Delaware Business Bankruptcy Report: Morris James LLP Lawyers and Attorneys

George L. Miller, Chapter 7 Trustee of World Health Alternatives, Inc. v. McDonald (In re World Health Alternatives, Inc.), Case No. 06-10166 (PJW), Adv. Pro. No. 07-51350 (PJW), 2007 WL 1670357 (Bankr. D. Del. June 8, 2007)

The United States Bankruptcy Court for the District of Delaware held that the Chapter 7 trustee of the estate of debtor World Health Alternatives, Inc. was not entitled to a preliminary injunction to prevent the settlement of litigation pending against the debtor’s officers and directors in the United States District Court for the Western District of Pennsylvania. The Trustee sought to preserve, as alleged property of the estate, the proceeds of a directors and officers liability policy that provided coverage, first to the debtor’s officers and directors, then to the debtor for indemnification claims by the officers and directors and, lastly, for direct claims against the debtor. The trustee failed to demonstrate a likelihood of success on the merits in establishing that the proceeds were included in the property of the estate because there were no claims directly against the debtor in the District Court litigation, and because the directors and officers did not assert any indemnification claims against the debtor under the policy.

Prior to the February 20, 2006 filing of its Chapter 11 petition in the United States Bankruptcy Court for the District of Delaware, debtor World Health Alternatives, Inc. purchased a company management liability policy that provided three types of coverage, to be paid in the following priority: Coverage A insured the directors and officers against damages and defense costs that they were legally obligated to pay in connection with certain types of claims made against them; Coverage B provided for reimbursement of the debtor for indemnification costs as to the directors and officers; Coverage C insured the debtor for certain securities claims made directly against it. The policy had a $5 million limit, but also contained a provision that limited coverage to $2 million under certain circumstances. The policy was a “wasting policy” in which the limits of liability for a settlement or judgment were reduced by the amount of legal costs and expenses incurred during the course of the defense. Its Insured v. Insured Exclusion also excluded from coverage any action brought on behalf of World Health against the directors and officers. The policy lapsed on July 18, 2006. The policy covered claims made against the directors and officers during the period of July 18, 2005 through July 18, 2006.

In August 2005, reports of management irregularities led to the filing of a series of class action lawsuits in the United States District Court for the Western District of Pennsylvania alleging securities violations. In October 2005, a shareholder filed a derivative action on behalf of World Health. The District Court consolidated the class actions and the derivative action, and thereafter, the plaintiffs filed a consolidated and amended complaint that did not name World Health as a defendant and did not include the claims asserted in the derivative action. On August 31, 2006, the parties settled the consolidated action, and thereafter filed a settlement agreement with the Court. The settlement provided for payment of $1.7 million from the insurance policy, an additional $1 million from one of the individual defendants and stock from a second individual defendant. The settlement proceeds were tendered to lead counsel in the consolidated action, in its capacity as escrow agent, pending approval of the settlement.

On October 31, 2006, the case was converted to Chapter 7, and the next day the plaintiff in this adversary proceeding was appointed trustee of the debtor’s estate. After the settlement agreement in the consolidated action was filed, the Trustee filed a motion to intervene in the consolidated action, which the District Court denied. On May 21, 2007, the Trustee commenced an adversary proceeding against the debtor’s directors and officers, alleging breach of fiduciary duty, unjust enrichment and other claims in connection with their roles as directors and officers of the debtor. At the same time, the Trustee filed a motion for a preliminary injunction and to enforce the automatic stay, requesting that the Bankruptcy Court enjoin the approval of the settlement of consolidated action and to direct the escrow agent to turn over the portion of the settlement proceeds from the insurance policy.

The Bankruptcy Court addressed the motion under the familiar standard that requires the movant to show a reasonable probability of success on the merits, irreparable harm to the movant in the absence of relief, an analysis of the harm to the non-moving party, and consideration of the public interest.

The most important question before the Court was whether the proceeds of the policy were property of the estate. Although many cases addressed this question, the Court discerned certain guiding principles, including that when an insurance policy provides coverage only to the debtor, courts will typically find that the proceeds are property of the estate, but when the coverage is only for directors and officers, the proceeds are not property of the estate. However, when the policy covers both the company and directors and officers, and there is risk that payment of the proceeds to the directors and officer will result in insufficient coverage of the debtor, then the proceeds are property of the estate and are shielded by the automatic stay. However, there were also cases finding that proceeds are not property of the estate where a debtor is covered for indemnification, but indemnification has not occurred, is hypothetical or speculative.

Applying the teaching of these cases, the Court concluded that the proceeds of the debtor’s policy were not property of the estate because there were no remaining claims against the debtor in the consolidated action, and the debtor was not being sued for indemnification. The Court also found that, to the extent that the Trustee sought to recover from the directors and officers, the Trustee was not entitled to preference over the settlement of the consolidated action.

The Court also noted additional obstacles to the Trustee’s burden to show likelihood of success on the merits, such as the Insured v. Insured Exclusion, the Trustee’s failure to bring a claim before the policy lapsed and the priority of payments under the policy that required that payments first be made to Coverage A insureds. Therefore, finding that the Trustee could not show likelihood of success on the merits, the Court did not consider the other factors, and denied the Trustee’s motion.

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Haskell v. Goldman, Sachs & Co. (In re Genesis Health Ventures, Inc.), Adv. Pro. No. 04-53375 (PJW), 2007 WL 1321730, -- B.R. -- (Bankr. D. Del. May 4, 2007)

In this adversary proceeding commenced by investors in reorganized debtor Genesis Health Ventures, the non-debtor defendants requested leave of the United States District Court for the District of Delaware to take an interlocutory appeal from a decision of the Bankruptcy Court denying the defendants, who were senior secured debt holders, the protections of 11 U.S.C. § 1144. The defendants moved for a stay of proceedings pending the district court’s decision. The bankruptcy court granted a limited stay of the proceedings, balancing the need to move forward with the possibility that the request may remain before the district court for an extended period without being decided.

The plaintiffs in this adversary proceeding in the United States Bankruptcy Court for the District of Delaware were a group of 275 investors that owned 55% of the outstanding debentures of the debtor, Genesis Health Ventures, Inc., worth over $205 million. The plaintiffs’ claims were subordinate to $1.3 billion in senior secured debt held by the defendants. The plan of reorganization in the debtor’s case was confirmed in 2001, and awarded 94.3% of newly issued equity in the debtor to the defendants, and just 3.8% to the debenture holders. This figure represented a very small return on the claims of the plaintiffs.

Approximately two and a half years after the plan confirmation date, the plaintiffs commenced an adversary proceeding that alleged that the debtor and defendants conspired to artificially deflate the debtor’s historic and projected EBITDA, convincing the court that the new equity in the debtor was of little value, and that, therefore, the senior secured debt holders were entitled to receive the vast majority of the shares. Plaintiffs contended that if accurate figures were presented to the court, they would have shown that there was enough value to pay off all junior creditors, including the plaintiffs.

In an earlier proceeding, the court granted the defendants’ motion to dismiss, holding that the plaintiffs claims were barred as untimely under 11 U.S.C. § 1144, and under the doctrines of res judicata and collateral estoppel. The United States District Court for the District of Delaware affirmed as to the claims against the debtor, but reversed and remanded as to the defendants, directing the bankruptcy court to reconsider whether section 1144 would apply to the defendants, who were all non-debtors. On remand, the bankruptcy court decided that the claims against the defendants were not barred under section 1144 because an award of damages against the defendants would not upset the confirmed plan, but ruled that the plaintiffs were barred from pursuing claims of EBITDA manipulation that came to light prior to confirmation. However, the court found that plaintiffs alleged that defendants orchestrated four EBITDA manipulations that plaintiffs did not discover until after plan confirmation. The court also denied defendants’ motion to dismiss with respect to those manipulations, applying the fraud exceptions to the doctrines of res judicata and collateral estoppel.

The defendants filed a motion in the district court for interlocutory appeal of the bankruptcy court decision, and requested that the bankruptcy court stay proceedings and extend the time for defendants to file an answer to the complaint. That request was the subject of the instant opinion.

In deciding whether to grant a motion to stay, the court is required to consider (1) whether the stay applicant has made a strong showing that he is likely to succeed on the merits; (2) whether the applicant will be irreparably injured absent a stay; (3) whether issuance of the stay will substantially injure the other parties interested in the proceeding; and (4) where the public interest lies.

