Bill [Fretz], it will not have any impact on covenant." (Ex. D-2; Carrow Tr. at 82:4-10, Jan. 25, 2018.) Carrow testified that in this email, he was referring to the option, or buyback, agreement. (Carrow Tr. at 82:9-11, Jan. 25, 2018.) That same day, Fretz sent an email to Frorer regarding the retitling of the Pet360 shares, which reads as follows:
(Ex. D-8.) Fretz testified that in this email, he was discussing retitling the shares into the name of Frorer Partners. (Fretz Tr. at 128:2-130:10, Jan. 23, 2018.) Fretz testified that he relied on the advice of his accountant, Carrow, that the retitling of shares would have no impact on Covenant. (
Carrow disputes this testimony, however, and said that he never told Defendants that transferring title to the Pet360 shares from Covenant to Frorer Partners would have no impact. (Carrow Tr. at 112:5-8, Jan. 25, 2018.) Carrow testified that when the shares were retitled, that transaction would in fact have to be reflected on Covenant's tax returns because the transfer was a taxable event. (
Peter Frorer also executed a Personal Guarantee dated February 23, 2013 by which he personally guaranteed Frorer Partners' loan to Covenant. (Ex. D-20; Carrow Tr. at 79:14-80:4, 180:20-21, Jan. 25, 2018.) This Personal Guarantee was part of the additional collateral that Frorer Partners obtained to support the three loans. (Carrow Tr. at 80:5-7, Jan. 25, 2018.)
After extensive negotiations and Frorer's repeated threats to sue Covenant and Defendants on behalf of Frorer Partners, Defendants agreed to transfer to Frorer Partners' title to the Pet360 shares that had been pledged as collateral for the Covenant Loan. (Fretz Tr. at 126:3-12, Jan. 23, 2018; Freeman Tr. at 219:16-220:4, Jan. 23, 2018.) Accordingly, on or about March 27, 2013, Covenant transferred title to 2,978,989 Pet360 common shares into the name of Frorer Partners ("March 2013 Transfer"). (Ex. P-18; Fretz Tr. at 29:1-12, Jan. 23, 2018.)
The transfer of title to the Pet360 shares had to be approved by Pet360's preferred shareholders, so to effectuate the transfer, Fretz sought the assistance of Matthew Murray, controller of Pet360, who generally handled transfers of shares. (Ex. D-19; Fretz Tr. at 30:5-19, Jan. 23, 2018; Freeman Tr. at 53:8-54:4, Jan. 24, 2018; Weatherup Dep. at 58:4-19.) Pet360 approved the transfer of title to the shares from Covenant to Frorer Partners. (Freeman Tr. at 220:20-24, Jan. 23, 2018; Weatherup Dep. at 66:2-14.) The March 2013 Transfer was authorized by an "Agreement, Certification and Acknowledgement," signed by Defendants on behalf of Covenant. (Ex. P-18; Freeman Tr. at 220:5-22, Jan. 23, 2018.)
After the March 2013 Transfer, Frorer continued to demand more Pet360 shares to further collateralize the Frorer Partners Loans. (Doc. No. 15 at 4.) On September 15, 2013, at the direction of Defendants, Covenant transferred title of an additional 2,000,000 Pet360 common shares into the name of Frorer Partners ("September 2013 Transfer"). (
The evidence of record does not prove that the Frorer Partners Loans ever were consolidated or treated as one single obligation but instead shows that they always were treated as separate loans. No evidence was presented at trial that the loans ever were treated as a single obligation on Covenant's books and records or that any of Covenant's funds ever were used to pay the loans as a single obligation. Fretz confirmed that none of Covenant's money was ever used to pay either of Defendants' personal loans. (Fretz Tr. at 122:11-13, Jan. 23, 2018.)
