z Bankruptcy Litigation Blog : Litigation Lore

The Mass of Contradictions that Define "Bad Boys" in Sports, Art, Life, and the Law

The phrase “bad boys” is one that conjures up a multitude of contradictory connotations. In sports, the Detroit Pistons wore the moniker proudly as they pummeled their way to consecutive NBA championships. Those bad boys, however, are long gone and now the same team is just plain bad

In art, Jerry Bruckheimer produced “Bad Boys” in 1995 and “Bad Boys II” in 2003, starring Will Smith and Martin Lawrence as bad boy Miami detectives. These likeable actors, however, failed to convey much of a bad boy image and critics panned the movies. Not deterred, a third installment, “Bad Boys III,” is scheduled for 2015, but it too (like "Die Hard 5") is likely to disappoint.

In life, John Alleman had become a Las Vegas sensation. Starting in about June 2011, he stood outside the Heart Attack Grill for nothing more than the love of the place (and some occasional free food) and colorfully pitched and cajoled people to sample such delicacies as Flatliner Fries, Butterfat Shakes, and the king-of-them-all, the Quadruple Bypass Burger (which holds the Guinness World Record for the “most calorific burger”). Late last year, this bad boy suffered a massive heart attack at a bus stop and died, thus ending his short—but glorious—reign as Sin City’s leading tempter of fate.

In the law, bad boys often find they pay a hefty and quite disproportionate price for their bad acts. Consider, for example, the case of Michael Turner. This bad boy received a $40,000 insurance settlement check three days before he filed bankruptcy and then cashed the check three days after he filed bankruptcy, using about one-quarter of the proceeds to pay down a mortgage while pocketing the rest.  His failure to disclose this asset in his bankruptcy schedules, as mandated by the Code, led a grand jury three years later to return a six-count indictment against him that eventually resulted in a bankruptcy fraud conviction and a 27 month jail sentence.  The 11th Circuit recently upheld his sentence as appropriate under today’s harsh federal sentencing guidelines. United States v. Turner, 2013 WL 510092 (11th Cir., Feb. 12, 2013) (PDF).

Some bad boys, however, manage to avoid the cudgel of the law by seizing onto a loophole that averts near certain doom. Consider, for example, bad boy Bernie Kurlemann, whose bank fraud conviction was reversed because the statute only criminalizes “false statements.”  Since he kept his mouth shut and told only half the truth, the court ruled, he couldn’t be convicted under a statute that does not criminalize “half-truths,” “material omissions,” or “concealments.”   United States v. Kurlemann, 2013 WL 513976 (6th Cir., Feb. 13, 2013) (PDF). True, Kurleman was still convicted on bankruptcy fraud charges, but that paled in comparison to the time he would have served had the bank fraud conviction been upheld.

Finally, consider so-called "bad boy" bank guaranties, where one’s personal liability to a lender is instantly multiplied from a fraction of the loan amount to the full indebtedness simply because one engaged in any one of various enumerated “bad acts” (such as waste, fraud, misappropriation, bankruptcy, receivership, violation of special purpose entity covenants, or incurrence of subordinate debt without the lender's consent). Here in Illinois, bad boy Laurance Freed, developer of the long-vacant “Block 37” on North State Street in Chicago, committed such a bad boy act when he had the temerity to contest the bank’s appointment of a receiver and file defenses to the bank’s foreclosure action. Though the ensuing delays were but a mere nuisance for the bank, that didn’t stop the Illinois Appellate Court from affirming that (i) Freed’s nominal challenges to the bank’s actions triggered the full $206 million recourse liability (up from $50 million) and (ii) the increase was not wholly disproportionate to the damages suffered by the bank from having to deal with the nuisance litigation and so was not an unenforceable penalty. In sum, the Court held, if you’re a “bad boy” under your own contractual definition of one, don’t expect a Court to bail you out of your own mess. Bank of America v. Freed, 2012 WL 6725894 (Ill. App. Ct., December 28, 2012) (PDF).

In conclusion, there’s a clear moral to this story:

Except perhaps in sports and art, being a bad boy can be hazardous to life (RIP Mr. Alleman), liberty (Turner / Kurlemann), and the pursuit of happiness (Freed)!

Thanks for reading!

Copyright Steve Jakubowski 2013

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7th Circuit Nixes Attempts to Hold Investment Bankers Responsible for Matters Beyond Their Engagement Agreements

Often, the only unencumbered assets left after a company goes bankrupt are potential causes of action against deep-pocketed professionals that witnessed or contributed to the debtor’s demise.  Of course, it’s one thing to allege misconduct; proving it (as noted here) is a horse of a different color.  A trilogy of recent decisions from the 7th Circuit Court of Appeals, however, demonstrates the increasing impatience of courts with plaintiffs who, as the 7th Circuit’s Chief Judge Frank Easterbrook recently put it in one of these cases, sue the debtor's professionals in an “attempt to find a deep pocket to reimburse investors for the costs of managers’ blunders.”  HA2003 Liquidating Trust v. Credit Suisse Secs. (USA) LLC, 517 F.3d 454 (7th Cir. 2008) (pdf)

The latest failed effort is found in a decision authored by Judge Diane P. Wood, as compassionate and fairand inspirational!–a judge as you’ll find (and possibly the next Supreme Court justice), in Joyce v. Morgan Stanley & Co., Inc., 2008 WL 3844111 (7th Cir. 8/19/08) (pdf).  In this case, Morgan Stanley, once the advisor to RCN, was engaged by 21st Century Telecom Group in late 1999, just before the telecom industry busted, to serve as 21st Century’s financial advisor in an ill-fated stock-for-stock merger with RCN.  As part of its engagement, Morgan Stanley delivered a “fairness opinion” to 21st Century’s board.  Between the 12/12/1999 date of the merger agreement and the 4/28/2000 effective date of the merger, RCN’s stock price plummeted and 21st Century’s stockholders ended up left holding the bag.

Nobody, however, leaves Ed Joyce–a famed Chicago commercial litigator–holding the bag and gets away with it, at least not without a good fight.  The problem for Ed, however, was finding a deep pocket to compensate him and his fellow stockholders for their losses, not an easy task particularly since they first filed suit more than six years after the merger’s effective date.  In their one-count complaint, which alleged “constructive fraud” on the part of Morgan Stanley, Ed and his fellow plaintiffs argued that Morgan Stanley had a duty to advise 21st Century’s shareholders about how to minimize their exposure to a potential drop in RCN’s stock price following execution of the merger agreement.  Morgan Stanley didn’t, they alleged, because that would likely have caused RCN’s stock price to decline.  Further, they alleged, Morgan Stanley didn’t want that to happen because of its conflict-of-interest stemming from the fact that it had served as RCN’s financial advisor before the merger.

Judge Wood, together with Judges William J. Bauer and Terence T. Evans, agreed that Ed and the other shareholders had standing to sue because their claims were direct, not derivative.  That’s all they agreed with, however.   While everyone recognized that in order to tag Morgan Stanley with liability, Morgan Stanley had to owe the 21st Century shareholders a fiduciary duty, here’s where the wheels fell off the bus because the 7th Circuit would not agree that Morgan Stanley owed the 21st Century shareholders a duty of full and fair disclosure.  To the 7th Circuit, the duties of Morgan Stanley were rooted in its engagement agreement, and no extra-contractual fiduciary duty existed to require Morgan Stanley to advise the 21st Century shareholders about hedging strategies that might minimize their exposure to fluctuations in the value of RCN stock.  Judge Wood wrote:

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Be Careful What You Wish For: Delaware Chancery Court Provides a Cautionary Tale Against Perfunctory Requests "For Other And Further Relief As The Court Deems Just And Equitable"

Thanks to Francis Pileggi, Delaware's premier blogger, for kindly alerting me to Nelson v. Emerson, 2008 WL 1961150 (Del. Ch., 5/6/08), in which Vice Chancellor Strine issued a well-crafted discourse on the interplay between Delaware's law governing corporate fiduciaries and federal bankruptcy law governing their conduct.  Francis wrote a long post quoting extensively from Vice Chancellor Strine's opinion, which I strongly recommend you first read, and will not repeat here.

Briefly, in this case, the company's former officer, director, and shareholder, wearing his tough guy hat as the company's major secured creditor, unsuccessfully challenged the company's bankruptcy filing in Chicago, with Bankruptcy Judge Jack B. Schmetterer issuing a lengthy opinion finding that (i) the former insider's claims should be only partially recharacterized as equity, but not equitably subordinated, and (ii) most importantly for purposes of this post, the debtor's chapter 11 filing was not in bad faith because there was a business to reorganize and the filing was a "rational reaction" to the creditor's threat to foreclose on debtor's business assetsRepository Technologies, Inc. v. Nelson (In re Repository Technologies, Inc.), 363 B.R 868 (Bankr. N.D. Ill. 2007) (pdf). 

District Court Judge Amy St. Eve, who's had one of the more interesting years as federal judge while overseeing the Tony Rezko and Lord Conrad Black of Crossharbour trials, heard the appeal in her spare time, and affirmed Judge Schmetterer's decision in its entirety.  Nelson v. Repository Technologies, Inc., 381 B.R. 852 (N.D. Ill. 2008) (pdf).  This opinion itself is worth reading for its reminder that "[b]ankruptcy is not a 'free-for-all' equity balancing act" and that dicta is defined by the Seventh Circuit (see my previous post entitled, Judge Posner's "Dictum" on "Dicta") as what a court "says" not what it "holds."  Id. at 867, 873.  As regards the latter point, Judge St. Eve concluded, "Nelson's argument that the Bankruptcy Court's language is dictum is defeated by his own motion requesting a finding of bad faith in support of dismissing [Repository]'s bankruptcy case."  Id., 381 B.R. at 873

After Judge St. Eve had ruled, Nelson backtracked and recrafted his theory of the case as a breach of fiduciary duty case instead of a bad faith bankruptcy case and filed a complaint in Delaware Chancery Court asserting that management breached its fiduciary duties to the corporation by filing bankruptcy in bad faith.  Adopting the standards for claim preclusion from the 7th Circuit, not Delaware (which were noted to be essentially the same as the 7th Circuit's), Vice Chancellor Strine held that Nelson was collaterally estopped from asserting a breach of duty claim based on management's alleged bad faith in filing the bankruptcy petition because, in the first instance, Judge St. Eve had already ruled in the district court case that Judge Schmetterer's finding on the bad faith issue was not "dicta."  As an aside, one has to wonder whether Nelson miscalculated by first having the District Court, not the Chancery Court, decide whether Judge Schmetterer's ruling was dicta.  Indeed, Judge St. Eve's own ruling looks a bit like dicta itself, since that ruling on dicta really wasn't essential to affirming Judge Schmetterer's decision.  But once she was asked to decide whether it was in fact dicta, and she did so decide, then Nelson was most definitely bound by that result.

