Preparing for Potential Liquidation, Deb Stores Seeks Approval of Lease & Contract Rejection Procedures

Deb Stores Holding LLC today sought approval from the Delaware bankruptcy court for approval of procedures governing the rejection of executory contracts and unexpired leases.  The procedures are likely to be necessary unless a buyer interested in acquiring the retailer’s assets to operate on a going-concern basis steps up and submits a bid in the very near future.  Deb Stores filed for bankruptcy protection on December 4th and quickly sought approval of bidding procedures to run a sale process with a stalking horse bid from a contractual joint venture composed of Hilco Merchant Resources, LLC and Gordon Brothers Retail Partners, LLC.  If the Hilco/Gordon Brothers bid is ultimately approved by Judge Kevin Gross, the result would be going-out-of-business sales at the company’s remaining 290 stores (an additional seven stores were already in the process of being closed before the bankruptcy filing) and a complete liquidation of the company.  The store locations are all leased by Deb Stores.

*** This article first appeared as a breaking news alert on Commercial Bankruptcy Investor. ***

The proposed rejection procedures provide for the following process:

Rejection Notice. The Debtors will file a notice (the “Rejection Notice”) setting forth the proposed rejection of one or more Contracts and/or Leases and will serve the Rejection Notice via overnight delivery service, email or fax on: (i) the Counterparty (and its counsel, if known) under the respective Contract or Lease at the last known address available to the Debtors; (ii) with respect to real property Leases, any known third party having an interest in personal property located at the leased Premises; (iii) counsel to the prepetition term loan agent; (iv) counsel to the prepetition revolving loan lender and DIP lender; (v) the Office of the United States Trustee of the District of Delaware y; and (vi) counsel to the Committee.

Content of Rejection Notice. With respect to Leases, the Rejection Notice shall set forth the following information, based on the best of the Debtors’ information: (i) the street address of real property; (ii) the name and address of the Landlord; and (iii) the date on which the Debtors will vacate the Premises. With respect to all other Contracts to be rejected, the Rejection Notice shall set forth the following information, based on the best of the Debtors’ information: (i) the name and address of the Counterparty; and (ii) a brief description of the Contract to be rejected.

Objections. Should a party in interest object to the Debtors’ proposed rejection of a Contract or Lease, such party must file and serve a written objection so that it is filed with this Court and actually received by the following parties no later
than seven calendar days after the date the Rejection Notice is filed: (i) counsel to the Debtors; (ii) counsel to the prepetition term loan agent; (iii) counsel to the prepetition revolving loan lender and DIP lender; (iv) the U.S. Trustee; and (v) counsel to the Committee. Each Objection must state with specificity the ground for objecting to the proposed Contract or Lease rejection.

Effects of Failing to File an Objection to a Rejection Notice. If no Objection to a Rejection Notice is timely filed and served, the applicable Contract or Lease shall be deemed rejected on the effective date set forth in the Rejection Notice, or, if no such date is set forth, the date the Rejection Notice is filed with this Court; provided, however, that the effective date of a rejection of a real property Lease shall not occur until the later of (i) the date the Debtors file and serve a Rejection Notice for the Lease or (ii) the date the Debtors relinquish control of the Premises by notifying the affected Landlord in writing of the Debtors’ surrender of the Premises in “broom clean” condition and turn over keys, key codes, and security codes, if any, to the affected Landlord.

Effects of Filing an Objection to a Rejection Notice. If a timely Objection to a Rejection Notice is filed and received in accordance with the Rejection Procedures, the Debtors shall schedule a hearing on such Objection and shall provide at least seven days’ notice of such hearing to the objecting party and the Objection Notice Parties. If this Court ultimately upholds the Debtors’ determination to reject the applicable Contract or Lease, then the applicable Contract or Lease shall be deemed rejected (i) as of the Rejection Date or (ii) as otherwise determined by this Court as set forth in any order overruling such objection.

Consent Orders. Any Objection may be resolved without a hearing by an order of this Court submitted on a consensual basis by the Debtors and the objecting party.

Deadlines for Filing Claims. Claims arising out of the rejection of Contracts or Leases must be filed, on or before the later of (i) the deadline for filing proofs of claims established by this Court in these chapter 11 cases or (ii) 21 days after the Rejection Date. If no proof of claim is timely filed, such claimant shall be forever barred from asserting a claim for rejection damages and from participating in any distributions that may be made in connection with these chapter 11 cases.

Treatment of Security Deposits. If the Debtors have deposited funds with a Counterparty or Landlord as a security deposit or other arrangement, such Counterparty may not setoff or otherwise use such deposit without the prior authority of this Court or agreement of the Debtors.

New Bankruptcy Opinion: IN RE MICROBILT CORPORATION – Court of Appeals, 3rd Circuit, 2014





No. 14-1139.

United States Court of Appeals, Third Circuit.

Submitted Under Third Circuit LAR 34.1(a) October 30, 2014.
Filed: December 10, 2014.

Before: McKEE, Chief Judge, GREENAWAY, JR., and KRAUSE, Circuit Judges.



KRAUSE, Circuit Judge.

The Microbilt Corporation (“Microbilt”) filed an adversary complaint in Bankruptcy Court against Chex Systems, Inc. (“Chex”), Gunster, Yoakley, & Stewart, P.A., and David Wells (collectively, “Gunster”), asserting claims for tortious interference and for violation of the Florida Uniform Trade Secrets Act (“FUTSA”). [1] The Bankruptcy Court granted Chex’s motion compelling arbitration on most of the counts and granted Gunster’s motion for summary judgment on those that remained. The District Court affirmed, and Microbilt now raises two issues on appeal. [2]

First, Microbilt argues that the District and Bankruptcy Courts erred in holding that Florida’s absolute litigation privilege applies to the disclosure of trade secrets allegedly in violation of FUTSA, or, in the alternative, that we should certify this question to the Florida Supreme Court pursuant to 3d Cir. LAR 110.1. [3] Florida’s litigation privilege provides legal immunity for “any [tortious] act occurring during the course of a judicial proceeding . . . so long as the act has some relation to the proceeding,” regardless of the nature of the underlying dispute. [4]

Microbilt relies on several recent cases carving out exceptions from the privilege for certain acts that occur before, after, or outside of a judicial proceeding, but these exceptions have no relevance to the present case. [5] Here, Gunster attached copies of a Microbilt subsidiary’s invoices to customers as an exhibit to a complaint filed for breach of contract in the Middle District of Florida, allegedly disclosing Microbilt’s trade secrets in violation of FUTSA. It is well-settled under Florida law that the absolute litigation privilege applies to statements in pleadings filed with the court. [6] We reject the contention that decisions from other states applying foreign law are relevant here. For these reasons, we agree with the District and Bankruptcy Courts that Gunster’s conduct was privileged and that any amendment to the complaint would be futile. [7] We also decline to certify a settled question of law to the Florida Supreme Court. [8]

Second, Microbilt argues that the District and Bankruptcy Courts erred in dismissing and referring to arbitration its claims for tortious interference with contract and tortious interference with prospective economic advantage. If a valid arbitration clause exists and the dispute falls within the substantive scope of that clause, we must compel the parties to arbitrate the dispute. [9] The Resale Agreement between Chex and Microbilt contemplates that “[a]ny dispute, difference, controversy or claim arising out of or relating to this Agreement shall be settled by binding arbitration. . . .” [10] Microbilt alleged that Chex committed tortious interference by disclosing information defined under the terms of the Resale Agreement as “confidential” to Gunster and the general public. [11] Though nominally framed as tort claims, these claims relate to the parties’ obligations under their contract, and as such, they are arbitrable under the broad scope of the arbitration clause in the Resale Agreement. [12]

For the foregoing reasons, we affirm the District Court’s decision upholding the decision of the Bankruptcy Court.

[*] This disposition is not an opinion of the full Court and pursuant to I.O.P. 5.7 does not constitute binding precedent.

[1] F.S.A. §§ 688.001-688.009.

[2] The District Court had appellate jurisdiction over the final order of the Bankruptcy Court under 28 U.S.C. § 158(a)(1). We have jurisdiction to hear this appeal under 28 U.S.C. § 158(d) and 28 U.S.C. § 1291.

[3] We may certify a question to a state court “[w]hen the procedures of the highest court of a state provide for certification to that court by a federal court of questions arising under the laws of that state which will control the outcome of a case pending in the federal court. . . .” 3d Cir. LAR 110.1.

[4] Echevarria, McCalla, Raymer, Barrett & Frappier v. Cole, 950 So. 2d 380, (Fla. 2007) (quoting Levin, Middlebrooks, Mabie, Thomas, Mayes & Mitchell, P.A. v. United States Fire Ins. Co., 639 So. 2d 606, 608 (Fla. 1994) ).

[5] See, e.g., DelMonico v. Traynor, 116 So. 3d 1205, 1208, 1211-14 (Fla. 2013) (confirming the vitality of the absolute litigation privilege for acts that have some relation to a judicial proceeding, but holding absolute privilege does not extend to alleged defamatory ex-parte, out-of-court statement to potential nonparty witnesses in the course of investigating a pending lawsuit); Fridovich v. Fridovich, 598 So. 2d 65, 69 (Fla. 1992) (holding absolute litigation privilege does not extend to defamatory statements made to authorities prior to initiation of a criminal proceeding).

[6] DelMonico, 116 So. 3d at 1217; see also Fla. R. Civ. P. 1.130(b) (“Any exhibit attached to a pleading shall be considered a part thereof for all purposes.”).

[7] See Oran v. Stafford, 226 F.3d 275, 291 (3d Cir. 2000) .

[8] See Francisco v. United States, 267 F.3d 303, 308 n.5 (3d Cir. 2001) .

[9] Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth Inc., 473 U.S. 614, 262 (1985) ; CardioNet, Inc. v. Cigna Health Corp., 751 F.3d 165, 172 (3d Cir. 2014) .

[10] Resale Agreement at ¶ 29.

[11] Each of the relevant claims cites the Resale Agreement’s definition of “Confidential Information.” (Compl. at ¶ 63; 72; 81; 88.)

[12] See Mitsubishi, 473 U.S. at 622 n.9 ; Southland Corp. v. Keating, 465 U.S. 1, n.7 (1984) ; Collins & Aikman Prods. Co. v. Bldg. Sys., Inc., 58 F.3d 16, 20-21 (2d Cir. 1995) .

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New Bankruptcy Opinion: IN RE GTM ENERGY PARTNERS, LLC – Dist. Court, ND Alabama, 2014


ROY DOBBINS, Appellant,


WILLIAM S. KAYE, Plan Administrator, et al., Appellees.

Case No. 1:14-cv-00817-RDP.

United States District Court, N.D. Alabama, Eastern Division.

December 9, 2014.


R. DAVID PROCTOR, District Judge.

This matter is before the court on the appeal filed by Roy S. Dobbins from the bankruptcy court’s March 6, 2014 Order sustaining objections by the Chapter 11 Plan Administrator, William S. Kaye, to the proof of claim filed by Dobbins on behalf of Southern Energy Development Company, Inc. (“SEDCO”).

I. Background

This case involves an October 2013 claim by Dobbins that debtor GTM Energy Partners, LLC failed to pay all royalties owed to SEDCO — a corporation owned by Dobbins’ wife — in connection with a 2004 mining lease that expired in 2009.

A. The 2004 Lease

Lowell Barron and SEDCO were the record owners of the Property when the 2004 Lease was executed. (Bankr. Case Doc. # 741-2). Dobbins, acting on behalf of SEDCO [1] , and Barron executed a coal mining lease dated November 4, 2004, in favor of D & E Mining, LLC (the “2004 Lease”). (Bankr. Case No. Case 11-80568-JJR11 (hereinafter “Bankr Case”) Doc. # 741-3 at 1, 4; Doc. # 1-4 Dobbins Dep. 60:15-61:2). D&E Mining subsequently assigned the 2004 Lease to GTM Energy Partners, LLC (“GTM”), and GTM mined the Barron/SEDCO Property until approximately September 2009. (Doc. # 1-4 Dobbins Dep. 70:6-17). By its own terms, the 2004 Lease expired on November 4, 2009. (Bankr. Case Doc. # 741-3 at 1). The 2004 Lease provides for the following consideration:


A. LESSEE shall pay the LESSOR 10% per ton based on the Pit Price and based on the LESSOR owning the mineral rights or at 5% based on the pit price if the mineral rights are not owned. All production royalties are to be paid on the twentieth (20th) day of each month for all coal mined and sold from the demised premises during the next preceding month.

(Doc. # 1-4 at p. 119) (emphasis added). The term “Pit Price” is not defined in the 2004 Lease. (Id). The term “Sale Price” is later defined to include “BTU Bonus” or “BTU Penalty.” (Id.).

According to GTM, all royalties due were paid in full at the end of the lease. (Doc. # 1-2 at 24). GTM did not pay the lessors any BTU bonuses or penalties because there was no provision for that in the lease. (Doc. # 1-2 at 25). Following the expiration of the lease in 2009 until October 2013, neither Dobbins nor Barron ever contacted GTM claiming they were owed any money under the 2004 Lease. (Doc. # 1-2 at 24).

B. GTM Files Chapter 11 Bankruptcy

On February 16, 2011, more than a year after the 2004 Lease expired, GTM filed a chapter 11 bankruptcy petition with the United States Bankruptcy Court for the Northern District of Alabama, and that filing commenced the underlying bankruptcy case. (Bankr. Case Doc. # 1). When GTM filed its bankruptcy case, neither Dobbins’ address shown in the 2004 Lease, nor any other address for Dobbins, was included in the mailing matrix.

In May 2011, the bankruptcy court approved a sale of substantially all of the assets of GTM. (Bankr. Case Doc. # 247 at 1, 16). Shortly after the sale closed, on June 27, 2011, the deadline for filing proofs of claim in the Bankruptcy Case expired. (Bankr. Case Doc. # 695 at ¶ 5). On December 12, 2011, the bankruptcy court confirmed GTM’s chapter 11 plan (the “Plan”). (Bankr. Case Doc. # 451). Dobbins was not scheduled as a creditor, and there was no evidence that he received any notice of GTM’s bankruptcy proceedings.

The Plan contemplated that, after payment of all allowed claims with interest, and payment of the fees and expenses of the Plan Administrator, the remaining assets of GTM would be turned over to the equity holders of the company. (Bankr. Case Doc. # 349 at 2, 11-16, 18-22). As of September 2013, the Plan Administrator had paid all allowed proofs of claim timely filed in the Bankruptcy Case, with interest at the Plan rate. (Bankr. Case Doc. # 683 at 1-3).

C. Dobbins’s Proof of Claim

On October 9, 2013, Dobbins filed a proof of claim in the bankruptcy case on behalf of SEDCO (the “Proof of Claim”). (Bankr. Case Claim # 72-1 (Doc. # 687-1); Doc. # 1-1 McGee Dep. 46:2-5). The Proof of Claim asserts an unsecured, pre-petition claim in the amount of $452,606.00, consisting of the following: (a) $52,597.84 for “premiums for BTU which would have been at least 10% of my total royalties received;” (b) $100,009.00 for “coal mined from my property in 2007 and 2008 [that] went to the washer and I was never paid for . . . it would have been approximately 25% of total mined . . . for this period;” and (c) $300,000.00 for “damages for trespassing on my property.” [2] In support of the Proof of Claim, Dobbins attached only a prepared summary. The 2004 Lease was not attached, nor were any other supporting documents. (Bankr. Case Claim # 72-1 (Doc. # 687-1) at 1, 3-4).

On October 23, 2013, the Plan Administrator filed an objection to the Claim (the “Objection”). (Bankr. Case Doc. # 695). Among other grounds, the Plan Administrator objected to the Claim on the basis that Dobbins failed “to attach a lease or other writing establishing his purported rights to the amount claimed” and, instead, “attached certain historical figures and seeks to extrapolate the amounts he alleges are owed from those amounts.” (Bankr. Case Doc. # 695 at ¶ 17). Further, the Objection stated that “there is no basis” for the BTU premium claimed and that the claim for washer coal “also is not supported by any evidence.” (Bankr. Case Doc. # 695 at ¶¶ 18-20).

