I am in the middle of a game right now, so I'll ask the question the shortest way I can.
Does breath affect figures with shadow cloak if they are more then the adjacent space away?
I say of course ( I'm the one making the attack with breath )
The player party says no way (mostly because he doesn't want to take possible damage)
Reading breath it sides with me, reading shadow cloak it sides with the player party.
Would it matter that they are sitting in trees vs. natural ability?

That's a tricky one.

If you strictly play by the rules, only the figure in the little square next to the monster would be affected byt the breath attack. If a hero (or another monster in fact) with shadowcloak stands more than one space away from the breathing monster, it is not "adjacent" and not affected.

Shadowcloak states: A figure with the Shadowcloak ability is only affected by attacks made by adjacent figures. The figure does not suffer any wounds or effects from attacks originating farther than one space away.

If you want to play with real world logic, shadowcloak means you are hiding with the environnement and people cannot attack you when you are far (not adjacent), because they cannot see you. When they are next to you, you can see them and attack. But if a creature breath fires or there is a blast attack, the hiding figure would still be hurt even if the monster didn't see it. Collateral damage.

So it depends on your style of play, but in the rulebook, your players are right.

Zearthling said:

Shadowcloak trumps breath.

It is a general rule (these figures are affected) coming up against a specific rule ( this figure is not affected in this circumstance).

It makes no difference how shadowcloak was obtained.

When it doubt take the rules as they are written. Don't read into them or even apply real world logic else your run into a whole lot of problems.

Corbon said:

+1 If this weren't the case, then Merick would be able to blast heroes in trees from afar, and heroes with breath runes could still hit deep elves from afar, etc. If you want to hit something with shadowcloak, you're gonna have to move adjacent, which pretty much negates breath unless the template can also hit a non-shadowcloaked hero from a spot adjacent to the one that is shadowcloaked.

When a Shadowcloak figure is caught by an Blast, Bolt or Breath attack (or in general any multyarea attack), then the Shadowcloak figure is affected if (and oonly if) it is adjacent to the attacker. This was noted in version 4 of the FAQ (althought I can't find it in the last version) with the following example: In order for a hero to damage a Deep Elf (with Shadowcloak) using a Blast weapon without suffering damage, he/she must be adjacet to the Deep Elf but in diagonal.

Let's see if I can find it... yea, here it is.

Q: How does Shadowcloak interact with Blast? Is the
origin of the attack considered to be the attacker or the
space from which the Blast originates?
A: The origin of the attack is still considered to be the
attacker. If a hero with a Blast attack wishes to hit a
Shadowcloaked monster without hitting himself, he should
move adjacent to the monster and target the attack in a
(potentially empty) square such that the monster, and not
the hero, is hit.

The last FAQ treat the same the thre B habilities (Breath, Blast and Bolt) so you it would be the same for breath.

Incidentally, this question has nothing to do with RtL, as Breath is a base game ability and Shadowcloak is from AoD.

Well, if you don´t own AoD, Shadowcloak is introduced by RtL (or even ToI)...