Still, Vice Chancellor Strine covered his bases by not relying exclusively upon Judge St. Eve's holding that Judge Schmetterer ruling wasn't dicta, and instead undertook his own independent analysis of Judge Schmetterer's decision, drawing the following important two conclusions:

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Delaware's Premier Blogger Wins Important Motion Before Delaware's Judge Walsh Imposing the Caremark Fiduciary Duty on Corporate General Counsel

Davey and Zack are now 6 1/2 months, and finally consistently sleeping through the night!  The temperature in Chicago has also finally hit 60 degrees in Chicago, for only the seventh time this year. Put 'em together, add another great post from my good friend Francis X. Pileggi, the Lou Gehrig of legal blogging, and--without making any vows--it's time to dust off the blog and awaken from my blogging hibernation.  Thanks to those who've reached out to me in the interim with their kind words, comments, suggestions, and encouragement.

Here's a link to Francis's recent post on his Delaware Corporate and Commercial Litigation Blog about a decision handed down by one of the country's preeminent bankruptcy judges, Judge Peter J. Walsh, in Miller v. McDonald (In re World Health Alternatives, Inc.), 2008 WL 1002035 (Bankr. D. Del. 4/9/08) (pdf). In this decision, Judge Walsh refused to dismiss this complaint filed by Francis and his colleagues against Brian Licastro, the former vice-president of operations and in-house general counsel of World Health Alternatives.  The opinion is a must read because--

  • it explicitly extends the so-called Caremark duties to officers of a corporation, and in particular here, to the VP-operations and in-house general counsel, who was alleged "responsible for failing to implement any internal monitoring system and/or failing to utilize such system as is required by Caremark and Araneta"; (Op. at 26.)  
  • it sustains, by a narrow margin, a corporate waste count against the VP/GC, despite his not having personally benefited from the alleged waste, based on the allegation that he was "aware of the alleged corporate waste and took no action, as fiduciaries, to prevent such conduct";  (Op. at 33.)
  • it upholds a negligent misrepresentation count against the VP/GC alleging that "if [he] properly performed his duty as in-house counsel, these misrepresentation[s] [in public filings] would not have been made and the resulting harm [resulting in a $2.7 million payout in a shareholder class action] would have been avoided.  (Op. at 36-37.)

On January 14, 2007, I linked to various 27 bankruptcy-related cases discussed on Francis's blog.  Time for an update linking to the next 27 bankruptcy-related posts by Francis since then:

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Judge Peck Rules in Iridium's Bankruptcy That Stock Market Valuations Are No "Fool's Game"

As every blogger will agree, "thank goodness for guest bloggers!" (especially with my wife now 37 weeks and counting--laboriously so--with twins).

Today's guest blog is from my colleague at The Coleman Law Firm, Elizabeth E. Richert, who has been at my side--for better or for worse--since her graduation from Duke Law School in 2001.

If you're wondering how I had the time to blog, it's in large measure because Elizabeth does a lot of the spade work for me.  If you're also wondering why I'm not blogging as regularly, well, Elizabeth's starting to do that for me too.   Unfortunately, I don't think she does diapers (but see training video here).

So thanks Elizabeth for stepping up to the plate, and congratulations on your first of what I hope will be many more excellent posts!

***

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Damages for Deepening Insolvency: Judges Posner and Kaplan Consider the Elements of Proof

Back from a blogging R&R to take time to smell the roses, catch up on the ever-burgeoning e-precedent file, reflect on a year gone by since my mom's passing, and--most significantly--get the house ready for Malthusian growth with a pair of twins due sometime next month (adding to the two young Jakubowski's already here)!  So please excuse my patchy blogging as of late, but as Livy first wrote, "better late than never..." (though, for the sake of completeness, I suppose I should add that Livy concluded, "but better never late").

Anyway, back to blogging, and thanks for reading.

As Bob Eisenbach, Francis Pileggi, and Scott Riddle were quick to observe, the Delaware Supreme Court just put the official kibosh on "deepening insolvency" as an independent cause of action.  That is not the end of the story for bankruptcy litigators, however, since Vice-Chancellor Strine's opinion in Trenwick America Litigation Trust v. Billet, 906 A.2d 168 (Del. Ch. 2006) (pdf), upon which the Delaware Supreme Court relied, doesn't address whether deepening insolvency remains valid as a theory of damages. 

As to the latter point, as I recapped here and here, last year the Third Circuit in Seitz v. Detweiler, Hershey & Assocs., P.C. (In re CitX, Inc.), 448 F.3d 672 (3d Cir. 2006) (pdf), held that--at least under Pennsylvania law--deepening insolvency "is not an independent form of corporate damage" and that its earlier decision in Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001) (pdf), "should not be interpreted to create a novel theory of damages for an independent cause of action like malpractice ... [or] for any other cause of action, such as fraud."  In support of this proposition, the Third Circuit pointed to bankruptcy lawyer/novelist Sabin Willett's oft-cited article, The Shallows of Deepening Insolvency, 60 Bus. Law. 549, 575 (2005), for the proposition that "[w]here an independent cause of action gives a firm a remedy for the increase in its liabilities, the decrease in fair asset value, or its lost profits, then the firm may recover, without reference to the incidental impact upon the solvency calculation."

Two recent opinions authored by the Seventh Circuit's Judge Posner and the Southern District of New York's Judge Lewis A. Kaplan, however, don't adopt this per se rule (or at least, as regards Judge Kaplan, not in its entirety).  In Fehribach v. Ernst & Young LLP, 2007 WL 2033734 (7th Cir. 7/17/07) (pdf), Judge Posner provides the following short discourse on the "controversial theory" of deepening insolvency as a theory of damages (including answering how shareholders might be "ineluctably" harmed by a company's deepening insolvency):

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Enron's "Project Truman": Unraveling a Universe of Masterful Illusions

The Truman Show is Jim Carrey's greatest acting moment and one of Peter Weir's greatest directorial moments.  In this first reality TV show from which all current variants have been spawned, Jim Carrey plays Truman Burbank, an unwanted baby who's been adopted by T.V. Corp. to play the lead role in a world that everyone in the world, but him, knows has been staged. 

But what do The Truman Show and Enron have in common?  More than one might think.  Apparently between August 2001 and December 2001, Enron considered engaging Goldman, Sachs & Co. to explore--as Goldman described it in recent Court filings--"options for the company in response to declines in its stock price and perceived takeover vulnerability and to consider the company's need to prepare for hostile takeovers and sale transactions that might improve its balance sheet."

Goldman's adversaries in litigation allege in this complaint that Enron's $1 billion prepayment of short-term commercial paper within 5 weeks of the bankruptcy filing at face value (instead of the junk market price they were really worth) was both a preferential and a fraudulent transfer (Goldman got about $300 million).  They also disputed Goldman's innocuous description of its discussions with Enron, preferring instead to characterize them as "discussions of a potential engagement under which Goldman would serve as a consultant to advise Enron on ways to stave off the pending financial debacle." 

Curiously, the nickname Goldman pinned on the project was "Project Truman.Deal nicknames often say a lot about the nature of the deal, and given that Enron was by any measure the greatest financial illusion in corporate history, attaching the moniker "Project Truman" on the potential engagement is a telling premonition of trouble afoot.  Still, no one yet has fessed up to who chose that nickname for the project--or why.

Notably, the only reference to "Project Truman" in any actual substantive document produced in the litigation to date is in these "Discussion Materials" that were distributed at a "Project Truman" lunch meeting that Ken Lay and Andrew Fastow had scheduled with Goldman in Woodland, Texas for September 6, 2001, just five days before the tragedy of 9/11 sent the financial markets into a tailspin and effectively dried up whatever liquidity remained at Enron.

On page 6 of the Discussion Materials, the bold-faced-boxed-word "Truman" rests atop a decision tree detailing Enron's "next steps" after "Truman."  Based on the discussion at page 5 of the materials entitled "What Message Do You Deliver to the Street," the boxed reference to "Truman" sure looks like a convenient tag for the preceding page's 12-point Truman-esque bubble-bursting "message to the street."  The Goldman decision tree under the bold boxed word "Truman" suggests that once "Truman" confronts reality, one should first measure the effect of that reality check on "credit stability."  If the effect is positive (or "yes"), then continue to the next level down and determine whether "establishing counterparty confidence" can be achieved.  Conversely, if the effect on credit stability is negative (or "no"), then say sayonara to Enron in a "quick sale."  For his part, Fastow had this to say about the Project Truman meeting with Goldman, which was quite a different spin on the meeting than Lay recounted at trial.

Back now to the avoidance litigation over the pre-bankruptcy payoff of the junk commercial paper.  In February of this year, a few of the defendants in this protracted litigation (docket here) requested from Goldman all documents relating to Project Truman.  Goldman respectfully declined, arguing that it was irrelevant.  The defendants moved to compel production (joined by the Enron litigation trust).  Goldman objected and the movants replied (as did Enron).

Judge Arthur Gonzalez (a former 13 year veteran schoolteacher in New York's public schools who won the equivalent of the "Bankruptcy Judge Lottery" by having been randomly selected to be the presiding judge -- at the same time -- over the two largest bankruptcies of all time: Enron and Worldcom), took little time to decide this discovery dispute.  Just nine days after about 800 pages in briefs and exhibit attachments had been finally submitted, he issued this ruling granting the motion to compel production, concluding:

light of (1) the discovery posture of this case following a denial of a motion to dismiss and motion to stay discovery; (2) the broad definition of relevance articulated in Fed. R. Civ. P. 26, (3) the overall relevance of the Project Truman materials to the issues of Goldman’s agency and good faith, and (4) the acknowledged lack of burden on Goldman to produce such material, this Court finds that the motion to compel is warranted.

Judge Gonzalez also rejected Goldman’s suggestion for an in camera review of the materials, stating:

Such review is more appropriate in circumstances involving privileged or confidential information. The Court agrees with the Movants that a court’s in camera inspection “is no substitute to full disclosure to, and review of the disputed materials, by a litigant’s counsel, who is best positioned to know the party’s strategy and assess the relevance vel non of the information contained within the disputed materials.

Of course, my theory on why Truman was selected as the nickname for the deal is complete speculation.  But considering that the movie had been released three years earlier, and only two years earlier on video, perhaps the movie was still fresh in the mind of a Goldman deal kingpin looking for a creative--and apt--nickname for the bursting of the greatest financial illusion in corporate history.  Time will tell.

