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February 29, 2012 Articles

Revival of the Adverse Domination Doctrine

The death spiral of a corporation or a bank can be a long one, and if the directors work to prop up the institution, the discovery of misconduct may be delayed for years.

By Michael White and Nathan Viavant

The death spiral of a corporation or a bank can often be a long one. All the while, the directors and officers may be taking steps to prop up the failing institution. As a result, the discovery of misconduct may be delayed for years and, in many instances, may not occur until after the statute of limitations has expired. The current economic crises and resulting litigation aptly demonstrate the problems and solutions to pursuing claims against directors and officers in such circumstances.

Since the consequences of the current financial crisis began to become clear at the end of 2007, the Federal Deposit Insurance Corporation (FDIC) has closed hundreds of banking institutions, and it will likely close hundreds more in the near future. One recent article put the total number of banks that have disappeared since 2007 by failure, merger, or acquisition at roughly 1,000, with 865 banks still on the FDIC’s “problem” list at the end of June 2011. Victoria McGrane, “FDIC’s Latest Closings: Its Own Offices,” Wall St. J., Oct. 3, 2011. FDIC bank closures have often been followed by allegations of nonfeasance, malfeasance, and even fraudulent lending and banking practices attributable to bank directors and have resulted in claims by the FDIC against the bank’s directors. Most of the claims available are based on alleged violations of state law and are subject to state statutes of limitation as short as two years.

Historical Development of the Doctrine of Adverse Domination
During a previous financial crisis, the savings and loan turmoil of the 1980s, the Resolution Trust Corporation (RTC), predecessor to the FDIC, successfully relied on the doctrine of adverse domination to revive otherwise stale state-law claims for breach of fiduciary duties. What is the likelihood such claims can succeed in the current political, economic, and legal climate? The answer may be found in the reincarnation of the doctrine of adverse domination. This doctrine allows courts to decline to enforce state statutes of limitation that would otherwise bar claims against bank directors for breaches of fiduciary duties.

In general, a statute of limitation for breach of fiduciary duty against the directors of a corporation begins to run from the time of their wrongful acts. What happens, however, when one or more of those directors exercises control or influence to prevent the discovery or pursuit of the claims? While the answer to this question has been determined to be one of state law, federal courts ruling under state law have developed and applied the doctrine of adverse domination in a way that may continue to open the door to otherwise stale claims.

Most often, the doctrine is described as “merely a corollary of . . . [the] discovery rule, applied in the corporate context,” RTC v. Farmer, 865 F. Supp. 1143, 1154 n.11 (E.D. Pa. 1994) (citing In re Lloyd Securities, 153 B.R. 677, 685 (E.D. Pa. 1993)), to toll the statute of limitations while a corporate plaintiff continues under the domination of the wrongdoers; in other words, until they cease to be directors. As a practical matter, many courts find that where the agents of the corporation who know of the injury are themselves the wrongdoers, the corporation cannot “discover” knowledge known only to its offending agents:


It is the “inherently unknowable” character of the injury that is the critical factor that governs the applicability of the discovery rule . . . . A corporate plaintiff does not have “knowledge” of an injury to itself until those individuals who control it know of the injury and are willing to act on that knowledge.

Id. at 1155.

As a result, the adverse domination rule “presumes that actual notice will not be available until the corporate plaintiff is no longer under the control of the erring directors.” Hecht v. RTC, 333 Md. 324, 635 A.2d 394, 405 (Md. 1994).

Courts also often apply the related rationale of equitable estoppel. Under these principles, courts seek to prevent the culpable directors from benefiting from their lack of action on behalf of the corporation:


Is it logical to assume that the directors, in whom the bank has entrusted the discretion to sue, would authorize the initiation of an action against themselves for their own improprieties? To permit bank directors who control and dominate the affairs of a bank to benefit from their own inaction by finding that, as a matter of law, limitations run from the moment of their commission of improprieties, is a result which justice could not tolerate.

FDIC v. Bird, 516 F. Supp. 647, 651 (D.P.R. 1981).