At some point, Defendants signed a document titled "Collateral Release and Loan Extension Agreement" ("Collateral Release") to extend the Covenant Partners Loan because the original note for the loan, signed on or about March 8, 2011, had expired. (Doc. No. 15 at 4; Fretz Tr. at 21:4-6, 22:19-23:12 Jan. 22, 2018.) Although the Trustee argues that the Collateral Release consolidated all three loans, Defendants deny that the version of the Collateral Release in evidence is the version they signed. (Ex. P-19; Fretz Tr. at 73:24-74:13, Jan. 22, 2018; Freeman Tr. at 221:10-222:16, Jan. 23, 2018.) Defendants do not have a copy of the Collateral Release they signed. (Fretz Tr. at 21:4-8, Jan. 23, 2018; Freeman Tr. at 5:4-6, Jan. 24, 2018.) Regardless, the Collateral Release in evidence, which Defendants argue is not the version they signed, makes no reference to Defendants' personal loans from Frorer Partners. (Fretz Tr. at 119:8-13, Jan. 23, 2018.) And although the Collateral Release in evidence references a note attached as Addendum A, a note was neither attached nor ever located. (
Finally, an Assignment dated December 31, 2013, by which Frorer Partners assigned each loan to Peter Frorer in exchange for Frorer's payment of $800,000, is further evidence that the Frorer Partners Loans were at all times treated separately.
After the September 2013 Transfer, Frorer continued to demand additional Pet360 common shares from Covenant, but Covenant did not transfer any more shares to Frorer Partners or to Frorer individually. (Doc. No. 15 at 4.) The evidence showed that it was the intent of Covenant and of Frorer Partners that Covenant's Pet360 shares would be returned to it once the Covenant Loan was repaid. And as noted, in the event the Covenant Loan went into default, Frorer Partners would be entitled to only the value of the loan's principal and interest, and any value in the Pet360 shares above that amount would be returned to Covenant. (Fretz Tr. at 122:5-8, Jan. 23, 2018; Freeman Tr. at 41:14-19, Jan. 24, 2018.) But at the end of 2013, Peter Frorer refused to return Covenant's Pet360 shares in exchange for other collateral. (Fretz Tr. at 52:17-23, Jan. 23, 2018; Carrow Tr. at 101:4-8, Jan. 25, 2018.)
In December 2013, Carrow found out that title to Covenant's Pet360 shares had been transferred into the name of Frorer Partners without an option agreement. (Carrow Tr. at 116:10-13, Jan. 25, 2018.) When he found out, Carrow told Fretz that transferring title to the shares without an option agreement was a taxable event and that if his firm were to prepare tax returns for Covenant for 2013, they would have to reflect the transfer. (
In December 2014, Weatherup traveled to Phoenix, Arizona to meet with the then CEO of Petsmart, David Lenhardt, and discussed with Lenhardt a potential acquisition of Pet360 by PetSmart ("PetSmart merger"). (Weatherup Dep. at 76:16-77:1.)
By the beginning of 2014, Peter Frorer owned at least 12,581,044 common shares of Pet360, making him the largest common shareholder.
At some point after Frorer became Pet360's largest common shareholder, Weatherup had him sign a confidentiality agreement so that he could be more open with Frorer about Pet360's business.
On June 11, 2014, Frorer sent an email to Fretz and his attorney purporting to "foreclose" on the Pet360 shares that were transferred in the March and September 2013 Transfers and indicating that he intended to keep all of the Pet360 shares for himself. (Doc. No. 15 at 5.)
On June 30, 2014, Lenhardt signed and sent a letter of intent ("LOI") on behalf of PetSmart to Weatherup proposing to purchase all the common stock of Pet360. (Ex. D-17; Doc. No. 15 at 5; Weatherup Dep. at 30:3-33-5.) The LOI provided that total consideration for the purchase would be $160 million, with $130 million in cash and $30 million paid through an earn-out.
Thereafter, on July 9, 2014, Weatherup and Frorer met at Pet360's offices, and Weatherup informed Frorer of the terms of the LOI that Lenhardt recently had sent. (Weatherup Ex. 6; Doc. No. 15 at 5; Weatherup Dep. at 30:3-33:5.) Weatherup explained to Frorer the total purchase price of the Petsmart merger and that it was expected to result in a common share purchase price of slightly under $1.
On July 30, 2014, Frorer executed an Assignment Agreement with the Commonwealth of Pennsylvania through the Attorney General pursuant to which Frorer or his "controlled designee" would purchase the $2.5 million judgment that had been entered against Covenant on April 3, 2013 in the Attorney General Lawsuit, at a price substantially below the judgment amount.