© Steve Jakubowski 2007

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11th Circuit Nicely Tells JT Money, Who Lost Both the Royalties and Copyrights to His Sound Recordings, "You Got F***** in the Industry"

Bankruptcy and restructuring attracts one who yearns to be a "Renaissance Man" because business failure is everywhere and does not discriminate among industries...including, for example, the rap industry.  Indeed, only bankruptcy can prompt one to ask:  "Why were the prices for rap/hip-hop slashed [in Tower Records' bankruptcy sale] vastly more than those of every other genre of music?"

Rap stars, of course, are no strangers to bankruptcy, though generally you won't find their case without knowing "what their mommas named them."  Perhaps the most famous rapper to have gone bankrupt is MC Hammer (a/k/a Stan Burrell), who filed for bankruptcy in 1996 with debts of $14 million, and whose song copyrights were recently sold for $2.7 million.  [Hammer is now a blogger, minister, and proud father!]


Not surprisingly, rappers' bankruptcies are highly contentious, as demonstrated by the long rap sheets (i.e., bankruptcy dockets) in Hammer's never-ending case, and--more recently--in the bankruptcy cases of the legendary Death Row Records and its founder Marion "Suge" Knight, Jr.

But, "what goes around, comes around," as the not-so-old saying goes, even (or especially) in the rap business.  In 1998, Death Row filed a complaint for nondischargeability against Hammer, and obtained a $1.7 million nondischargeabilty judgment against him.  Now, Nathaniel Hale (not the famous spy, but Snoop Dogg's less-but-still famous cousin Nate Dogg), just filed his own multimillion nondischargeability complaint against Death Row's founder, who has clearly seen better days.

This long-winded introduction, however, is just by way of background to the real point of this blog post, which is to recap the 11th circuit's decision this week in Thompkins v. Lil' Joe Records, Inc., 2007 WL 316302 (11th Cir. 2/5/07) (pdf), which can be boiled down to simply this:

A once successful rap recording company (2 Live Crew Luther Campbell's acclaimed Luke Records) enters into a contract with a future rap star (Jeff Thompkins, a/k/a JT Money of Poison Clan) in which JT unconditionally transfers all right, title, and interest in his sound recording copyrights to Luke Records in exchange for a "guaranteed" royalty stream.  Six years later, in 1995, Luke Records is tied up in chapter 11, where it eventually rejects JT's contract and transfers the copyrighted sound recordings to Lil' Joe Records in a "free and clear" bankruptcy sale.

JT subsequently sues Lil' Joe Records for copyright infringement, claiming that rejection of his executory agreement also rescinded Luke Records' ownership of the copyrights.  The 11th Circuit, however, disagreed and held that ownership rights in the copyrighted song recordings did not revert back to JT upon rejection of the executory portions of the transfer agreement.  The 11th Circuit wrote:

[T]he bankruptcy court's Confirmation Order did not effectively rescind the 1989 Agreement and reverse the executed transfer of the Poison Clan Song copyrights to Luke Records.  The rejection had no effect on Luke Records' ownership of the copyrights, and they passed from the estate to Lil' Joe under the terms of the Joint Plan and Confirmation Order....  Accordingly, [JT] cannot support a claim of copyright infringement against Lil' Joe as to the Poison Clan Songs, and we affirm the grant of summary judgment on that claim in favor of Lil' Joe.

In other words, to quote the rap group Souls of Mischief, "You got f**ked in the industry!"

2/8/07 UpdateBe sure to check out Bob Eisenbach's follow up to this post where he analyzes how novice IP holders can avoid getting f**ked in the industry as poor JT Money just did.

2/22/07 UpdateFor those more interested in IP issues in bankruptcy, here are two presentations I'm delivering at this scheduled event of the Licensing Executive Society Winter 2007 Meeting in San Francisco:

  • IP Licensing & BankruptcyAn Issue Spotting Checklist for Analyzing Questions Regarding Assumption, Rejection, and/or Assignment of IP Licenses in Bankruptcy

                -   and  -

© Steve Jakubowski 2007

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The Student Finance Corp. Debacle: Pepper Hamilton's Court Retort

Back from my blogging vacation, during which I instead devoted significant chunks of spare time to bringing current a project I started in 2004 -- that of electronically sorting cases, articles, and news stories from the past 3-5 years (now numbering about 10,000) into various topical e-folders in MS-Outlook, thus putting my entire precedent file literally at my fingertips.  The quantum leaps in productivity from technology never cease to amaze me!  What in the early 90's absorbed the full-time efforts of two paralegals to assemble and maintain and entire banks of cabinets on high-rent office floors to store, today can be compiled, archived, and retrieved by me alone from the comfort of wherever I'm sitting in 1/50th the time it once took.  Remember the sea-change effected not that long ago by the fax, prompting many a young lawyer to ask "what did people ever do without a fax?"  How incredibly fast the world has changed!  Hopefully, however, Stephen Hawking and his scientist friends are wrong and all this rapid change doesn't spell our swift destruction!

Anyway, being nearly done with that project -- for now -- it's back to blogging.  Lots of interesting case developments have passed through my porous sieve, but it's hard to pass up commenting on today's salacious front page story in the Wall Street Journal (referenced here) about the collapse of Student Finance Corp. (SFC) and the actions of its counsel, Pepper Hamilton (and partner W. Roderick Gagne in particular).

Most of the article's central allegations regarding Pepper Hamilton's culpability rest upon the allegations made in the trustee's 67 page, first amended complaint.  In its 12/22/05 ruling on Pepper Hamilton's motion to dismiss, however, the Court tossed most of the trustee's more attenuated claims against Pepper Hamilton (such as deepening insolvency, negligent misrepresentation, and aiding and abetting breach of fiduciary duty), while leaving intact the trustee's primary causes of action for breach of fiduciary duty and professional malpractice.  Stanziale v. Pepper Hamilton, et. al. (In re Student Finance Corp.), 335 B.R. 539 (D. Del. 2005) (pdf).

The WSJ article concludes that "Pepper Hamilton's own day in court against the bankruptcy [trustee] ... is scheduled for October."  In fact, however, if Pepper Hamilton's latest arguments to the Court succeed, there will be no day in Court for Pepper Hamilton (or if there is, it'll be a short day), since the guts of the trustee's complaint will have been eviscerated and there will be little of real substance left to litigate!

What is it that led to Pepper Hamilton's surge of optimism?  None other than the Third Circuit's recent decision (reviewed at length here) in Seitz v. Detweiler, Hershey & Assocs., P.C. (In re CitX Corp.), 448 F.3d 672 (3d Cir. 5/26/06) (pdf), which (as noted here) arguably went farther than it needed to by "hold[ing], unnecessarily, that deepening insolvency is not a valid theory of damages for other independent torts." 

Pepper Hamilton picked up on this theme that CitX (or Seitz) should be broadly construed to apply to other independent torts and within weeks of the decision filed this "omnibus brief" in support of its motion for judgment on the pleadings.  In it, Pepper Hamilton advanced the following argument:

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7th Circuit's KO's Retired Pilots' Objection to UAL's Confirmed Reorganization Plan

As predicted here, Judge Posner sealed the fate of UAL’s retired pilots by rejecting their challenge to UAL’s confirmed plan (and thanks to How Appealing’s Howard Bashman for his post declaring this blog's prediction "correct" following issuance of the opinion). In re UAL Corp., No. 06-2780 (7th Cir. 10/25/06) (pdf / WL). 

Along the way, Judge Posner made the following observations that bankruptcy practitioners should find of interest:

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"A Pox On Both Your Houses": NY's Judge Stan Bernstein Next Tosses Plaintiff's Business Valuation Expert in Another "Must Read" Decision

Last December, I reported here on NY Bankruptcy Judge Stan Bernstein's "must read" opinion in Chartwell Litigation Trust v. Addus Healthcare, Inc. (In re Med Diversified, Inc.), 334 B.R. 89 (Bankr. E.D.N.Y. 2005) (pdf), in which he barred the defendants' valuation expert, Scott Peltz, from testifying in a $7.5 million fraudulent transfer case, finding both that Mr. Peltz failed to qualify as a business valuation expert and that his testimony was unreliable "because he did not employ the same level of intellectual rigor that characterizes the practice of an expert in the field of business valuation."

With no one left to rebut the plaintiff's proposed valuation expert, one would have expected that the post-confirmation litigation trust would be laughing all the way to the bank, but last week, in this written opinion, Judge Bernstein put a pox on the plaintiff's house by equally ripping the plaintiff's expert, Robert Cimasi, and finding that his testimony and report also were "fundamentally unreliable."  Chartwell Litigation Trust v. Addus Healthcare, Inc. (In re Med Diversified, Inc.), 2006 WL 2242288 (Bankr. E.D.N.Y. 8/2/06).  In reaching this conclusion, Judge Bernstein pulled no punches, writing:

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More Questions from the 3rd Circuit's Recent "Deepening Insolvency" Decision

Last month, in a post entitled "Deepening Insolvency: The Third Circuit Steps Back from the Breach," I discussed the Third Circuit's recent decision in CitX Corp., Inc. v. Detweiler, Hershey & Assocs., P.C., 2006 WL 1453117 (3d Cir. 5/26/06) (pdf), in which the Court delivered two bombshells:  the first, that negligence alone will not establish liability for deepening insolvency; the second, that deepening insovlency is not a valid theory of damages to support a negligence claim.

Most bombshells raise many questions in their aftermath, and this case is no different.  Yesterday, the Andrews Bankruptcy Litigation Reporter published an article entitled "Deepening Insolvency or Deepening Confusion?" (Westlaw only), co-authored by Jenner & Block's Ron Peterson, Jerry Switzer, and Phil Nelson.  

The article reviews the history of deepening insolvency and the decision itself, and finishes by mentioning a few of the "unanswered questions" raised by the decision, including:

  • "Is a deepening insolvency cause of action the only claim a plaintiff may bring for harm to an already-insolvent company? Surely the 3d Circuit did not intend this result."  

     

  • "As [In re] Global [Service Group, LLC, 316 B.R. 451 (Bankr. S.D.N.Y. 2004)] suggests, when, if ever, will a defendant have deepened a company's insolvency without committing some other intentional tort or breaching an independent fiduciary duty?"  

     

  • "If a plaintiff brings claims for fraud and breach of fiduciary duty in addition to a deepening insolvency claim, what is the proper measure of damages for these causes of action if not the deepening of the corporation's insolvency?"  

     

  • "Must a plaintiff show two different (and presumably conflicting) measures of its damages, one for the deepening insolvency cause of action and one for all other claims? Surely that cannot be the case, but CitX suggests otherwise."

In the end, the authors conclude, "it appears that CitX went too far."  They write:

If the 3d Circuit was intent on holding that mere negligence is not the proper basis for a deepening insolvency claim, it should have stopped there. By going farther to hold, unnecessarily, that deepening insolvency is not a valid theory of damages for other independent torts, the 3d Circuit has created an unworkable situation that simply deepens the confusion regarding deepening insolvency.

