Notable Reported Cases for the Week Ending 11/20/05

Here's our popular weekly roundup of significant recently decided cases involving complex bankruptcy disputes for the week ended 11/20/05. Enjoy!


Administrative Claim - Critical Vendor - Setoff: In re TSLC I., Inc., 332 B.R. 476 (Bankr. M.D. Fla., 11/1/05)

Plan - Feasibility: In re Repurchase Corp., 332 B.R. 336 (Bankr. N.D. Ill., 10/31/05)

Plan - Third Party Release: Simmons v. 22 Acquisition Corp., 2005 WL 3018726 (E.D. Tex., 11/10/05)

Preference - Ordinary Course: In re Terry Manufacturing Company, Inc., 2005 WL 3003701 (M.D. Ala., 11/9/05)

Setoff - Mutuality: Universal Guaranty Life Ins. Co. v. Health Receivables Management, Inc. (In re Health Management Limited Partnership), 332 B.R. 360 (Bankr. C.D. Ill., 11/2/05).

Bonus Supplement: Reed Smith's guide to recent bankruptcy decisions.


Administrative Claim - Critical Vendor - Setoff: In re TSLC I., Inc., 332 B.R. 476 (Bankr. M.D. Fla., 11/1/05). The lawyers at Sheppard Mullin recently added a post to its Bankruptcy and Restructuring Blog titled, "Critical Vendor Orders: Boon or Bane in Preference Cases?" That post noted:

[A] "critical vendor order" protects the vendor by allowing the debtor to pay most or even all of its outstanding invoices, as well as providing some assurance of payment for ongoing sales. What these orders very often do not provide is protection from so-called "preference" claims for recovery of amounts paid to the vendor during the 90 days prior to bankruptcy.

The TSLC case presents a variant on that problem. In TSLC, Avondale Mills, Inc., one of four critical vendors, applied for payment of an administrative claim based on an allegedly improper setoff by the debtor that, according to the Court, arose as follows:

After the Petition Date, Avondale delivered additional goods to the Debtor. The Debtor then informed Avondale that certain pre-petition shipments were defective and sought deductions of $38,412.62. Instead of offsetting these charges against Avondale's pre-petition shipments, the Debtor offset them against Avondale's post-petition shipments. Avondale argues that the Debtor's setoff against a post-petition administrative claim--which will be paid in full--rather than against a pre-petition unsecured claim--which will not be paid in full--is improper. As a result of the Debtor's setoff, Avondale claims damages of $8,642.85--the difference between receiving a pre-petition setoff amounting to 77.5 cents on the dollar and receiving a dollar-for-dollar post-petition setoff. Avondale asserts that these damages will constitute a cost of administration if the Debtor does not reverse its setoff.

In granting Avondale's application for an administrative expense claim based on the debtor's postpetition setoff, the Court stated:

Courts have found that [Bankruptcy Code] section 558 preserves to the debtor any pre-petition defenses a debtor may have, including any right to setoff. Additionally, unlike [Bankruptcy Code] section 553--which gives creditors a right to set off a mutual debt owed to the debtor only if both debts arose prior to the start of the bankruptcy action--courts applying section 558 have eliminated the pre-petition/post-petition distinction and have allowed debtors to set off pre-petition claims against post-petition obligations.

The Debtor cites ... authority that section 558 allows it to set off pre-petition charges for defective goods against post-petition shipments from Avondale. This situation, however, is distinguishable from those ... cases. None of the creditors in the cases cited above had a pre-petition claim against the debtor; all involved a post-petition administrative claim by the creditor and a pre-petition setoff the debtor claimed against the creditor, but no offsetting pre-petition balance due the creditor from the debtor.

Here, the Debtor had a pre-petition claim against Avondale of $38,412.62 for defective goods shipped pre-petition against the $1,472,355.49 the Debtor owed Avondale--a classic setoff situation governed by section 553. After the petition date, the Debtor paid Avondale 77.5 percent of its pre-petition claim without offsetting Avondale's pre-petition debt for defective goods. Now, the Debtor proposes to set off 100 percent of Avondale's pre-petition debt against Avondale's post-petition administrative claim, saving Debtor--and costing Avondale--more than $8,000 or the 22.5 percent difference between a pre-petition and post-petition setoff. The Critical Vendors Order, however, expressly contemplated that some adjustments might be necessary to amounts owed pre-petition by the Debtor.