Under either of these rationales, the doctrine will not apply if other non-culpable directors or the shareholders have actual knowledge of the culpable director’s misconduct. Int’l Rys. of Cent. Am. v. United Fruit Co., 373 F.2d 408, 414 (2d Cir. 1967).

Learning from Past Lessons
Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) in 1989 to respond to the 1980s’ savings and loan debacle. The FIRREA established the RTC and gave it the power to pursue claims against directors and officers. The RTC typically filed suit against the directors and officers in federal court, and, as a result, much of the jurisprudence on the doctrine involves federal courts interpreting and applying state statutes of limitation. The federal courts did not, however, create the doctrine from whole cloth. The doctrine is often traced back to the 1967 case of International Railways of Central America v. United Fruit Co., in which the court ruled that


a plaintiff who seeks to toll the statute [of limitations] on the basis of domination of a corporation has the burden of showing a full, complete and exclusive control in the directors or officers charged. . . . This principle must mean at least that once the facts giving rise to possible liability are known, the plaintiff must effectively negate the possibility that an informed stockholder or director could have induced the corporation to sue.

373 F.2d at 414.

With these principles as building blocks, the RTC filed hundreds of lawsuits on behalf of failed institutions against the institutions’ directors and officers. The RTC faced a difficult challenge, however, because the defendants often asserted that the applicable state statutes of limitation had run by the time the RTC was able to investigate and prosecute the claims. To get around this problem, the RTC often successfully invoked the doctrine of adverse domination, relying on its two related principles that knowledge of the wrongdoing should not be imputed to the corporation for so long as the offending directors and officers were in control and that the corporation could not discover and act upon the wrongdoing so as to trigger the running of the statute of limitation until those directors and officers were ousted.

Over the ensuing years, most courts that have considered the doctrine have embraced it, although they have done so to varying degrees and with differing rationales. They have differed on the degree of domination of the board required for the corporation to claim tolling under the doctrine, the burden of proof as to domination, and the degree of culpability that the plaintiff must allege against the directors. State interpretations of the common-law discovery rule, the imputation of corporate knowledge, and the application of the discovery rule in negligence cases also can bear on how the state court will apply the doctrine of adverse domination.

Application of the Doctrine Throughout the Country
Before discussing the differences in application of the doctrine, it should be noted that a few courts have either rejected the doctrine outright or refused to evolve discovery-rule or equitable-estoppel doctrines into a formal recognition of adverse domination. See RTC v. Armbruster, 52 F.3d 748, 751–52 (8th Cir. 1995); RTC v. Artley, 28 F.3d 1099 (11th Cir. 1994); FDIC v. Cocke, 7 F.3d 396 (4th Cir. 1993); RTC v. Everhart, 37 F.3d 151, 155 (4th Cir. 1994). As explained by one federal court ruling under Virginia law, the doctrine of equitable estoppel was sufficient, without embracing adverse domination, to “hold that a statute of limitations is tolled until a person intentionally misled by a putative defendant could reasonably discover the wrongdoing and bring action to redress it.” Cocke, 7 F.3d at 402. As this decision suggests, whether or not a court will embrace adverse domination under the laws of a given state depends, in part, on whether there exists an independent state discovery rule recognizing tolling and the nature of the state’s doctrine of equitable estoppel.

While a majority of state high courts and federal circuits interpreting state law have recognized the doctrine of adverse domination—as stated by West Virginia’s highest court, “Indeed, the adverse domination doctrine appears to be well settled law in many states, and it has been generally accepted by federal courts to be the law of states that have not yet explicitly ruled on the subject themselves,” Clark v. Milam, 452 S.E.2d 714 (W. Va. 1994) (citing cases)—they have embraced a variety of standards in doing so. As a result, divisions have emerged on a number of issues that are essential to understanding the application of adverse domination in varying jurisdictions, including the level of control required to prove domination, the degree of culpability required, and the burden of proof. FDIC v. Dawson, 4 F.3d 1303, 1309 (5th Cir. 1993).