Thereafter, Frorer took steps on behalf of Tripartite to cause the Prothonotary to issue a writ of execution to execute on the judgment. (
On August 21, 2014, the PetSmart merger was announced to the public, and on approximately September 29, 2014, the merger closed. (Doc. No. 15 at 6; Fretz Tr. at 57:24-58:5, Jan. 23, 2018; Weatherup Dep. at 15:9-13, 80:4-20.) Neither Fretz nor Freeman knew about the merger before August 21, 2014. (Weatherup Ex. 6; Fretz Tr. at 135:2-5, Jan. 23, 2018; Freeman Tr. at 42:7-23, Jan. 24, 2018.) Freeman also confirmed that while he was on the Pet360 Board, he did not know anything about the merger. (Freeman Tr. at 43:11-17, Jan. 24, 2018.)
Total consideration for the PetSmart merger, as described in the LOI, was $160 million, with $130 million of the consideration in cash and a $30 million earn-out, which ultimately was not paid. (Weatherup Dep. at 78:14-79:7.) Following the Petsmart merger, the 4,978,989 common shares that had been transferred from Covenant to Frorer Partners during the March and September 2013 Transfers were redeemed for cash consideration of approximately $0.793 per common share, totaling $3,948,338.28. (Doc. No. 15 at 6.)
After the PetSmart merger was announced on August 21, 2014, counsel for Defendants spoke with the SEC to find a solution to the fact that Frorer still held Covenant's Pet360 shares. (Fretz Tr. at 135:12-25, Jan. 23, 2018.) Defendants testified that the SEC suggested they file a Chapter 7 petition for bankruptcy on behalf of Covenant to get the shares back. (
On September 19, 2014, Defendants caused Covenant to file a Chapter 7 petition in the Bankruptcy Court with the goal of getting the Pet360 shares that had been transferred to Frorer Partners returned.
On March 24, 2015, the Trustee and Defendants entered into a Tolling Agreement, effective that same day. (Doc. No. 15 at 6; Ex. D-14.) On April 15, 2016, they entered into an Addendum that extended the Tolling Agreement until March 24, 2017 (together, "Tolling Agreement"). (
(
On December 19, 2014, the Trustee commenced and prosecuted an adversary proceeding against Peter Frorer, Frorer Partners, Frorer Associates, LLC, Tripartite, and the Prothonotary, to recover the Pet360 shares. (Doc. No. 15 at 6.) The Trustee brought claims against Frorer and his related entities for fraudulent transfers, fraud, conversion, unjust enrichment, aiding and abetting breach of fiduciary duty, and other related claims. (Ex. P-42; Seitz Tr. at 95:24-10; 141:2-10, Jan. 24, 2018.) In the adversary proceeding, the Trustee sought to unwind the transfer of the following Covenant Pet360 shares to Frorer Partners and the proceeds from the sale of those shares to PetSmart: (1) 2,978,989 Pet360 common shares retitled to Frorer Partners on March 27, 2013; (2) 2,000,000 Pet360 common shares retitled to Frorer Partners on September 15, 2013; and (3) 2,766398 Pet360 common shares surrendered to the Prothonotary for Tripartite on September 11, 2014, for a total of 7,745,387 of Covenant's Pet360 common shares owned or controlled by Frorer. (Ex. D-22 at 3-4.)
This action was settled in June 2016, and the Bankruptcy Court approved the settlement on August 8, 2016. (Doc. No. 15 at 6.) As a result of the settlement, Covenant's bankruptcy estate recovered the proceeds of all of these Pet360 shares at the full price paid for them by PetSmart in the PetSmart merger, bringing in $6,897,729.13 to Covenant's bankruptcy estate. (Ex. P-43, § 2; Seitz Tr. at 102:1-103:14, Jan. 24, 2018.)