D. Hearing on the Objection to the Proof of Claim

The bankruptcy court set the Objection for evidentiary hearing on December 5, 2013. (Bankr. Case Doc. # 696 at 1). At the December 5, hearing, Dobbins had a change of counsel and, at Dobbins’s request, the hearing on the Objection was continued over a month until January 9, 2014, in order to allow the parties time to complete discovery. The bankruptcy court advised all parties that the January 9, 2014 hearing would not be continued. (Doc. # 1-3 at 7:11-18).

The Plan Administrator promptly initiated discovery in November 2013 and took the depositions of Barron, Dobbins, and McGee, the SEDCO Corporate Representative. Dobbins did not initiate any discovery until two days before the January 9, 2014, hearing when he issued a subpoena to the Plan Administrator to appear at the hearing and to produce documents. (Bankr. Case Doc. # 736 at 1-3). The bankruptcy court quashed the subpoena. Dobbins has not appealed that ruling. (Bankr. Case Doc. # 753 at 10).

On January 9, 2014, the day of the final evidentiary hearing, Dobbins filed an amended proof of claim (the “Amended Proof of Claim”). (Bankr. Case Claim # 72-2). The bankruptcy court disallowed the Amended Proof of Claim as untimely. Dobbins has not appealed that ruling. (Bankr. Case Doc. # 753 at 1). The bankruptcy court also denied Dobbins’s request for a further continuance and proceeded to take testimony and admit certain depositions. The Plan Administrator and Jem-Coal, LLC, one of the equity holders of GTM, objected to the admission of Exhibits 13 and 14 to those depositions because, they asserted, (1) those exhibits are not relevant to the claims asserted in the Proof of Claim, (2) they constitute inadmissible hearsay (for which there is no exception), and (3) they were not properly authenticated. (Bankr. Case Doc. # 741 at 4-5; Doc. # 1-2 at 70:7-72:6).

Exhibit 13 to the McGee deposition purports to be a public record of an audit by the Office of Surface Mining for April 1, 2007 through March 31, 2009, dated September 16, 2009 (the “OSM Audit”). (Bankr. Case Doc. # 745-5 at 1). However, some pages of the Audit were not included. The missing pages were marked as Exhibit 14. (Doc. # 1-4 McGee Dep. 82:10-19). These exhibits were not originals or certified copies and no custodian of records testified as to their authenticity. Additionally, Exhibit 13 contains information on coal mined outside the time period for the OSM Audit, and post-dating the term of the 2004 Lease. (Bankr. Case Doc. # 745-5 at 10-11, 13-14, 18-24). Exhibit 14 contains summaries of reported and audited tonnage by permit, only one of which is for the Barron/SEDCO Property, and that permit includes other properties. (Bankr. Case Doc. # 745-6 at 1, 3-5; Doc. # 1-2 at 27:20-28:5). Neither Exhibit 13 nor Exhibit 14 references BTU premiums or distinguishes between washer and non-washer coal, the subjects of Dobbins’s Proof of Claim. (Bankr. Case Doc. # 745-5 and 745-6).

E. The Bankruptcy Court’s Order

On March 6, 2014, the bankruptcy court sustained the Plan Administrator’s Objection to Dobbins’s claim. (Bankr. Case Doc. # 753). The Plan Administrator objected to the Claim asserting (1) that the language of the 2004 Lease did not create any entitlement to BTU premiums for the lessor, and (2) that no amounts remained owing under the 2004 Lease. The bankruptcy court held that Dobbins’ earnest belief that he did not get paid for BTU premiums and washer coal was simply not sufficient to support his Claim. Dobbins admitted that his Claim was based on speculation and conjecture: “I just pulled that out of my head.” (Doc. # 1-4 Dobbins Dep. 139:19-140:1). This testimony, the bankruptcy court held, was sufficient to negate the prima facie evidentiary presumption he initially enjoyed under F.R. Bankr. P. 3001(f), and he never met his burden of proof needed to support his Claim. (Bankr. Case Doc. # 753 at 9).

The bankruptcy court also sustained the Plan Administrator’s objections to Exhibits 13 and 14, concluding those exhibits were not authenticated and are inadmissible hearsay. The bankruptcy court also noted that it was difficult to determine if all the pages of the audit were included and even whether all the pages pertain to the same audit. (Bankr. Case Doc. # 753 at 11).

II. Standard of Review

This court has jurisdiction to hear appeals from orders of the Bankruptcy Court. 28 U.S.C. § 158(a). A bankruptcy court’s findings of fact are reviewed for clear error and its legal conclusions de novo. Educ. Credit Mgmt. v. Mosley (In re Mosley), 494 F.3d 1320, 1324 (11th Cir. 2007) .

A finding of fact is clearly erroneous even when there is evidence to support it, if “the reviewing court on the entire evidence is left with the definite and firm conviction that a mistake has been committed.” Anderson v. City of Bessemer City, N.C., 470 U.S. 564, 573 (1985) (citation, internal quotation marks, and alterations omitted). As the reviewing court, this court must give “due regard to the bankruptcy court’s opportunity to judge the credibility of the witnesses.” In re Englander, 95 F.3d 1028, 1030 (11th Cir. 1996) . An appellate court may affirm the lower court “where the judgment entered is correct on any legal ground regardless of the grounds addressed, adopted or rejected” by the lower court. Bonanni Ship Supply, Inc. v. United States, 959 F.2d 1558, 1561 (11th Cir. 1992) .

“Whether an evidentiary presumption has been rebutted is a question of fact reviewed for clear error.” Garner v. Shier (In re Garner), 246 B.R. 617, 619 (9th Cir. BAP 2000) . Evidentiary rulings are to be reviewed under the abuse of discretion standard. See In re Moore, 165 B.R. 495, 498 (M.D. Ala. 1993) (citing U.S. Anchor Mfg., Inc. v. Rule Indus., Inc., 7 F.3d 986, 993 (11th Cir. 1993) (“A [trial court’s] evidentiary rulings are not disturbed unless there is clear showing of abuse of discretion.”)).

III. Discussion

The court will not sugar coat it — Appellant Dobbins’ description of the issues to be decided in this appeal is virtually unintelligible. (Doc. # 5 at 6-7). However, the Plan Administrator has stated (and this court agrees) that the following are the questions that must be resolved in reviewing the Bankruptcy Court:

1. Whether the bankruptcy court erred in holding that the initial presumption of validity to Dobbins’ proof of claim was rebutted in this case;

2. Whether the bankruptcy court properly considered the deposition testimony of Dobbins and Charles McGee; and

3. Whether the bankruptcy court abused its discretion in excluding Exhibits 13 and 14.

A. The Initial Presumption of Validity Was Rebutted

A verified proof of claim against a bankruptcy estate is presumed valid until the debtor objects. 11 U.S.C. § 502(a). The objection must contain some substantial factual basis to support its allegation of impropriety, and overcome the creditor’s prima facie case. In re Bagget Bros. Farm Inc., 315 Fed. Appx. 840, 843 (11th Cir. 2009) (quoting Matter of Mobile Steel Co., 563 F.2d 692, 701 (5th Cir. 1977) and Matter of Multiponics, Inc., 622 F.2d 709, 714 (5th Cir. 1980) ) (quotation marks omitted). [3] If the debtor satisfies his obligation, the burden then shifts back to the creditor “to prove the validity of the claim by a preponderance of the evidence.” Id. (quoting 4 Collier on Bankruptcy ¶ 502.02[3][f] (15th ed. rev. 2007)).

Only proofs of claim complying with Bankruptcy Rule 3001 are entitled to the initial presumption of validity. Fed. R. Bankr. R. 3001(f). Subsection (c)(1) of Bankruptcy Rule 3001 requires that when a claim is based on a writing (such as the 2004 Lease in this case), a copy of such writing shall be filed with the proof of claim. Fed. R. Bankr. R. 3001(c)(1). Thus, although the bankruptcy court did not rely on this ground, the failure to attach a supporting contractual document, such as the 2004 Lease to the proof of claim, would result in a loss of the presumption of validity and relieve the objecting party of the burden of going forward. Here, the 2004 Lease was not filed with the Proof of Claim, and therefore, it does not appear that the initial presumption of validity should have even been applicable in this case.

But even assuming that the evidentiary presumption applies, GTM satisfied its burden of going forward by proffering evidence that amounts due under the lease were paid and by credibly calling into question Dobbins’s assertion that there was any outstanding balance. See In re Bagget Bros. Farm Inc., 315 Fed. Appx. at 843 ; In re Garvida, 347 B.R. 697, 706 (9th Cir. BAP 2006) .

The language of the 2004 Lease did not provide for the payment of BTU premiums. The 2004 Lease (which again was not attached to the Proof of Claim) provides for the following consideration:


A. LESSEE shall pay the LESSOR 10% per ton based on the Pit Price and based on the LESSOR owning the mineral rights or at 5% based on the pit price if the mineral rights are not owned. All production royalties are to be paid on the twentieth (20th) day of each month for all coal mined and sold from the demised premises during the next preceding month.

(Doc. # 1-4 at p. 119) (emphasis added). The term “Pit Price” is not defined in the 2004 Lease. (Id). The term “Sale Price” is later defined to include “BTU Bonus” or “BTU Penalty.” (Id.). However, BTU Bonus is not specified as a part of the Pit Price. This evidence credibly called into question whether Dobbins was entitled to the amounts he claimed were owed. [4]

Further, GTM presented testimony that all royalties due were paid in full at the end of the lease. (Doc. # 1-2 at 24). GTM did not pay the lessors any bonuses or penalties because there was no provision for that in the lease. (Doc. # 1-2 at 25). Furthermore, the record evidence demonstrates that, following the expiration of the lease in 2009 until October 2013, neither Dobbins, nor Barron, ever contacted GTM claiming they were owed any money under the 2004 Lease. (Doc. # 1-2 at 24).

Giving “due regard to the bankruptcy court’s opportunity to judge the credibility of the witnesses,” In re Englander, 95 F.3d at 1030, this court cannot say that the bankruptcy court erred in holding (1) that any presumption of validity that may have attached to Dobbins’s proof of claim was rebutted in this case, and (2) that Dobbins failed to present sufficient credible evidence to support his claim. See In re Garner, 246 B.R. at 619 .

B. The Bankruptcy Court Properly Considered the Deposition Testimony of Dobbins and Charles McGee

Dobbins next contends that the bankruptcy court erroneously failed to consider all of the deposition testimony of Dobbins and McGee, particularly with respect to Exhibits 13 and 14. However, the express language of the bankruptcy court’s Order states: “The Court has considered the pleadings, including Dobbins’ proof of claim and exhibits thereto, the evidence presented at the hearing, including testimony given in court and through depositions, and arguments of counsel, and for the reasons that follow, the Court will sustain the Objection to Claim.” (emphasis added) (Bankr. Case Doc. # 753 at 2). A trial court need not recite every shred of evidence it considered. Holton v. City of Thomasville School Dist., 425 F.3d 1325, 1353-54 (11th Cir. 2005) ; see also Thorn v. Jefferson-Pilot Life Ins. Co., 445 F.3d 311, 322 n.12 (4th Cir. 2006) (“We will not assume, however, that simply because the district court did not mention the report in its written order it failed to consider the evidence.”).

As discussed above, a bankruptcy court’s findings of fact are reviewed for clear error. Clear error is a deferential standard of review. See, e.g., Manning ex rel. Manning v. Sch. Bd., 244 F.3d 927, 940 (11th Cir. 2001) . As the Supreme Court has explained, a “finding is `clearly erroneous’ when although there is evidence to support it, the reviewing court on the entire evidence is left with the definite and firm conviction that a mistake has been committed.” Anderson v. City of Bessemer City, 470 U.S. 564, 573 (1985) (quoting United States v. United States Gypsum Co., 333 U.S. 364, 395 (1948) ). The law is well settled that “[i]f the [trial] court’s account of the evidence is plausible in light of the record viewed in its entirety, the [reviewing] court . . . may not reverse it even though convinced that had it been sitting as the trier of fact, it would have weighed the evidence differently.” Anderson, 470 U.S. at 573-74 . Indeed, this court may reverse the bankruptcy court only when “on the entire evidence” the court is “left with the definite and firm conviction that a mistake has been committed.” Id. at 573 (marks and citation omitted).

After reviewing the record in this matter, although there may have been conflicting evidence, this court is not left with the conviction that a mistake has been committed and has not discerned any clear error.

C. The Bankruptcy Court Did Not Abuse its Discretion When it Excluded Exhibits 13 and 14.

Although the bankruptcy court admitted the depositions taken in this matter into evidence, it did not admit the deposition exhibits. (Doc. # 1-2 at 70:7-76:19, 108:10-110:24). At the evidentiary hearing, the bankruptcy court expressly stated “there are no exhibits to those depositions that have come in.” (Doc. # 1-2 at 76:18-19). The court then independently evaluated the objections after briefing by counsel. (Doc. # 1-2 at 108-110; Bankr. Case Doc. # 753 at 10-11).

Evidentiary rulings are to be reviewed under the abuse of discretion standard. U.S. Anchor Mfg., Inc., 7 F.3d at 993 . As to Exhibits 13 and 14, the bankruptcy court sustained the objections to their admission because they were not authenticated and they contain inadmissible hearsay. The bankruptcy court also noted that it was “difficult to determine if all the pages of the audit are included and even whether all the pages pertain to the same audit.” (Bankr. Case Doc. # 753 at 10-11). No competent witness testified that these exhibits were true and correct copies of what they purported to be. Moreover, on the face of the exhibits there appear to be mismatched or internally inconsistent dates and page numbers, handwritten notes, and other indicia of tampering.

The exhibits at issue purport to be records of the Office of Surface Mining, a public office. Under Federal Rule of Evidence 803(8), a “record or statement of a public office” may be excepted from the general rule excluding hearsay if it meets certain conditions and “neither the source of information nor other circumstances indicate a lack of trustworthiness.” Fed. R. Evid. 803(8)(B). However, the exhibits proffered indicate a lack of trustworthiness on their face. For example, Exhibit 13’s cover page states that the audit covers April 1, 2007 to March 31, 2009, and the audit is dated September 16, 2009. (Bankr. Case Doc. # 745-5 at 1). However, Page 12 includes information for the third quarter of 2009 (the months of July, August, and September), which is later than the dates claimed to be covered by the audit. (Bankr. Case Doc. # 745-5 at 12). Pages 13 through 15 include information from 2010, as do pages 18 through 21, and Page 22 begins discussing 2011. (Bankr. Case Doc. # 745-5 at 13-15, 18-22). And Exhibit 14 purports to be a five page document, but contains seven pages. (Bankr. Case Doc. # 745-6 at 1-7).

The bankruptcy court acted within its discretion to deny admission of these documents under Rule 803(8). Wilson v. Attaway, 757 F.2d 1227, 1245 (11th Cir. 1985) . Having reviewed these exhibits in conjunction with the record in this matter, the court cannot say that the bankruptcy court abused its discretion in excluding these documents. U.S. Anchor Mfg., Inc., 7 F.3d at 993 .

IV. Conclusion

For the foregoing reasons, the bankruptcy court’s March 6, 2014 Order sustaining objections by the Chapter 11 Plan Administrator, William S. Kaye, to the proof of claim filed by Dobbins on behalf of SEDCO is due to be affirmed with the costs of these proceedings taxed to the Appellant.

A separate order in accordance with the Memorandum Opinion will be entered.


[1] Dobbins stated he executed the 2004 Lease on behalf of SEDCO, not in his individual capacity, although there was nothing on the face of the 2004 Lease that would have indicated SEDCO had any interest in the Property or 2004 Lease. According to a deed dated April 20, 2011 — two months after the Debtor filed its bankruptcy petition — SEDCO conveyed its interest in the Property to Dobbins and his wife in their individual capacities.

[2] Dobbins subsequently waived the $300,000 trespass portion of the Proof of Claim. (Bankr. Case Doc. # 748 at 4, item 3).