© Steve Jakubowski 2006

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Deepening Insolvency: The Third Circuit Steps Back from the Breach

At my alma mater's faculty blog, my friend and former classmate, Professor Bob Rasmussen, writes about a business's "Prime Directive"; that is, "first hire the right person as CEO, [then] ensure that the CEO is shown the door at the appropriate time."  Bob concludes his post by noting that "law can influence the discussion. Doctrines such as lender liability, equitable subordination, and the tort of deepening insolvency, if pushed too far, can make lenders hestitate, thus prolonging the tenure of managers that need to go."

Speaking of "pushing too far," consider the highly controversial case of Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001) (pdf), in which the Third Circuit -- "predicting Pennsylvania law" -- declared that deepening insolvency is a separate and independent tort in Pennsylvania and that the resultant "injury" from this tort is "to [a debtor's] corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life."   

In Seitz v. Detweiler, Hershey & Assocs., P.C. (In re CitX, Inc.), 2006 WL 1453117 (3d Cir. 5/26/06) (pdf), the Third Circuit pushed back in a follow up to its much-maligned opinion in Lafferty.  In CitX, the Third Circuit commented on the controversy spawned by Lafferty, stating (at footnote 11):

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Chicago's Judge Susan Sonderby Issues a Wide-Ranging Opinion Upholding Kmart's Attempt to Recover Now Discredited "Critical Vendor" Payments

Once upon a time, bankruptcy courts -- like the one overseeing Kmart's chapter 11 case in late 2002 -- routinely entered orders (like these) granting the debtor "open-ended permission to pay any debt to any vendor deemed 'critical' in the exercise of unilateral discretion, provided that the vendor agreed to furnish goods on 'customary trade terms' for the next [several] years."

This preference of one creditor group over another (in Kmart's case amounting to over $300 million in preferential postpetition payments to about 2330 so-called "critical" vendors) irked one small band of excluded vendors and creditors enough that they appealed the bankruptcy court's decision...and won! In re Kmart Corp., 359 F.2d 866 (7th Cir. 2004) (pdf).

In striking down these payments, the 7th Circuit's Judge Easterbrook took direct aim at the use of Bankruptcy Code section 105(a) (which allows a bankruptcy to "issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of" the Bankruptcy Code) to justify such preferential payments through incorporation of the old "necessity" doctrine. He wrote:

[Bankruptcy Code section 105] does not create discretion to set aside the Code's rules about priority and distribution; the power conferred by § 105(a) is one to implement rather than override. Every circuit that has considered the question has held that this statute does not allow a bankruptcy judge to authorize full payment of any unsecured debt, unless all unsecured creditors in the class are paid in full. We agree with this view of § 105. "The fact that a [bankruptcy] proceeding is equitable does not give the judge a free-floating discretion to redistribute rights in accordance with his personal views of justice and fairness, however enlightened those views may be." [Citation omitted.]


A "doctrine of necessity" is just a fancy name for a power to depart from the Code. Although courts in the days before bankruptcy law was codified wielded power to reorder priorities and pay particular creditors in the name of "necessity"-today it is the Code rather than the norms of nineteenth century railroad reorganizations that must prevail. [Those court decisions] predate the first general effort at codification, the Bankruptcy Act of 1898. Today the Bankruptcy Code of 1978 supplies the rules. Congress did not in terms scuttle old common-law doctrines, because it did not need to; the Act curtailed, and then the Code replaced, the entire apparatus. Answers to contemporary issues must be found within the Code (or legislative halls). Older doctrines may survive as glosses on ambiguous language enacted in 1978 or later, but not as freestanding entitlements to trump the text. (Citations omitted)

Even before the 7th Circuit issued its decision upholding the district court's reversal (pdf) of Judge Sonderby's "first-day" order approving the "critical vendor" payments, Kmart filed a host of short, nearly identical two-count complaints (like this) against hundreds of entities that received the challenged payments. Count I of these complaints sought avoidance of the payments under Code sections 549 (dealing with avoidable postpetition transfers) and 550. Alternatively, Count II sought recovery under Section 105, the bankruptcy lawyer's refuge of last resort.

In a wide-ranging, 62 page unpublished opinion, Judge Sonderby denied the creditors' motion to dismiss Count I, but granted the motion to dismiss Count II. In so doing, the opinion --

  • details the complex procedural history of the case, including the quick thinking employed by the litigants when the district court's bombshell reversal came down a mere two days before the start of Kmart's confirmation hearing (pp. 2-13);
  • rejects the movants' "plain meaning" arguments that recovery should be denied under Code section 549 because the Court had previously authorized such payments (pp. 13-24);
  • notes the banishment by the 7th Circuit of the term "equitable mootness" from the local lexicon (pp. 20-21);
  • dissects when a "private right of action" arises in the bankruptcy context (such as "in connection with alleged violations of the discharge injunction and the filing of inflated secured claims"), and concludes that no such "separate and independent action exists under §105(a)" (pp. 24-33);
  • reviews at length the doctrine of judicial estoppel and its inapplicability to this case, finding not only that Kmart was not "exploiting" the 7th Circuit's reversal of the critical vendor order, but that "application of the doctrine under the circumstances of this case would itself amount to [] a perversion [of the doctrine of judicial estoppel]" (pp. 33-48);
  • affirms the adequacy of provisions in the confirmed plan purporting to retain these avoidance actions, even though the pre-confirmation plan modifications were made without attempting to resolicit votes on the plan (pp. 48-58);
  • and

  • punts the remaining arguments, including detrimental reliance, equitable estoppel, and recoupment, as "fact-intensive defenses inappropriate for disposition at this time" (pp. 58-61).

Judge Sonderby obviously has long ruminated about the mess spawned by the reversal of her "critical vendor" order. Now, in an unpublished decision, she has given us much to ruminate about too.

© Steve Jakubowski 2006

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Illinois Bankruptcy Court Denies Trustee's Attempt to Exercise Control Over Nondebtor Corporation's Assets

Jonathan Alper of the Florida Bankruptcy Law Blog considers here the following situation involving an individual chapter 7 debtor client where the bankruptcy trustee sought to control the business in which the debtor was the sole shareholder:

The debtor's assets included 100% of the stock in an operating business with assets including real property. The question arose concerning the debtor's operation of the business after filing personal bankruptcy. Since the debtor's stock is part of the bankruptcy estate, does the trustee by virtue of owning all the stock assume control of the business? Or, can the debtor as president of the business operate the business including disposing of business assets after filing? In this case, the trustee took the position that the debtor's bankruptcy did not act as a stay against business operations.

Similar questions were addressed this week by Judge Mary P. Gorman of the Bankruptcy Court for the Central District of Illinois in Swartz v. Billingsly (In re Billingsley), 2006 WL 538437 (Bankr. C.D. Ill., 3/6/2006) (pdf). The difference between the situation facing Judge Gorman and that posited by Jonathan is that in Judge Gorman's case, the debtor only owned 50% of the non-debtor corporation's stock, whereas in Jonathan's example, the debtor owned 100% of the non-debtor's stock.

This difference is significant because when the trustee is the sole shareholder, it should have the freedom to run the non-debtor corporation as it pleases (subject to compliance with state law corporate formalities). Conversely, when the trustee controls 50% or less of the non-debtor's equity, significant decisions involving the non-debtor would require the consent of other equity participants, and thus the trustee could not make unilateral decisions regarding the non-debtor corporation's affairs.

Here's what Judge Gorman said:

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Judge Leif Clark Cites to Adam Sandler's "Billy Madison" in Dismissing Pro Se Defendant's Convoluted Motion

In an article entitled A Matter of Style, 19-SEP Am. Bankr. Inst. J. 32 (2000), San Antonio's Bankruptcy Judge Leif M. Clark wrote these noteworthy remarks:

A lawyer is more than a mouthpiece, more than an agent, more than a mere compendium of legal truths. A lawyer is more than a mere translator of a client's desires. A lawyer is representative not just of the client's interests, but in some ways the embodiment of the client. It is for that reason that a lawyer's style is more than just stylistic. How a lawyer comes off in court can all too often dramatically affect the perception the judge is likely to develop of both the client and the merits of the client's position in a case. In short, style matters. Some styles work better than others, of course. Every judge has their favorite style, as well as styles that rub them the wrong way. (Emphasis added).

So what does Judge Clark do when someone's style REALLY rubs him the wrong way? He calls him the bankruptcy equivalent of Adam Sandler in the movie Billy Madison, and writes this:

Before the court is a motion entitled "Defendant's Motion to Discharge Response to Plaintiff's Response to Defendant's Response Opposing Objection to Discharge." As background, this adversary was commenced on December 14, 2005 with the filing of the plaintiff's complaint objecting to the debtor's discharge. Defendant answered the complaint on January 12, 2006. Plaintiff responded to the Defendant's answer on January 26, 2006. On February 3, 2006, Defendant filed the above entitled motion. The court.cannot determine the substance, if any, of the Defendant's legal argument, nor can the court even ascertain the relief that the Defendant is requesting. The Defendant's motion is accordingly denied for being incomprehensible. [FN 1]
[FN 1] Or, in the words of the competition judge to Adam Sandler's title character in the movie, "Billy Madison", after Billy Madison had responded to a question with an answer that sounded superficially reasonable but lacked any substance,
Mr. Madison, what you've just said is one of the most insanely idiotic things I've ever heard. At no point in your rambling, incoherent response was there anything that could even be considered a rational thought. Everyone in this room is now dumber for having listened to it. I award you no points, and may God have mercy on your soul.
Deciphering motions like the one presented here wastes valuable chamber staff time, and invites this sort of footnote.

I'm sure many judges have often felt that litigants (pro se or not) deserve to be thrashed as Adam Sandler was in Billy Madison. I suspect, however, that judges are more often inclined to invoke that most famous of movie lines, "Frankly, my dear, I don't give a damn."

Special thanks to an anonymous donor for the tip to Judge Clark's ruling.

[NB: Judge Clark was one of the first to rip BAPCPA's anti-consumer protection provisions when he penned an article in 2003 entitled Things Change, 22-MAY Am. Bankr. Inst. J. 40 (2003). He said:

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New York Bankruptcy Court Finds No Post-Confirmation Jurisdiction Exists to Support Reorganized Debtor's Case Against Penthouse Magazine Founder

The case of Penthouse Media Group v. Guccione (In re General Media, Inc.), 2005 WL 3529148 (Bankr. S.D.N.Y., 12/27/05), involves an adversary proceeding filed by the reorganized debtor against Bob Guccione, the debtor's former Chairman and CEO. Mr. Guccione is best known for having founded Penthouse Magazine, as well as such quality, trend-setting publications as Spin Magazine and Omni Magazine. Unquestionably, however, his absolutely worst legacy shall always be the movie Caligula, which cost a whopping $20 million in 1979 and is often cited, to this day, as possibly the worst film ever made.