Alternatively, the Debtor argues that the pre-petition setoff was waived by virtue of the Critical Vendor and Reclamation Orders. Again, the Debtor ignores the fact that the Critical Vendor Order took into account that the final pre-petition figures might need modification. That is precisely the situation here.


Plan - Feasibility: In re Repurchase Corp., 332 B.R. 336 (Bankr. N.D. Ill., 10/31/05). In this chapter 11 case, the debtor sought reconsideration of the Court's order denying plan confirmation and dismissing the chapter 11 case of the debtor corporation, which was jointly owned by Mr. Leon Greenblatt and his wife. The sole asset of the debtor was its net operating losses ("NOL's").

The Court conducted an evidentiary hearing on the debtor's reconsideration motion and upheld its previous rulings. The debtor's creative focus was on its claimed right to a discharge under Bankruptcy Code section 1141 on the basis that the plan was not a liquidating plan and that all three conditions of Bankruptcy Code section 1141(d)(3) were not implicated by the proposed plan. Most importantly, according to the debtor, the plan did not contemplate the liquidation or sale of the debtor's NOL's and thus Code section 1141(d)(3)'s limitations were not triggered. Moreover, the debtor argued, liquidation wasn't assured because of the possibility that the debtor could accomplish a merger or acquisition post-confirmation.

The Court responded that the issue wasn't the legality of the debtor's right to a discharge under Bankruptcy Code section 1141, but--more fundamentally--whether the plan was feasible. In denying the debtor's plan confirmation request, the Court stated, in pertinent part:

Mr. Greenblatt testified that the NOLs were going to be used as a means of generating operating post-confirmation capital. In addition, he indicated that he and his wife were going to utilize all of the NOLs. Despite the unclear nature of how these NOLs are going to be "monetized," it appears that the NOLs are not going to be sold to satisfy creditor's claims. Thus, there is some logic behind Debtor's argument that his Plan to "monetize" was not a plan to "liquidate."

But that issue need not be decided. Even if Debtor is correct that inclusion of the discharge provision in its Amended Plan was not illegal since the Plan did not expressly provide for "liquidation" of the NOLs, it overlooks the overriding issue determined at the confirmation hearing--lack of plan feasibility. Under evidence heard at the confirmation hearing, Debtor's Amended Plan was not feasible.

Debtor's argument is that under some precedent the mere possibility of feasibility is enough. But if metaphysical possibility of feasibility were sufficient, judges would be obligated to trade their robes for crystal balls....

Debtor chose to solely rest this burden on the testimony of its president, Mr. Greenblatt. Debtor was given ample opportunity to prove that confirmation was warranted. Afterwards, findings of facts that highlighted the glaring deficiencies in the proposed Plan were dictated from the bench. This included a finding that Debtor had failed to prove that funding was available to finance the $100,000 to be paid to creditors or the $500,000 as capital required to restart that business, as required by the Plan. The only evidence offered on that point came in the form of Mr. Greenblatt's testimony that his wife would be the contributing source for needed capital and that Debtor would also enter into "sharing agreements" for unitization of its NOLs for the purpose of generating cash for post-confirmation operations. But in the absence of any form of corroboration or contract from the alleged sources of these funds, Mr. Greenblatt's testimony amounted to nothing more than sheer speculation and wishful thinking.

Allowing Debtor's confirmation to be based on a "hope against hope that the financing [would] actually materialize" post-confirmation without some form of corroboration would go against a bankruptcy judge's duties of ensuring that the Plan complies with the provisions of the Bankruptcy Code. As the Plan's proponent, Debtor had the obligation of proving that the Plan, as proposed, was feasible. Optimistic but hollow declarations from Debtor's President about hopes for funding did not satisfy its burden of proof.... Here the testimony of Debtor's officer about hopes for funding was neither corroborated nor credible.... (Citations omitted).