[3] In Bonner v. City of Prichard, 661 F.2d 1206, 1209 (11th Cir. 1981) (en banc) , the Eleventh Circuit Court of Appeals adopted as binding precedent all decisions of the former Fifth Circuit handed down prior to the close of business on September 30, 1981.

[4] A reviewing court may affirm on any grounds supported by the record. Parks v. City of Warner Robins, 43 F.3d 609, 613 (11th Cir. 1995) .

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New Bankruptcy Opinion: GREDE v. THE BANK OF NEW YORK – Dist. Court, ND Illinois, 2014

FREDERICK J. GREDE, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust, Plaintiff,



No. 08 C 2582.

United States District Court, N.D. Illinois, Eastern Division.

December 10, 2014.


JAMES B. ZAGEL, District Judge.

On November 3, 2010, I issued an opinion concerning three claims on appeal made by Frederick J. Grede Liquidation Trustee of the Sentinel Liquidation Trust against Bank of New York Mellon (“BNYM”). Grede v. Bank of New York Mellon, 441 B.R. 864 (N.D.Ill. 2010) . On appeal, the Seventh Circuit affirmed in part, reversed in part, and remanded for further proceedings on two of Grede’s theories of liability, to wit, the assertion that fraudulent transfer law and the doctrine of equitable subordination require a judgment in Trustee’s favor. The Seventh Circuit concluded that this Court’s factual findings demonstrated an actual intent to hinder, delay, or defraud in support of Grede’s fraudulent transfer claim, and remanded the case back to this Court for further analysis of Trustee’s claim under 11 U.S.C. § 548(a)(1)(A). In reversing and remanding Grede’s equitable subordination claim, the Seventh Circuit found the Court’s findings of fact to be “internally inconsistent” and sought clarification from this Court on two critical issues:

(1) What exactly did BNYM know before Sentinel’s collapse? Specifically, did BNYM know that Sentinel was engaged in misconduct of any kind (including abuse of the loan proceeds)?

(2) Was BNYM’s failure to investigate Sentinel before its collapse merely negligent? Or was it reckless? Or was it deliberately indifferent?

I now clarify my prior opinion and findings of fact which were based, not only on what the witnesses said, but, more importantly, also on the conduct and actions of witnesses.

I incorporate by reference my earlier opinion on the merits and the Seventh Circuit’s opinion, and I will reprint both prior opinions as appendices to this ruling.

I. Equitable Subordination

A. Standard

Trustee seeks to lower all of BNYM’s claims to a level below all other creditors’ claims and to transfer any liens supporting BNYM’s claims to Sentinel’s estate under the doctrine of equitable subordination. 11 U.S.C. § 510(c). Courts will subordinate a claim (i.e. chose to disregard an otherwise legally valid transaction) when alleged conduct of a claimant either injured other creditors or conferred an unfair advantage to the claimant, but not when subordination is inconsistent with the Bankruptcy Code. In re Lifschultz Fast Freight, 132 F.3d 339, 347 (7th Cir. 1997) ; See In re Kreisler, 546 F.3d 863, 866 (7th Cir. 2008) (quoting United States v. Noland, 517 U.S. 535, 538-39, 116 S.Ct.1524, 134 L.Ed.2d 748 (1996) ). As the Seventh Circuit acknowledged, subordination of a claim on the grounds of equity upsets legitimate expectations and increases uncertainty, and so, the doctrine of equitable subordination is typically limited to findings of “(1) fraud, illegality, breach of fiduciary duties; (2) under-capitalization; [or] (3) claimant’s use of the debtor as a mere instrumentality or alter ego.” Lifschultz, at 345.

Additionally, the Seventh Circuit expressed concern regarding the difficulty of proving that a creditor has engaged in inequitable behavior—a difficulty it noted is especially pronounced when subjectively examining the conduct of an outside creditor whose interests are not necessarily aligned with the interests of the debtor. In re Sentinel Management Group, Inc., 728 F.3d 660, 2013 WL 4505152, 70 Collier Bankr.Cas.2d 566, 58 Bankr.Ct.Dec. 93, Comm. Fut. L. Rep. P 32,717 (C.A.7 (Ill.), 2013) (hereafter Grede Appeal). For this reason, the Courts of Appeal have been particularly hesitant to invoke the doctrine of equitable subordination outside of cases involving insiders of closely held corporations and do not ordinarily identify precisely the nature of wrongful conduct that is sufficient to invoke equitable subordination against an outside creditor. In re Granite Partners, L.P., 210 B.R. 508, 515 (Bankr.S.D.N.Y.1997) . The reported decisions on this point are not legion. In a prominent case of corporate insiders attempting to convert worthless equity interests into secure debt, the Seventh Circuit, in 1990, did apply equitable subordination and went on to note that “[c]ases subordinating the claims of creditors that dealt at arm’s length with the debtor are few and far between.” Kham & Nate’s Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351, 1356 (7th Cir. 1990) . Based on this precedent and decisions from other circuits, I concluded the trigger for equitable subordination in this case is whether BNYM’s conduct is egregious and conscience-shocking.

The Seventh Circuit did not decide whether that standard is proper because it concluded that my relevant findings of the appropriate facts were internally inconsistent. The Seventh Circuit found two statements, in particular, to be apparently inconsistent with each other: (1) “The evidence at trial revealed BNYM’s knowledge that Sentinel users were using at least some of the loan proceeds for their own purposes;” and (2) credibility of BNYM’s employee’s testimony that “[BNYM] neither knew nor turned a blind eye to the improper actions of Sentinel.” Application of a standard of liability does not work very well when the trial court’s facts are not internally consistent.

After review of the extensive briefing in this case, trial transcript, and significant motions, it has become clear to me that my opinion left open more than one legitimate understanding of the grounds for some of my conclusions about important facts. One example of a lack of clarity arises from my failure to note, specifically, what BNYM knew of Sentinel’s intent. So too, should some of the wording—my own and those of the litigants—have been more precise. “Know” and its pairing with “knowingly” are not always accurate enough. In some cases, the better word is “believe.” One who believes something to be true is, effectively, one who thinks, rightly or wrongly, that he knows it to be true.

This case is one in which BNYM has neither believed nor disbelieved certain things about Sentinel, and thus BNYM concluded that certain things were unimportant or immaterial to BNYM. I should have made my word usage and context clear. I now clarify, first, whether BNYM actually knew, before Sentinel’s collapse, that Sentinel was engaged in misconduct of any kind (including abuse of the loan proceeds), and, second, whether BNYM’s failure to investigate Sentinel before its collapse was, at most, merely negligent, or rather, reckless or deliberately indifferent.

B. Subjective Knowledge: Did the Bank Actually Know that Sentinel Engaged in Misconduct?

I address the question of whether BNYM actually knew (i.e. had subjective knowledge) that Sentinel’s management was improperly using loan proceeds for their own enrichment, namely, trading for Sentinel’s own account with loan proceeds secured by collateral from client’s segregated funds. As sought by the Seventh Circuit, I make clear what I had found to be the extent of BNYM’s knowledge about Sentinel’s practices, including how BNYM could know that Sentinel users were using at least some of the loan proceeds for their own purposes, without knowing or turning a blind eye to Sentinel’s improper actions.

It is true that both the testimony and conduct of BNYM’s officials revealed that BNYM knew that Sentinel was using at least some of the loan proceeds for its own purposes. Sentinel claimed to be pursuing a leveraged trading strategy using loaned funds to increase investment with respect to its own assets and the assets of its clients, and BNYM knew that Sentinel used loan proceeds in its proprietary trading, its house account. Sentinel and its insiders had collateral of its own for leveraged investing—approximately $10 million in securities of these Sentinel investors and, according to the Trustee’s expert, about $230 million in securities that were not attributed to Sentinel’s customer groups. As part of Sentinel’s investment practice, Sentinel’s own assets and those of its clients were contained in a single, undifferentiated pool of securities and cash, and all resulting gains and losses were shared by all clients and the Sentinel insiders. What followed from this strategy was that not all the collateral used to support loans to finance trading was the property of all the Sentinel investors. Rather, every client had a piece of the pool, as did Sentinel. Any client could redeem the cash value of its share of the pool of assets. Redemptions were made promptly and the deadline for claiming same day redemption did not close until late in the afternoon. Eric Bloom, a Sentinel insider, told BNYM that Sentinel had permission, generally, to use client’s segregated funds as collateral for leveraged trading. The evidence does not show that Sentinel secured BNYM’s loans with specific assets belonging to specific clients, or that BNYM knew that Sentinel was using specific client assets to secure whatever part of the loan Sentinel might be using for its own leveraged investing.

While BNYM neither had nor sought data to track each transfer of collateral, BNYM did pay attention to the loans. Beginning in November 2005, BNYM received copies of Sentinel’s monthly Form 1-FR that Sentinel filed with the CFTC. Over the course of BNYM’s ten-year relationship with Sentinel, Joseph Ciacciarelli, Terence Law, and Stephen Brennan on occasion perfunctorily reviewed the Form 1-FRs. I found credible their testimony that, having credited Sentinel’s claim that removal from segregation was consented to by its clients, they neither looked for nor found any segregation violations. This was so because BNYM officers believed Eric Bloom’s unequivocal statement that his clients gave Sentinel the right to move assets from segregated accounts and place them in lienable accounts to pursue its leveraged trading program through overnight loans.

BNYM had a list of pledged securities. When Sentinel offered securities as collateral, BNYM had to evaluate the specific securities. It believed that the loans were properly secured. Throughout June and July, the loan was over secured. BNYM was attending to its frequent loans and pricing securities in lienable accounts and giving those securities a margined value, a substantial margin below current value to insure that the loan amount would be covered even if the price of the securities (including stocks, bonds, etc.) were to fall. BNYM knew a lot about Sentinel’s business, excepting that which matters most in this case: the designation of Sentinel’s accounts from which they came.

Had BNYM known the amount of any loan which supported Sentinel’s own trading, the portion which supported its futures merchants, and the portion from non-futures customers, then BNYM might have been able to calculate the portion of the loan proceeds used for trading. It may have been able to determine whether those assets and the customer assets were held in a single, undifferentiated pool. BNYM did not, however, have access to records showing how Sentinel, itself, allocated the funds. Two reports that Sentinel did not provide BNYM— Sentinel’s daily statement of segregation and Active and Matured Securities Report—would have enabled an outsider, like a regulator, to identify allocation of assets on any given date and the allocation of loan proceeds. In fact, BNYM relied on its knowledge that Sentinel operated a business regulated under federal laws, including the Commodities Exchange Act, and was audited annually by a firm of Certified Public Auditors who issued an annual unqualified audit opinion approving Sentinel’s statement of its financial position. In addition, the National Futures Association examined Sentinel annually through 2006. As it was, BNYM did not know, from what Sentinel did report, whether, on any given day, Sentinel transferred customer securities, as well as other assets, as collateral for loan proceeds that Sentinel would use to finance its own trades. Sentinel could legally trade for itself, and BNYM believed it did. BNYM did not know or believe that Sentinel was engaging in misconduct before it collapsed.

One bank employee worried that Sentinel was using the loan money to trade without putting its own collateral up. Mark Rogers wrote a note to those BNYM employees who worked on the Sentinel account and questioned how Sentinel was able to post so much collateral when its capital was $2 million. Rogers answered his own question in these words, “I have to assume most of this collateral is for somebody else’s benefit. Do we really have rights on the whole $300MM?” Rogers did not claim he knew or believed that all the collateral was for somebody else’s benefit. He came closer to an affirmative statement when he “assumed” that most of the collateral was for somebody else’s benefit, but this too was not an assertion of belief or knowledge. Assuming arguendo that Rogers knew, rather than guessed, that some portion of the collateral was posted for the benefit of insiders, he did not assume that all of it came from the accounts of Sentinel’s clients.

Even so, Rogers’ inquiry does not focus on the interests of Sentinel or its clients, but on BNYM’s rights to “the whole $300MM.” Law replied to Rogers’ concern by writing, “We have a clearing agreement which gives [us] a full lien on the box position outlined below.” In fact, both Rogers and Law knew before the email was sent that there was a clearing agreement that gave BNYM a lien on any securities in the collateral account. What I conclude Rogers was doing was seeking reassurance that the lien was enforceable. And I conclude Law and his colleagues’ response to Rogers was considered and cleared by bank officers who believed it to be a “well-advised and carefully worded statement.” And with that, the one question that Rogers raised concerning a matter material to BNYM was answered in mid-June, about two months before Sentinel collapsed.

The testimony and demeanor of the bank officers and others left no doubt in my mind that the sudden demise of Sentinel, precipitated by Sentinel’s immediate halt of customer redemptions on August 13, 2007, was a complete surprise to BNYM officials. BNYM believed that there were coming changes in what was useful as collateral and, based on this belief, changed some of its procedures in dealing with Sentinel. Some at BNYM thought that its business with Sentinel, as a customer, would come to an end because of these changes, but it did not know that Sentinel was on the brink of collapse. BNYM officials had not foreseen the possible end of Sentinel as an operating enterprise. BNYM also did not know anything that would have led it to believe that Sentinel, whose loans were over secured and had been so for months, would collapse or need to be looked at more closely. BNYM, in short, did not foresee the possible demise and default of Sentinel, and BNYM did nothing that can properly be labeled as egregious or conscience shocking.

C. Objective Knowledge: Was BNYM’s Conduct Reasonable, Negligent, Reckless, or Deliberately Indifferent?

From the beginning of this litigation to now, the Trustee has continuously invoked the two-part mantra that BNYM “knew or should have known” of Sentinel’s misconduct. When this formula is consistently invoked by lawyers, it is usually a signal that proving the “knew” may not be doable, and the Trustee’s difficulty, in the end, was that BNYM did not know of misconduct of any sort. Nonetheless, the Trustee mainly, if not entirely, seeks to prove “should have known,” so I now turn to whether BNYM should have known about, but was reckless or deliberately indifferent towards, Sentinel’s misconduct.

In my prior opinion, I was critical of some of BNYM’s course of conduct depending entirely on the security of the collateral. I expressed the view that, while not legally obligated to do so, some bank employees could or should have done a more effective job of protecting BNYM’s own interests by taking a closer look at Sentinel’s operations and records. To that end, I indicated that, even if BNYM was only concerned with protecting its own interests, a diligence process that excluded verification of whether Sentinel had the right to pledge the relevant collateral, such that it adequately secured BNYM’s loans, seemed to be “ineffective and reckless.”

I further found that a reasonably prudent person would have taken a closer look at the 1-Rs—reports that revealed with relatively cursory review that Sentinel was violating its segregation requirements. As I previously found, Ciacciarelli, Law, and Brennan did indeed review the 1-FRs on occasion, but failed to undergo the closer examination that might have revealed such violations. Nevertheless, BNYM neither knew nor turned a blind eye to the improper actions of Sentinel. There is a range of actions that a reasonably prudent person could have and might have taken in this situation. This is to say that even if a reasonably prudent person would have, and certainly “could” have, conducted a more rigorous inspection of Sentinel’s operations or reporting, it would not be unreasonable for such a person to decline to take a closer look at the 1-FRs or other documentation. While what BNYM elected to do was less than I thought was wise, it remains that mere negligence—or ineptitude—is insufficient to establish inequitable conduct. [1] BNYM was neither “deliberately indifferent” nor “reckless” in dealing with its legal obligations by failing to investigate Sentinel’s misconduct.

So too it is not unreasonable for a bank, in general, to protect its interest in having its loan paid back in full by relying solely on the cash value of the collateral. What BNYM must do is to check the quality and suitability of the collateral, which it did by evaluating the securities and fixing their cash values. And it is not necessarily negligent or reckless to accept collateral without further checking its provenance, particularly where pledged securities had been used for a long time without problems for BNYM. After years of successful loans to Sentinel, BNYM had been satisfied with Eric Bloom’s representation, on behalf of Sentinel, that it had the right to pledge the securities. [2] BNYM could reasonably accept Bloom’s word.

