This case should sufficiently concern private equity investors who extend secured credit, appoint a board member, are granted an option to purchase the business, and then foreclose and take over the business when the debtor–predictably–defaults.

In this 12/8/17 decision (In re Comprehensive Power, Inc., 2017 WL 6327192, Bankr. D. Mass), Judge Panos notes that the lender (“Moog”) moved to dismiss the Chapter 7 Trustee’s recharacterization / fraudulent transfer complaint because “it is merely a non-insider creditor that extended a loan to the Debtor after the parties executed financing documents memorializing the transaction, which included a security agreement granting Moog a security interest in substantially all assets of the Debtor.”

All Moog did, it argued, was enforce its rights as a secured creditor post-default under the transaction documents by accepting surrender of the collateral through a strict foreclosure and then credit bidding about 1/3 of its $6 million loan at a UCC sale. And sure, its board designee was funneling confidential information, but don’t private equity lenders always designate a board member precisely to ensure they get confidential information given the amount of the lender’s capital that is at risk? What’s wrong with that?

Well, Judge Panos found enough wrong with it to sustain all of the Trustee’s counts against the lender except for equitable subordination.  He sustained the Trustee’s recharacterization count because 6 of 11 AutoStyle factors were present, stating:

Here, drawing reasonable inferences in his favor, the Trustee has pleaded sufficient facts in support of at least six of the recharacterization factors, sufficiently stating a plausible claim for recharacterization of Moog’s debt. While the Trustee admits that the names given to the documents align with traditional naming constructs for financial instruments, he argues that, overall, there were components of the transaction that revealed its true nature to be equity rather than debt. With respect to the recharacterization factors, the Trustee points to allegations relating to the presence or absence of a fixed maturity date and schedule of payments and the presence or absence of a fixed rate of interest and interest payments to support his contention that the terms of the instruments and circumstances of the transaction were “atypical.”

Specifically, the Trustee alleges: (i) Moog’s standard practice was to engage in acquisitions, not provide loans, thereby indicating that Moog was implementing a unique “loan-to-own” transaction rather than establishing a true lender-borrower relationship; (ii) monthly interest payments were outside of the norm; (iii) the Debtor could extend maturity if the option was not exercised by Moog in connection with the Option Agreement; and (iv) Moog obtained substantive rights in the context of the transaction which are not typically given to traditional lenders, such as the right to appoint a representative to the Debtor’s Board and an option to acquire the Debtor’s assets or stock. Compl. ¶¶ 24–26, 50.

With respect to the source of repayments, the Trustee alleges that parties contemplated that the Moog financing could be repaid through Moog’s acquisition of the Debtor’s assets or stock, which could potentially support a claim for recharacterization. Id. Exs. A–B. As to the adequacy or inadequacy of capitalization, the Trustee alleges that the Debtor was undercapitalized and/or insolvent during relevant times, including at the time of the Surrender Agreement. Id. ¶¶ 32–34. The Trustee supports the allegation that the Debtor was undercapitalized and/or insolvent by further alleging that the Debtor (i) suffered losses in 2012 and 2013 that would have bankrupted the Debtor if it did not receive cash advances; (ii) encountered cash flow problems just months after receiving “advances” from Becana and others; (iii) had “trouble keeping pace with payments owed to employees, vendors and others”; (iv) depleted the $6 million in funding received from Moog in just a few months; and (v) defaulted on obligations to Moog less than ten months after the financing transaction. Id. ¶ 49. Whether evidence supporting these allegations could contradict the Trustee’s theories regarding the value of the Debtor’s business at the time of the transactions with Moog is a consideration that is more appropriately addressed when the record has been developed.

Regarding the Debtor’s ability to obtain financing from outside lending institutions, the Trustee alleges that the Debtor encountered cash flow problems and required further cash only months after receiving $6 million from Moog, suggesting the Debtor would be unlikely to obtain a traditional loan because of its cash flow issues. Id. ¶¶ 49, 51. The Trustee further alleges that no sinking fund was available to the Debtor to provide repayments, which Moog acknowledges, but argues is a “neutral” factor with respect to recharacterization. Mot. ¶ 61.

In sum, taken together, the factual allegations and the inferences drawn in favor of the Trustee are sufficient to state a plausible recharacterization claim.

In sustaining the actual fraudulent transfer claims against the lender, he stated:

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

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:Continue Reading 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”

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:Continue Reading Delaware’s Premier Blogger Wins Important Motion Before Delaware’s Judge Walsh Imposing the Caremark Fiduciary Duty on Corporate General Counsel

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!

***Continue Reading Judge Peck Rules in Iridium’s Bankruptcy That Stock Market Valuations Are No “Fool’s Game”

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

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

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:Continue Reading The Student Finance Corp. Debacle: Pepper Hamilton’s Court Retort