For me, the case has special sentimental value because 25 years ago, while cooling my heels in New York City between college and law school, I spent two hours a week as private tutor to Mr. Guccione's youngest son at Mr. Guccione's very posh E. 67th Street townhouse (reportedly NY's largest residence), which was at the heart of the dispute in this case.

Anyway, in this case, the reorganized debtor filed a five count complaint against Mr. Guccione. The first three counts sought turnover of certain intellectual property, as well as 10 unnamed items of property still in the townhouse, which he was now renting from a third-party owner. The final two counts alleged conversion and breach of fiduciary duty for a certain transaction involving possible self-dealing. [NB: In fact, the 10 items likely were imported statutes and other antiques or antiquities of immense weight and value, as to which there were pre-confirmation disputes over whether the items were fixtures of personal property under applicable non-bankruptcy law. Imagine, though, what fun David Letterman would have with this "top ten" list!]

Guccione moved to dismiss for lack of subject matter jurisdiction and for failure to state a claim on which relief can be granted. The Court summarized the positions of the parties on these issues as follows:

Guccione argues, in the main, that the Court lacks subject matter jurisdiction. In addition, he contends that a turnover action will not lie post-confirmation because there is no trustee and no estate. Next, he maintains that the Plan released him from liability based on pre-petition conduct other than conduct that was fraudulent, willful or grossly negligent. Finally, he asserts that the plaintiff should be estopped from asserting the claims because they were not raised during the bankruptcy case or disclosed to the creditors, and the plaintiff procured Guccione's support for confirmation without disclosing its intention to bring this action.


The plaintiff counters that (1) the Court retained jurisdiction over these claims in the Plan, (2) the plaintiff acquired the right to pursue these claims as consideration for PET's funding of the Plan, and (3) the turnover claims were preserved under the Plan. Furthermore, the Townhouse Property was the subject of a prior Court order, which the First Cause of Action seeks to enforce. Lastly, some of the damage claims are clearly within the statute of limitations, and the release defense, which excludes intentional wrongs, cannot be decided on a motion to dismiss.

In dismissing the action based on lack of subject matter jurisdiction, the Court noted that "a party invoking the bankruptcy court's post-confirmation jurisdiction must satisfy two requirements":

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Judge Posner's "Dictum" on "Dicta"

A popular method of distinguishing a case that contains harmful reasoning is to call it "mere dicta." In Tate v. Showboat Marina Casino Partnership, 05-1681 (7th Cir., 12/13/05), Judge Richard Posner ponders exactly what "dicta" (or, better put, "dictum") is. He wrote:

The plaintiffs call the statements in Harkins that we quoted merely "dicta"�that is, things the court said, not what it held; and only what a court holds is binding (within the limits of stare decisis, discussed below) in subsequent cases. But what does "dictum" (the singular of "dicta," the two words being used interchangeably by most opinion writers these days) mean exactly? There are two principal contenders. The first�that dictum is anything besides the facts and the outcome�is unacceptable; as a practical matter, it would erase stare decisis because two cases rarely have identical facts. Michael Dorf, "Dicta and Article III," 142 U. Pa. L. Rev. 1997, 2035-37, 2067 (1994). But Harkins and this case do have identical facts; so even if "dictum" were construed so broadly, these plaintiffs would be out of luck.


The sensible alternative interpretation is that the holding of a case includes, besides the facts and the outcome, the reasoning essential to that outcome. Henry J. Friendly, "In Praise of Erie�and of the New Federal Common Law," 39 N.Y.U.L. Rev. 383, 385-86 (1964) ("a court's stated and, on its view, necessary basis for deciding does not become dictum because a critic would have decided on another basis").

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Enron's Retention Bonuses Avoided by Texas Court as Preferential Transfers and Intentional and Constructive Fraudulent Transfers

Thanks to Tom Kirkendall for his post on his Houston's Clear Thinkers blog to a 102 page opinion (available here also) issued by Dallas' Bankruptcy Judge Robert McGuire in a case that challenged the grant (and funding) of over $100 million in retention bonuses to approximately 300 highly-coveted energy traders and related management employees on the eve of Enron's bankruptcy filing in December 2001.

Tom K. says that BAPCPA's "recent amendments to the Bankruptcy Code limit the precedential value of the decision [because] [u]nder those amendments, pre-petition retention bonuses to key employees are now presumed to be voidable transfers and are expressly subject to Bankruptcy Court approval even if made prior to the commencement of a bankruptcy case." Let me add two qualifications to this comment:

First, while Tom K. is right that Bankruptcy Court approval is now needed for all proposed postpetition payments of retention bonuses (even if the bonuses were authorized prepetition), BAPCPA's amendments to new Code Section 548(a)(1)(B)(ii)(IV) do not presume that prepetition retention bonuses payments are voidable. Rather, such payments are voidable under the new Code section only to the extent that (i) the debtor "received less than a reasonably equivalent value in exchange," and (ii) the transfers were made to "an insider," "under an employment contract," and "not in the ordinary course of business." Notably, the new law does not appear to shift the burden of proof, which remains with the plaintiff/trustee as to all elements.


Second, the case has significant precedential value for a bankruptcy litigator because of the Court's analysis (often extensive) of such bread and butter issues for a bankruptcy litigator as:

  • when an "antecedent debt" arises for preference purposes (pp. 38-43);
  • whether the "new value" defense applies (pp. 43-48);
  • whether the "ordinary course" defense applies to the preference action [N.B.: discussion of what constitutes "ordinary course" for purposes of an affirmative defense to a preference action may well become the standard in future litigation under new Code section 548(a)(1)(B)(ii)(IV) regarding whether a prepetition payment under an employee contract was in the "ordinary course"] (p.48);
  • whether the debtor "was insolvent" at the time of the transfer (both from a "balance sheet" and "equitable" perspective and from a "going concern" vs. "liquidation" perspective) (pp. 48-79);
  • whether, applying the doctrine of Moore v. Bay (the case I love to hate), there existed at least one pre-existing creditor with standing to avoid the transaction (pp. 82-84);
  • whether the bonuses, being on the eve of bankruptcy, were intentional fraudulent transfers (pp. 86-88);
  • whether the bonuses were accepted for value and in good faith under Code section 548(c) (pp. 89-94);
  • whether "reasonably equivalent" value was given in exchange (pp. 94-97).

This matter was initiated by the "Official Employment-Related Issues Committee of Enron Corporation (the "Employment Committee"), an official committee formed by the US Trustee in Enron's bankruptcy case primarily to investigate these challenged payments and to commence avoidance litigation regarding them, as appropriate. Initially, over 300 defendants were sued, 40 of whom went to trial to defend their right to the bonuses (several of whom, the record suggests, apparently were unaware of the saying that "one who represents himself has a fool for a client and an idiot for a lawyer").

With extensive references to the voluminous record (which included over 1,000 documentary exhibits), Judge McGuire methodically ruled that:

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7th Circuit Denies Secured Lenders' Request to Unscramble a Court-Approved Settlement that Rejected an Executory Contract Instead of Abandoning It to the Lenders

The Seventh Circuit has just issued a short, important decision in a case in which a chapter 11 debtor's secured creditors challenged the right of the chapter 11 trustee to settle an executory contract dispute with the contracting party instead of abandoning the debtor's rights under the contract to them. In re Resource Technology Corp., 2005 WL 3336525 (7th Cir., 12/9/05).

In this case, the debtor had entered into a prepetition agreement with a party (Chastang) to build a gas collections system for collecting methane gas from landfills. The contract was the subject of three successive adversary proceedings, with the final result being a settlement between the Chastang and the trustee whereby the Chastang would release the debtor/trustee from its executory obligations, forgive a promissory note, release any damage claims, and pay $75,000 in exchange. For its part, the trustee would release the debtor's rights under the contract to complete the gas collection system and collect the methane gas.

The debtor's principal secured creditors, holding $40 million in debt secured by a floating lien on the debtor's assets, objected to the settlement, offering to pay the estate $200,000 and release $2 million in debt in exchange for the debtor's contract rights. The trustee preferred this deal, and asked the bankruptcy court to permit it to abandon the contract rights to the lenders, who claimed a security interest in all the debtor's contract rights.

Judge Wedoff, Chief Judge for the Bankruptcy Court for the Northern District of Illinois, however, concluded that an executory contract cannot be abandoned under 11 U.S.C. § 554, and that the trustee could only assume or reject the contract 11 U.S.C. § 365. Further, Judge Wedoff held, once the contract has been assumed (as was the case here), the debtor's only options are to perform under the contract, or to breach. According to Judge Wedoff, "[a]bandonment would just break the debtor's promise and support a claim for damages; it could not transfer Resource Technology's rights to the lenders." Thus, Judge Wedoff approved the settlement with the Chastang and the district court affirmed. In re Resource Technology Corp., 2005 WL 2588860 (N.D. Ill., 3/18/05).

In affirming the lower courts' rulings, the 7th Circuit touched upon a number of important concepts that bankruptcy practitioners regularly consider. For starters, the Court addressed the ever-present issue of mootness in bankruptcy. Here, the lower courts denied all requests for a stay pending appeal, thus resulting in consummation of the settlement and a third party's assumption of the debtor's contract responsibilities for completion of the system and collection of gas. Notably, the 7th Circuit held that these changed circumstances did not moot the lenders' appeal. Judge Easterbrook, who delivered the opinion of the Court's panel that included fellow University of Chicago law professors Judge Richard Posner and Judge Diane Wood, wrote:

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Moore v. Bay Nearly Sinks Campbell Soup in Fraudulent Transfer Litigation Challenging the 1998 Vlasic Spinoff

Back in 1998, Campbell Soup spun-off its Vlasic Foods and other "specialty" (i.e., "dog") businesses to its shareholders. Campbell also transferred a $500 million debt obligation to the spun-off entity (VFI). The spun-off entity didn't perform too well thereafter, and filed for bankruptcy nearly three years later. A post-confirmation litigation trust (VFB) was created to pursue fraudulent transfer claims against Campbell. Nearly 96% of the VFB creditor interests arose from a $200 unsecured debenture offering fifteen months after the spin-off. Another VFB creditor interest was VFI's landlord, who had a $1.66 million claim. Significantly, Campbell entered into this lease before the spin-off and VFI assumed it on the date of the spin-off. The rest of the creditors were small trade creditors.