As to the likelihood of success on the merits, although the court expressed confidence that its opinion on the issue of whether section 1144 applied to claims for damages against non-debtors was correct, it acknowledged that this was an issue that had not been addressed in a reported opinion in the Third Circuit and that therefore there might be substantial grounds for a difference of opinion.

The court also found that if the stay were not granted, the defendants would have to expend significant resources defending the action, even though the district court might later reverse the bankruptcy court. Therefore, the defendants would have lost the benefit of protection from litigation over a confirmed plan that section 1144 was supposed to provide. Meanwhile, the court held that there was little grounds to find that the plaintiffs would be injured if the stay was granted. Although the plaintiffs articulated concerns that the passage of time would impair their ability to present evidence in support of their claims, the court credited defendants’ observation that the plaintiff waited two and a half years after plan confirmation to bring the action. Finally, the court found that the “public interest” factor favored the defendants because, although it is not in the public interest to let a case languish on the docket awaiting trial, it also not preferable to require parties to go to the expense of preparing for trial when a reversal on interlocutory appeal could moot all that expensive preparation.

Although overall the factors weighed in favor of the defendants, the court expressed concern about the loss of evidence because of the passage of time. Accordingly, the court crafted a compromise by granting defendants a stay of proceedings to expire at the earliest of (1) six months from the date of the issuance of the opinion (May 4, 2007); (2) entry of a ruling by the district court denying defendants’ motion for leave to appeal; (3) entry of a ruling by the district court affirming the bankruptcy court. Defendants were also granted two weeks following the expiration of the stay to answer the plaintiffs’ complaint.

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In re W.R. Grace & Co., Case No. 01-01139 (JKF), 2007 WL 1138467, -- B.R. -- (Bankr. D. Del. Apr. 17, 2007)

The law firm of Speights & Runyan filed thousands of claims on behalf of creditors in the W.R. Grace & Co. bankruptcy. The debtors moved to expunge and disallow 71 of these claims, contending that Speights & Runyan lacked express authority to file the proofs of claim as of the time that they were filed. The United States Bankruptcy Court for the District of Delaware held that, although a claimant may authorize the filing of a claim after it is filed, if the ratification occurs after the bar date has passed, that ratification is insufficient to make the claim timely filed. Accordingly, because authorization for these 71 claims was not established as of the deadline for filing proofs of claim, the Court expunged and disallowed the claims.

The debtors, W.R. Grace & Co. and its affiliates, moved to disallow 71 property damages claims filed and signed by the law firm of Speights & Runyan for which Speights failed to establish that authority to execute the proofs of claim existed prior to the March 31, 2003 claim bar date. In each of these cases, written authority was either undated or dated after the bar date.

The debtors argued that the party signing the proof of claim must have express authority to do so at the time of the filing. Speights contended that, under Fed. R. Bankr. P. 3001(b), the requirement that a proof of claim be signed by an authorized agent can be satisfied under the doctrine of ratification.

The attorney-client relationship is an agent-principal relationship that is subject to the ratification doctrine. Under this doctrine, the agent does not need to have prior authority before acting on behalf of the principal, but can ratify the agent’s act after the fact. The United States Bankruptcy Court for the District of Delaware rejected the debtors’ argument that actual authority must have existed at the time the proofs of claim were executed, finding that a proof of claim may be saved by ratification. However, the Court, relying on U.S. Supreme Court precedent, held where there is a deadline to act, such as here, the ratification must take place by the deadline. Because the claimants would not have been permitted to file proofs of claim after the bar date, the act of ratifying such actions after the bar date cannot be used a means of extending the bar date for such claimants. In so holding, the Court noted that if ratification after the bar date were to be permitted, it would undermine the purposes of a bar date by extending indefinitely the time in which creditors might make good their assertion of claims, thereby disrupting the claims process. Therefore, the Court disallowed and expunged the 71 claims.

Note: Since the Court entered its order expunging these claims, the claimants have filed notices of appeal. Also, three claimants filed a motion for reconsideration, contending that, at the hearing in this matter, the debtors did not seek to expunge their claims for which evidence of timely authorization had been presented [Docket No. 15421]. As of the date hereof, the Court has not taken action with respect to that motion.

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In re RNI Wind Down Corp., Case No. 06-10110 (CSS), 2007 WL 949647 (Bankr. D. Del. March 29, 2007)

The Plan Administrator in the bankruptcy case of RNI Wind Down Corporation and its affiliated debtors objected to a request for payment of fees and expenses pursuant to the debtors’ plan of reorganization by the indenture trustee of pre-petition notes of the debtors. The parties agreed to a settlement and moved for approval of the agreement. The Delaware Bankruptcy Court refused to approve the settlement, finding that the legal invoices and request for fees were so heavily redacted and inspecific as to make it impossible for the court to determine whether they were reasonable, and thus whether the settlement was equitable and fair. The court also determined that the plan did not modify the indenture agreement, which was a pre-petition contract among non-debtors, and that it lacked jurisdiction over claims arising under the indenture.

In the bankruptcy case of RNI Wind Down Corporation and its affiliated debtors, the United States Bankruptcy Court for the District of Delaware was presented with two related motions concerning the payment of legal fees incurred by U.S. Bank National Association as the indenture trustee under certain pre-petition notes of the debtors. The motions presented the following questions: (i) whether the court should approve a settlement of a claim objection where approximately 50% of the indenture trustee’s legal fees would be borne by the debtors’ estates; and (ii) whether the court should interpret the terms of debtors’ confirmed plan of reorganization to limit the indenture trustee’s legal fees to those recoverable from the debtors’ estates when the terms of indenture provide otherwise.

With respect to the first question, the court did not approve the settlement, finding that the legal invoices underlying the indenture trustee’s claims were so heavily redacted that the court could not determine the likelihood of success on the merits of the claims. As to the second question, the court held that the plan did not modify the indenture, including its terms providing the indenture trustee with a charging lien against the proceeds of the notes. Moreover, whether such a charging lien might properly have been asserted under the terms of the indenture was outside the court’s jurisdiction.

Prior to the petition date, the debtors raised cash through the issuance of certain subordinated notes for which U.S. bank acted as indenture trustee. The notes matured following the petition date. Pursuant to the debtors’ plan, the indenture trustee was eligible for payment of its fees and expenses by the estate subject to documenting such fees and expenses to the plan administrator, and agreement that they were reasonable.

In total, the indenture trustee sought reimbursement for approximately $607,000 in fees and expenses, to which the plan administrator filed objections. The indenture trustee and plan administrator agreed to settle the claim for $300,000. The indenture trustee had withheld approximately $600,000 from payments to the noteholders in reliance on its right under the indenture to assert a charging lien against such funds because of non-payment in the bankruptcy case.

In deciding whether to approve the settlement, the court was required to determine whether the settlement was “fair and equitable” applying the test prescribed by the United States Court of Appeals for the Third Circuit: (i) the probability of success in litigation; (ii) the likelihood of success in collection; (iii) the complexity of the litigation involved, and the expense, inconvenience and delay necessarily attending it; and (iv) the paramount interest of the creditors.

The likelihood of success in collection was not at issue, as the plan administrator had reserved funds sufficient to pay in full. However, the analysis of the probability of success in litigation was made all but impossible because the indenture trustee’s legal invoices were so heavily redacted for privilege. Accordingly, it was impossible for the court to assess what services were provided, and whether they were reasonable. The court also noted that the most heavily-redacted items were those connected with the highest billing rates. Finally, U.S. Bank sought payment of almost $64,000 in internal fees, but provided no description for the basis of those fees, rendering it impossible for the court to assess the reasonableness of those fees.

The inquiry into the complexity of the litigation involved, and the expense, inconvenience, and delay necessarily attending it, weighed in favor settlement, as it almost always would because settlement reduces the complexity and inconvenience of litigation. The interest of creditors test also weighed in favor of approving the settlement, subject to two complicating factors. The first was that unsecured creditors had already received payment in full, so the distribution was for the benefit of equity holders, and not creditors. The second was that, if the indenture trustee were to successfully assert its charging lien with respect to unreimbursed fees and expenses, the note holders would suffer a reduction in payments, albeit a de minimis one. However, this risk did not outweigh the benefits.

Thus, although it was only the probability of success in litigation factor that weighed against the settlement, its weight was so great that the court was unable to determine that the settlement was equitable and fair.