Long term stable banking relationships can give rise to actions based, in some part, on trust. That BNYM did not take further steps to investigate Sentinel’s practices for misconduct and, instead, relied on Sentinel’s statements is reasonable in the specific setting of this case. Good faith reliance is an inescapable requisite of a banking finance enterprise. BNYM is neither a father’s keeper nor a partner (despite the current advertising of some banks) of those companies to whom it loans money for business operations. A bank loan is an arm’s length deal. It is both legally and economically wrong to require of a bank the kind of systemic oversight that a parent or holding company often chooses to exercise over a subsidiary. Banks can exercise oversight if they choose, but that oversight is to ensure that the bank’s interest, and not the interest of the debtor, is protected. Close surveillance of the integrity of the debtor and its conduct might be better for a bank, particularly at the outset of the relationship, but this is not an iron-clad duty a bank owes to its debtor or to the debtor’s clients.

Furthermore, close surveillance of a customer is not cheap and it might be reasonably thought unnecessary, particularly when the debtor is regulated or registered by federal agencies or self-regulatory organizations, all of which were essential to the continued existence of Sentinel. As previously noted, the National Futures Association examined Sentinel annually through 2006, and an independent outside auditor, McGladrey & Pullen LLP and its predecessor Altschuler, Melvoid and Glasser LLP (collectively “McGladrey”), was retained that issued annual unqualified audit opinions approving Sentinel’s statement of its financial position. There is no evidence in the record that either the auditor or regulator—independent entities with the power of oversight over Sentinel—knew or should have known of wrongdoing before Sentinel’s collapse. BNYM management could fairly rest on the protection of the collateral for its loan at least until such time as the NFA or auditors or, in this case, an inability to honor requests for customer redemptions started the bells ringing. BNYM, I concluded, neither knew nor should have known that Sentinel was misusing loan proceeds or participating in any other misconduct.

Based on this and my observations at trial, I found that BNYM acted within the realm of reason when it took great care to insure its loans were backed by adequate collateral. It had lengthy experience banking for Sentinel, which had appeared to BNYM to be professional and honest. [3] This does not mean that BNYM had blind faith in Sentinel. BNYM paid close attention to the loans and the collateral. The loans, and there were many, were paid until nearly the end. Rogers raised questions of Sentinel’s conduct which several other bankers considered. These other bankers concluded that the lien on collateral would be valid and enforceable. BNYM dealt often with the Sentinel account and at times made efforts to reduce the size of the loan. The reductions in the loans were neither drastic nor indicative of BNYM’s loss of faith in the basic honesty of Sentinel.

It was also reasonable for BNYM to believe the statement of Eric Bloom that Sentinel was authorized to transfer securities from segregated accounts to lienable accounts. Unknown to BNYM was that Bloom’s transfer authority was nil. Other than Bloom’s lie, undetected by its own auditors or regulators, nothing in Sentinel’s conduct throughout the banking relationship did lead BNYM to doubt his integrity. BNYM accepted Bloom’s word against its own interests when Bloom instructed BNYM to remove millions of dollars of securities from collateral accounts to segregated accounts.

When BNYM officers made that choice, they did not know, nor did they believe (with the possible exception of Rogers), that Sentinel was untruthful in its representations and wrongly misusing customer assets as collateral. Rogers’ view that BNYM needed more information about how a company with small capital could put up large collateral was not enough to sound an alarm to which BNYM had to respond. Rogers wrote “I have to assume” when commenting on his views of Sentinel’s practice. Rogers’ testimony and his demeanor convinced me that he thought that BNYM should have investigated Sentinel (how it would do this he did not say). Rogers had questions but not answers. He made it clear that he did not know what Sentinel did and could not have reached an actionable belief about Sentinel. The opinion of his fellow bank officials Terrence Law, Stephen Brennan, Joseph Ciacciarelli, and others took the view, based on research and a review of its contract, that the clearing agreement gave BNYM a full lien on the box position outlined. In the end, Rogers, and only Rogers, worried—not believed or knew— about the possibility that BNYM’s lien might fail to some unknown degree. No other BNYM official agreed with him, all thought the clearing agreement left the loan unimpaired. There is nothing in this exchange of bank personnel that necessitates that a reasonably prudent person would have believed that Sentinel had engaged in misconduct. BNYM did not know or believe that Sentinel was misusing the collateral of others, nor was it unreasonable for BNYM to trust Eric Bloom until it was too late. The decision to rely on the full lien, then, is and was a reasonable policy choice for BNYM to make. [4]

D. Whether BNYM’s Failure to Act on Its Constructive Knowledge Requires That BNYM’s Claim Be Subordinated

As I have clarified the extent of BNYM’s knowledge, I now revisit the ultimate issue of whether to apply equitable subordination to BNYM’s rights to collect on the collateral which secured its large loan to Sentinel. In order to subordinate a claim, I must conclude that (1) the claimant engaged in some type of inequitable conduct; (2) the misconduct resulted in injury to the creditors or conferred an unfair advantage on the claimant; and (3) subordination is not inconsistent with the provisions of the Bankruptcy Code. In re Mobile Steel Co., 563 F.2d 692, 699-700 (5th Cir. 1977) ; see In re Kreisler, 546 F.3d 863, 866 (7th Cir. 2008) . While this test is applicable whether the claim to be subordinated is that of an insider or a non-insider, the Trustee’s burden of proof is fairly high when equitable subordination is sought against a bank that was neither a Sentinel insider nor a fiduciary to Sentinel. Kham & Nate’s Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351, 1356 (7th Cir. 1990) . What the Trustee must prove is that BNYM knew or was unjustifiably indifferent to Sentinel’s misconduct. This was my holding. To prevail, Sentinel had to show that BNYM actually knew (subjectively knew) enough about the facts of what Sentinel was doing to require BNYM to make further investigation of Sentinel’s conduct. The Trustee cannot simply show, after the fact, that BNYM could have put together all the objective pieces of information that BNYM had about Sentinel and should have known it had to investigate Sentinel’s conduct. It is also not enough simply to say that another more conservative bank could have acquired enough objective information that it is deemed to have known what it did not subjectively know about Sentinel. The primary difficulty with compiling all the objective pieces of information and interpreting them to reach a compelling need for a bank to act is that the risk of hindsight bias often makes the purely objective information an unreliable and unfair ground on which to judge the conduct of BNYM officers. I have found that BNYM employees were neither aware of nor deliberately indifferent toward Sentinel’s misconduct. As BNYM’s behavior was neither egregious nor conscience shocking, it does not satisfy the requirements for equitable subordination.

II. Fraudulent Transfer, Counts I and II

A. Actual Intent to Defraud

The Trustee seeks to avoid (i.e. eliminate) and recover five transfers from Sentinel to BNYM that occurred on June 1, June 26, June 29, July 17, and July 31, 2007 (“Specific Transfers”) [5] as fraudulent under § 548(a)(1)(A) of the Bankruptcy Code and § 5(a) of the Illinois Uniform Fraudulent Transfer Act (“UFTA”). A debtor may seek to avoid a fraudulently made transfer of property that is a barrier to the recovery of assets (e.g., a lien against a property). A lien may identify the specific security attached to a loan for any person who seeks a specific security and give preference to creditors over unsecured and undersecured creditors. Here, the Trustee, at a bare minimum, seeks to avoid BNYM’s entire lien against those Sentinel assets which BNYM was entitled to take, and presumably sell, until it collected the amount of the loan which Sentinel was unable to pay back.

At trial, the Trustee’s expert witness James Feldman opined that the transfers at issue took place, in one instance, in the closing out of repo positions and, in two instances, the structuring of collateral by moving securities between accounts. Specifically, the Specific Transfers of June 1, 26, 29 and July 17, three of which occurred after a repo lender returned large amounts of collateral in the form of physical securities to Sentinel, were in very large part taken out of segregated accounts and sent to Sentinel’s “SEN” clearing account. The July 30th and 31st transfers were very largely transferred out of lienable “clearing” accounts and sent back to Seg I accounts—$263 million in government securities and $248 million in DTC securities. The Trustee seeks a finding that the five Specific Transfers were fraudulent and that, consequently, BNYM’s entire lien, as of the Petition Date, on Sentinel’s accounts and assets in the amount of $312 million must be avoided.

In order to avoid the Specific Transfers as fraudulent, Plaintiff must first demonstrate that: (1) Sentinel had an interest in the transferred property; (2) Sentinel transferred the property with actual intent to hinder, delay or defraud its creditors; and (3) the Specific Transfers occurred within the applicable statutory period. 11 U.S.C. § 548(a)(1)(A); 740 ILL. COMP. STAT. 160/5(a)(1). Whether Sentinel transferred the property with actual intent to defraud its customers is the question the Seventh Circuit addressed and remanded to this Court.

In my prior opinion, I concluded that the Trustee had not proven Sentinel’s actual intent to hinder, delay, or defraud other creditors or to strip itself of assets when it made these transfers. This is largely a result of my belief that Sentinel’s conduct arose, instead, from its attempt to stay in business. The Seventh Circuit expressed no doubt that Sentinel’s motive was to stay in its legitimate business and even reasoned that Sentinel’s actions in wrongfully transferring segregated funds into its clearing accounts were the natural consequence of its attempt to do so. Nonetheless, the Seventh Circuit, citing persuasive precedents, held that even one who has the best intentions, with no thought of harm, could still possess an actual intent to defraud. United States v. Segal, 644 F.3d 364, 367 (7th Cir. 2011) ; United States v. Davuluri, 239 F.3d 902, 906 (7th Cir. 2001) . Relying on my factual findings, the Seventh Circuit found that Sentinel knowingly exposed its FCM clients to a substantial risk of loss of which they were unaware in violation of the Commodities Exchange Act (“CEA”) and, thus, acted with the intent to defraud. Consequently, the Seventh Circuit concluded that the Trustee should be able to avoid BNYM’s lien under § 548(a)(1)(A).

After review of the record and consideration of the question anew, I understood I erred when deciding at trial that Sentinel could not have the intent to defraud others without having any intent to cause harm. Here, Sentinel commingled its client assets with Sentinel’s assets in an unlawful manner and exposed its FCM clients to a substantial risk of loss of which they were unaware. While Sentinel may have intended to save its business and its client’s funds, the actions of Sentinel were in violation of the CEA. The remand noted, however, that, even with this finding of actual intent to defraud, there remained more than a little work to be done with respect to the fraudulent transfer under 11 U.S.C. § 548(a)(1)(A) and stated that there were defenses available to BNYM that had not yet been addressed.

B. Defenses, 11 U.S.C. §§ 548(c) and 550

BNYM has asserted two defenses under 11 U.S.C. § 548(c) and 11 U.S.C. § 550 against avoiding the Specific Transfers. I address each in turn.

1. BNYM Acted in Good Faith, 11 U.S.C. § 548(c)

First, BNYM argues that the Specific Transfers should not be avoided under § 548(c) because BNYM, as a transferee, received liens for value in exchange for giving value to Sentinel in good faith. The Trustee argues that BNYM had inquiry notice of Sentinel’s possible insolvency and, so, its actions in transacting with Sentinel were not in good faith. The Seventh Circuit, noting that a § 548(c) defense is generally unavailable to any creditor who “has sufficient knowledge to place him on inquiry notice of the debtor’s possible insolvency,” sought clarification from this Court on what BNYM knew before Sentinel’s collapse. Grede Appeal; In re M & L Bus. Mach. Co., 84 F.3d 1330, 1334-36 (10th Cir. 1996) ; Scholes v. Lehmann, 56 F.3d 750, 756 (7th Cir.1995) .

The Trustee argues that whether BNYM acted with “good faith” must be assessed under the objective standard, Donohoe v. Consolidated Operating & Production Corp., 30 F.3d 907, 912 (1994) (good faith typically determined by examining whether reasonable diligence was used); Brown v. Third Nat’l Bank (In re Sherman), 67 F.3d 1348, 1357 (8th Cir. 1995), while BNYM argues that a hybrid of the objective and subjective standards must be applied in this case. In re M & L Bus. Mach. Co., 84 F.3d 1330, 1334 (10th Cir. 1996) (good faith is lacking only if “a diligent inquiry would have discovered the fraudulent purpose”). I do not agree that the state law defined by UCC 8-503 is a useful source of guidance in deciding whether BNYM acted in good faith.

To say, as Trustee does here, that the good faith defense fails because BNYM knew or should have known that Sentinel was acting improperly is both understandable and pointless since I have found that BNYM neither knew nor should have known of Sentinel’s bad conduct. Perhaps more important than arguments over the precise standard of good faith (and the UCC’s collusion standard applicable to a “purchaser” and a “securities intermediary”) is the rule that absent BNYM’s actual knowledge of bad conduct or its ignoring what it should have known, the only conclusion is that BNYM here has acted in good faith.

I find that, even under a purely objective standard, BNYM acted in good faith.

I do not believe the Trustee argues that BNYM did not act in good faith because law or an accepted practice requires a bank to rule out by investigation any wrongful conduct of Sentinel and BNYM failed to do so. There is no such requirement. However, where there are grounds to believe that a bank should have known of the misconduct of its borrower, investigation may be required. The law and practice do not require inquiry, and inquiry notice of a regulated enterprise was not present here.

I find, in large part based on my credibility determinations at trial, that several clues reveal that the loans were made in good faith. First, I found as a fact, that BNYM did not know that the loans were secured with collateral that was not within Sentinel’s right to post. Sentinel’s investment strategy was based on using pooled funds of Sentinel and its clients, which allowed Sentinel and its customers to maximize the value of the overnight loan to customers. Sentinel had good business reason to use this strategy, and BNYM had no reason to disbelieve Eric Bloom when he represented that Sentinel was allowed to use client’s segregated funds as collateral. Moreover, any inquiry BNYM might have made would likely have been fruitless, as BNYM believed, even to its own detriment, the lies told by Eric Bloom.

The Trustee next contends that because BNYM extended enormous loans secured with excess collateral, it was not acting in good faith. Receiving collateral in exchange for a loan is one of the various methods, each with its own costs and benefits, in which a bank can manage the risk it takes in extending a loan. It was within BNYM’s rights to use collateral to manage the risk it took in extending a loan to Sentinel, and its reliance, even exclusively, on collateral was reasonable. BNYM and Sentinel had a fairly long history of extending loans and not needing to use the collateral which secured Sentinel’s loans. BNYM had made such loans for many months, accepted assets for collateral and, in fairly short order (a day or a few days), Sentinel paid back the loan and BNYM returned the collateral—even as recently as two months prior to Sentinel’s bankruptcy. The day came when the loan was not paid and BNYM kept the collateral. There was nothing, I have found, that would have or should have informed BNYM that this long time set of transactions would suddenly change in nature.

The Trustee suggests that BNYM knew that Sentinel was on the verge of a collapse because it forced the loan balance down from a peak of $573 million in June 2007 to around $312 million by August 17, 2007. It is true that BNYM surmised that Sentinel was going through a rough patch and that its business was not as robust as in the past. It is also true that BNYM sought to increase protection of its own financial interests, in light of these increased risks, by lowering its loan balance and over securing its loans. It is even true that BNYM suspected that its relationship with Sentinel might come to an end. I did not find, however, that BNYM had a premonition that the “rough patch” would lead to Sentinel’s ultimate downfall. Rather, it was precisely because of its own stricter lending requirements that BNYM guessed that Sentinel may no longer be BNYM’s client in the future if it could find a bank whose lending policies were more lenient than BNYM’s newer and tighter ones.

2. Recovery Limitations under 11 U.S.C. § 550

Under § 550, a trustee is only allowed to recover property transferred or the value of such property from the transferee; here, because BNYM gave full consideration for the Specific Transfers, BNYM argues that § 550 bars the Trustee from any additional recovery. Additionally, BNYM argues that it returned securities to Sentinel and that avoidance of BNYM’s entire lien would allow double recovery to the Trust as prohibited under § 550(d). The Trustee contends that it may recover from multiple entities and that returning some or even all of the securities does not legitimize the avoidable transfer. Nostalgia Network, Inc. v. Lockwood, 315 F.3d 717, 720 (7th Cir. 2002) . While the Trustee concedes that its recovery is limited to a single satisfaction, Freeland v. Enodis Corp., 540 F.3d 721, 740 (7th Cir. 2008), he argues that BNYM did not truly return the securities, but rather “exchanged” the securities for either replacement securities or the proceeds of the sale of these securities.