How Much Control Is Required to Demonstrate Domination?
As the name suggests, adverse domination requires that the company, through its board members, be “dominated” by culpable wrongdoers. Courts disagree, however, as to the level of board domination required to toll a statute of limitations. Courts recognizing adverse domination generally apply either the “complete domination test” (sometimes referred to as the “single disinterested director” test) or, more commonly, the “majority domination test” to determine whether the wrongdoers sufficiently dominate the corporation to invoke adverse domination. Under the complete domination test, the plaintiff must prove that no informed director was capable of suing or willing to do so. As explained by one court, a plaintiff has the burden to show “a full, complete and exclusive control in the directors or officers charged.” Farmers & Merchants Nat’l Bank v. Bryan, 902 F.2d 1520, 1523 (10th Cir. 1990); see also RTC v. Farmer, 865 F. Supp. 1143, 1157 (“[T]he plaintiff must negate the possibility that an informed person or persons could have induced the corporation to initiate suit.”). This test presents a high bar to the plaintiff, and a number of courts have explained the practical problem with such a high standard. As one court described it, “this rule is considered harderto satisfy than the majority version [of the adverse domination doctrine] because it relies on no presumption of domination,” even after a plaintiff has shown that a majority of directors were culpable. FDIC v. Henderson, 61 F.3d 421, 427 (5th Cir. 1995).

In contrast, the majority test requires a plaintiff to “show only that a majority of the board members were wrongdoers during the period the plaintiff seeks to toll the statute.” Dawson, 4 F.3d at 1310 (finding that the majority rule, “a more prophylactic approach,” would apply under Texas law). This standard presents a much more manageable burden to a plaintiff seeking to toll a statute of limitations. Under the majority test, even courts applying a “narrow” interpretation of adverse domination have held that, while the plaintiff must show that a majority of directors was culpable, “it is not necessary to sue a majority of the board to obtain a finding of adverse domination.” Henderson, 61 F.3d at 426. Decisions on adverse domination have identified no specific element of state law predicate to a choice between the complete domination and majority domination standards. However, the practical considerations of meeting the high standard of the complete domination test and the reality of board domination have prompted most courts to favor the majority domination standard. As the Oregon Supreme Court stated, “We conclude that the ‘disinterested majority’ version of the [adverse domination] doctrine more closely mirrors human nature.” FDIC v. Smith, 980 P.2d 141, 148 (Or. 1999). As another court explained:


As long as the majority of the board of directors are culpable they may continue to operate the association and control it in an effort to prevent action from being taken against them. While they retain control they can dominate the non-culpable directors and control the most likely sources of information and funding necessary to pursue the rights of the association. As a result it may be extremely difficult, if not impossible, for the corporation to discover and pursue its rights while the wrongdoers retain control.

Dawson, 4 F.3d at 1310.

What Level of Misconduct Must Be Shown to Trigger the Doctrine?
Congress amended the FIRREA in 1994 to toll state statutes of limitation for claims of “fraud, intentional misconduct resulting in unjust enrichment, or intentional misconduct resulting in substantial loss to the institution.” 18 U.S.C. § 1821(d)(14)(C). Even before that amendment, some state courts set the bar at fraudulent or intentional misconduct. See, e.g.RTC v. Farmer, 865 F. Supp. 1143, 1157 (E.D. Pa. 1994).

Whether lesser degrees of culpability will also toll state statutes of limitation is a matter of state law. See, e.g.RTC v. Acton, 49 F.3d 1086, 1090 (5th Cir. 1995). Accordingly, the standards applied vary depending on applicable state law. At least one court has found that the degree of culpability is irrelevant and that the statute of limitations is tolled because the plaintiffs cannot determine the cause of action. See Clark v. Milam, 452 S.E.2d 714, 719 (W. Va. 1994) (“[R]egardless of whether the alleged wrongdoing was intentional or merely negligent, the knowledge of officers’ and directors’ wrongdoing cannot be imputed to the corporation because those officers’ and directors’ control over the corporation prevents it from learning of the misconduct that is injuring it.”) Some courts apply the doctrine to claims of simple negligence. They often do so by analogizing to how courts use the discovery rule in other claims grounded in negligence, such as medical malpractice. See, e.g.RTC v. Scaletty, 891 P.2d 1110, 1117 (Kan. 1995); RTC v. Hecht, 818 F. Supp. 894 (D. Md. 1992). While one might imagine that the business-judgment rule could shield directors against claims of mere negligence, directors of financial institutions in particular are generally responsible for a higher standard of care. See, e.g., Norma Hildenbrand, “D&O Liability: Expansion via Regulation,” 111 Banking L.J. 365, 379 (1994).