As observed above, July 12, 2005 was the date set aside for Debtor to prove that its Amended Plan should have been confirmed. What Debtor is essentially requesting is a "do-over" so that it can correct glaring deficiencies in its initial attempt to satisfy its burden of proof. Furthermore, the newly created evidence that Debtor wishes to offer cannot be deemed as "newly discovered." Necessary evidence should have been prepared and presented during the confirmation hearing.

The findings of facts and conclusions of law on which denial of confirmation was based were properly measured against the record Debtor developed during the original confirmation hearing and will not now be based upon the record it wishes it had created by now presenting newly created evidence. Debtor request to reopen the judgment under Rule 59(a) is therefore denied. (Citations omitted).


Plan - Third Party Release: Simmons v. 22 Acquisition Corp., 2005 WL 3018726 (E.D. Tex., 11/10/05). The plaintiffs in this case alleged negligent treatment and care received while residents at the debtor senior living center which filed for Chapter 11 protection on November 28, 2001. Plaintiffs alleged GE HFS Holdings, Inc. ("GE") was directly vicariously responsible, as financer of debtor's center, and as active participant in the center's day to day management decisions.

GE moved for dismissal of Plaintiffs' Complaint pursuant to Rule 12(b)(6). GE argued that it could not be vicariously or derivatively liable for the acts of the debtor because the Plaintiffs did not file their claims before the Bankruptcy Court's bar order in respect of potential tort claims. The court was unpersuaded, stating:

GE's argument that the Bankruptcy Court's barring of potential tort claims against 22 Acquisition Corp. also barred potential tort claims against GE is misplaced. "Section 524 [of the Bankruptcy Code] prohibits the discharge of debts of nondebtors." In addition, "[a] discharge in bankruptcy does not extinguish the debt itself, but merely releases the debtor from personal liability for the debt. Section 524(e) specifies that the debt still exists and can be collected from any other entity that might be liable." GE was not a debtor in the 22 Acquisition Bankruptcy and thus any potential claims against GE for injuries to [plaintiffs] from the alleged mismanagement of [the debtor] were not discharged. The cases cited by GE do not accurately state the law regarding nondebtor liability for debtor debts in bankruptcy. Instead, they only restate the general legal proposition that a plaintiff must first establish direct liability of an agent in order for a principal to be held vicariously liable. While GE emphasizes that the Plaintiffs never filed a claim in [the debtor's] bankruptcy proceeding and thus allegedly waived their ability to recover from [the debtor], a plaintiff's failure to file in the bankruptcy proceeding should not impair the right to file suit against another party who may be liable on the debt. (Citations omitted).


Preference - Ordinary Course - New Value: In re Terry Manufacturing Company, Inc., 2005 WL 3003701 (M.D.Ala. 11/9/05). The Trustee moved to set aside allegedly preferential payments to a supplier, Bonifay, which asserted an "ordinary course of business" defense. The Bankruptcy Court ruled in favor of the trustee, and the supplier appealed.

At issue is the timing of the payments that the debtor, Terry Manufacturing ("Terry"), made to its supplier, Bonifay. The debtor's payments from July 23, 2001 to March 24, 2003 ranged anywhere from 98 to 321 days late. Bonifay permitted late payments because it depended on Terry for business and because of its long-standing business relationship with Terry.

In January of 2003, in an effort to get Terry "current," Bonifay requested that Terry pay $21,500 per week, "each and every week, without fail." Terry made these payments for two months, and reverted to paying off specific invoices as it could in March of 2003.
Terry filed its Chapter 11 petition on July 7, 2003, and in the 90 days immediately preceding the filing, Terry made six payments to Bonifay, totaling $107,713.15. The Trustee sought recovery of these six payments as preferential.

On appeal, the sole issue was whether the bankruptcy court gave appropriate weight to the long-standing business relationship between the Debtor and its supplier. Both parties agreed that the six payments were made in the preference period, and that unless they fell within the "ordinary course" statutory exception, they were avoidable preferential transfers. The District Court went through a long analysis, and concluded that the payments were not in the ordinary course, stating: "Because the court concludes that the relationship between Terry and Bonifay lacked stability, particularly immediately prior to the preference period, these six payments made during the preference period were not according to ordinary business terms."