On September 13, 2005, Judge Jordan from the United States District Court for the District of Delaware, issued this 74 page post-trial memorandum (parts 1, 2, and 3 here) containing its findings of fact and conclusions of law. In the end, the Court found that Campbell's encumbering VFI with over $500 million in debt at the time of the spin-off did not constitute a constructive fraudulent transfer.

Students of bankruptcy litigation will learn much from delving into the details of this litigation, which pitted a litigation team from Andrews & Kurth led by John Lee against a litigation team from Wachtell Lipton led by Mike Schwartz. The amended complaint (which sought more than $500 million from Campbell), the entire nearly 4,900 page trial transcript (encompassing 10 days of fact witness testimony in March 2005 and 5 days of expert witness testimony in August 2005), and all post-trial submissions are available here.

The Court's decision denying relief to the VFB litigation trust received little attention, and didn't even earn a slip copy citation in the West Reporter System (though West did just report Judge Jordan's decision denying VFB's motion for a new trial [at 2005 WL 3293039] and the decision of a NJ appellate court upholding a decision that Campbell Soup's insurer was not required to defend or indemnify Campbell in connection with the VFB litigation [at 885 A.2d 465]).

What's also interesting about this case is how VFB almost avoided a $500 million transaction because its trustee could step into the shoes of a single remaining creditor (the corporate landlord owed only $1.66 million) whose claim was in existence at the time of the spin-off transaction in 1998. Under Moore v. Bay, this trustee standing in the shoes of this single creditor could accomplish in bankruptcy what all the creditors combined could not do outside of bankruptcy: that is, avoid the entire transaction by proving that VFI was rendered insolvent by the transaction.

As to this point, the Court matter of factly made the following conclusions of law (see Opinion pt. 2, at pp. 45-46):

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NY Bankruptcy Judge Stan Bernstein Tosses Expert's Business Valuation Opinion in a "Must Read" Decision

Self-proclaimed "true" (i.e., non-bankruptcy) litigators who find themselves having to litigate in bankruptcy's free-wheeling arena often lament that "nothing's inadmissible in bankruptcy; everything just goes to the weight of the evidence." Obviously, this is a tremendous over-simplification, and Judge Barry Russell's 1,800 page manifesto, the Bankruptcy Evidence Manual (2005 ed., Thomson/West), is a testament to the fact that everything is clearly not admissible in bankruptcy.

Still, one has to sit up and take note when Judge Stan Bernstein from the Eastern District of New York, in Chartwell Litigation Trust v. Addus Healthcare, Inc. (In re Med Diversified, Inc.), 2005 WL 3077228 (Bankr. E.D.N.Y., 11/14/05), not only bars an expert from testifying in a high-stakes fraudulent transfer case, but adds:

Since this particular issue has not been discussed by any other bankruptcy court, this Court has taken the pains to present a comprehensive analysis of the gatekeeper function in the hope that it may be useful to other bankruptcy judges, the business bankruptcy bar, and, tangentially, the bankruptcy law professoriat.

The Court described the "narrow issue" under submission as whether, in litigation to recover an alleged $7.5 million constructive fraudulent transfer, "the Defendants' proposed expert witness, Scott P. Peltz (Peltz) is qualified and whether his purported expertise satisfies the standards of relevance and reliability under Daubert."

The subject matter of his testimony was "the value of 100% of the shares of the defendant, Addus Healthcare, Inc. (Addus)," a privately held healthcare concern, and "the reasonably equivalent value of an alleged option payment of $7.5 million paid by the Plaintiffs' predecessor in interest, Med Diversified, Inc. (Med D), for a 6 1/2 month extension to close its purchase of these shares."

Mr. Peltz was the Defendants' sole expert on all issues of business valuation. After three full days of intense voir dire on his qualifications, the Court barred his testimony and report and issued a lengthy opinion explaining its reasoning, significant portions of which are set forth below. Obviously, not a good day for the defense.

For anyone interested in bankruptcy litigation, and particularly in issues of business valuation (which invariably require expert testimony), this case is mandatory reading. The Court wrote:

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DC Bankruptcy Court Rejects Deepening Insolvency Claims as Duplicative, But Allows Other Related Counts in Trustee's Serpentine Complaint Against Debtors' Former D&O's and Lawyers

The Bankruptcy Court for the District of Columbia has released about 16 opinions for publication this year, and five of them have related to the litigation spawned by the Greater Southwest Community Hospital Corp. ("GSCH") bankruptcy. GSCH's bankruptcy case commenced in November 2002, and its reorganization plan was confirmed in April, 2004. Under the plan, the debtor's operations vested in the "Reorganized Debtors," and the debtor's litigation assets vested for the benefit of pre-confirmation creditors in the "DCHC Liquidating Trust" (the "Trust"). Sam J. Alberts was named Trustee, and the Trust was funded with $1 million to cover some of the litigation expense.

Judge Teel, the bankruptcy judge assigned to the case, recently issued a lengthy opinion in the case, Alberts v. Tuft (In re Greater Southeast Community Hospital Corp.), 2005 WL 3036507 (Bankr. D.D.C., 10/31/05), in which he addressed the defendants' Rule 12(b)(6) motion to dismiss for failure to state a claim upon which relief can be granted.

The Court summarized the complaint's allegations as follows:

The Trust alleges that DCHC's former directors and officers (the "D & O Defendants"), with assistance from two law firms (collectively the "Law Firm Defendants"), Epstein Becker & Green P.C. ("Epstein Becker") and Kutak Rock LLP ("Kutak Rock"), negligently and in some instances intentionally drove the Debtors further into debt in furtherance of a Ponzi scheme perpetrated by the Debtors' primary if not sole lender, National Century Financial Enterprises ("NCFE"), and its subsidiary and affiliated lenders (collectively the "NCFE Entities"). It seeks recovery not only for assets actually drained out of the Debtors' estates prior to their bankruptcy filings, but also for the debt accumulated by the Debtors in the years leading up to DCHC's bankruptcy filing--an amount totaling $242 million.

The Trust's Complaint contained a total of twenty-one counts, broken down as follows as to the various defendants:

As Against All Defendants: (A) Deepening insolvency claims (Counts X-XII); (B) Claims as a hypothetical judgment lien creditor under § 544(a) (which, according to the complaint, "permits it to (1) to pursue claims that such creditors would hold for breach of fiduciary duty and (2) garnish or 'seize' the Trust's own claims and prosecute those claims as a creditor rather than as a representative of the estate") (Count XV)


As Against the D&O Defendants: (A) Breach of fiduciary duty (Counts I-V); (B) Corporate waste (Counts V-IX)

As Against the Law Firm Defendants: (A) Aiding and abetting fiduciary duty (Count XIII); (B) Malpractice (Count XIV); (C) Aiding and abetting "deepening insolvency" (Count XI); (D) Fraudulent conveyance (Counts XVI-XXI)

As to the defendants' motion to dismiss, the Court's holdings are summarized as follows:

(1) The Court dismissed the "deepening insolvency" claims (Counts X-XII), stating that they were a mere "re-packaging" of the breach of fiduciary claims with respect to the D&O Defendants and the malpractice claims with respect to the Law Firm Defendants.

(2) The Court further dismissed the Section 544(a) claim (Count XV), stating that "the Trust cannot use § 544(a) to bring claims separate from those of the estate or to constructively "seize" the estate's claim in the guise of a creditor."

(3) The Court dismissed the breach of fiduciary duty claims with respect to the D&O Defendants relating to the NCFE Entities' lending practices (Counts I and I-V), as well as the claims alleging corporate waste (Counts V-VII and IX).

(4) The Court did not dismiss Count VIII with respect to loans made to officers for which no consideration was provided in exchange.

(5) The legal malpractice claim (Count XIV), which challenged the sufficiency of the opinion letters that the Law Firm Defendants prepared, survived the motion to dismiss. The Court stated that the allegations regarding these opinion letters were "far from precise," but that they were sufficient at this stage of litigation to state a claim for malpractice.

(6) Finally, the Court rejected the Law Firm Defendants' res judicata and judicial estoppel arguments, as well as the statute of limitations and in pari delicto affirmative defenses that were common to all Defendants.

Excerpts from the Court's opinion on the Court's dismissal of the "deepening insolvency" and section 544 claims follow:

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10th Circuit Rules that a Professional's Flat Monthly Fee Payments Must Be Reasonable, and that Houlihan Lokey "Isn't a Categorically Superior Financial Firm"

Recently, I pointed to a case where a law firm got tripped up on language in a retention order stating "compensation will be [insert approved terms], or as otherwise may be allowed by the Court upon proper application thereof." See In re Toohey, 2005 WL 2850417 (Bankr. W.D. Ky., 10/27/05).

Along these lines, the 10th Circuit in In re Commercial Financial Services, Inc.,, (2005 WL 274669) (10th Cir., 10/25/05), cut a $1.9 million fee request by Houlihan, Lokey, Howard & Zukin Capital ("Houlihan"). Here, among other things, the Court focused on boilerplate-type language in the retention application stating that Houlihan's fee request would be "[s]ubject to the approval of the court" as well as to "final review by the Bankruptcy court as to the relative fairness" of the proposed fee.

The case provides a rare glimpse into high-stakes contested fee hearings, with the Court noting:

In its brief, Houlihan goes to great pains to distinguish the quality and nature of its work from all of the other financial advisors present in the case in an apparent effort to demonstrate that its employees were of an entirely superior class and should not be compared with the other financial advisors [like DSI, Intecap, Policano, and ABS LLC].... Even if we were to assume Houlihan was more skilled than the other financial advisors in this case, we note the bankruptcy court awarded Houlihan's employees a fee at the "high end" of the pay scale for comparable financial advisors. Houlihan, however, has provided no legitimate basis for concluding it is a categorically superior financial firm.

Significant chunks of the Court's opinion follow for those interested in the juicy details supporting this judicial slam:

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An Insurer's Standing in Mass Tort Bankruptcy Cases: Finding the Right Rule and/or Reaching the Right Result

Bankruptcy Code section 1109(b) gives a "party in interest" the right to raise, and appear and be heard on, any issue in a chapter 11 case. Two recent cases involving insurers of debtors in mass tort asbestos-related bankruptcies came to different conclusions as to whether insurers have standing to object to issues arising in the bankruptcies of their insureds. In In re Congoleum Corp., (2005 WL 2559715) (3d Cir., 10/13/05),the Third Circuit held that a debtor asbestos-manufacturer's insurers had standing to challenge the retention of Gilbert, Heintz & Randolph, LLP as special insurance counsel under Bankruptcy Code section 327(e). Conversely, in In re A.P.I., Inc., (2005 WL 2630662) (Bankr. D. Minn., 10/15/05), the Bankruptcy Court found that the insurers lacked standing to object to confirmation of the debtor-insured's asbestos-related plan because plan confirmation would not have any material collateral impact on pending state court insurance coverage litigation between the insurer and the debtor-insured.