As an initial matter, the Trustee argues with faint hope that § 550 does not apply because § 551 automatically preserves the avoided property for the benefit of the estate. Rodriguez v. Drive Fin. Serv., L.P. (In re Trout), 609 F.3d 1106, 1109-10 (10th Cir. 2010) ; People’s Bank & Trust Co. v. Burns, 95 Fed. App’x 801, 804 (6th Cir. 2004) ; Suhar v. Burns (In re Burns), 322 F.3d 421, 427-28 (6th Cir. 2003) . Section 551 of the Bankruptcy Code, however, clearly has no relevance or application in this case, and I will apply § 550 here.

Trustee maintains a broad attack against the entirety of BNYM’s collateral, but fails to specifically identify the collateral it is seeking. This is significant because the Trustee cannot, in my view, rightfully claim a valid interest in all of the collateral that BNYM had on the eve of Sentinel’s bankruptcy unless it can specifically identify the collateral and prove some type of relationship to the collateral held by BNYM. The Trustee in this case faces the complications that arise with repeated overnight (or short term) loans. Assets go in and out of collateral. The relationship between a particular item in collateral and the loan it secures may not be discernable. Transfers of specific collateral for a specific overnight loan may not be clear. Here, there were periods of time during which Sentinel received daily or frequent loans regularly. The Trustee’s approach was to deal with the loan and collateral in play close to the demise of Sentinel, and the Trustee did not identify what specific interest in the securities he sought to invoke. There was a loan of $312 million plus interest against collateral of $697 million, but the Trustee never introduced evidence tying the Specific Transfers to specific collateral in BNYM’s hands on the Petition Date.

Perhaps it is precisely because the Trustee could not identify through records, accounts, or inventory what Sentinel used to secure its loans, or perhaps it is simply in order to avoid BNYM’s right to use the five Specific Transfers of security as collateral that the Trustee has maintained this broad attack against the entirety of BNYM’s collateral. The Trustee conceded that BNYM’s cushion was $395 million above what BNYM was owed. The Trustee’s current position is that his target is avoidance of all liens granted rather than the value of the transfers. This does not make sense. The lien is not the only method by which BNYM can use collateral to be made whole. Here, BNYM loaned Sentinel $312 million and Sentinel provided an amount of collateral which secured the $312 million and no more. Trustee’s right to recover remains only to the extent it leaves the estate in the same position that it would have been without the transfer. Freeland v. Enodis, 540 F.3d 721, 739 (7th Cir. 2008) (no recovery can be had from parties who participated in a fraudulent transfer but did not benefit from it). Therefore, Trustee cannot avoid BNYM’s entire lien.

I now turn to the question of whether BNYM gave full consideration for the Specific Transfers, and consequently, what claim the Trustee has to be made whole. BNYM delivered $312 million or so which the Trustee has not returned. BNYM has the right to liquidate the collateral up to the amount of the existing loan and return any assets that exceed the amount of the money due under the terms of the loan. All that occurred here was an exchange of collateral for loans of cash. The Specific Transfers at issue were not designed to drain Sentinel’s assets, but were attempts to continue conducting business and paying off existing creditors by keeping its line of credit open, presumably to stay in business. Even so, the transfers can be voidable if they resulted in draining of the asset pool. The assets of Sentinel were not depleted; they were held as security for repayment of the loan. Rather, in exchange for the collateral, BNYM gave Sentinel a loan of significant value which only added to Sentinel’s asset pool. And the recipient of the millions from BNYM was Sentinel and only Sentinel. What Trustee would have under its plan is a windfall recovery of the millions loaned to Sentinel by BNYM plus the entire collateral that secured these loans. The Trustee cannot force BNYM to pay twice the value of its loan by avoiding the fraudulent Specific Transfers.


1. I did not find that BNYM engaged in “egregious misconduct” sufficient to subordinate its lien against Sentinel.

2. The June 1, June 26, June 29, July 17, and July 31 transfers, while made with fraudulent intent, cannot be avoided as they were made in good faith and the Trustee has failed to adequately identify the securities to be avoided.

[1] For purposes of deciding the question of the Bank’s mental state when it decided to go no further in looking at Sentinel, once BNYM decided that its full lien was all BNYM needed to protect itself against Sentinel, I decided that the worst that could be said about BNYM would be that it was negligent in dealing with Sentinel. I did not find as a matter of fact or law that BNYM was negligent in its conduct with respect to the Sentinel loans, let alone reckless. The Trustee argued that bankers believed Rogers’ assumption was valid and may have believed that the assumption was true but did not conclude that the bankers did so. I found as a fact that they did not come to believe or credit Rogers’ assumption.

[2] I leave aside the question of whether the Trustee has shown that the particular securities posted as collateral were, in fact, securities which Sentinel had the right to pledge.

[3] I take judicial notice that the government has charged Sentinel’s leader with criminal acts of misrepresentation. I do not consider the possible significance of the indictment’s allegations, the truth of which is still the subject of post-verdict litigation.

[4] I do not retreat from my view that BNYM’s management of its business with Sentinel was not as thorough as it could have been. I wrote that the officers “would have been better bankers if they had made a more rigorous inspection of Sentinel’s operations or its reporting.” More scrutiny is often useful but not legally required in a case like this. The decision not to go further than reliance on the collateral is neither negligent nor reckless in the context of Sentinel’s operations, where a good number of bank officials believed that the lien was enough protection for BNYM. While I believe that a more intrusive examination might be a more effective approach in general, there are no reasons to believe that the bank’s officers would have done better than Sentinel’s regulators and independent auditors. Sentinel’s leadership was not honest, and the firm survived its dishonest practices for quite a long time. I noted in my original decision that “[i]n closing, Trustee (implicitly recognizing the difficulty and impracticality of direct contact with Sentinel’s clients) argued that BNYM employees should have at least asked Eric Bloom whether he had the power to transfer assets from segregated or lienable accounts and signed a clearing agreement authorizing the pledge.” Bloom had said he had the power to transfer assets from segregated or lienable accounts and signed a clearing agreement which stated that Sentinel had the right to pledge those securities. Given Eric Bloom’s willingness to act as he did, the effort of the better banker would not, I believe, have changed anything. We are, in short, a very long way from egregious and conscience-shocking behavior by BNYM.

[5] As the Trustee did not pursue the July 30, 2007 transfer, I decline to address whether this transfer must be avoided as fraudulent.

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New Bankruptcy Opinion: IN RE EC MORRIS CORP. – Bankr. Appellate Panel, 6th Circuit, 2014

In re: E.C. MORRIS CORP., Debtor.

No. 14-8016.

Bankruptcy Appellate Panel, Sixth Circuit.

Decided and Filed: December 10, 2014.


Rodd A. Sanders, RODERICK LINTON BELFANCE, LLP, Akron, Ohio, Matthew R. Duncan, BUCKINGHAM DOOLITTLE & BURROUGHS, LLC, Akron, Ohio, for Appellees.

Before: HARRISON, HUMPHREY, and LLOYD, Bankruptcy Appellate Panel Judges.


MARIAN F. HARRISON, Bankruptcy Appellate Panel Judge.

ECM Chemicals, LLC, and Edward C. Morris (“Appellants”) appeal the order of the United States Bankruptcy Court for the Northern District of Ohio (“Bankruptcy Court”) denying their Motion to Enforce Order Approving Compromise of Claims. Specifically, the Appellants seek to stop Ergon Refining, Inc., and Rentwear, Inc. (“Appellees”) [1] from pursuing successor liability claims against them based on the Chapter 7 Trustee’s compromise of the estate’s claims against the Appellants. For the reasons that follow, the Panel AFFIRMS the Bankruptcy Court’s denial of the Appellants’ motion.


The issue in this case is whether the Bankruptcy Court correctly denied the Appellants’ motion for lack of jurisdiction.


The United States District Court for the Northern District of Ohio has authorized appeals to the Panel, and no party has timely elected to have this appeal heard by the district court. 28 U.S.C. § 158(b)(6), (c)(1).

A final order of the bankruptcy court may be appealed as of right pursuant to 28 U.S.C. § 158(a)(1). For purposes of appeal, a final order “ends the litigation on the merits and leaves nothing for the court to do but execute the judgment.” Midland Asphalt Corp. v. United States, 489 U.S. 794, 798, 109 S. Ct. 1494, 1497 (1989) (citation omitted). “`[T]he concept of finality applied to appeals in bankruptcy is broader and more flexible than the concept applied in ordinary civil litigation.'” Millers Cove Energy Co., Inc. v. Moore (In re Millers Cove Energy Co., Inc.), 128 F.3d 449, 451 (6th Cir. 1997) (citations omitted). “This finality requirement is considered `in a more pragmatic and less technical way in bankruptcy cases than in other situations. . . . In bankruptcy cases, a `functional’ and `practical’ application [of Section 158] is to be the rule.'” Lindsey v. O’Brien, Tanski, Tanzer & Young Health Care Providers of Connecticut (In re Dow Corning Corp.), 86 F.3d 482, 488 (6th Cir. 1996) (citations omitted).

The Appellees make the argument that the Bankruptcy Appellate Panel lacks jurisdiction because the order dismissing the adversary proceeding was “without prejudice.” However, the Appellants are not appealing the order dismissing the adversary. Instead, the Appellants are appealing the Bankruptcy Court’s denial of their “Motion to Enforce Order Approving Compromise of Claims” based on a lack of subject matter jurisdiction, and the denial of a motion for lack of jurisdiction constitutes a final order and may be appealed as of right. See Thickstun Bros. Equip. Co., Inc. v. Encompass Servs. Corp. (In re Thickstun Bros. Equip. Co., Inc.), 344 B.R. 515, 517 (B.A.P. 6th Cir. 2006) (citation omitted). [2]

Questions of subject matter jurisdiction are reviewed de novo. Todd v. Weltman, Weinberg & Reis Co., L.P.A., 434 F.3d 432, 435 (6th Cir. 2006) (citation omitted). “Under a de novo standard of review, the reviewing court decides an issue independently of, and without deference to, the trial court’s determination.” Menninger v. Accredited Home Lenders (In re Morgeson), 371 B.R. 798, 800 (B.A.P. 6th Cir. 2007) (citation omitted). Essentially, the reviewing court decides the issue “as if it had not been heard before.” Mktg. & Creative Solutions, Inc. v. Scripps Howard Broad. Co. (In re Mktg. & Creative Solutions, Inc.), 338 B.R. 300, 302 (B.A.P. 6th Cir. 2006) (citation omitted).


In 2009, the Debtor’s financial problems were significant. To address the issue, Appellant Edward C. Morris (“Mr. Morris”), principal of the Debtor, formed Appellant ECM Chemicals, LLC (“ECM Chemicals”), on January 1, 2010. Next, Mr. Morris had the Debtor grant him a security interest in its assets and recorded the financing statement with the Secretary of State on January 5, 2010. On January 10, 2010, Mr. Morris executed a bill of sale and assignment transferring his security interest in the Debtor’s assets to ECM Chemicals. The Debtor continued to operate at a loss, and on July 27, 2010, the Debtor, through Mr. Morris, voluntarily surrendered its assets to ECM Chemicals and was dissolved on January 4, 2011. Prior to bankruptcy, the Appellees filed state court actions against the Debtor and the Appellants, as well as unnamed John Does, alleging successor liability, fraudulent transfer, fraud, and breach of fiduciary duty, all under state law. The Debtor filed a voluntary Chapter 7 petition on March 26, 2012.

During the bankruptcy, the Chapter 7 Trustee filed an adversary proceeding against the Appellants and another defendant, Edwin L. Nowlan (“Mr. Nowlan”), a lien holder against the Debtor, to avoid fraudulent transfers. The Chapter 7 Trustee settled with the Appellants and Mr. Nowlan, and after evidentiary hearings, the Bankruptcy Court approved the settlement. The order approving the compromise “authorized, empowered, and directed” the Chapter 7 Trustee to cause a dismissal of the adversary proceeding with prejudice. The Chapter 7 Trustee then submitted, and the Bankruptcy Court entered, an order dismissing the adversary “without prejudice.” The adversary was then closed on July 9, 2013. The Chapter 7 Trustee filed his Final Account and Distribution Report on November 4, 2013. The Debtor, as a corporation, did not receive a discharge.

After the bankruptcy proceedings were completed, the Appellees reactivated their respective state court litigation against the Appellants. [3] On January 9, 2014, the Appellants filed a Motion to Enforce Order Approving Compromise of Claims, asking the Bankruptcy Court to enjoin the Appellees from pursuing their state law claims against the Appellants because such claims were barred by res judicata. The Appellants asserted that the Bankruptcy Court had jurisdiction to provide the relief requested pursuant to 11 U.S.C. § 105. In addition, the Appellants argued that Stern v. Marshall, ___ U.S. ___, 131 S. Ct. 2594 (2011), did not prevent the relief sought because the state law claims deal directly with the Debtor’s assets and because the Bankruptcy Court had jurisdiction to take the necessary action to ensure that such claims do not undermine the Bankruptcy Court’s order and the integrity of the bankruptcy process.

The Bankruptcy Court held a hearing on the Motion to Enforce, adjourning to give the parties the opportunity to brief the jurisdictional issues. At a second hearing, the Bankruptcy Court denied the Motion to Enforce, stating:

With respect to the relief sought in the motion to enforce, I find that the Court is not authorized to enter final judgment. Among the factual findings that I make in support of this are that this was a Chapter 7 case of a corporate entity in which no discharge was entered. The agreement between the Trustee and the movants today did not include the respondents. The respondents’ litigation was pending prior to the bankruptcy filing. And the — that litigation raises state law claims over which there would not have been federal — any federal jurisdiction absent a bankruptcy case.

Under these circumstances, based both on the Stern case and, unfortunately for [the movants’ counsel], the Law case, which was decided just yesterday and addressed the scope of Section 105 in bankruptcy proceedings, I do not believe this Court to have jurisdiction to enter a final judgment on this motion.

. . . .

Based on the foregoing, the Court determines that the motion before me today should be denied.

The Appellants appealed the Bankruptcy Court’s denial of the Motion to Enforce.



Bankruptcy courts have subject matter jurisdiction over proceedings “arising under title 11, or arising in or related to cases under title 11.” 28 U.S.C. § 1334(b). The most expansive of these categories is “related to” jurisdiction. Therefore, only a determination of whether the matter is “related to” the bankruptcy is necessary in assessing 28 U.S.C. § 1334(b) jurisdiction. Michigan Emp’t Sec. Comm’n v. Wolverine Radio Co. (In re Wolverine Radio Co.), 930 F.2d 1132, 1141 (6th Cir. 1991) (citation omitted).

A civil proceeding is “related to” a bankruptcy case where “the outcome of that proceeding could conceivably have any effect on the estate being administered in bankruptcy.” In re Dow Corning Corp., 86 F.3d at 489 (citation and internal quotation marks omitted). A claim is “related to” the bankruptcy proceeding “if the outcome could alter the debtor’s rights, liabilities, options, or freedom of action (either positively or negatively) and which in any way impacts upon the handling and administration of the bankrupt estate.” Id. See also Celotex Corp. v. Edwards, 514 U.S. 300, 308 n.6, 115 S. Ct. 1493, 1499 (1995) (“[C]ases make clear that bankruptcy courts have no jurisdiction over proceedings that have no effect on the estate of the debtor.”).