The second motion before the court was the motion of certain note holders to compel U.S. Bank to remit the $600,000 that was held back and for damages, costs and expenses incurred by the note holders in bringing the motion to compel. U.S. Bank argued that the court lacked subject matter jurisdiction over the question of whether it could properly assert a charging lien. The court agreed, finding that it lacked related to jurisdiction over this dispute, as its outcome would have no effect on the debtors’ estates because no further payments out of the estate on account of such claims remained to be made. However, the court proceeded to analyze whether the plan modified the indenture, which would vest the court with jurisdiction to enforce the plan confirmation order. The note holders argued that the plan modified the indenture to limit the payment to U.S. Bank of fees and expenses paid from the estates. If the note holders were subject to the charging lien, they argued, they would receive less than 100% on their allowed claim, which would be inconsistent with the plan and disclosure statement.

The court determined that it lacked authority to modify the indenture, which was a private contract between non-debtors, except pursuant to applicable law. However, the note holders pointed to no such law permitting the court to modify the indenture. Also, the note holders did not allege that the indenture was modified by its own terms. Interestingly, the court expressed that it was not troubled that the provision for payment in full would be rendered superfluous, stating that plans often contain provisions that have little or no effect, such as provisions for the retention of jurisdiction, even where no such jurisdiction might exist. Accordingly, the court found that it lacked subject matter jurisdiction over the charging lien dispute, and that the plan did not modify the indenture.

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Consolidated SWINC Estate and SWE&C Liquidating Trust v. ACE USA, Inc. (In re Stone & Webster, Inc.), Adv. Pro. No. 07-50390 (PJW), 2007 WL 1334498, -- B.R. -- (Bankr. D. Del. May 4, 2007)

The liquidating trusts of the Stone & Webster debtors commenced an adversary proceeding against insurers of the debtors in connection with a coverage dispute that had been waged for many years, including well before the petition date. The insurers moved for a determination of the core/non-core status of the adversary proceeding. The United States Bankruptcy Court for the District of Delaware determined that the suit was merely a pre-petition state law breach of contract action over which the court had no jurisdiction under the United States Supreme Court’s decision in Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50, 71 (1982).

The plaintiff, successors in interest to debtors Stone & Webster, commenced this adversary proceeding in the United States Bankruptcy Court for the District of Delaware against insurers ACE USA, Inc. and Century Indemnity Co. seeking damages and a declaration that policies issued by the insurers to the debtors cover alleged environmental liabilities of the debtors. Century brought this motion for a determination that the adversary proceeding is non-core.

Prior to the debtors’ bankruptcy filing, Southern Union Company and Narragansett Electric Company filed environmental tort claims against the debtors. The plaintiff alleged that Century’s predecessor in interest failed to fulfill its duty to defend and indemnify the debtors in connection with these environmental claims. Southern Union and Narragansett filed proofs of claim in the debtors’ cases for costs incurred and future cleanup costs. The debtors settled the claims with Southern Union and Narragansett, agreeing to pay $5 million and 50% of any recovery from insurers, up to $10 million. Century objected to the motion to approve the settlement, but the objection was overruled and the settlement approved.

Plaintiffs commenced this adversary proceeding on January 26, 2007 alleging the following counts against Century and Ace: (1) breach of contract; (2) breach of an implied covenant of good faith and fair dealing; and (3) violation of Rhode Island General Law § 9-1-33, which prohibits an insurer from refusing in bad faith to pay a claim under an insurance policy. Plaintiffs also requested a declaratory judgment stating that (1) Plaintiffs have complied with all terms and conditions of the policies; (2) Century had a duty to defend the Debtors in connection with the Southern Union and Narragansett claims or to compensate the Debtors for their reasonable costs of defending such claims, and Century breached that duty; and (3) Plaintiffs' claim in connection with the settlement with Southern Union and Narragansett is covered by the policies.

In addition to filing a motion for determination of core/non-core status, Century also filed a motion to withdraw the reference to the United States District Court for the District of Delaware.

As the Court noted, the Third Circuit test for a determination of core or non-core status first requires an examination into whether the matter fits within one of the categories of core proceedings provided at 28 U.S.C. § 157(b)(2). If it does not, the court must apply the following test set forth in Halper v. Halper, 164 F.3d 830, 836 (3d Cir. 1999): “’a proceeding is core [1] if it invokes a substantive right provided by title 11 or [2] if it is a proceeding, that by its nature, could arise only in the context of a bankruptcy case.’” Also, in Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50, 71 (1982), the United States Supreme Court held that bankruptcy courts are constitutionally restricted when it comes to adjudication of pre-petition state law claims, but that there is no such impediment to deciding post-petition state law causes of action. Such post-petition actions are typically core. The court also noted that some courts assess whether the claim may bring an economic benefit to the estate. If there is an economic benefit to the estate, then that may support the exercise of related-to jurisdiction over a non-core claim under 28 U.S.C. § 157(a); however that is a separate inquiry from the core/non-core one.

Century argued that the adversary proceeding was non-core because (i) no substantive rights under the Bankruptcy Code were involved; (ii) the proceedings could have existed outside the bankruptcy case; and (iii) the claims arose pre-petition. The plaintiff countered that this was a post-petition claim, arguing that Century’s alleged failure to defend and indemnify occurred after the debtors’ petition date, although the plaintiffs did not contest that this dispute had been going on long before the petition date. The settlement agreement between the debtors and Southern Union and Narragansett was merely the outcome of this long process. Therefore, the Court held that the claims arose pre-petition. The Court also rejected the plaintiff’s argument that this dispute could only occur inside bankruptcy because it is interrelated with Southern Union and Narragansett’s proof of claim and the settlement agreement. Instead, the Court found, these disputes were unrelated to the actual substantive coverage dispute.

Also, the fact that the Court approved the settlement agreement did not make the dispute core. The same type of settlement could have been effected if the debtors had never filed the bankruptcy petitions. In sum, this was merely a pre-petition breach of contract claim that the U.S. Supreme Court held could not be heard by Non-Article III judges, such as bankruptcy judges. The court also rejected as irrelevant the argument that because the plaintiffs might win and bring a recovery to the estate, the adversary proceeding was core.

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In re W.R. Grace & Co., Case No. 01-01139, Docket No. 15197 (Bankr. D. Del. April 13, 2007)

The State of Montana filed a motion for relief from the automatic stay to join debtor W.R. Grace & Co. as a third-party defendant in asbestos-related litigation pending in Montana state courts. The claims asserted in those actions arose out of Grace’s former vermiculite mining and processing operation in Montana.

The United States Bankruptcy Court for the District of Delaware analyzed Montana’s request under the standard articulated by the court in In re Rexene Products Co. and In re Continental Airlines, Inc. That standard requires consideration of the prejudice and hardships to the parties, as well as the likelihood that the creditor would ultimately prevail on the merits. The court denied the motion, finding that the debtor, the bankruptcy estate and the other creditors would suffer great prejudice if Montana were permitted to proceed against the debtor in state court, and that Montana’s claims for indemnity and contribution were premature, but preserved in Montana’s proof of claim.

W.R. Grace & Co. was named as a defendant in Montana state court actions relating to claims arising from the mining and processing of vermiculite containing asbestos in Montana. Following Grace’s bankruptcy, the state of Montana was named as a co-defendant in many of these actions, but these actions were stayed as to the debtor by virtue of the automatic stay. Other actions were commenced post-petition, and named Montana as a defendant, but not the debtor. These claims allege that the debtor and Montana were negligent in failing to warn the plaintiffs about the dangers of exposure to asbestos.

The State of Montana moved for relief from the automatic stay to join Grace as a third-party defendant in these actions. In deciding the motion, the court applied the three-part test articulated by the United States Bankruptcy Court for the District of Delaware in In re Rexene Products Co. and In re Continental Airlines, Inc. Those cases teach that the court is to consider (i) whether any great prejudice to either the bankruptcy estate or the debtor will result from continuation of the civil suit; (ii) whether the hardship to the non-bankrupt party by maintenance of the stay considerably outweighs the hardship to the debtor; and (iii) the probability of the creditor prevailing on the merits.

The bankruptcy court considered these factors and denied the motion for relief from the automatic stay. The court found that the debtor would suffer substantial hardship if the stay were modified because the debtor petitioned for bankruptcy to address in a single forum its asbestos liabilities. If the State of Montana were permitted to join the debtor in the Montana actions, the debtor would be forced to duplicate its defense efforts, unnecessarily depleting estate resources. This would undermine the purpose of the automatic stay.