Later, in November 2016, Covenant's bankruptcy estate recovered an additional $627,054.43 in distributions regarding the Pet360 shares through the settlement of shareholder lawsuit that had been filed by Pet360's common shareholders in the Court of Chancery of Delaware,
Before Covenant filed its Chapter 7 petition, the SEC had been investigating certain transactions involving Covenant. (Doc. No. 15 at 7; Seitz Tr. at 86:19-87:11, Jan. 24, 2018.) In August 2015, the Trustee and the SEC entered into a settlement in which the SEC received an unsecured claim
On July 18, 2016, the Trustee filed this action in the Bankruptcy Court against Defendants, alleging one count of breach of fiduciary duty of care and loyalty and seeking to recover the amount of the SEC's claim and other alleged damages related to the recovery of the Pet360 shares and other expenses allegedly incurred in pursuing the Frorer parties. (Ex. P-1.)
The Trustee alleges that Defendants breached their fiduciary duties to Covenant by: (1) causing Covenant to make unauthorized loan advancements to Keystone from 2008 to 2010; (2) causing Covenant to issue unearned Performance Fees to its General Partner in 2009 and 2010; (3) causing Covenant to improperly transfer its Pet360 shares to Frorer Partners in March and September 2013; (4) using Covenant's Pet360 shares as collateral for their personal loans from Frorer Partners by consolidating their loans with the Covenant Loan; and (5) failing to account for various assets of Covenant. (Ex. P-1 ¶ 173; Doc. No. 37.) Defendants have advanced numerous arguments on why each of the Trustee's theories for breach of fiduciary duty fails.
A four-day bench trial was held on the breach of fiduciary duty claim. During the bench trial, "in addition to resolving legal issues, the [Court's] role . . . includes evaluating the credibility of witnesses and weighing the evidence."
In stating its conclusions of law, the Court first will address the three Motions in Limine filed by Defendants before trial. Then, it will discuss what fiduciary duties were owed by Defendants. Finally, the Court will discuss each of the Trustee's theories for breach of fiduciary duty and Defendants' arguments in opposition to it. As previously noted, because the Trustee has not met his burden to prove by a preponderance of the evidence that Defendants breached their fiduciary duties to Covenant, judgment will be entered in favor of Defendants.
As an initial matter, Defendants filed three Motions in Limine in the Bankruptcy Court, which they renewed in this Court. The Court will address each Motion in Limine in turn.
Defendants argue that the Court should exclude all SEC Offers of Settlement from evidence because they are barred under Federal Rules of Evidence 408 and 410. Rule 408 addresses the admissibility of compromise offers and negotiations, while Rule 410 concerns the admissibility of pleas, plea discussions, and related statements. Fed. R. Evid. 408, 410. The Trustee responds that he is not seeking the admission into evidence of any of the SEC Offers of Settlement and therefore there is nothing for the Court to rule on regarding this Motion. Because the Trustee is not seeking the admission of the SEC Offers of Settlement and because the Court has not considered the SEC Offers as evidence, this Motion in Limine (Bankruptcy Adversary No. 16-00226-SR, Docket No. 64) will be denied as moot.
Defendants assert that since the SEC Offers of Settlement are inadmissible, all other evidence derived from the Trustee's negotiations with the SEC and which led to the SEC Offer of Settlement should also be excluded under Federal Rule of Evidence 408 and under Federal Rules of Evidence 801 and 802 as inadmissible hearsay. In response, the Trustee argues that regarding evidence of the SEC's investigation, Defendants have not identified any outstanding issues upon which the Court must rule or any particular Exhibit to which this Motion relates. The Trustee also states that the Court has already ruled at trial on Defendants' objection to evidence relating to negotiations with the SEC. (
Any evidence regarding the Trustee's negotiations with the SEC is inadmissible as evidence of a compromise or settlement under Rule 408 and as hearsay under Rules 801 and 802. Rule 408 provides in relevant part as follows:
Fed. R. Evid. 408(a). Here, any evidence regarding the Trustee's negotiations with the SEC is inadmissible as evidence relating to an offer of settlement and as conduct during negotiations regarding the settlement of a claim. Further, as the Court already ruled at trial, evidence derived from the Trustee's negotiations with the SEC is inadmissible hearsay under Rules 801 and 802. (
Finally, Defendants argue that any evidence containing statements made by Peter Frorer should be excluded as inadmissible hearsay. Defendants further assert that they have repeatedly attempted to depose Frorer but to no avail, that he is living permanently in Costa Rica, and that any statements made by him are highly suspect and should be excluded from evidence as inadmissible hearsay. The Trustee responds that the Court should deny Defendants' Motion in Limine (Bankruptcy Adversary No. 16-00226-SR, Docket No. 68 ) to exclude all of Frorer's out of court statements because the Court cannot make a blanket ruling regarding all of Frorer's statements but instead must address each statement and its particular purpose individually.