Other courts require some affirmative showing of misconduct, particularly where FIRREA claims are at issue, or suggest a minimum requirement of gross negligence. FDIC v. Jackson, 133 F.3d 694, 699 (9th Cir. 1998) (“Because applying the adverse domination doctrine to negligent conduct is more consistent with its past approach, we hold that the Arizona Supreme Court would find that, at a minimum, gross negligence, rather than merely fraud or intentional misconduct, tolls the statute of limitations.”).

Who Has the Burden to Prove Adverse Domination?
Under the complete domination test and the majority test, the plaintiff has the burden of proving adverse domination. See, e.g.FDIC v. Dawson, 4 F.3d 1303, 1311 (5th Cir. 1993). In the last decades, however, courts have begun applying tests that combine the level of domination with the burden of proof. See, e.g.FDIC v. Smith, 980 P.2d, 141, 147–48 (Or. 1999); Wilson v. Paine, 288 S.W.3d 284, 288 (Ky. 2009). Courts embracing the complete domination test, for example, apply a “single disinterested director” version of the doctrine in which “a plaintiff has the burden of showing that the culpable directors had full, complete, and exclusive control of the corporation, and must negate the possibility that an informed director could have induced the corporation to sue.” Smith, 980 P.2d at 145 (citations omitted).

Courts applying a majority test regarding the level of corporate domination now apply a “disinterested majority” version of the doctrine, which initially places the burden on the plaintiff to show that a majority of the board is culpable. Dawson, 4 F.3d at 1310; Wilson, 288 S.W.3d at 288 (“A majority of jurisdictions follow the disinterested majority test, whereby a plaintiff is required to show that a majority of the board members were wrongdoers during the period the plaintiff seeks to toll the statute of limitations.”). Once the plaintiff has met its burden under this standard, the burden shifts to the defendant to prove that some member of the board was willing and able to sue on behalf of the corporation. See, e.g.FDIC v. Henderson, 61 F.3d 421, 426 (5th Cir. 1995) (“Proof that a majority of the board is actively and purposefully engaged in the wrongdoing reverses the presumption that informed directors will induce the corporation to sue culpable ones and thereby establishes that the institutions are dominated by directors adverse to the claims in question.”); Hecht v. RTC, 635 A.2d 394, 406 (Md. 1994); RTC v. Scaletty, 891 P.2d 1110, 1113 (Kan. 1995); RTC v. Grant, 901 P.2d 807, 816 (Okla. 1995). The Oregon Supreme Court, for example, favors the majority test/disinterested majority burden of proof, saying, “Because a board composed of a majority of culpable directors will rarely, if ever, facilitate the assertion of claims against its members, it is appropriate that those directors bear the burden of proving otherwise.” Smith, 980 P.2d at 148.

The Potential for Broader Application of the Adverse Domination Doctrine
While this article has explored the contours of the adverse domination doctrine in the context of actions involving financial institutions, the doctrine is not necessarily limited to that arena. The rationales supporting the doctrine apply with equal force to private actions, as demonstrated by the International Railways case credited with first enunciating the doctrine. If the facts and the equities warrant relief from the time bar of an applicable statute of limitations, the doctrine of adverse domination can be an effective tool to overcome that bar and allow a claim to be heard. See, e.g.Safecard Servs., Inc. v. Halmos, 912 P.2d 1132 (Wyo. 1996).

Keywords: litigation, business torts, adverse domination doctrine, misconduct, statute of limitations

Michael White and Nathan Viavant – February 29, 2012