In the present case, the pending pre-petition state lawsuits against the non-debtor Appellants for successor liability are not directed at the Debtor or the Debtor’s estate, and most importantly, will have no impact on the bankruptcy estate. The Debtor’s bankruptcy has been fully administered by the Chapter 7 Trustee, who has filed a Zero Bank Statement/Final Account indicating that there are no estate assets remaining. Accordingly, the Bankruptcy Court correctly held that it did not have subject matter jurisdiction. [4]

The Court notes that the Chapter 7 Trustee might have pursued these state court lawsuits as property of the estate or through his rights and powers under 11 U.S.C. § 544 while the bankruptcy case was pending. See Hatchett v. United States, 330 F.3d 875, 886 (6th Cir. 2003) (“[T]he trustee has the exclusive right to bring an action for fraudulent conveyance during the pendency of the bankruptcy proceedings”); Rieser v. Hayslip (In re Canyon Sys. Corp.), 343 B.R. 615, 659 (Bankr. S.D. Ohio 2006) (“Allowing a bankruptcy trustee to pursue general creditor claims `ensures that the estate will not be wholly or partially consumed for the benefit of one creditor, or even a small number of creditors.'” (citation omitted)). However, once the bankruptcy case was closed, these lawsuits were no longer the Chapter 7 Trustee’s to pursue or administer. Hatchett, 330 F.3d at 886 (citations omitted) (Once the bankruptcy proceedings are over, an individual creditor may pursue state law claims for fraudulent conveyance.). The Chapter 7 Trustee either settled and thus, administered the claims in these state lawsuits, or he abandoned them. Either way, the bankruptcy case is closed, there are no assets to administer, including these pre-petition state court lawsuits, and therefore, the Bankruptcy Court no longer has jurisdiction. See Travers v. Bank of Am., N.A. (In re Travers), 507 B.R. 62, 72 (Bankr. D.R.I. 2014) (citation omitted) (“Jurisdiction of bankruptcy courts being temporal, the `related to’ jurisdiction of this Court over . . . claims evaporated upon the Trustee’s abandonment of the claims, the Debtor’s discharge, and the closure of the case.”); SG & Co. Ne., LLC v. Good, 461 B.R. 532, 539-40 (Bankr. N.D. Ill. 2011) (jurisdiction lapses when property is transferred out of the estate).

B. 11 U.S.C. § 105(a)

Nor could the Bankruptcy Court rely on 11 U.S.C. § 105(a) as a basis for jurisdiction to enforce its order approving the compromise and settlement between the Chapter 7 Trustee and the Appellants. The Chapter 7 Trustee did not raise issues of state law successor liability in the adversary, and the Appellees were not parties to the adversary. In In re Wolverine Radio, the Sixth Circuit rejected the proposition that a provision of the Bankruptcy Code could serve as an additional grant of jurisdiction, stating that “even were we to view this case solely as a proceeding to obtain an order pursuant to section 105(a), the power of the bankruptcy and district courts to hear this case is limited to the grant of jurisdiction in 28 U.S.C. § 1334.” 930 F.2d at 1140 n.13 . Here, the Appellants have paid the Chapter 7 Trustee $25,000 in settlement, the Chapter 7 Trustee has distributed all available assets, and there is nothing left for the Bankruptcy Court to enforce. With nothing to enforce, 11 U.S.C. § 105(a) does not create jurisdiction. See Law v. Siegel, ___ U.S. ___, 134 S. Ct. 1188, 1194 (2014) (“[W]hatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code.” (internal quotations and citations omitted)).


Finally, the Bankruptcy Court correctly denied the Appellants’ request to enjoin the state court proceedings. Pursuant to the Anti-Injunction Act, “[a] court of the United States may not grant an injunction to stay proceedings in a State court except as expressly authorized by Act of Congress, or where necessary in aid of its jurisdiction, or to protect or effectuate its judgments.” 28 U.S.C. § 2283. The core message of the Anti-Injunction Act is one of respect for state courts. The Act broadly directs “that state courts shall remain free from interference by federal courts. . . .” Atl. Coast Line R.R. Co. v. Bhd. Locomotive Eng’rs, 398 U.S. 281, 282, 90 S. Ct. 1739 (1970) . The exceptions, designed for important purposes, “are narrow and are `not [to] be enlarged by loose statutory construction.'” Choo v. Exxon Corp., 486 U.S. 140, 146, 108 S. Ct. 1684, 1689 (1988) (citation omitted). “Any doubts as to the propriety of a federal injunction against state court proceedings should be resolved in favor of permitting the state courts to proceed. . . .” Atl. Coast Line, 398 U.S. at 297 .

The relitigation exception to the Anti-Injunction Act is designed to apply the concepts of claim or issue preclusion. Choo, 486 U.S. at 147 . This exception is to be strictly and narrowly construed since “[d]eciding whether and how prior litigation has preclusive effect is usually the bailiwick of the second court,” which is the state court in this instance. See Smith v. Bayer Corp., ___ U.S. ___, 131 S. Ct. 2368, 2375 (2011) (citation omitted) (emphasis in original). “For that reason, every benefit of the doubt goes toward the state court; an injunction can issue only if preclusion is clear beyond peradventure.” Id. at 2376 (internal citation omitted). In the present case, there is no reason the state court should not determine the preclusive effect of the Bankruptcy Court’s order upon the state law claims, just as bankruptcy courts are regularly called upon to determine the preclusive effect of state court judgments in bankruptcy. Accordingly, injunctive relief is not appropriate in this case.


For the reasons stated, the Bankruptcy Court’s order denying the Appellants’ Motion to Enforce Order Approving Compromise of Claims is AFFIRMED.

[1] On August 26, 2014, the Appellants filed a notice of settlement with Rentwear, Inc. Accordingly, the only remaining appellee is Ergon Refining, Inc.

[2] At the hearing, the Bankruptcy Court and the parties discussed the fact that the order dismissing the adversary was without prejudice. At the end of the discussion, the Bankruptcy Court stated “[b]ut right now I’ve gone way — way too far into the weeds. This matter came before me on a motion to, quote, enforce order approving compromise of claims. . . .”

[3] At the hearings in the Bankruptcy Court and in the pleadings filed with the B.A.P., the Appellees have maintained that they are only pursuing the successor liability claims in the state court litigation.

[4] There is no need to determine whether this is a core or non-core proceeding under 28 U.S.C. § 157 because “§ 157 only comes into play if the court first determines it has jurisdiction under § 1334. Section 157 does not create jurisdiction when it does not exist under § 1334.” Johnston v. City of Middletown (In re Johnston), 484 B.R. 698, 713 (Bankr. S.D. Ohio 2012) .

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New Bankruptcy Opinion: SPORTMAN’S LINK, INC. v. KLOSINSKI OVERSTREET, LLP – Court of Appeals, 11th Circuit, 2014




SOHAIL ABDULLA, Interested Party-Appellant.

No. 14-12606, Non-Argument Calendar.

United States Court of Appeals, Eleventh Circuit.

December 10, 2014.

Before WILLIAM PRYOR, JULIE CARNES and FAY, Circuit Judges.



Sohail Abdulla appeals pro se the denial of his motion for disgorgement of fees and objection to the distribution of assets to Klosinski Overstreet, LLP, for its legal representation of Abdulla’s former business, Sportsman’s Link, Inc., during its bankruptcy proceeding. We affirm.

Sportsman’s retained Klosinski to assist in filing a petition for bankruptcy under Chapter 11, and Abdulla paid Klosinski a $20,000 retainer. Later, Sportsman’s petition was converted to a Chapter 7 petition, and the Chapter 7 Trustee retained Klosinski as special counsel to pursue preference and fraudulent transfer actions for the Sportsman’s estate. Klosinski filed 23 adversary proceedings and recovered more than $500,000 for the estate.

In July 2011, Sportsman’s, through counsel, filed an adversary proceeding against Klosinski for legal malpractice and breach of its fiduciary duties. The Chapter 7 Trustee filed an application to compromise the controversy for $20,000. Sportsman’s objected and argued that Klosinski’s failure to disclose its connections to two creditors, Georgia Bank & Trust Company of Augusta and Fairway Ford of Augusta, Inc., violated Federal Rule of Bankruptcy Procedure 2014(a) and should result in a disgorgement of fees related to those collections.

After a full-day evidentiary hearing on the Trustee’s application, the bankruptcy court approved the compromise as reasonable because Sportsman’s was not damaged by Klosinski’s failure to disclose, but the bankruptcy court reserved ruling on whether Klosinski should disgorge its fees pending a report and recommendation from the United States Trustee. The US Trustee reported that, although Klosinski did not have an actual conflict of interest, it had violated Rule 2014 by failing to disclose its connections with the two creditors. The US Trustee moved to sanction Klosinski and recommended that the bankruptcy court reduce Klosinski’s fees by $15,241.88 for its work in the Chapter 11 proceeding and by $12,589.84 for its work in the Chapter 7 proceeding.

In May 2012, the bankruptcy court held a hearing to impose sanctions on Klosinski for its violation of Rule 2014(a), which Abdulla and Sportsman’s counsel failed to attend. The bankruptcy court determined that Klosinski’s failure to disclose its connection to Georgia Bank during the Chapter 11 proceeding was purposeful and material and reduced Klosinski’s fees in that proceeding by $20,000. The bankruptcy court also reduced Klosinski’s fees in the Chapter 7 proceeding by $30,000 for its ongoing failure to disclose its association with Georgia Bank and required Klosinski to forfeit its entire fee of $3,300 for failing to disclose its previous representation of Fairway.

After the deadline expired to object to the Trustee’s final report, Abdulla moved pro se for disgorgement of fees and objected to the distribution of the assets of the Sportsman’s estate to Klosinski. Abdulla sought disgorgement of a $20,000 retainer fee that he had given Klosinski and he objected to the payment of fees to Klosinski until there was “an investigation by an independent Special Counsel to examine the actions of all the attorneys involved.” Abdulla alleged that Klosinski had wrongfully induced Sportsman’s to enter a contract with another law firm; had made misrepresentations in its disclosures to the bankruptcy courts; and had concealed some of its fee arrangements. Abdulla also repeated in his motion the allegations made by Sportsman’s that Klosinski had committed legal malpractice and breached its fiduciary duties.

The district court denied Abdulla’s motion. The district court ruled that Abdulla lacked standing to seek the disgorgement of fees because he did not have a pecuniary interest in the retainer he had paid on Sportsman’s behalf or in the fees paid by Sportsman’s estate. The district court denied Abdulla’s request for a sua sponte investigation because he would not benefit from the disgorgement of Klosinski’s fees and because it was “satisfied . . . after [a] review of the record . . . that the Bankruptcy Court [had] sufficiently policed Sportsman’s former attorneys and punished them for any misconduct.”

We conclude that Abdulla has abandoned any challenge that he might have made to the denial of his request for the disgorgement of fees. “While we read briefs filed by pro se litigants liberally, issues not briefed on appeal by a pro se litigant are deemed abandoned.” Timson v. Sampson, 518 F.3d 870, 874 (11th Cir. 2008) (internal citations omitted). Abdulla states that he “do[es] not expect any money from this case” and requests that we review the denial of his request for his “allegations and . . . evidence to be investigated and considered by an independent authority.” We deem abandoned Abdulla’s request for the disgorgement of fees.

Abdulla lacks standing to request a special investigation about Klosinski’s representation of Sportsman’s. To appeal an order entered in a bankruptcy proceeding, a person must be “directly, adversely, and pecuniarily affected” by the decision. In re Ernie Haire Ford, Inc., 764 F.3d 1321, 1325 (11th Cir. 2014). Abdulla cannot benefit from an investigation that would result in further sanctions being imposed on Klosinski because those sanctions would flow to Sportman’s estate, not to Abdulla.

Even if Abdulla had standing to request further investigation of Klosinski, the district court did not abuse its discretion. The district court has inherent powers to discipline attorneys for misconduct and to investigate if it has been a victim of fraud, but “[b]ecause of their very potency, inherent powers must be exercised with restraint and discretion.” Chambers v. NASCO, 501 U.S. 32, 43-44, 50 111 S. Ct. 2123, 2132 (1991). The district court took “seriously [the] allegations” against Klosinski and reasonably determined that the bankruptcy court had adequately investigated and punished Klosinski. The record reflects that the bankruptcy court examined Sportsman’s contentions and the reports, evidence, and arguments of the Chapter 7 Trustee and the US Trustee and made an independent determination that, although Klosinski’s misconduct did not constitute malpractice, its failure to disclose violated Rule 2014(a) and warranted harsher sanctions than those recommended by the US Trustee. In the light of the thorough examination of Klosinski’s conduct by the bankruptcy court, the district court reasonably “exercised . . . restraint” and declined to conduct a further investigation.

We AFFIRM the denial of Abdulla’s motion for disgorgement of fees and objection to the distribution of assets.

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New Bankruptcy Opinion: MATTER OF AFY, INC. – Bankr. Court, D. Nebraska, 2014

IN THE MATTER OF: AFY, INC., Chapter 7, Debtor(s).




Case Nos. BK10-40875, A14-4060.

United States Bankruptcy Court, D. Nebraska.

December 11, 2014.



This matter is before the court on the defendants’ notice of removal (Fil. No. 1). Brian J. Koenig, Kristin M.V. Krueger, and Donald L. Swanson represent the defendants. Jerrold L. Strasheim represents the plaintiffs.

This is a lawsuit brought by current shareholders of AFY, Inc., against former shareholders of the corporation concerning the terms of the sale of the former shareholders’ stock to the current shareholders. The buyers and sellers are all members of the same extended family. The individual plaintiffs filed bankruptcy petitions in early 2010 and the matters at bar have been in litigation in one form or another ever since. This court has ruled that AFY and Korley Sears owe the defendants in this case more than $5 million; one of those orders is final (the claim against AFY), and one is currently on appeal in the United States District Court (the claim against Korley Sears). Notwithstanding those rulings, the plaintiffs filed this lawsuit in Madison County District Court on October 20, 2014, alleging breach of contract as to the stock sale agreement, breach of fiduciary duty, unjust enrichment, conspiracy and tortious interference with business expectancies, and abuse of process.

The defendants removed the case to this court pursuant to 28 U.S.C. § 1452(a), which provides that a party may remove any claim or cause of action in a civil action to the district court for the district where such civil action is pending when the federal court has jurisdiction of such claim or cause of action under 28 U.S.C. § 1334. Section 1334(a) gives the federal district courts “original and exclusive jurisdiction over cases under title 11,” which are bankruptcy cases themselves. Section 1334(b) gives federal courts non-exclusive jurisdiction over “all civil proceedings arising under title 11, or arising in or related to cases under title 11.” Those civil proceedings are further divided into two categories: core proceedings and non-core, related proceedings. Core proceedings are those cases arising under title 11, or arising in a case under title 11, while non-core, related-to proceedings are those which could conceivably have an effect on the estate being administered in bankruptcy.

Certainly, the validity of the proofs of claim of the defendants against the bankruptcy estates of AFY, Inc., and Korley Sears are core proceedings within the jurisdiction of the Bankruptcy Court to enter final judgment. 28 U.S.C. § 157(b)(2)(B). However, those issues have already been decided by this court and the plaintiffs’ causes of action are matters of common law; they are not sufficiently inherent to the bankruptcy case that they could be considered core proceedings. In that regard, § 1334(c)(1) permits a court to abstain from hearing a particular proceeding in favor of the state courts: “[N]othing in this section prevents a district court in the interest of justice, or in the interest of comity with State courts or respect for State law, from abstaining from hearing a particular proceeding arising under title 11 or arising in or related to a case under title 11.”

In deciding whether permissive abstention under § 1334(c)(1) is appropriate under the broad statutory guidelines of the interests of justice or comity, and keeping in mind “the premise that federal courts should exercise their jurisdiction if it is properly conferred and that abstention is the exception rather than the rule,” [1] courts consider the following factors:

(1) the effect or lack thereof on the efficient administration of the estate if a court recommends abstention;

(2) the extent to which state law issues predominate over bankruptcy issues;

(3) the difficult or unsettled nature of the applicable law;

(4) the presence of a related proceeding commenced in state court or other non-bankruptcy court;

(5) the jurisdictional basis, if any, other than 28 U.S.C. § 1334;

(6) the degree of relatedness or remoteness of the proceeding to the main bankruptcy case;

(7) the substance rather than the form of an asserted “core” proceeding;

(8) the feasibility of severing state law claims from core bankruptcy matters to allow judgments to be entered in state court with enforcement left to the bankruptcy court;

(9) the burden on the bankruptcy court’s docket;

(10) the likelihood that the commencement of the proceeding involves forum shopping by one of the parties;

(11) the existence of a right to a jury trial; and

(12) the presence in the proceeding of non-debtor parties.