The Court will deny Defendants' Motion in Limine (Bankruptcy Adversary No. 16-00226-SR, Docket No. 68) insofar as it seeks to exclude all of Frorer's out of court statements wholesale. The Court acknowledges, however, that any evidence containing Frorer's out of court statements offered to prove the truth of the matter asserted in the statements is inadmissible unless it fits within an exception to the rule against hearsay.
The parties seem to have assumed that Delaware's statute of limitations applies to the breach of fiduciary duty claim.
Federal courts apply the choice of law rules of the forum state, which in this case is Pennsylvania.
Under Delaware law, the statute of limitations for breach of fiduciary duty is three years. Del. Code Ann. Tit 10 § 8106(a);
Along with Pennsylvania's statute of limitations, this Court also must apply Pennsylvania law governing relevant tolling principles.
Under Pennsylvania law, "the statute of limitations begins to run as soon as a right to institute and maintain suit arises."
Under Pennsylvania law, however, "certain tolling principles" may apply "to ameliorate the sometimes-harsh effects of the statute of limitations."
Plaintiff generally "bears the burden of showing that the discovery rule tolls the statute of limitations."
Reasonable diligence means that the plaintiff "pursued the cause of his injury with those qualities of attention, knowledge, intelligence and judgment which society requires of its members for the protection of their own interests and the interests of others."
Correspondingly, under Pennsylvania law, equitable tolling can suspend the statute of limitations from running in three circumstances:
Defendants submit that the Trustee's claim for breach of fiduciary duty based on Covenant's loan advances to Keystone and the payments of unearned Performance Fees is barred by the statute of limitations. In response, the Trustee appears to invoke the discovery rule and the doctrine of fraudulent concealment to toll the applicable statute of limitations, arguing that Defendants did not disclose their conduct to Covenant's investors. The Court will address each set of transactions in turn.
The evidence at trial showed, and the parties have stipulated, that between April 28, 2008 and June 1, 2010, Covenant made loans to Keystone totaling $1,203,058. (Doc. No. 15 at 2; Ex. D-10; Fretz Tr. at 25:23-25, Jan. 22, 2018.) Under Pennsylvania law, the statute of limitations began to run for each loan advancement on the date that that loan advancement was made.
In addition, no equitable tolling principle applies to resurrect a breach of fiduciary duty claim based on the loan advancements to Keystone. As noted, the Trustee bore the burden at trial of showing that the statute of limitations should be tolled. The Trustee failed to meet his burden of proving that either the discovery rule or the doctrine of fraudulent concealment should apply. As to the discovery rule, the Trustee was required to show that Covenant or its investors exercised "`reasonable diligence' in ascertaining the existence of the injury and its cause."
As to fraudulent concealment, the Trustee has failed to provide evidence that Defendants took any affirmative action to conceal or mislead Covenant's investors from discovering the loans. Rather, the evidence at trial showed that the loans to Keystone were disclosed in Covenant's tax returns, as well as its books and records. (Fretz Tr. at 26:9-27:15, Jan. 22, 2018; Carrow Tr. at 72:20-73:11, 117:19-24, Jan. 25, 2018.) And although Defendants did not disclose to investors in writing that they were loaning money to Keystone, Fretz testified that he talked to the investors and told many of them what Defendants were doing. (Fretz Tr. at 36:24-37:17, Jan. 22, 2018.)
The Trustee has put forth no evidence here of any affirmative conduct on the part of Defendants to conceal the loan advances being made and thus has failed to prove fraudulent concealment.
Not only did the evidence show that Defendants did not conceal the loans, it also did not show that assuming Defendants had a fiduciary duty to the investors, they were ever silent about the loans. Based on this record, the Trustee has failed to meet his burden of proving that any equitable tolling principle applies to toll the statute of limitations for breach of fiduciary duty based on the loans Defendants caused Covenant to make to Keystone. Accordingly, the Trustee's claim based on this conduct is barred by the statute of limitations.