In addition, the court determined that going forward with the state court actions would undermine the reorganization process. Discovery in the bankruptcy case on personal injury liabilities and property damage claims was already underway, and trial dates were set, all as prerequisites to the process of crafting a plan of reorganization. If relief were granted, members of the debtor’s organization who were working on the reorganization process would be forced to work on the Montana actions.

Also, it appeared far from certain that judgment would be entered against the state of Montana. Therefore, the debtor would be required to participate in a case before any alleged contribution or indemnity claims even accrued. There was also the risk that, even if such claims were ripe, the outcome of the cases could result in different treatment of those claims than for similar claims within the bankruptcy process, offending the principle of similar treatment for similarly situated creditors.

In sum, Montana failed to show that the balance of hardships tipped in its favor, or that the claims at issue in the state court actions were distinguishable from other asbestos claims that were to be addressed through the bankruptcy case. Montana had filed its proof of claim in the bankruptcy case, and its indemnification and contribution claims would be addressed through the claims resolution process. Therefore, finding that the prejudice to the debtors, the estate and other creditors far outweighed any prejudice to the state, the court denied Montana’s motion.

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Forklift LP Corp. v. iS3C, Inc. (In Re Forklift LP Corp.), 363 B.R. 388 (Bankr. D. Del. 2007)

In connection with pending litigation over a failed post-petition software upgrade, the plaintiff asserted that even if its challenge to defendant’s right to payment was unsuccessful, the defendant’s administrative claim was subject to the provisions of the confirmed Plan, which, the plaintiff contended, resulted in defendant receiving less than full payment. Defendant moved for partial summary judgment on its right to receive payment in full, arguing that the Plan was ambiguous. The Court agreed, and held that the ambiguity in the Plan would not deny defendant its right to payment in full in light of the clear language of the Confirmation Order, the Disclosure Statement and the doctrine of judicial estoppel.

After the Debtor filed for bankruptcy in April, 2000, it sought an order authorizing retention of the Defendant, iS3C Consultancy Services Ltd., as a computer consultant in connection with a proposed software upgrade. The budgeted amount for the upgrade was approximately $450,000. Several milestones were to be achieved, but the Defendant ceased work prior to completing all the milestones. The parties disputed which party was responsible for the failed upgrade.

Thereafter iS3C filed an administrative claim for $458,470.08. Prior to plan confirmation, the Debtor objected to iS3C’s claim and filed an adversary action seeking disgorgement of amounts previously paid to iS3C. Neither the claim objection nor the adversary were resolved prior to plan confirmation, but the debtor represented to the Court that the Plan provided means to pay iS3C’s claim in full if it were allowed at a later date. The Court thereafter confirmed the Plan.

In an effort to avoid administrative insolvency and conversion of the case, some of the administrative claim holders, but not iS3C, agreed to receive deferred distribution from the proceeds of avoidance actions, thereby giving up the right to receive full payment as required by 11 U.S.C. § 1129(a)(9)(A). As it turned out, holders of these “Allowed Deferred Claims” would receive only 10% of their claims. At the crux of the dispute between the Debtor and iS3C was the fact that the Plan provided that any claim that was allowed subsequent to the Effective Date of the Plan was, by definition, an “Allowed Deferred Claim. Of note, however, was the inconsistency that distributions were only to be received by “Allowed Deferred Claims that have agreed to a deferred Distribution.” In this Motion for Partial Summary Judgment by iS3C, the Court was only asked to determine whether, if iS3C’s claim were ultimately allowed, whether it would be entitled to full payment or whether it would be entitled to the 10% return being made to Allowed Deferred Claims.

The Debtor argued that because iS3C’s claim had not been allowed as of the Effective Date of the Plan, the claim was an Allowed Deferred Claim and therefore subject to the distribution schedule and reduced payment. However, the Debtor offered no explanation for how iS3C would fit into a distribution to “Allowed Deferred Claims that have agreed to a deferred Distribution.”

The Defendant argued that while its claim was not allowed prior to the Effective Date, it did not fit into one of the categories of creditors who were to receive deferred distributions and therefore it did not have an Allowed Deferred Claim.

The Court noted the “troublesome contradiction” between terms of the Plan, and noted that allowing iS3C anything less than payment in full would be contrary to 11 U.S.C. § 1129(a)(9)(A).

The Court therefore found that the Plan was ambiguous and looked for other ways to interpret its provisions. Ultimately the Court focused on three methods of interpretation to resolve the dispute: (1) review of the confirmation order; (2) judicial estoppel; and (3) review of extrinsic evidence of the Debtor’s intent when drafting the Plan.

Looking at the confirmation order, which the Court held to take precedence over contradictory language in the Plan, the Court noted the factual finding that the Plan complied with 11 U.S.C. 1129(a)(9) by providing for payment in full of administrative claims on or as soon as practicable after the Effective Date.

The Court observed that the confirmation order was not the only document that stated that the plan conformed with Section 1129(a)(9)(A). Indeed, in the Debtor’s own Memorandum in support of plan confirmation, it proposed that the Plan conformed to the requirements of 1129(a)(9). Noting that this statement “directly contradicts” plaintiff’s argument that iS3C’s claim was to be paid over time and in a reduced amount, the Court applied the doctrine of judicial estoppel to preclude the Debtor from “chang[ing] the argument to its own advantage to avoid paying Defendant in full.”

Turning to an examination of extrinsic evidence of the Debtor’s intent, the Court again found that the confirmation order, supporting memorandum, and, in addition, the Debtor’s own disclosure statement, all provided for payment in full to administrative claimants. The Court cited favorably the rule that ambiguities are to be resolved against the party drafting the contract, and found that the extrinsic evidence of the Debtor’s intent supported the conclusion that iS3C would be entitled to payment in full if its claim were ultimately upheld.

The Court therefore granted iS3C partial summary judgment on that point, and entered an order requiring the Debtor to pay iS3C in full as soon as practicable after the claim was allowed, if ever.

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Giuliano v. Fairfield Group Health Care Centers Ltd. P'ship (In Re Lexington Healthcare Group, Inc.), 363 B.R. 713 (Bankr. D. Del. 2007)

The Chapter 7 Trustee filed a complaint against a nursing home landlord under Section 542 of the bankruptcy code seeking turnover of a $2.2 million security deposit posted by the Debtor’s predecessor. The landlord filed a motion to dismiss under FRBP 12(b)(6) claiming that a turnover action under Section 542 may only be used to obtain property which is undisputedly property of the bankruptcy estate. Noting that the Trustee had not pled an absolute right to the security deposit, and that a genuine dispute existed over rights to it, the Court agreed and dismissed the turnover action.

In 1995, Lexington Healthcare Group, LLC entered into a nursing home lease with Fairfield Group Health Care Centers Limited Partnership. Pursuant to the lease, Lexington (the Debtor’s predecessor) paid a $2.28 million “Security Deposit.” The lease was assigned to the Debtor in May 1997.

After the Debtor filed bankruptcy, the Trustee commenced an action against Fairfield and others under Section 542 of the bankruptcy code seeking turnover of the $2.28 million to the estate. Fairfield and the other defendants moved to dismiss the complaint pursuant to FRBP 12(b)(6).

The Court first noted that FRBP 12(b)(6) required the Court to accept all well pled allegations in the complaint as true and view them in the light most favorable to the Trustee. However, the Court also observed that previous Delaware bankruptcy court decisions had held that a trustee may only use Section 542 to compel a turnover of property that is not in dispute.

In this case, Fairfield argued that the Debtor’s predecessor intended the security deposit to be rent and additional consideration paid under the lease. In addition, there was no provision in the lease for return of the security deposit. The Court agreed with Fairfield that there was a material dispute over title to the security deposit. An examination of the lease revealed that the security deposit was to be applied by the landlord toward damages or defaults, or alternatively to the last months of the initial term of the lease. Because the Debtor had rejected the lease, and there was no “plain and unambiguous . . . clear, objective basis for concluding that the security deposit is property of the estate,” a turnover action pursuant to Section 542 was not appropriate, and the Court dismissed that count of the complaint.

The Court declined to dismiss entirely the complaint, finding that Count 2 of the complaint stated a claim that the security deposit was debt owed to the estate. The Court also declined to dismiss two individual defendants on the asserted basis that they were “disassociated partners” of Fairfield. To the contrary, at the time of entering the lease, the two individuals were general partners of Fairfield. Whether they were disassociated partners (and therefore not liable) was an issue of fact that was not ripe for disposition on the motion to dismiss.