Stabler v. Beyers (In re Stabler), 418 B.R. 764, 769 (B.A.P. 8th Cir. 2009) (citing Williams, 256 B.R. at 893 -94 and In re Chicago, Milwaukee, St. Paul & Pac. R.R. Co., 6 F.3d 1184, 1189 (7th Cir. 1993) (“Courts should apply these factors flexibly, for their relevance and importance will vary with the particular circumstances of each case, and no one factor is necessarily determinative.”)).

Section 1452(b) also permits equitable remand of a removed action: “The court to which such claim or cause of action is removed may remand such claim or cause of action on any equitable ground.” The analysis used to determine whether equitable remand under § 1452(b) is appropriate is virtually identical to the permissive abstention analysis, with the consideration of four additional factors:

(1) whether remand serves principles of judicial economy;

(2) whether there is prejudice to unremoved parties;

(3) whether the remand lessens the possibilities of inconsistent results; and

(4) whether the court where the action originated has greater expertise.

Farmers Bank & Trust Co. v. Chickasaw Prop., LLC (In re Burrow), 505 B.R. 838, 849-50 (Bankr. E.D. Ark. 2013).

The majority of these factors favor abstention and remand. As noted above, the allegations in the pending complaint pertain solely to state law causes of action. The case does not involve any bankruptcy law issues and no issues exclusive to bankruptcy. The plaintiffs have requested a jury trial and do not consent to entry of final judgment by the bankruptcy court. The state court is in the best position to determine the various issues raised in the complaint. To the extent the defendants feel that certain of the plaintiffs’ claims are precluded due to prior rulings by this court in the bankruptcy cases, they are able to raise those preclusion arguments in state court. Those preclusion arguments are not bankruptcy issues or unique to bankruptcy courts. For these reasons, this court will abstain from hearing the lawsuit and will remand the case to state court.

IT IS ORDERED: This lawsuit should be remanded to the District Court of Madison County, Nebraska. Relief from the automatic stay is hereby granted to the parties to pursue the state court litigation. The parties are directed to file a copy of this order with the Madison County District Court.

[1] Williams v. Citifinancial Mortg. Co. (In re Williams), 256 B.R. 885, 894 (B.A.P. 8th Cir. 2001) .

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New Bankruptcy Opinion: IN THE MATTER OF WESTERN BIOMASS ENERGY, LLC – Dist. Court, D. Nebraska, 2014


MIDWEST RENEWABLE ENERGY, LLC, a Nebraska limited liability company, Plaintiff,



Nos. 3:13BK50937, A12-4028-TLS, 7:11CV5009

United States District Court, D. Nebraska.

December 10, 2014.


LYLE E. STROM, Senior District Judge.

This matter is before the Court after review of plaintiff’s status report (Filing No. 56).

IT IS ORDERED that the plaintiff shall advise the Court, in writing, on or before June 1, 2015, as to the status of the bankruptcy proceedings and whether plaintiff intends to proceed against the parties not in bankruptcy, while the case is stayed as to the party in bankruptcy, or intends to wait until relief from the automatic stay is requested and obtained from the Nevada bankruptcy Court.

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New Bankruptcy Opinion: IN RE CAFE LA PLAGE MANAGEMENT, INC. – Bankr. Court, D. Puerto Rico, 2014


Case No. 14-01977 (MCF).

United States Bankruptcy Court, D. Puerto Rico.

December 11, 2014.



Pending before the Court is Lionstone IV Properties, LLC’s (“Lionstone”) motion for summary judgment (Docket No. 123) and Cafe La Plage Management, Inc.’s (“Debtor”) opposition and cross motion for summary judgment (Docket No. 128) regarding the issue of payment of postpetition rent, pursuant to 11 U.S.C. § 365(d)(5). For the reasons stated below, Lionstone’s motion for summary judgment is granted and Debtor’s cross motion is denied.


The Debtor filed a voluntary petition under Chapter 11 of the Bankruptcy Code on March 14, 2014. Prior to its petition for relief, Debtor leased a real estate property from Lionstone to operate a hotel and restaurant business. [1] The parties signed a lease agreement on April 1, 2009. [2] This agreement stated that the monthly lease payment to be paid to the Lionstone by the Debtor was to be calculated as a percentage of the monthly “gross revenue” of the operations of the business. The percentages to be paid were: 20% of hotel operations earnings up to $100,000 and 25% of any amount greater than $100,000.

The Debtor has not made any postpetition rent payments since the filing of the petition. As a result, Lionstone filed a motion requesting payment of these monies by the Debtor (Docket No. 77). The parties do not dispute that postpetition rent is owed, but have divergent interpretations of the lease agreement and the amounts due. At the hearing held on September 24, 2014, the parties agreed that the matter before the Court is a legal issue regarding the interpretation of the term “gross revenue,” which is used in the lease agreement and is the basis for calculating the amount to be paid in rent by the Debtor. After the parties filed their respective motions for summary judgment, the Court conducted an oral argument on December 3, 2014.


This Court has jurisdiction of the subject matter pursuant to 28 U.S.C. §§ 1334, 157(a) and the “Standing Order of Resolution for Bankruptcy Cases” dated July 19, 1984 (Torruella, C.J.), which refers title 11 proceeding to Bankruptcy Court. This is a core proceeding in accordance with 28 U.S.C. § 157(b).


The issue before the Court is the determination of the amount owed by the Debtor in postpetition rent. This entails deciding what definition of “gross revenue” should be used in this calculation.

The Debtor argues that the amount owed in postpetition rent should be calculated based on “gross revenue” as defined by the Internal Revenue Service (“IRS”) standards that allegedly deduct operating expenses from the final amount which is to be considered “gross revenue.”

Lionstone argues that the amount owed in postpetition rent should be based on “gross revenue” as defined by the lease agreement between the parties that does not deduct operating expenses from the revenue generated by the Debtor.



Rule 7056 of the Federal Rules of Bankruptcy Procedure makes Fed. R. Civ. P. 56(a) applicable in adversary proceedings. Rule 56(a) governs summary judgments and states that:

[a] party may move for summary judgment, identifying each claim or defense — or the part of each claim or defense — on which summary judgment is sought. The court shall grant summary judgment if the movant shows that there is no general dispute as to any material fact and the movant is entitled to judgment as a matter of law.

Fed. R. Civ. P. 56(a).

Under Rule 56(c) summary judgment is proper:

if the pleadings, depositions, answer to interrogations, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to judgment as a matter of law . . . The plain language of Rule 56(c) mandates the entry of summary judgment, after adequate time for discovery and upon motion, against a party who fails to make a showing sufficient to establish the existence of an element essential to the party’s case, and on which that party will bear the burden of proof at trial.

Celotex Corp. v. Catrett, 477 U.S. 317, 322 (1986) .

In regard to material facts, the substantive law will identify which facts are material. “Only disputes over facts that might affect the outcome of the suit under the governing law properly preclude the entry of the summary judgment determination. Factual disputes that are irrelevant or unnecessary will not be counted.” Anderson v. Liberty Lobby, Inc., 477 U.S. 242 (1986) .


In the instant case, Lionstone and the Debtor entered in a lease agreement for the use of commercial property. This fact is uncontested and the lease agreement is included in the record. [3] In its “Reply to Motion for Summary Judgment,” the Debtor states that “Lionstone is entitled to post-petition rent in consonance with [the] terms of [the] Lease, applicable law and 11 U.S.C. § 365(d)(3).” [4] Neither party has contested the fact that postpetition rents are due to Lionstone. The issue at hand lies not in the existence of a debt owed to Lionstone for postpetition rent, but rather the amount owed and the contractual interpretation that should be used in its calculation.

To resolve this contractual dispute, we turn to state law which governs property interests. Unless a different result is required by a federal interest, there is no reason to analyze such interests differently simply because an interested party is involved in a bankruptcy proceeding. “Uniform treatment of property interests by both state and federal courts within a State serves to reduce uncertainty, to discourage forum shopping and to prevent a party from receiving `a windfall merely by reason of the happenstance of bankruptcy’. Lewis v. Manufacturers Nat’l Bank, 364 U.S. 603, 609 .” Butler v. United States, 440 U.S. 48, 55 (1979) .

In Puerto Rico, contracts are legally binding from the moment that consent, subject matter and the cause of the obligation concur; and from that moment, obligations are created that are legally binding between the contracting parties. Arts. 1213 & 1214 of the Civil Code, P.R. Laws Ann. Tit. 31, §§ 3391, 2994 (1990). “Contracts are perfected by mere consent, and from that time they are binding, not only with regard to the fulfillment of what has been expressly stipulated, but also with regard to all the consequences which, according to their character, are in accordance with good faith, use, and law.” Art. 1210 of the Civil Code, P.R. Laws Ann. Tit. 31, § 3375 (1990).

“The principle of `pacta sunt servanda’ establishes the obligatory force of a contract according to its terms and necessary consequences that are born from the good faith.” Banco Popular de Puerto Rico v. Sucecion Talavera, 174 D.P.R. 686, 693 (2008) (our translation); Art. 1044 of the Civil Code, P.R. Laws Ann. Tit. 31, § 2994 (1990). The contracting parties may make the agreement and establish the clauses and conditions which they may deem advisable, provided they are not in contravention of law, morals, or public order. Art. 1207 of the Civil Code, P.R. Laws Ann. Tit. 31, § 3372 (1990). However, it has also been decided that certain contracts require interpretation to be able to assess the nature of the obligation in which the parties incurred. Sociedad Legal de Gananciales Irizarry v. Sociedad Legal de Gananciales Garcia, 155 D.P.R. 713 (2001) .

The Puerto Rico Civil Code establishes guidelines to be used in the interpretation of a contract: “If the terms of a contract are clear and leave no doubt as to the intentions of the contracting parties, the literal sense of its stipulations shall be observed. If the words should appear contrary to the evident intention of the contracting parties, the intention shall prevail.” P.R. Laws Ann. Tit. 31, § 3471 (1990); Mega Media Holdings, Inc. v. Aerco Broad. Corp., 852 F. Supp. 2d 189 (D.P.R. 2012) . When the terms of the contract are clear and leave no doubt about the intention of the parties, it is unnecessary to apply the rules of interpretation. Art. 1233 of the Civil Code, P.R. Laws Ann. Titl. 31, § 3471 (1990). Regarding the clear terms of the contract:

Article 1233 specifies exactly when extrinsic evidence should be considered. As explained before, only if the literal terms of the contract are in doubt will it be necessary in the first place to examine or interpret the contract with the help of extrinsic evidence. To argue that the intention of the parties takes precedence over a written contract does not change the analysis under Article 1233. The reason that clear and unambiguous terms will not be altered is not that the written word has taken precedence over the intention of the parties when they entered into the contract; rather, under Article 1233, the clear terms of a contract are given preference over subsequent allegations because these terms are supposed to represent in the first place the real intent of the parties at the time they entered into the contract.

Hopgood v. Merrill Lynch, Pierce, Fenner & Smith, 839 F. Supp. 98 (D.P.R. 1993) .

It has been decided that “clear terms” are those that by themselves are lucid enough to be understood in only one sense, without giving way to doubt, controversies, nor diversity of interpretation and to understand them, they do not need reasoning or demonstrations susceptible to contesting. Sucecion Ramirez v. Tribunal Superior, 81 D.P.R. 357 (1959) . On the other hand, a contract clause is ambiguous when it is susceptible to be understood or interpreted in different ways or manners.

In regards to generalized terms in a contract, Article 1225 of the Civil Code states that “[h]owever general the terms of the contract may be, there should not be understood as included therein things and cases different from those with regard to which the persons interested intended to contract.” P.R. Laws Ann. Tit. 31, § 3473 (1990). In addition, Article 1236 of the Civil Code states that “[i]f any stipulation of a contract should admit of different meanings, it should be understood in the sense most suitable to give it effect.” P.R. Laws Ann. Tit. 31, § 3474 (1990). When considering the interpretation of contracts, it has been established that:

[a]lthough the courts must consider the intention of the parties when interpreting a contract, while doing this, we must assume loyalty, correctness and good faith in its drafting, and interpret it in a way that can lead to the results that conform to the contractual relationship and that follow ethical guidelines. In other words, the courts cannot find darkness or distort the interpretation of contracts in order to arrive at absurd or unjust conclusions.

Irizarry, 155 D.P.R. 713 (our translation).

The courts cannot arrive at results that differ from that text of the contract, which is what gathers the will of the parties. The courts have the faculty of looking after the compliance of contracts and should not relieve a party of its contractual obligation when the contract is legal, valid and without error. De Jesus Gonzalez v. Autoridad de Carreteras, 148 D.P.R. 255 (1999) .

In our case, the contract signed by the parties, establishes that the rent due is based on a percentage of amounts received by the Debtor through business operations. In its relevant clause, the lease agreement states that:

3.1.1 Participating Rent.

(a) Amount. For each Accounting Period, Tenant shall pay “Participating Rent” in arrears on or before the twentieth (20th) day of each succeeding month with respect to the prior month in an amount equal to twenty percent (20%) of the Gross Revenue for said month up to $100,000 of Gross Revenue and twenty five percent (25%) of any amount over $100,000 of Gross Revenue for said month. [5]

The parties agreed to the previously stated terms and the Debtor retained possession of the property, performing operations that generated revenues that are to be analyzed for the purpose of determining the applicable rent amount. The parties do not dispute the percentages that apply to the rent calculation. We must only address the interpretation of “gross revenue” included in the previously mentioned clause and use this definition to compute the rent in question.

In the definitions section of the lease agreement, a specific definition of “gross revenue” is included whereby such term is defined as follows:

`Gross Revenues’ shall mean all revenues, receipts, and income of any kind derived directly or indirectly by Tenant or any sub-tenant from or in connection with the Leased Property or operation of the Hotel including, but not limited to room rentals and food and beverage sales sold and delivered on or off the Hotel whether for cash or credit, paid or collected, determined in accordance with GAAP and Uniform System of Accounts, excluding, however, (a) funds furnished by Landlord, (b) federal, state and municipal excise, sales and use taxes and room taxes collected directly from patron and guests or as part of the sales price of any goods, services or displays, such as gross receipts, admissions, cabaret or similar or equivalent taxes and paid over to federal, state or municipal governments, (c) gratuities paid directly to an employee, (d) proceeds of insurance and Awards, (e) proceeds from sale of furnishings, fixtures and equipment which are permitted pursuant to the terms of this Agreement, (f) all loan proceeds from financing or [refinancing] of the Hotel or interests therein or components thereof, (g) interest earned on funds deposited into the Reserve Fund and (h) judgments and awards, except any portion thereof arising from normal business operations of the Hotel. [6]

As stated in its Reply, the Debtor contends that the definition of “gross revenue” that should be applied is the one present in Section 62 of the IRS Code. Debtor alleges that:

[P]ursuant to IRS standards, “gross income” of an incorporated business is defined as taxable income, consists of total revenues less costs of goods sold, selling and administrative expenses, interest, and extraordinary item.

26 U.S.C. § 62. [7]

However, the Debtor provides no basis upon which the Court should apply the definition of “gross income” as it appears in the IRS Code instead of the definition of “gross revenue” that was agreed upon in the lease agreement. The definition of “gross revenue” agreed to by the parties is clear and unambiguous. Debtor failed to present a legal basis to justify the application of a definition that is different to the one present in the agreement. The definition, as constructed in the agreement, does not contradict any local or federal statute. Thus it is the law between the parties even though Debtor may not favor the provision at this point in time. Therefore, the definition of “gross revenue” to be used in the calculation of rent, is the one included in the lease contract, which is based on all income generated by the Debtor’s business. [8] No more, no less.

The Court used the Monthly Operating Reports submitted by the Debtor to calculate the amount of postpetition rent owed to Lionstone. [9] The total amount of postpetition rents owed from the gross revenues received from March 2014 to October 2014 is $152,106.51. To reach this number, all monthly revenue generated by the Debtor up to $100,000 was multiplied by 20% and any amounts over $100,000 were multiplied by 25%. The table below illustrates the monthly payments and the total payment due to Lionstone by Debtor.