As noted, in 2009 and 2010, Defendants were awarded Performance Fees through the General Partner pursuant to § 10.7 of the LPA. Under Pennsylvania law, the statute of limitations began to run for each Performance Fee on the date that that Performance Fee was paid.
Like the loans to Keystone, no equitable tolling principle applies to the breach of fiduciary duty claim based on the Performance Fees. Neither the discovery rule nor the doctrine of fraudulent concealment applies to the Performance Fees because the evidence showed that the Performance Fees and their amounts were disclosed to the limited partners each year in their K-1 tax documents. Each year, each Limited Partner received a K-1 tax document prepared by Carrow that showed the Performance Fee debited from that Limited Partner's account. (
The Trustee has put forth no evidence that Defendants ever took any affirmative action in an effort to conceal the fact that they were awarded Performance Fees in 2009 and 2010. The Trustee argues that Defendants failed to disclose that the Performance Fees were not being calculated in accordance with the LPA. But this is merely the Trustee's legal argument about how the LPA should be interpreted. Defendants testified at trial that they thought the Performance Fees were being calculated in accordance with the proper interpretation of the LPA. (Fretz Tr. at 97:3-10, Jan. 23, 2018; Freeman Tr. at 17:2-10, Jan. 24, 2018.) The Trustee has failed to meet his burden of showing that equitable tolling should apply to the Performance fees. For all these reasons, any claim based on the award of Performance Fees is therefore barred by the statute of limitations.
In addressing the internal affairs of a limited partnership, a court's first task is to determine what duty a general partner owes to the limited partners.
§ 15-404(b). And a partner's duty of care to the partnership and to the partners "is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law." § 15-404(c).
"Absent a contrary provision in the partnership agreement, the general partner of a Delaware limited partnership owes the traditional fiduciary duties of loyalty and care to the Partnership and its partners."
The policy of the Delaware Act is "to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements." Del. Code Ann. tit. 6 § 17-1101(b);
The Delaware Act, § 17-1101(d), provides as follows:
§ 17-1101(d). That is, under the Act, an LPA may "disclaim fiduciary duties, and replace them with contractual duties."
Accordingly, if an LPA has validly disclaimed fiduciary duties, "limited partners cannot rely on traditional fiduciary principles to regulate the general partner's conduct" but "must look exclusively to the LPA's complex provisions to understand their rights and remedies."
"[P]rinciples of contract preempt fiduciary principles where the parties to a limited partnership have made their intentions to do so plain."
Against this framework, the Court turns to Covenant's LPA. Section 1.2 of the LPA provides that Covenant is a limited partnership under the Delaware Act and that the Act governs the rights and liabilities of the partners,
(
Additionally, as noted earlier, §§ 7 and 8 of the LPA allow the General Partner to self-deal and have conflicts of interest with Covenant regarding investments and business activities. (Ex. P-39, LPA §§ 7, 8.) Section 7 provides in relevant part:
(
(
Here, Covenant's LPA has not disclaimed the General Partner's duty of care but has disclaimed its duty of loyalty. As to the duty of care, the closest the LPA comes to addressing this duty is in § 12.1, which states that "[t]he General Partner shall exercise the authority granted herein to the best of its abilities and shall use its best efforts to carry out the business of the Partnership." (
By contrast, §§ 7 and 8 of Covenant's LPA contradict the default duty of loyalty by allowing the General Partner to self-deal and have conflicts of interest with Covenant and thus disclaims the traditional duty of loyalty. (Ex. P-39, LPA § 12.1.) In this case, the default duty of loyalty would "intrude upon the contractual rights or expectations of the general partner" given that the LPA unambiguously provides that the General Partner may self-deal and have conflicts of interest with Covenant regarding investments and business activities.
Because, as noted, the default duty of care applies to Defendants' conduct, but the default duty of loyalty does not, the Court need only determine whether Defendants' actions violated the duty of care. The Court also will discuss, however, Defendants' actions in the context of what was required of them by LPA.
As previously explained, under the Delaware Act, a partner's duty of care to the partnership and to the partners "is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law." Del. Code Ann. tit. 6 § 15-404(c). The duty of care requires that partners "inform themselves, before making a business decision, of all material information reasonably available to them . . . and reasonably inform themselves of alternatives."