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Integrated Water Res., Inc. v. Shaw Envntl., Inc. (In re IT Group, Inc.), 361 B.R. 417(Bankr. D. Del. 2007).

The Plaintiff in this adversary proceeding sought to amend its complaint to add a claim for breach of contract against the IT Trust. The Plaintiff asserted that the Trust had violated the terms of a settlement agreement and releases contained therein by assigning its claims against the Plaintiff to a third party. The Court granted the motion to amend, finding that there was no undue delay by the Plaintiff, there was no undue prejudice to the Trust, and that the proposed amendment was not futile.

Prior to the petition date, Integrated Water Resources, Inc. (IWR) retained IT Corporation as a subcontractor for various environmental remediation projects. IWR alleged that IT Corp. breached the contract. Shortly after IT Corp. filed bankruptcy in 2002, it executed an agreement with Shaw Group, Inc. pursuant to which Shaw agreed to purchase substantially all of the Debtor’s assets. The Court approved the asset sale.

After the Debtor’s chapter 11 plan was confirmed in 2004, the Debtor’s remaining assets were vested in the IT Trust. In early 2005, the Court approved a stipulation between the Trust and IWR that resolved all controversies between them. The Trust represented in the stipulation that neither it nor the Debtor had assigned any claim against IWR. IWR likewise represented that it had not assigned claims against the Debtor or the Trust. Additionally, the stipulation contained releases in favor of IWR as to all present and/or future claims the Trust or the Debtor might have.

In October 2005, Shaw sued IWR in California for damages relating to the environmental remediation contract. In 2006, IWR sued Shaw and the Trust in Bankruptcy Court seeking (1) indemnification of expenses and fees to defend the Shaw action; (2) indemnification for any liability to Shaw; (3) determination of IWR’s rights under the contract, sale order and stipulation; and (4) injunctive relief against Shaw.

In January 2007, IWR sought leave to amend the complaint to add a claim for breach of contract arising from the Trust’s alleged breach of the stipulation and releases. The Trust opposed the motion for leave, arguing that there had been undue delay in filing the motion, that it would suffer undue prejudice and that amendment would be futile. The Court disagreed with the Trust.

The Court noted that IWR’s 6 month delay in filing the motion to amend was not “undue”. No discovery had taken place, no scheduling order had been entered, and no trial was scheduled.

The Court also found that the Trust would not suffer undue prejudice. Any inconvenience to the Trust in having to defend the new claim, or the concommittant strengthening of IWR’s legal position, did not constitute sufficient prejudice. Again, the court noted that the new claim would not require additional discovery since no discovery at all had yet taken place. Further, the Court held that the Trust would have adequate time to prepare its defense to the claim.

Finally, the Court noted that the proposed amendment was not futile. The proposed amendment would properly assert a claim for breach of contract. Further, the Court held that if it determined that the remediation contract was assigned to Shaw, it could also conclude that the Trust had breached the settlement and releases.

The Court therefore granted leave to IWR to amend its complaint to assert a breach of contract claim against the Trust.

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In re Global Home Prods., LLC, Case No. 06-10340 (KG), ---- B.R. ----, 2007 WL 689747 (Bankr. D. Del. March 6, 2007).

The debtors proposed bonus plans for management and certain sales staff, which were based on performance and incentives. The debtors’ unionized employees objected to the plan, characterizing it as a Key Employee Retention Plan (KERP), approval of which was subject to the rigorous requirements of 11 U.S.C. § 503(c). The court approved the plans, finding that section 503(c) was inapplicable, as the plans were primarily incentivizing, rather than retentive or in the nature of severance. Accordingly, the court measured whether the plans were formulated according to a proper exercise of the debtors’ business judgment, and finding that they were, approved them under the less exacting business judgment standard of 11 U.S.C. § 363.

Debtor Global Home Products, LLC filed a motion for an order approving and authorizing a management incentive plan and a sales bonus plan. Under these plans, the debtor would pay management bonuses based on performance and incentives, and eligible sales staff would receive an incentive-based bonus plan.

The debtors’ fiscal year began on April 1, 2006 (ten days before the debtors commenced their cases) and would end on March 31, 2007. The management plan would award each eligible employee, on a quarterly basis and as a percentage of their base salary, up to four (4) potential incentive payments payable if the Management Plan's minimum EBITDAR and/or Cash Flow objectives are met at the end of each of four relevant periods within the fiscal year. The management plan was comprised of two components: EBITDAR goal objectives and cash flow goal objectives. The components were both weighted to count for 50% of each potential quarterly payment. To remain eligible to receive payments, eligible employees were required to be employed with the debtors as of the last day of the particular quarter on which the requisite EBITDAR and/or cash flow objectives were actually achieved.

As to Mark Eichhorn, the debtors’ Interim Chief Executive Officer and President of debtor Anchor Hocking, in lieu of quarterly payments, the management plan provided for an amortization based upon a formula of Eichhorn’s existing obligations owed to debtors in the amount of $310,000 in respect of a prepetition loan and relocation allowance advanced to him prepetition in connection with expenses incurred pursuant to his relocation from Illinois to Ohio. The Debtors and Eichhorn agreed to quarterly amortizations of the relocation obligation based upon a formula. Under no circumstances would the total amortization ever exceed the amount of the relocation obligation. However, unlike other Eligible Employees, Eichhorn was not entitled to any additional benefit if the debtors exceed 100% of the EBITDAR and Cash Flow objectives.

Debtors estimated that the total cost of the management program would range between $890,000 up to a maximum of $2,700,000.

Under the sales plan, eligible sales managers were entitled to receive up to (i) 30% of their annual salaries based on the annual percentage increase of annual sales for their division calculated at the end of the 2007 fiscal year over the prior year, plus (ii) a 15% bonus payment pursuant to the same terms and conditions applicable to the management plan.

Unionized employees of the debtors objected to the plans, characterizing them as so-called Key Employee Retention Programs that were subject to the strictures of 11 U.S.C. § 503(c)(1) and (3).

The court overruled the objections, finding that 11 U.S.C. § 503(c) was inapplicable as the plans were not primarily to retain personnel, and were not in the nature of severance. Instead, the court found that the plans were meant to motivate employees. In so concluding, the court took guidance from Judge Burton Lifland’s findings in the Dana Corporation bankruptcy case in the United States Bankruptcy Court for the Southern District of New York. In Dana, the court rejected the debtor’s first proposed incentive plan, finding it to be nothing more than a KERP. However, Judge Lifland approved a revised plan, finding that it was similar to bonus programs offered by the Dana debtor pre-petition, and was therefore within Dana’s ordinary course of business, and a proper exercise of Dana’s business judgment.

The Delaware court adopted the analysis employed by Judge Lifland to determine whether the bonus plans were a proper exercise of the debtors’ business judgment, considering (1) whether there was a reasonable relationship between the plan proposed and the results to be obtained; (2) whether the cost of the plan was reasonable in the context of the debtors’ assets, liabilities and earning potential; (3) whether the scope of the plan was fair and reasonable, i.e., whether it applied to all employees, or discriminated unfairly; (4) whether the plan was consistent with industry standards; (5) what were the due diligence efforts of the debtors in investigating the need for a plan, analyzing which key employees needed to be incentivized, what was available, and what was generally applicable to the debtors’ particular industry; and (6) whether the debtor received independent counsel in performing due diligence and in creating and authorizing the incentive compensation.

The court found that all of these requirements were met, with the exception of consultation with independent counsel. However, because the bonus programs were almost identical to plans previously used by the debtors, and were approved by the debtors’ compensation committee and board of directors, the lack of proof of that factor did not favor a finding that the plans were improper. The court was satisfied that the plans were primarily incentivizing, and any retentive effect was coincidental because the same plans were used prepetition, when retention was not the motive. Although the debtors conceded that all compensation is retentive, the court was satisfied that the primary goal of the plans was to create value for the debtors by motivating performance. Accordingly, the court approved the plans as a proper exercise of the debtors’ business judgment under 11 U.S.C. § 363.