Setoff - Mutuality: Universal Guaranty Life Ins. Co. v. Health Receivables Management, Inc. (In re Health Management Limited Partnership), 332 B.R. 360 (Bankr. C.D. Ill., 11/2/05). Here, the debtor commenced an adversary proceeding against a collection agency employed by the debtor prepetition. The court analyzed whether the contract with the collection agency was "executory," and found that it was. The collection agency continued to collect receivables postpetition, even after it had been terminated as collection agent, and sought to offset amounts collected post-petition against prepetition amounts due. The Court denied the creditor's setoff motion, holding:

The Plaintiff concedes that the Defendant was holding $15,043.88 as of March 31, 2003, from the March collections and that the Defendant was entitled to take its contingent fee ($3,657.01) and set off $11,386.87 against the sums owed to it by the Debtor. This was a permissible setoff of mutual pre-petition obligations. As to the remaining $22,987.58 which it applied to debts owed by the Debtor to the Defendant from October, 2002, through December, 2002, this was clearly an impermissible setoff of a pre-petition claim against a post-petition obligation.

The Defendant asserts that it is entitled to the $8,208.56 that it earned for its collection work from April, 2003, through September, 2003. There is no basis for this claim. The bankruptcy was filed on April 2, 2003, and the Defendant was fired the next day. The Defendant was never hired by the bankruptcy estate to collect accounts receivable. The Defendant acted strictly as a volunteer when it chose to continue collecting accounts receivable. The Defendant's motivation was not to benefit the bankruptcy estate--none of these funds made it to the bankruptcy estate--but rather to pay off the debt owed to it by the Debtor. A creditor cannot expect to ignore the explicit instructions of the Debtor and the provisions of the Bankruptcy Code and expect to get paid for work which does not benefit the bankruptcy estate.


Bonus Supplement: Reed Smith's guide to recent bankruptcy decisions, categorized by the following headings:

-- Equitable Subordination of ESOP Stock Redemption Reversed: Merrimac Paper Company, Inc. v. Harrison (In re Merrimac Paper Co., Inc.), 420 F.3d 53 (1st Cir. 2005)

-- Court Could Oversee Sale of Ships Not Within Its Jurisdiction: Universal Oil Ltd. v. Allfirst Bank (In re: Millenium Seacarriers, Inc., et al.), No. 04-0631-bk, 04-0633-bk (2d. Cir., Aug. 11, 2005)

-- Judge Rejects the Release of Debtor's Principals From Personal Liability: In re M.J.H. Leasing, Inc. and M.A.T. Marine, Inc., Nos. 04-18802-WCH, 04-19106-WCH (Bankr. D. Mass., Aug. 5, 2005)

-- Cases of Note:

* Creditor prosecution of debtor claims: Adelphia Communications Corp., et al. v. Bank of America, N.A., et al., No. 02-41729 (Bankr. S.D.N.Y., Aug. 30, 2005)

* Attorney liability for fraud: JP Morgan Chase Bank v. Winnick, et al., No. 03 Civ. 8535 (GEL) (S.D.N.Y., Aug. 16, 2005)

* Fraudulent transfer releases: In re Gentek Inc., et al., No.02-12986 (Bankr. D. Del., Aug. 11, 2005)

* Substantive consolidation: Lisanti, et al. v. Lubetkin (In re Lisanti Foods, Inc., et al.), No. CIV. A. 03-388 (D.N.J., Aug. 9, 2005)

* Merger financing: General Electric Capital Corp. v. D'Agostino Supermarkets, Inc., No. 03 CV 8539 (RO) (S.D.N.Y., July 18, 2005)

* Fiduciary duty: In re Toys "R" Us, Inc., Shareholder Litigation, Cons. C.A. No 1212-N (June 24, 2005)

© Steve Jakubowski 2005

Hat tip to Ryan Zeller and Kelly Frame.

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