It's not easy to reconcile these two cases: the insurers in Congoleum are granted standing; the insurers in A.P.I. are not. Still, both opinions seemingly yielded the "better" result. In A.P.I., by denying standing to the insurers, 83 thorny objections to the plan were eliminated, thus clearing the way to confirmation. Conversely, in Congoleum, granting the insurers standing enabled them to expose cozy relationships among law firms on opposite sides of the table, thus giving the Third Circuit an opportunity to deliver a stern message regarding professional responsibilities in bankruptcy. Still, the A.P.I. case is so strong for asbestos debtors trying to prevent insurers from gaining standing in bankruptcy that one has to wonder whether this case will lead to Minnesota's bankruptcy court becoming the "Delaware" (i.e., the preferred venue) of asbestos bankruptcies.

Summaries of these two cases follow:

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Avoidance Actions Are All or Nothing, the Fourth Circuit Rules

Many lawyers and clients unfamiliar with the upside-down world of avoidance litigation tend to think that traditional rules of setoff should govern the resolution of avoidance action litigation: "the debtor's entitled to "x"; the creditor's entitled to "y"; net-net...." As the Fourth Circuit reminds us in In re Coleman, (2005 WL 2665798) (4th Cir., 10/20/05), avoidance litigation often starts with a more "all or nothing" approach.

The case reminds me of another classic "all or nothing" type case that often trips people up: Moore v. Bay, 284 U.S. 4 (1931). Unlike today's weighty US Supreme Court opinions, Moore v. Bay is only one page. Apparently that's all Justice Oliver Wendell Holmes (then about 90 and one year from retirement) had the strength to say about the topic. Subject to some important nuances, that case is generally understood to mean that a transfer avoidable by a bankruptcy trustee as to a single creditor (even as to just a nickel), is avoidable to the entire extent of the transaction (even if the transaction is worth millions). This is as inequitable a result as one gets in bankruptcy, and if any bankruptcy case deserves to be reviewed again by the US Supreme Court it's Moore v. Bay, but that's a discussion for another day.

In the Fourth Circuit's Coleman case, a bank initiated foreclosure proceedings against a debtor's home, which was stayed by the debtor's chapter 11 filing on the day before the planned foreclosure sale. The Fourth Circuit described the interesting procedural posture of the case as follows:

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Expert's "Half-Baked" Opinions Thrown Out in Action Against UAL's ESOP Trustee

Summers v. UAL Corporation, et al., (2005 WL 2648670) (N.D. Ill., 10/12/05), pitted the United Airlines ESOP participants against the plan trustee, State Street Bank and Trust Company, among others. In their complaint, the plaintiffs claimed that when UAL's stock prices declined prior to UAL's filing for bankruptcy, the UAL ESOP Committee, State Street Bank (the plan trustee), and others failed to take appropriate action to protect plan assets (e.g., by diversifying the ESOP's stockholdings and shedding UAL shares). All defendants except State Street Bank settled.

Plaintiffs and State Street filed cross-motions for summary judgment, and State Street Bank moved to strike or exclude the opinions and testimony of Plaintiffs' expert witness, Lucian Morrison ("Morrison"), who opined that "UAL's bankruptcy was imminent in October 2001, and that Defendants failed to act prudently by neglecting to sell the UAL stock to protect the interests of the Plan participants." United's bankruptcy imminent in October, 2001? Doesn't sound too unreasonable if you were in the bankruptcy or turnaround business at the time, does it? Now just try and prove it!

In granting State Street's motion to exclude the Morrison's opinion, Judge Deryeghiayan reminded us that "the district court acts as a 'gatekeeper with respect to testimony proffered under Rule 702 to ensure that the testimony is sufficiently reliable to qualify for admission,' " and opined:

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A Bankruptcy Spin on the IPO Allocation Litigation

As people in the oil & gas business know, some wells never go dry. The IPO allocation shareholder litigation, which spawned hundreds of shareholder suits against investment banks who had improperly allocated shares in hot IPO's to favored investors, is one such well that is now yielding tangible benefits for bankruptcy estates. In In re Quintus Corp, (2005 WL 2594600) (Bankr. D. Del. 10/13/05), the Bankruptcy Court for the District of Delaware, recently refused to dismiss a chapter 11 trustee's complaint against Donaldson, Lufkin & Jenrette Securities Corporation. In Quintus, the trustee's complaint alleged that DLJ caused the stock issued in Quintus' 1999 IPO to be underpriced because it was simultaneously allocating the underpriced shares to favored clients who, in exchange, would share part of their profits with DLJ through side agreements. Notably, the Court in Quintus refused to dismiss any counts of the Complaint, which alleged not only breach of fiduciary duty, but also breach of the covenant of good faith and fair dealing, breach of contract, fraud and fraudulent concealment, negligence, and unjust enrichment.

This case represents another recent victory for bankruptcy estates in actions against securities underwriters who underpriced and misallocated an issuer's IPO shares during the high-tech boom of the late 1990's. Recently in EBC I Inc. v. Goldman Sachs & Co., (2005 WL 1346859) (N.Y., 6/7/05), for example, the New York Court of Appeals, in a case of first impression, held that a valid claim for breach of fiduciary duty had been asserted against Goldman Sachs, the lead underwriter in eToys' IPO. There, the Court stated that when Goldman set the IPO price of eToys' stock, it had a duty to advise eToys of conflicts of interest stemming from an alleged scheme that resulted in Goldman netting millions of dollars in kickbacks from clients who had flipped the debtor's discounted stock into the market at a windfall. This case, brought by the Creditors' Committee in the eToys bankruptcy case, is also notable because the New York Court of Appeals held that the complaint failed to state a claim for breach of contract, professional malpractice, or unjust enrichment. As such, unlike the Bankruptcy Court in Quintus, the Court in EBC I narrowed the complaint to a single breach of fiduciary duty count based on Goldman's role as adviser in setting the IPO price, while simultaneously failing to disclose its relationships with clients to whom it had allocated the discounted shares.


© Steve Jakubowski 2005

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Valuing Returned Goods in Preference Litigation: Putting a Bankruptcy Spin on Unspun Yarns

There's plenty of yarns spun in bankruptcy litigation, but rarely do you see one involving a bankrupt yarn spinner. The case of Active Wear, Inc. v. Parkdale Mills, Inc., (2005 WL 2453102) (W.D.Va., 10/4/2005) provides such a tale.

In this case, the defendant provided the debtor with much yarn to be spun into whole cloth. When the debtor could spin no more, and ceased operations, it still had significant quantities of the defendant's unspun yarn in inventory. It also owed the defendant $2 million in unpaid bills. The defendant promptly made a reclamation claim for return of certain unused yarn, the value of which was determined to be $11,428.88. The defendant subsequently picked up all the unused yarn held by the debtor, who reduced the outstanding debt owed to the defendant by $134,849.50.

Within 90 days of the yarn's being reclaimed by the defendant, an involuntary Chapter 7 bankruptcy was filed against the debtor, which was not contested. The debtor subsequently brought a preference action against the defendant seeking to recover as preferential the value of the property transferred within 90 days of the petition date.

The Bankruptcy Court held that the debtor could recover, as a preferential transfer, the liquidation value of certain yarn returned, valued at $27,459.00. On appeal, the debtor argued that the yarn should have been valued at fair market value (or the "price which Parkdale could realize from re-selling the yarn"). The Court held:

Active Wear [the debtor] may be correct that the term "value," in 11 U.S.C. § 550 refers to "fair market value;" however, the appellant's assertion that "fair market value" is determined by the value of the property to the creditor is misplaced. Instead, "fair market value" refers to the value that the debtor/bankrupt could receive for the property in a liquidation sale....


Case law and statutory law demand that the value which must be assigned to the yarn in this case is the fair market value that could be obtained for the yarn in a liquidation sale held by Active Wear. Furthermore, to give Active Wear credit for the fair market value that could be realized by Parkdale after the return of the yarn, would require giving Active Wear the benefit of Parkdale's expense in employing its expertise, time, good will, and advertising to re-sell the yarn to another of its customers. Such a result is not supported by case law, statutory law, or common sense.

It's not clear what would have happened in this case had Active Wear not ceased operations but had remained an operating entity, and whether in such instance the court would have allowed for a "going concern" type valuation of the returned inventory. The stark language of this case, however, doesn't seem to support such a spin.


© Steve Jakubowski 2005

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The Extraterritorial Reach of Avoidance Actions: Still Up in the Air

A recent case from Chicago's bankruptcy court in the Florsheim Group bankruptcy, (2005 WL 2461145) (Bankr. N.D. Ill., 9/30/05), examines the extraterritorial reach of preference actions, in this case against a Taiwanese company that voluntarily contracted with the debtor to deliver goods in the United States, but otherwise had no connection with the US. With the parties wisely stipulating to the relevant facts, resolving certain defenses, and agreeing to the amount of judgment if the debtor should prevail, three related issues remained for resolution by the Court:

© Steve Jakubowski 2005

1) whether the preferential transfers occurred in the United States or abroad;


2) if the transfers occurred abroad, whether Congress intended §§ 547 and 550 of the Bankruptcy Code to apply extraterritorially; and

3) in any event, whether principles of international comity weigh against applying § 547 to the transfers.

After careful review, the court concluded that the preferential transfers occurred primarily in the United States, and that it therefore didn't have to consider the most interesting question--that is, whether Congress intended to apply § 547 extraterritorially. The court concluded that principles of international comity don't apply either since there was no parallel proceeding in any other country that competed with the bankruptcy case, and entered judgment in favor of the debtor in the amount agreed between the parties.

This case is a quick and worthwhile read for those of you involved in preference litigation that raises extraterritoriality concerns.


Steven Jakubowski

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Post-Confirmation Jurisdiction and "New Conseco": A Tale of Two Cases

The bankruptcy court overseeing Conseco's massive bankruptcy case has issued a second opinion addressing the scope of a bankruptcy court's post-confirmation jurisdiction in litigation involving the reorganized - or "New" - Conseco. In its earlier ruling (318 B.R. 425), the court concluded that it did not have jurisdiction over the reorganized debtor's adversary proceeding against the debtor's former officers and directors who had defaulted under Conseco's prepetition loan programs. The court reasoned that bankruptcy's broad "related to" jurisdiction is far more limited following plan confirmation than it is pre-confirmation, and that it "exists primarily to ensure that the plan is implemented and to protect estate assets devoted to implement the confirmed plan."