"[L]iability for breaching the duty of care `is predicated upon concepts of gross negligence."
Here, the Trustee has failed to prove that Defendants engaged in "grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law" in pledging and later retitling Covenant's Pet360 common shares as collateral for the Covenant Loan.
By December 2011, the Covenant Loan had not been repaid and was in default. (Fretz Tr. at 104:21-25, 114:12-16, Jan. 23, 2018; Freeman Tr. at 8:24-9:3, Jan. 24, 2018.) As a result, Frorer, on behalf of Frorer Partners, began to demand better collateral to secure the defaulted Covenant Loan and wanted the Pet360 shares retitled from the name of Covenant into the name of Frorer Partners. (Fretz Tr. at 65:13-15, 67:23-68:1, 70:14-71:31, Jan. 22, 2018; 31:8-19, 124:20-23, Jan. 23, 2018.) For approximately a year, Defendants battled with Frorer and his auditors over the retitling. (Fretz Tr. at 125:9-14, Jan. 23, 2018.) During this time, Fretz reached out to Carrow, Covenant's accountant, regarding the possibility of creating an option, or buyback agreement between Covenant and Frorer Partners in an effort to stop the impending foreclosure of the Pet360 shares. (Carrow Tr. at 82:11-84:2, 114:16-23, Jan. 25, 2018.)
After extensive negotiations and Frorer's repeated threats to sue Covenant and Defendants on behalf of Frorer Partners, Defendants agreed to transfer to Frorer Partners title to the Pet360 shares that had been pledged as collateral for the Covenant Loan. (Fretz Tr. at 126:3-12, Jan. 23, 2018; Freeman Tr. at 219:16-220:4, Jan. 23, 2018.) Accordingly, on or about March 27, 2013, Covenant transferred title to 2,978,989 Pet360 common shares into the name of Frorer Partners. (Ex. P-18; Fretz Tr. at 29:1-12, Jan. 23, 2018.) Fretz testified that he did so in reliance on Carrow's advice that the retitling would have no impact on Covenant. (Fretz Tr. at 129:24-130:20, Jan. 23, 2018.) Carrow said that he never told Fretz that retitling would have no impact but instead had been referring to a potential buyback agreement when he gave that advice. (Carrow Tr. at 84:3-6, 112:5-8, Jan. 25, 2018.) This contradictory testimony does not mean that Defendants acted in violation of the duty of care. Fretz's recollection that he relied on the advice of their accountant is viewed by the Court as misunderstanding of what the accountant advised. It does not rise to the level of "grossly negligent or reckless conduct, intentional misconduct or a knowing violation of law". After the March 2013 Transfer, Frorer continued to demand more Pet360 shares to further collateralize the Frorer Partners Loans, and on September 15, 2013, at the direction of Defendants, Covenant transferred title of an additional 2,000,000 Pet360 common shares into the name of Frorer Partners. (Doc. No. 15 at 4; Fretz Tr. at 35:6-10, Jan. 23, 2018.)
Most importantly, the evidence at trial showed that at the time the shares were pledged and at the time the shares were retitled, the Pet360 common shares had no known value. Even Pet360's own CEO at the time said that in 2011, there was no public market for Pet360 stock. (Weatherup Dep. at 50:16-51:14.) He further explained that until Pet360's acquisition by PetSmart in late September 2014, the Pet360 shares were always highly negotiable, highly variable, and very hard to value. (
In pledging and then retitling the Pet360 shares into the name of Frorer Partners as collateral for the defaulted Covenant Loan, Defendants acted in an informed manner, considering the possibility that if they did not take action, Frorer Partners could in fact foreclose on the Pet360 shares. Accordingly, their conduct in this case was not "grossly off-the-mark."
Tellingly, Defendants' decision to pledge and then retitle Covenant's Pet360 common shares as collateral for the Covenant Loan is protected by the business judgment rule. Under Delaware law, the business judgment rule "generally protects the actions of general partners, affording them a presumption that they acted on an informed basis and in the honest belief that they acted in the best interest of the partnership and the limited partners."
In applying the business judgment rule, a court "will not substitute its judgment for that of the board if the latter's decision can be `attributed to any rational business purpose.'"