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In re Scott Acquisition Corp., Case No. 04-12594 (PJW), ---- B.R. ----, 2007 WL 676692 (Bankr. D. Del. March 6, 2007)

The Chapter 7 Trustee of the estate of debtors Scott Acquisition Corporation and Scotty’s Inc. filed a complaint against the debtors’ pre-petition counsel, asserting legal malpractice, breach of fiduciary duty and fraudulent transfer claims. The claims arose from a series of transactions between the debtors and insiders of the debtors, in which the defendants represented both the debtors and the insiders. The defendants filed a motion to dismiss the legal malpractice and breach of fiduciary duty claims, asserting that the trustee was estopped from prosecuting those claims by the equitable defense of in pari delicto. The United States Bankruptcy Court for the District of Delaware granted the motion, finding the in pari delicto defense barred those claims, but permitted the fraudulent transfer count to go forward.

Defendant Robert F. Mallett was the sole member of co-defendant Robert F. Mallett, LLC and a partner in the firm of Broad and Cassel P.A.. Mallett represented debtors Scott Acquisition Corporation and Scotty’s Inc. The plaintiff in this adversary proceeding, the Chapter 7 trustee of the debtors’ estates, filed a complaint alleging legal malpractice, breach of fiduciary duty and fraudulent transfer claims.

Operating in Florida, the debtors operated the Do-It-Best chain of home improvement stores, which they acquired in a 1998 purchase when the debtors’ management team purchased the chain from its prior owners. The plaintiff alleged that Mallett represented the debtors and several members of the management team in negotiating the purchase of the chain. The debtors financed this acquisition with a loan and line of credit from Congress Financial Corporation secured by virtually all of the debtors’ assets.

The trustee also alleged that Mallett represented both the debtors and insiders of the debtors in connection with a series of transactions in which the insiders purchased from the debtors various assets that the insiders then leased back to the debtors. The trustee alleged that the purchase price in each of these sales was below market, and was sufficient only to get Congress to release its liens. These transactions were not approved by shareholders, but were approved by the insider directors and the debtors’ general counsel. Several of the insiders thereafter sold the assets for considerable profits. Although the debtors and insiders executed conflict waivers, the trustee asserted that the defendants engaged in impermissible dual representations.

The trustee also alleged that the defendants engaged in further improper dual representations when the defendants represented the debtors and insiders in certain debenture and loan transactions under which the debtors borrowed funds from the insiders at high interest rates. Again, conflict waivers were executed by the parties.

The defendants moved to dismiss the complaint, contending that the claims were barred by the doctrine of in pari delicto, and that the statutes of limitation had expired. The defendants also contended that the trustee should be barred from bringing any claims benefiting Congress because Congress should not benefit from its role in the debtors’ wrongdoing.

The trustee argued that (1) the in pari delicto defense was limited to instances of fraud, a Ponzi scheme or criminal conduct; (2) in any event, the in pari delicto defense was inconsistent with Florida’s comparative fault statute; (3) the wrongful acts of the insiders cannot be imputed to the debtors because the insiders acted for their own benefit, and on their own initiative; and (4) the debtors’ wrongdoing cannot be imputed to a Chapter 7 trustee.

The court rejected the trustee’s argument that Florida law limited the in pari delicto defense to instances of fraud, a Ponzi scheme or criminal conduct. On the contrary, the court found that, under Florida law, the fraud or misbehavior of an agent is imputed to the principal under the in pari delicto doctrine. The absence of allegations or fraud, criminal conduct or a Ponzi scheme is irrelevant to the analysis.

The trustee also contended that Fla. Stat. § 768.81(2), which provides for comparative fault with respect to certain claims, including those sounding in professional malpractice, applied, and therefore trumped the in pari delicto doctrine. However, as the court noted, that statute expressly applied only to negligence cases. As the trustee did not claim negligence, and in fact alleged an intentional course of dealing by the defendants with the debtor, that section was held to be inapplicable. Moreover, the court noted that, even in negligence cases, Florida courts apply the in pari delicto doctrine without mention of the comparative fault statute. Accordingly, the court rejected the trustee’s argument that Florida’s comparative fault statute trumped the defendants’ in pari delicto defense.

The court also held that the adverse interest exception did not apply to estop the defendants from asserting the in pari delicto defense. Under the adverse interest exception, the wrongful acts of an agent are not imputed to the principal when the agent’s actions are adverse to the principal’s interests. The principal must benefit in no way from the agent’s actions. The trustee argued that the insiders’ wrongful acts could not be imputed to the debtors because the insiders acted for their own benefit. The court disagreed, noting that, although the insiders benefited, so too did the debtors, even if the benefits to the debtors were slight. However, the adverse interest exception did not apply unless there was no benefit at all to the principal. The court also noted that, even if the adverse interest exception applied, the sole actor exception to the adverse interest exception itself would impute the insiders’ actions to the debtor. Under the adverse interest exception, when the agent who acts adversely to the interests of the principal is the sole representative of the principal, the actions of the agent are imputed to the principal. Because the board of directors unanimously approved the transactions underlying this litigation, and the board of directors is a sole actor, the adverse interest exception would apply.

The trustee also argued that the in pari delicto defense could not be imputed from the debtors to a bankruptcy trustee. The court rejected this argument, finding that 11 U.S.C. § 541(a)(1), which states that the bankruptcy estate consists of “all legal and equitable interests of the debtor in property as of the commencement of the case, includes causes of action and supports the notion that the in pari delicto defense applies equally if a trustee asserts a cause of action on behalf of the debtor’s estate. Moreover, the court stated, every circuit court that has addressed the issue has found that the in pari delicto defense imputes to a bankruptcy trustee.

The defendants asserted that the trustee should also be estopped from asserting claims on behalf of Congress, contending that Congress knew about, participated in, agreed to and encouraged the transactions that resulted in payment of Congress’ loans to the debtor. The court rejected that argument, finding that the complaint did not allege such facts, and that, on a motion to dismiss, the court accepts as true all allegations in the complaint and draws all reasonable inferences from those facts, in a light most favorable to the plaintiff. Applying that standard, the court could not infer that Congress was a wrongdoer. Also, there was no evidence presented that Congress would be a beneficiary of any recovery, as it was not shown that Congress was a creditor of the Chapter 7 estate.

Finally, the parties’ briefing did not address the fraudulent transfer count, and because in pari delicto is not a defense to such a claim under Third Circuit precedent in Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., the court allowed the fraudulent transfer count to go forward. However, the court dismissed the legal malpractice and breach of fiduciary duty claims.

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Fruehauf Trailer Corp. v. Nat. Union Fire Ins. Co. of Pittsburgh, PA (In re Fruehauf Trailer Corp.), Case Nos. 96-1563–1572, Adv. Pro. No. 98-514, 2007 WL 676248 (Bankr. D. Del. March 2, 2007)

The defendants filed this motion to dismiss for failure to prosecute under Federal Rule of Civil Procedure 41(b), after a period of inactivity in the instant adversary proceeding of more than five years. The court denied the motion, finding that the plaintiff asserted cognizable claims, and that the most drastic sanction of dismissal was inappropriate. The Court held that giving the defendants the benefit of the doubt in all issues of fact that became vague as a result of the passage of time was sufficient to counter-balance the prejudice to defendants caused by the delay. In addition, the Court found that it was obliged to refer the matter to arbitration, pursuant to the agreement between the debtor and the defendants.

On October 6, 1998, Chriss Street, the trustee of the debtor, Fruehauf Trailer Corporation, commenced this adversary proceeding in the United States Bankruptcy Court for the District of Delaware against defendants National Union Fire Insurance Company of Pittsburgh, PA and American International Group, Inc. The debtor sought (1) to avoid and recover as preferential prepetition payments of insurance premiums by the debtor to the defendants, (2) to disallow the defendants’ scheduled claim and proof of claim against the bankruptcy estate, and (3) to recover excess collateral that the debtor alleged the defendants held. The defendants thereafter answered the complaint. In March of 1999, the defendants invited the plaintiff to pick up and copy six boxes of documents, pursuant to the defendants’ discovery obligations. The plaintiff did not pick the documents. No pretrial conference was ever held.

After a period of inactivity, in May 2000, the Court issued a notice of contemplated dismissal for failure to prosecute, to which the plaintiff replied that it needed more time to investigate the extent of the defendants’ liability. More than two years later, the court issued a second notice of contemplated dismissal for failure to prosecute, which was incorrectly captioned with the wrong adversary proceeding name, and to which the plaintiff did not respond. In August 2005, Daniel Harrow was appointed as the new trustee, and in November 2005, the plaintiff filed a notice to cancel a hearing that was to take place that month. This was the first filing by the plaintiff in the adversary proceeding in over five years. On December 19, 2006, the court held a status conference, and granted the defendants leave to file the instant motion to dismiss for failure to prosecute under Federal Rule of Civil Procedure 41(b), which applies to adversary proceedings through Federal Rule of Bankruptcy Procedure 7041.