More recently, the Conseco court held that, despite the fact that "the Seventh Circuit takes the most restrictive view of bankruptcy jurisdiction of any circuit," "related to" jurisdiction existed over an adversary proceeding in which New Conseco sought to enjoin a class action filed in Pennsylvania state court against the reorganized debtor based primarily on contracts that took effect post-confirmation. (2005 WL 2292706). This is because, the court explained, the question of whether the class action violates a discharge injunction is within the "core" jurisdiction of the court.

The existence of post-confirmation jurisdiction in a bankruptcy court is a fact intensive matter that requires careful consideration and planning before the plan is confirmed, not afterwards. And as these cases illustrate, resolution of the question can yield surprising and disappointing results for the losing litigant. Surely New Conseco didn't expect to be precluded from suing its officers and directors for prepetition loan defaults. Nor is it likely that the class action plaintiffs expected to have to defend themselves in the bankruptcy court for asserting claims that arose post-confirmation. Such are the traps that await experienced and unexperienced bankruptcy litigators alike. Caveat Litigator!

© Steve Jakubowski 2005

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When It Comes to Settlements, the Debtor in Possession Makes the Call

Generally, a creditors' committee or individual creditors seek derivative standing to sue when the debtor-in-possession (DIP) refuses to bring suit. Recently, the Second Circuit addressed a "converse situation" of first impression in In re Smart World Technologies, LLC: that is, whether derivative standing is approriate in the Rule 9019 settlement context when the debtor is alleged to be unjustifiably pursuing a claim and/or refusing to settle.

The Second Circuit's opinion provides many important lessons to bankruptcy litigators. One is that the buck apparently stops with the debtor-in-possession when it comes to pursuing and/or settling litigation claims. Another is that zealous advocacy of your client's interests, even when everyone--including the judge--thinks you're a moron, sometimes pays off.

In overturning the decision of the bankruptcy court, the Second Circuit stated:

We conclude that while authority to pursue a Rule 9019 motion may, in certain limited circumstances, be vested in parties to the bankruptcy proceeding other than the debtor-in-possession, those circumstances are not present here.... We do not rule out that in certain, rare cases, unjustifiable behavior by the debtor-in-possession may warrant a settlement over the debtor's objection, but this is not such a case.

In passing, the Second Circuit did not hide it's displeasure at the bankruptcy court's having apparently ruled more on emotion, than on a developed record:

[H]aving searched the record in vain for anything more than a conclusory statement from the bankruptcy court as to the merits of Smart World's claims against Juno, we find it difficult to understand how the lower courts could have formed such a firm opinion that Smart World's claims lacked viability.
At the Rule 9019 hearing, for instance, Smart World's counsel stated "[w]e think Your Honor needs to make a record here, and make findings as to the range of reasonableness as to the settlement." Counsel further offered to provide testimony as to "the factual circumstances underlying the various claims" and a "calculation based on [the witness's] knowledge of the potential value of the claims." The bankruptcy court brushed the offer aside, stating "[t]here's no need for him to do that." Even WorldCom's counsel pointed out to the bankruptcy court that it had not heard Smart World's explanation of its "theory of recoveries, claims and damages," a fact that the court found untroubling....
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Jury Trial Rights: You Snooze, Your Clients Lose

Two recent cases from Delaware (2005 WL 2148563) and Illinois (326 B.R. 116) remind us that a defendant's right to a jury trial in bankruptcy litigation should be timely asserted and periodically affirmed if it is to be preserved at the time of trial. Otherwise, the judge is likely to find that the right has been waived, even absent the defendant's filing of a proof of claim. Don't snooze on this one, or your client will lose.

© Steve Jakubowski 2005

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Estimation Proceedings: Rough Justice in a Rough World

Though they likely occur far less frequently than the drafters of the Bankruptcy Code originally expected, estimation proceedings in bankruptcy are one way to convert uncertainty into certainty.

A recent decision from Delaware's district court in the In re Federal-Mogul Global, Inc., bankruptcy case illustrates how estimation proceedings can swiftly -- and conclusively -- convert uncertainty into certainty, much to the chagrin of the losing parties who had toiled for years in complex litigation. The need to estimate the foreign asbestos claims arose because of a conflict between the plan's proponents and a committee representing the interests of approximately 3,200 municipalities, school districts, hospitals, businesses, and individuals who owned and operated buildings where asbestos products manufactured by the debtor's non-US subsidiaries were installed, and who had filed proofs of claim for damages in the debtor's US bankruptcy case.

The Court noted the importance in bankruptcy of reducing uncertain claims to certainty, however rough that justice may be. Without much ado, the Judge fixed total liability at $9 billion, and with one decisive blow, resolved decades of potential litigation against the debtor, to the sure dismay of not only the defendants whose claims would be significantly diluted, but the many asbestos lawyers for the defense whose gravy train would soon be coming to an end.

An interesting sidenote from a procedural perspective is that -- surprisingly given the magnitude of the claims involved -- neither the Debtors, nor any of the Official Committees in the Chapter 11 proceeding, nor the administrators appointed in the Debtors' United Kingdom insolvency proceedings, nor the trustees for the T&N Pension Trustees, nor any other U.S. or U.K. creditor made an appearance at the estimation hearing. Instead, the need for estimation of the foreign asbestos claims was precipitated by the conflict between the reorganization plan's proponents and the committee representing the approximately 3,200 British municipalities and agencies. In essence, the parties who did not appear at the estimation hearing did not have a dog in the fight (though that generally never stops bankruptcy shops from sending SWAT teams in anyway to observe). Perhaps they shunned the hearing under the theory that nothing good can come from their attendance (particularly on res judicata or issue preclusion grounds) and that prudence, therefore, is the better part of valor.

In deciding that estimation was clearly appropriate in resolving this dispute between competing claimants to a limited fund, the Court explained (citations omitted):

Estimation helps the court "avoid the need to await the resolution of outside lawsuits to determine issues of liability or amount owed by means of anticipating and estimating the likely outcome of these actions." The Bankruptcy Code [in section 502(c)] states that estimation is necessary when liquidation outside of bankruptcy would unduly delay the administration of the case. The object of such a proceeding is to establish the estimated value of a creditor's claim for purposes of formulating a reorganization plan. Although courts have disagreed about whether estimation is mandatory or permissive, it is apparent that the Bankruptcy Code requires an estimation in order to prevent undue delay in the administration of the estate. It is undisputed that the Personal Injury Claims are contingent and unliquidated, and that liquidation of each claim by a trial would unduly delay the administration of these cases. Moreover, the parties are attempting a plan for reorganization; thus, in accordance with the underlying principles in bankruptcy of promoting the quick and efficient administration of the estate, the estimation of the aggregate allowable amount on all United States and United Kingdom pending and future asbestos claims will be determined by this Court.
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Waxing Eloquently over a "Scorched Earth"

Bankruptcy litigation is generally no lovefest, but few cases are so vicious that they spur Judges to include famous quotes commenting on the perniciousness of base hatred, vengence, resentment, delusion, lies, and "scorched earth" litigation. In In re Nartron, the Honorable Jo Ann Stevenson, Chief Judge of the Bankruptcy Court for the Western District of Michigan, combined each subheading of her findings of fact and conclusions of law with apt quotes on the human condition.

The Beginning: "Mighty things from small beginnings grow." John Dryden (1631-1700)


Nartron and Amway Do Business: "Trust can be a powerful weapon." Unknown

The Long and Winding Litigious History Between Nartron and Amway/Alticore: "Hate traps us by binding us too tightly to our adversary." Milan Kundera (1929-

Richard J. Pluta's Betrayal of Nartron and Rautiola: "Resentment is like taking poison and waiting for the other person to die." Malachy McCourt, (1931-)

Nartron's Problems With General Motors: "Delusions, errors and lies are like huge, gaudy vessels, the rafters of which are rotten and worm-eaten, and those who embark in them are fated to be shipwrecked." Buddha (563-483 B.C.)

The Bankruptcy: "An eye for an eye makes the whole world blind." Mahatma Gandhi (1869-1948) [NB: Actually, the "eye for an eye" approach to compensation for damages is well-established in Jewish law as strictly monetary in nature. I suppose this explains why we don't hear of storehouses of eyeballs and other body parts being discovered in the archeological digs from the Temple Mount, at least not yet.]

Alticore's Motion to Appoint a Chapter 11 Trustee: "Scarcely any law [of humanity] is more openly transgressed, or more industriously evaded than that which [commands us] to forgive injuries and prohibits .. the gratification of the desire which every man feels to return pain upon him that inflicts it. Many who could have conquered their anger are unable to combat pride, and pursue offenses to the extremity of vengeance, lest they should be insulted by the triumph of an enemy." Samuel Adams (1722-1803)

Factual Findings: "I am here to make decisions and whether they prove right or wrong I am going to make them." Harry S. Truman (1884-1972)

The Court's Own Observations: "It is reasonable that everyone who asks justice should do justice." Thomas Jefferson (1743-1826)

Conclusions of Law: "You can't shake hands with a clenched fist." Indira Gandhi (1917-1984)

She ultimately decides, Solomonically, that "cause" has been established to appoint a Chapter 11 trustee, but that its powers would be limited.

Though she goes out of her way at the beginning of the opinion to praise counsel to these spiteful combatants for being "extremely well prepared and zealous in the pursuit of their clients' positions," the case leaves me wondering whether lawyers really deserve praise for scorching the earth, even if they're very good at it.

© Steve Jakubowski 2005

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Bankruptcy Courts and Ancillary Jurisdiction: "Fah-get About It!"

It is natural to think that a federal case involving a multiplicity of armed parties sharing a common nucleus of operative facts should be waged in one massive armageddon (provided of course that federal jurisdiction is appropriately found in the initial instance). This concept of "ancillary jurisdiction" has been codified in 28 U.S.C. 1367, and applies in district courts throughout the land.

Bankruptcy litigation, however, is a horse of a different color, as Judge Schmetterer reminds us in In re Ha-Lo Industries, Inc. (2005 WL 2160087), and a trap for the unwary. That case reminds us that even a host of apparent connections to the debtor and the estate (fraudulent transfer action of hundreds of millions of dollars, partial settlements, filed proofs of claim, D&O indemnities, recoveries directly inuring to creditors' benefit) will not necessarily confer subject matter jurisdiction over a third party complaint.

Failure to remember that bankruptcy courts can't exercise ancillary jurisdiction (at least in the 7th Circuit--check your own circuit to be sure) can lead to much wasted time and effort and a sure loss of critical momentum.

The case does leave you wondering whether the third party complaint would have been dismissed had the third party plaintiffs first filed a motion to withdraw the reference of the case to the district court, which then presumably could have exercised ancillary jurisdiction over the third party complaint (assuming the motion were granted), even though the proceeding was initially commenced in the bankruptcy court. Worthwhile considering if you're faced with a similar situation.

© Steve Jakubowski 2005

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