The business judgment rule also acts as a procedural guide for litigants.
Knowing now that Covenant's Pet360 common shares were purchased by PetSmart in late September 2014 for approximately $1 each, the Court cannot substitute its own judgment for that of Defendants. Defendants were not the guarantors of Covenant's success. Defendants acted on an informed basis with the honest belief that, considering all of the circumstances, they were acting in Covenant's best interest. That the Pet360 shares turned out to be worth more than what Defendants thought at the time does not show that they breached their duty of care. Their actions are attributable to a rational business purpose and are protected by the business judgment rule. For these reasons, the Court finds that Defendants did not breach their duty of care. And although no contract cause of action was pled by the Trustee, Defendants acted within the authority given to them by Covenant's LPA.
Although the Trustee argues that Defendants breached their fiduciary duties to Covenant by consolidating the three loans made to Fretz, Freeman, and Covenant into one loan and pledging Covenant's Pet360 shares as collateral for them, the evidence at trial failed to prove this occurred. The evidence presented at trial showed that at some point, Defendants signed a Collateral Release to extend the Covenant Partners Loan because the original note for the loan, signed on or about March 8, 2011, had expired. (Doc. No. 15 at 4; Fretz Tr. at 21:4-6, 22:19-23:12 Jan. 22, 2018.) Throughout the trial, Defendants both denied that the Collateral Release the Trustee had submitted in evidence was the version they had signed. (Ex. P-19; Fretz Tr. at 73:24-74:13, Jan. 22, 2018; Freeman Tr. at 221:10-222:16, Jan. 23, 2018.) Moreover, as noted, the Collateral Release in evidence makes no reference to the personal loans that Frorer Partners made to Defendants. (Fretz Tr. at 115:19-123, Jan. 23, 2018.)
Finally, an Assignment dated December 31, 2013, by which Frorer Partners assigned the loans to Frorer individually in exchange for Frorer's payment of $800,000, lists each loan separately and attaches as Exhibits the promissory notes for each loan. (Ex. D-25 at 2-3.) Based on the evidence presented, the Trustee did not prove that Defendants ever consolidated the loans and pledged the assets of Covenant for their own personal debts. Consequently, the Trustee has failed to prove that they breached any fiduciary duty on this basis.
The Trustee alleges that Defendants breached their fiduciary duties to Covenant by failing to maintain proper records and by failing to properly account for certain of Covenant's assets. (Doc. No. 37 at 32.) The Trustee further alleges that this failure violated § 10.1 of Covenant's LPA, which provides in relevant part that the "General Partner shall maintain complete and accurate accounts in proper books of all transactions of or on behalf" of Covenant. (Ex. P-39, § 10.1.) Specifically, the Trustee contends that the following assets are missing from Covenant's books and records: "R. Chakejian; 3190 Tremont; J. Irvine; Issimo Suites; Spotlight; Las Brisas; Market Street Advisors; and JASR." (Doc. No. 37 ¶ 115.)
As an initial matter, a review of the Trustee's Complaint in this case reveals that the Trustee did not plead this failure to maintain proper books and records as one of his bases for breach of fiduciary duty. (Ex. P-1 ¶ 173.) Moreover, conduct regarding the maintenance of Covenant's books and records does not appear in the facts alleged in the Complaint. (
The breach of fiduciary duty claim for failure to maintain adequate books and records also fails, however, because the evidence the Trustee put forth at trial did not prove by a preponderance of the evidence that Defendants in fact failed to account for investments. The Trustee failed to put forth sufficient evidence identifying what these investments were or what became of them. In fact, the Trustee gave virtually no insight at all as to the nature of these investments or what was done with them. Finally, at trial, Fretz discussed each of the assets listed above and what occurred regarding that asset. (Fretz Tr. at 162:1-167:2, Jan. 23, 2018.) Based on the evidence admitted at trial, the Trustee failed to prove any breach of fiduciary duty based on missing assets or failure to maintain Covenant's records.
Because the Court has been unable to find any breach of fiduciary duty by Defendants, the Trustee is not entitled to damages.
For the foregoing reasons, judgment will be entered in favor of Defendants and against the Trustee. An appropriate Order follows.
Fed. R. Civ. P. 52(a)(1).