In determining whether to grant a motion to dismiss under Rule 41, the Court considered (1) the extent of the party’s personal responsibility; (2) the prejudice to the adversary caused by the failure to meet scheduling orders and respond to discovery; (3) a history of dilatoriness; (4) whether the conduct of the party or the attorney was willful or in bad faith; (5) the effectiveness of sanctions other than dismissal, which entails an analysis of alternative sanctions; and (6) the meritoriousness of the claim or defense. The Court noted that not all of these factors needed to weigh in favor of the moving party, but that dismissal is a drastic remedy, and that resolution on the merits was preferred.

The extent of the party’s personal responsibility – the Court stated that, despite plaintiff’s protestations that defendants shared responsibility for the delays in the progress of the adversary proceeding, it is plaintiff’s responsibility alone to bring the matter to trial. However, the Court noted that the defendants should have filed the motion sooner, as, during the delay, the facts relating to plaintiff’s claims with respect to the excess collateral became more developed.

The prejudice to defendants – the defendants claimed that they were prejudiced by the delay because two important witnesses became unavailable during that time. Also, five of the six boxes of documents that the plaintiff did not pick up back in 1999 had gone missing in the interim. The court assumed that the unavailability of the witnesses and documents would prejudice the defendants.

History of Dilatoriness – Even though the plaintiff did not push for a preliminary hearing, discovery or trial, the Court held that this did not constitute dilatoriness, as the plaintiff responded to all orders and actions of the Court, with the exception of the second notice of contemplated dismissal, which the Court accepted was improperly captioned and may not have been received by the plaintiff.

Willfulness and bad faith – the Court found that the defendants failed to present any evidence of willfulness or bad faith. Also, the Court noted that Harrow had alleged mismanagement by Street, and given the uncertainty as to whether any claims would be asserted against Street, the Court had a concern as to whether the estate could be made whole if this potentially meritorious claim was dismissed.

Effectiveness of sanctions other than dismissal – the Court held that an effective sanction would be to rule that any issues of fact in this case that became vague or unresolvable due to the passage of time, the fading of memories, or the unavailability of deceased witnesses or lost evidence should be construed in the light most favorable to defendants. However, the Court noted that it was referring the matter to arbitration, and did not believe that the Court had jurisdiction to give such direction to the arbitrator.

Meritoriousness of the claim or defense – although it was difficult to assess the meritoriousness of the plaintiff’s claim because the factual record had not been developed, the Court stated that the plaintiff had, at least, asserted cognizable claims.

The Court therefore found that the first and second factors favored the defendants, the fifth weighed in favor of the plaintiff, and the remainder favored neither side. However, finding that the plaintiff’s claims were cognizable, the drastic remedy of dismissal was unwarranted. Instead, the Court held, giving the defendants the benefit of the doubt in all issues of fact that became vague as a result of the passage of time was sufficient to counter-balance the prejudice to defendants caused by the delay.

The remaining issue was the whether the dispute should be referred to arbitration. The defendants argued that the agreement between the parties mandated arbitration for disputes arising out of the interpretation of the agreement, and that this was such a dispute. The plaintiff argued that this was a matter of Bankruptcy Code principles, and that, therefore, arbitration was not required. The Court sided with the defendants, finding that the calculation of the correct amount of collateral required contractual interpretation, and was thus subject to the arbitration provisions of the agreement. Therefore, the Court ordered that the matter be referred to arbitration.

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Simon & Schuster, Inc. v. Advanced Marketing Services Inc. (In re Advanced Marketing Services Inc.), No. 07-50004 (CSS) (Bankr. D. Del. Feb. 27, 2007)

Simon & Schuster, a creditor of debtor Advanced Marketing Services, Inc., filed a reclamation claim against the debtor, and sought to have a temporary restraining order put in place to prevent the debtor from selling the S&S goods that were subject to the reclamation claim. The court denied the motion in a previously reported opinion. (here)

S&S then sought to pursue an appeal of the court’s interlocutory order denying the TRO motion, moved the District Court for leave to appeal, and requested that the Bankruptcy Court certify that the case was suitable for direct appeal to the United States Court of Appeals for the Third Circuit, pursuant to 11 U.S.C. § 158(d)(2). The Bankruptcy Court declined to decide the request, finding that, because the District Court and Bankruptcy Court were being asked to make an almost identical set of findings, judicial resources would best be used by deferring to the District Court to decide the motion for leave to appeal. Moreover, respect for the hierarchy of the courts warranted deference to the District Court.

Simon & Schuster requested from the United States Bankruptcy Court for the District of Delaware certification to appeal directly to the Third Circuit Court of Appeals from the Bankruptcy Court’s interlocutory order denying S&S’s motion for a temporary restraining order in connection with S&S’s reclamation claim against debtor Advanced Marketing Services, Inc. At the same time, S&S filed a motion in the District Court for leave to appeal the interlocutory order. Because of the interplay between Fed. R. Bankr. P. 8001(b) and 8003 on the one hand, and 28 U.S.C. § 158(d)(2) on the other, there arose the unusual situation of having essentially the same issue pending before two courts.

Under section 158(d)(2), which became effective on April 20, 2005 as part of the Bankruptcy Abuse Prevention and Consumer Protection Act, an appeal may be taken directly from the Bankruptcy Court to the Circuit Court of Appeals – bypassing intermediate appeal – if (i) the certification provisions set forth in that statute are followed and (ii) the Circuit Court authorizes the direct appeal. Under section 158(d)(2)(B), certification by the lower court is required if a request is made by a “majority of the appellants and a majority of the appellees.” Certification is also required if the court, “acting on its own motion or the request of a party,” determines that:
(i) the judgment, order, or decree involves a question of law as to which there is no controlling decision of the court of appeals for the circuit or of the Supreme Court of the United States, or involves a matter of public importance;
(ii) the judgment, order, or decree involves a question of law requiring resolution of conflicting decisions; or
(iii) an immediate appeal from the judgment, order, or decree may materially advance the progress of the case or proceeding in which the appeal is taken

Interim Rules 8001(f) and 8003(d) govern the implementation of section 158(d)(2). Interim Rule 8001(f)(2) provides that “a certification that a circumstance specified in 28 U.S.C. § 158(d)(2)(A)(i)-(iii) exists shall be filed in a court in which the matter is pending.” In an appeal from an interlocutory order, Interim Rule 8001(f)(2) provides that the matter is pending in the Bankruptcy Court until grant of leave to appeal under 28 U.S.C. § 158(a)(3) and in the District Court upon the granting of leave to appeal. Interim Rule 8001(f)(2)(A)(i)-(ii) further provides, in an appeal from an interlocutory order, only the Bankruptcy Court may make a certification until grant of leave to appeal and only the District Court may make a certification upon grant of leave to appeal.

Finally, Interim Rule 8003(d) provides that, in an appeal of an interlocutory order, if the District Court has not yet granted leave to appeal, the authorization of a direct appeal by a court of appeals under 28 U.S.C. § 158(d)(2) “shall be deemed to satisfy the requirement for leave to appeal.”

Because the District Court had not yet granted leave to appeal, the request for certification remained in the Bankruptcy Court, even though the more important issue, that of the motion for leave to appeal, remained before the District Court.

Under section 158(d)(2), the court must issue a certification if it determines the order at issue involves any of the following: (1) a question of law upon which there is no controlling decision of the Third Circuit or of the Supreme Court of the United States, (2) a matter of public importance; or (3) a question of law requiring resolution of conflicting decisions. 28 U .S.C. § 158(d)(2)(A)(i)-(ii). In addition, the court must issue a certification if it determines an immediate appeal from order at issue may materially advance the progress of the case or proceeding in which the appeal is taken.

At the same time, the District Court must consider virtually the same questions in deciding the motion for leave to appeal; leave to file an interlocutory appeal can be granted when the order at issue (1) involves a controlling question of law upon which there is (2) substantial difference of opinion, and (3) when immediate appeal from the order may materially advance the ultimate termination of the litigation.

The Bankruptcy Court found this scenario troubling because of the duplication of effort and analysis required of the Bankruptcy Court and the District Court. In addition, it is inconsistent with the hierarchy of the courts to have the Bankruptcy Court, rather than the District Court, decide whether leave should be granted to appeal from an interlocutory order. Also, even if the Bankruptcy Court issued the certification, the court of appeals would still have to authorize the direct appeal to have jurisdiction. This scenario could present the prospect of the District Court granting leave to appeal while the court of appeals declines to authorize the direct appeal. The Bankruptcy Court also noted that, in this matter, the motion for leave to appeal was more important than the request for certification, as evidenced by the briefing of the parties on those issues. Also, the debtor opposed the motion for leave to appeal, but stated that if the motion for leave to appeal were to be granted, it would not oppose the request for a direct appeal.

Accordingly, the court found that the best use of judicial resources, and appropriate deference to the authority of the District Court, demanded that the Bankruptcy Court refrain from deciding the request for certification.

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Broadway Advisors, LLC v. Hipro Elecs., Inc. (In re Gruppo Antico, Inc.), Case No. 02-1328 (PJW), Adv. Pro. No. 03-58480 (KJC), 2007 WL 414494 (Bankr. D. Del. Feb. 7, 2007)

Vendor Hipro Electronics, Ltd. of Taiwan sold computer parts to the debtor prior to the commencement of the debtor’s bankruptcy case. However, in the period running up to the petition date, the debtor sent payments for Hipro Taiwan invoices to another Hipro entity, Hipro Electronics, Inc., in Texas. Hipro USA forwarded those checks to Hipro Taiwan, who deposited the checks into their own account. The debtor, however, commenced a preference action against Hipro USA. Hipro USA filed a motion for judgment on the pleadings. The court held that, because Hipro USA never deposited the funds, it was not a transferee of the debtor, and therefore could not be liable for the avoidance of the payments that the debtor sent to Hipro USA.

Prior to the bankruptcy of Gruppo Antico, Inc., the debtor was a computer hardware provider. Hipro Electronics, Ltd. (“Hipro Taiwan”), a Taiwanese entity, sold power sources to the debtor. Hipro Taiwan was based in Taiwan, but had a California business office and bank account. During the preference period, the debtor paid Hipro Taiwan with wire transfers to Hipro Taiwan’s bank account. Shortly before the petition date, the debtor began remitting payment by check, in payment of invoices for sales by Hipro Taiwan, to Hipro Electronics, Inc. (“Hipro USA”). Hipro USA was based in Texas. Hipro USA advised the debtor not to send payment to them, but instead to render payment directly to Hipro Taiwan. The debtor, however, continued to mail checks to Hipro USA. Hipro USA did not deposit into its account any of the checks it received from the debtor. Instead, it forwarded them to Hipro Taiwan, who deposited the checks. 

The debtor commenced an adversary proceeding against Hipro USA, seeking to avoid and recover allegedly preferential payments. Hipro USA answered the complaint, admitting that it was a vendor of the debtor, and that it received the transfers, but denied that the alleged transfers could be avoided as preferences.

The plaintiff thereafter amended its complaint. Hipro USA then filed an amended answer in which it denied being a vendor to the debtor, and claimed that it did not receive the alleged transfers. The same day that Hipro USA filed its amended answer, the plaintiff also received Hipro USA’s answers to the plaintiff’s discovery requests, in which Hipro USA contended that it was not a vendor to the debtors, but only assisted with servicing Hipro Taiwan’s account with the debtor, and that Hipro USA was a mere conduit for payments from the debtor to Hipro Taiwan.

The plaintiff then filed a motion to file a second amended complaint, which the court granted, over Hipro USA’s objection. The second amended complaint added Hipro Taiwan as a defendant.

Hipro USA filed a motion for judgment on the pleadings (treated as a summary judgment motion at the hearing), arguing that it did not receive a transfer of an interest of the debtor in property, and that it was a mere conduit, rather than an initial transferee. The plaintiff objected, contending that Hipro USA’s action in first admitting it was a vendor and received the transfers, then denying such allegations, estopped it from denying liability, and that such “bad acts” estopped it from asserting a conduit defense.

The court held that, under the standard set forth by the Supreme Court in Barnhill v. Johnson, a transfer does not occur until payment is honored. Therefore, there was no transfer until Hipro Taiwan deposited the checks into their bank account. A transfer did not occur when Hipro USA received the checks. Thus, Hipro USA was not a “transferee.”

The court also rejected the plaintiff’s argument that Hipro USA was not permitted to assert the conduit defense. Because Hipro USA filed an amended answer to the first amended complaint, any admissions made in the first answer were superseded by the answer to the first amended complaint. Thus, the admissions of being a vendor, and having received the transfers, were not binding on Hipro USA.

Also, any “bad faith” conduct, if any, which might have estopped Hipro USA from asserting the equitable defense of being a conduit occurred, if at all, after the litigation commenced. Equitable estoppel only operates as to conduct occurring pre-litigation. Moreover, the behavior of Hipro USA that the plaintiff asserted rose to the level of bad faith, was not, in fact, bad faith conduct. Accordingly, the court granted judgment on the pleadings in favor of Hipro USA and against the plaintiff.

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Claybrook v. Consolidated Foods, Inc. (In re Bake-Line Group, LLC), Case No. 04-10104 (MFW), Adv. Pro. No. 06-50322 (PJW), 2007 WL 329695 (Bankr D. Del. Feb. 5, 2007)

The debtor came into possession of a check made payable to the preference defendant when the postman mistakenly delivered the check to the debtor. The debtor converted the check, depositing it into the debtor’s bank account. The defendant learned of the debtor’s actions, and demanded and received from the debtor a check to cover the funds that the debtor had converted. Days later, the debtor commenced its bankruptcy case.

The plaintiff in this adversary proceeding, the trustee of the debtor’s estate, sued the defendant to recover the payment as a preferential transfer. The court granted summary judgment in favor of the defendant, finding that the debtor converted the funds, and never had any interest in them that it could transfer.

The debtor and defendant in this adversary proceeding had no pre-petition relationship. The only connection between the parties was that they had offices in the same suburban Chicago office building. Several months before the petition date of debtor Bake-Line, a customer of defendant Consolidated Foods, mailed a check to Consolidated, which the postman apparently delivered to the debtor. Although the check was payable to Consolidated, the debtor deposited the check into its own account.

Consolidated thereafter learned what had happened, and requested and received from the debtor a check in the amount of the funds that the debtor wrongly deposited into its own account. Several days later, the debtor filed its bankruptcy petition.

The trustee of the debtor’s estate commenced a preference action against Consolidated to recover this reimbursement payment from the debtor to Consolidated. Consolidated then filed a motion for summary judgment.

The court granted the motion for summary judgment, finding that the trustee’s prima facie case failed for three reasons: (1) the transfer was not a transfer of an interest of the debtor in property because the debtor never had any interest in the money; (2) the transfer was not a transfer of an interest of the debtor in property because the debtor was holding the money in constructive trust for Consolidated while it was in the debtor’s bank account; and (3) Consolidated was not a creditor of the debtor, as contemplated by 11 U.S.C. § 547(b)(1).

The court held that, under Illinois state law, the debtor never acquired any equitable or legal interest in the funds. Therefore, they were not funds of the estate that would have been available for distribution to creditors. Accordingly, the trustee could not recover those funds in a preference action.

The court also found that the money was held in constructive trust by the debtor for Consolidated. Addressing an issue that is in controversy under Illinois law, the court found that a constructive trust came into existence when the debtor obtained possession of the funds, not, as the trustee urged, at such time as a judicial pronouncement was made that a constructive trust existed. Therefore, the funds went into constructive trust when the debtor deposited the funds into its own account. Accordingly, when the debtor transferred the funds to Consolidated, it was not transferring an interest of the debtor in property.

The trustee claimed that he could nonetheless recover the money under his strong arm power of section 544(a), arguing that a hypothetical creditor that obtained a judicial lien or an execution at the time of the petition date would have a right to the funds superior to Consolidated’s equitable interest. The court rejected this position, finding that Consolidated would have had superior rights to a hypothetical creditor who obtains a judicial lien or an execution. Because a constructive trust arose at the time that the debtor came into possession of the check, the constructive trust existed before any other hypothetical rights could have arisen.

Finally, the Court held that, independent of any of these other reasons, there could be no recovery because, under section 547(e)(3), no transfer could occur until the debtor has acquired rights in the property transferred. No matter how the debtor came into possession of the funds, it never had any rights in the check. The debtor merely converted the funds, and no rights in the funds could arise from conversion. For that same reason, the trustee’s strong arm powers could not defeat Consolidated’s title to the funds.

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