Month Gross Revenue Rent Due

March, 2014 $24.15 [10] $4.83
For April, 2014

April, 2014 $1,771.04 [11] $354.20
For May, 2014

May, 2014 $136,460.06 [12] $29,115.02
For June, 2014

June, 2014 $123,300.66 [13] $25,825.17
For July, 2014

July, 2014 $151,088.66 [14] $32,772.17
For August, 2014

August, 2014 $151,088.66 [15] $32,772.17
For September, 2014

September, 2014 $63,704.45 [16] $12,740.89
For October, 2014

October, 2014 $92,610.327 [17] $18,522.06
For November, 2014

Total $720,048.00 $152,106.51

In conclusion, Debtor is ordered to provide within thirty (30) days the payment of $152,106.51 and to pay monthly rent as it becomes due and payable in accordance with this ruling.


[1] Docket No. 113, “Answer to Objection to Claim 7,” Attachment No. 1, Lease Agreement, Lead Case No. 14-01977.

[2] Debtor has filed a motion to assume the lease agreement.(Docket No. 30). Lionstone has objected to the assumption, alleging that the contractual relationship was terminated and there is nothing to assume or reject. (Docket No. 37). The Court held in abeyance the resolution of Debtor’s motion to assume the lease until a final determination has been pronounced by the local court regarding the contractual relationship between the parties. (Docket No. 69). Therefore, we are not making any judgment as to the validity of the lease or the relationship between the parties and the parties are deemed not to have waived any legal argument pertinent to those issues. Our opinion is limited to the issue of payment of postpetition rents and the amounts due.

[3] Docket No. 113, “Answer to Objection to Claim 7,” Attachment No. 1, Lease Agreement, Lead Case No. 14-01977.

[4] Docket No. 128, “Motion for Summary Judgment re: Post-Petition Rent” at 9.

[5] Docket No. 113, “Answer to Objection to Claim 7,” Attachment No. 1, Lease Agreement, Lead Case No. 14-01977, at 9.

[6] Docket No. 113, “Answer to Objection to Claim 7,” Attachment No. 1, Lease Agreement, Lead Case No. 14-01977, at 4.

[7] Docket No. 128, “Motion for Summary Judgment re: post-petition rent,” at 11.

[8] The definition of “gross revenue” included in the contract does not provide for any operating expense deductions from total business revenue.

[9] The payment chart included herein is based on the numbers reflected in Debtor’s monthly operating reports. The Court is not passing judgment over the correctness of the amounts included in the monthly operating reports. If any objection is raised as to the correctness of these reports, the Court will address this matter accordingly.

[10] Docket No. 149, “Operating Report for the period of October, 2014.”

[11] Docket No. 45, “Operating Report for the period of March, 2014.”

[12] Docket No. 57, “Operating Report for the period of April, 2014.”

[13] Docket No. 94, “Operating Report for the period of May, 2014.”

[14] Docket No. 110, “Operating Report for the period of June, 2014.”

[15] Docket No. 112, “Operating Report for the period of July, 2014.”

[16] Docket No. 144, “Operating Report for the period of August, 2014.”

[17] Docket No. 141, “Operating Report for the period of September, 2014.”

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New Bankruptcy Opinion: IN RE BROOKE CAPITAL CORPORATION – Court of Appeals, 10th Circuit, 2014




SECURITY FIRST INSURANCE HOLDINGS, LLC, a Florida limited liability company; SOUTHERN FIDELITY MANAGING AGENCY, LLC, a Florida limited liability company; NORTHERN CAPITAL, INC., a Florida corporation, Defendants-Appellees.

No. 14-3017.

United States Court of Appeals, Tenth Circuit.

December 8, 2014.

Before KELLY, LUCERO, and MATHESON, Circuit Judges.


PAUL J. KELLY, Jr., Circuit Judge.

At the core of this case is a priority dispute over collateral sold in bankruptcy. Plaintiff-Appellant Citizens Bank & Trust Company (Citizens) sought a declaratory judgment that it had superior rights to the collateral—sale proceeds of certain stock—owned by the debtor in bankruptcy. The bankruptcy judge found largely in favor of Citizens and against various competing creditors including Defendant-Appellees Southern Fidelity Managing Agency, LLC, Security First Insurance Holdings, LLC, and Northern Capital, Inc. In re Brooke Capital Corp., Bankr. No. XX-XXXXX-X, 2012 WL 4793010 (Bankr. D. Kan. Oct. 5, 2012). The district court reversed, however, adopting the report and recommendation of a magistrate judge. S. Fid. Managing Agency, LLC v. Citizens Bank & Trust Co., Nos. 12-2702-JTM, 12-2707-JTM, 2014 WL 129336 (D. Kan. Jan. 14, 2014). The magistrate determined that the competing creditors had been assigned perfected security interests in the stock pursuant to Kan. Stat. Ann. § 84-9-310(c). Citizens now appeals from the district court’s decision. Our jurisdiction arises under 28 U.S.C. § 158(d)(1), and we reverse and remand for reinstatement of the bankruptcy judge’s decision.


A. BCC’s Loans and the Subsequent Loan Participation Agreements

On December 31, 2007, Brooke Capital Corporation (BCC) obtained a $12.38 million loan (the BCA Loan) from Brooke Capital Advisors (BCA), a majority-owned subsidiary of BCC. The loan was memorialized in a Commercial Loan Agreement and a Stock Pledge and Security Agreement. As security for the BCA Loan, BCC granted BCA a security interest in one-hundred percent of BCC’s “right, title, and interest” in First Life America Corporation (FLAC), another of BCC’s subsidiaries. Aplt. App. 102, 140, 146.

On the same date, BCC also obtained a $9 million loan from Citizens (the Citizens Loan) with a maturity date of May 31, 2008, a substantially shorter term than the BCA Loan. Id. 217. The Citizens Loan was secured by stock in other BCC affiliates, but not FLAC.

In March 2008, BCA began selling fractional interests or, “participations,” in its loan to BCC. Three of these participation agreements were executed on March 28 (the Participation Certificates). These agreements, with Defendant-Appellees Northern Capital, Security First Insurance Holdings, and Southern Fidelity Managing Agency (collectively, Participants) were virtually identical. The one difference was the size of the interest purchased: Northern Capital purchased an 8.07% interest for $1 million, Security First purchased a 40.4% interest for $5 million, and Southern Fidelity purchased a 24.22% interest for $3 million.

At the time these agreements were entered into, each Participant owed an outstanding debt to Brooke Credit Corporation, d/b/a Aleritas Capital Corporation (Aleritas), a BCC sister company. Each Participant had received a similar promise from Aleritas in connection with its purchase of a participating interest: if BCC or BCA defaults, “the participation amount will be applied to principal and interest on [Participant’s] current loan outstanding with Aleritas Capital.” Aplt. App. 167.

Pursuant to the Participation Certificates, BCA would make payments to the Participants on a pro-rata basis as BCC made payments on the underlying loan. A critical term of the deal, however, required BCA to repurchase each of the Participants’ interests by September 30, 2008. [1] Id. 166, 171, 192.

Insofar as collateral, the Participation Certificates provide:

7. SECURITY. The [BCA Loan] is secured by the following Property, all of which is evidenced by executed security agreements, assignments, mortgages, deeds of trust or other instruments in favor of [BCA]. A security interest in the Property is assigned and sold to Purchaser [Participant], subject to other provisions within this Agreement, in proportion to [Participant’s] Investment and is held by [BCA] for the benefit of [Participant]. Upon full payment of [Participant’s] investment plus interest thereon the security interest given to Purchaser will be null and void. Property description: . . . Pledge of 100% stock of First Life America Insurance Company.

Aplt. App. 164, 169, 188. BCA also made the following covenants, pursuant to Paragraph 12(A) of the agreements:

Seller will not, without Purchaser’s written consent, reduce principal or interest with respect to the [BCA Loan] or release or allow for the substitution of any Property, outside the normal course of dealing with Borrower so as to substantially reduce the possibility of repayment of the Loan.

Aplt. App. 165, 170, 189.

A fourth participation was purchased by First National Bank of Johnson County, predecessor to Defendant Bank of Kansas (BoK). [2] BoK obtained a 14.54% interest in the BCA Loan for $1.8 million. Like the other agreements, this agreement (the BoK Participation) purported to sell and assign a security interest in the FLAC stock. Additionally, it contained the same covenants contained in Paragraph 12(A) of the Participation Certificates, above. In total, BCA had sold 86.87% of the BCA Loan during the month of March.

Other terms of the BoK Participation differed materially from those of the Participation Certificates. See In re Brooke Capital Corp., 2012 WL 4793010, at *5-6. BCA had no obligation to repurchase BoK’s interest in the BCA Loan at any time. There was no evidence that BoK was in debt to any Brooke entities; accordingly, there was no promise that a pre-existing debt would be credited in the event of a BCC or BCA default. Additionally, BoK was entitled to receive a pro-rata share of borrower fees and was required to share in ancillary loan servicing expenses—rights and obligations that did not exist in the Participation Certificates.

B. The Workout Agreement

Shortly after BCC executed its loan agreements with Citizens and BCA, BCC began to experience financial difficulties and sought an extension on the May 31, 2008 maturity of the Citizens Loan. Citizens and BCC began “workout” discussions in an effort to accommodate BCC’s financial problems.

In an early communication between Citizens and BCC, BCC informed Citizens that it had long-term debt with BCA secured by its pledge of FLAC stock. BCC proposed a collateral swap that would meet both of the creditors’ needs. In essence, BCC informed Citizens that BCA was willing to release its lien on the FLAC stock so that Citizens could be paid from the sale proceeds of FLAC, when it sold.

As BCC and Citizens began working out the details of this deal, Citizens requested confirmation that BCA was willing to release its lien on the FLAC stock. It also inquired whether BCA had any creditors with a lien on its assets, including its security interest in FLAC. Aplt. App. 229. BCC responded that BCA had no creditors with a lien on assets, including the FLAC stock, and confirmed that BCA would release its lien on that stock when (1) the FLAC stock was sold; (2) Citizens released its lien on BCC’s other assets securing the original Citizens loan; and (3) Brooke Corporation pledged Citizens’ former collateral to BCA. Id. 227, 230.

On June 19, 2008, Citizens formally proposed terms and conditions of a new deal. Id. 235. Among other things, Citizens required “full agreement” from BCC and BCA that one-hundred percent of the sale proceeds of FLAC would be applied to the Citizens Loan. Id. BCC accepted the offer and documents (the Workout Documents) were prepared to memorialize the terms of the new deal. These documents included a Second Amendment to Promissory Note, a Security Agreement, a financing statement (UCC-1) filed by Citizens, and a Payment Agreement. Neither the June 19 offer nor the Workout Documents appear to indicate that Citizens’ release of its original collateral was a term of the new agreement.

The Payment Agreement was BCC and BCA’s written promise to apply FLAC sale proceeds to the Citizens Loan. The document was signed by representatives of both BCC and BCA. It provides:

If, in connection with any sale or other disposition of any equity interests or assets of FLAC, [either BCC or BCA] is entitled to receive, directly or indirectly, any proceeds from such sale or disposition, [that company] shall immediately pay such proceeds to [Citizens] to the extent necessary to satisfy all principal, interest and any other amounts then due [Citizens] by [BCC].

Id. 237.

BCC and Citizens also executed a Security Agreement, dated June 25, 2008. The Security Agreement grants Citizens a security interest in all of BCC’s personal property, including investment property such as the FLAC stock. Id. 240-48. Citizens filed a financing statement the next day which described the collateral as “All assets.” Id. 424.

Thereafter, Citizens inquired as to who was in possession of the FLAC stock and whether Citizens, or some other third party, could hold the stock so that Citizens could perfect its interest by control. Id. 278-79. Carl Baranowski, counsel for BCC and BCA, responded that he was holding the FLAC stock on behalf of BCA, “the first lienholder.” Id. 279. He also informed Citizens that the loan participants would likely object to Citizens holding the FLAC stock. As a concession, he offered to have the stock placed in escrow. This was the first that Citizens learned of the BCA loan participations. Nevertheless, Citizens agreed to have the stock placed in escrow.

On June 27, Citizens followed up on the previous communications. Citizens inquired about the identity of the participants and asked, “wouldn’t the existence of participants impair [BCA’s] ability to apply the proceeds from a sale of FLAC stock to pay the Citizens debt?” Id. 275. Mr. Baranowski responded:

Paying off Citizens with FLAC sale proceeds is OK because paying off Citizens frees up much collateral, and the participants have agreed to take only part of that freed collateral in substitution for FLAC, freeing up the rest of the collateral for other corporate purposes. Even though they are willing to substitute collateral, FLAC hasn’t sold and Citizens hasn’t been paid off yet, and until all that happens, they aren’t willing to give up their lien position.

Id. In Mr. Baranowski’s opinion, the collateral swap had two economic underpinnings: (1) the BCC stock that would serve as the “new” collateral for the BCA Loan had to be worth more than the FLAC stock; and (2) the FLAC proceeds, coupled with additional cash from “Brooke,” had to be sufficient to pay off the Citizens Loan, so that Citizens would release its original collateral. Aplt. App. 747. Citizens was apparently satisfied with Mr. Baranowski’s response.

Citizens, BCA, and BCC executed an Escrow Agreement on June 30, 2008, that placed approximately 1.5 million shares of FLAC common stock in escrow. The Escrow Agreement states that the stock was being placed in escrow to perfect Citizens’ and BCA’s security interests. Id. 250. The agreement identifies BCA as “First Lien Lender” and Citizens as “Second Lien Lender,” and acknowledges that BCA has consented to Citizens’ lien. Id.

In the summer of 2008, the value of BCC and FLAC stock dropped rapidly. FLAC’s value decreased to the extent that BCC no longer had enough cash to supplement potential FLAC proceeds to pay off the Citizens Loan.

In September 2008, BCC and several other entities were sued in federal court. A special master was appointed to take control of BCC and subsequently filed a Chapter 11 petition on BCC’s behalf. The special master, now trustee, filed a motion to sell the FLAC stock. The motion was granted and the stock was sold for $2.5 million. In June 2009, BCC’s bankruptcy was converted to a Chapter 7 proceeding. The instant action followed.

C. Proceedings in the Bankruptcy Court

As noted, Citizens filed this declaratory judgment action in bankruptcy court to determine priority rights to the FLAC proceeds. Following a three-day trial on the merits, the bankruptcy judge issued detailed findings of fact and conclusions of law. In re Brooke Capital Corp., 2012 WL 4793010. We address only those issues pertinent to the immediate appeal.

The bankruptcy court made several findings with regard to Citizens’ interest in the FLAC proceeds. As an initial matter, the court concluded that Citizens’ claim to the proceeds was superior to BCA’s; the express terms of the Payment Agreement effectively subordinated BCA’s interest to Citizens’.

More importantly, the court considered whether Citizens’ claim was superior to the claims of the Participants and BoK. Central to the court’s analysis was whether the participation agreements should be recharacterized as loans. If the transactions were true participations, rather than loans, the participants would be able to rely on BCA’s perfection in the FLAC stock to protect their interests.

The court concluded that the Participation Certificates were disguised loans, rather than true participations. As such, Participants were creditors of BCA who needed to take additional steps to perfect in some collateral. It is undisputed that Participants have never filed a financing statement or personally possessed any collateral. Thus, the court concluded that Participants held (at best) unperfected security interests that lose in a priority battle with Citizens, a perfected lien lender. It also noted that it was “mak[ing] no ruling about the specific property in which the three holders of the Participation Certificates were granted security interests under the recharacterized certificates.” Id. at *16 n.25.

The bankruptcy court reached a different conclusion with regard to the BoK Participation. Noting material differences between the BoK Participation and the Participation Certificates, the court concluded that BoK purchased a true participation. As a true participant, the question then became whether BoK, a non-party to the Payment Agreement, could be subordinated by BCA’s execution of the Payment Agreement. The court found that BCA was expressly precluded from subordinating its interests in the collateral without BoK’s consent. BoK never gave that consent. Thus, BoK was not bound by the Payment Agreement and its assigned, perfected security interest in 14.54% of the FLAC stock was superior to Citizens’ interest.

D. Proceedings in the District Court

The Participants appealed from the bankruptcy court’s order. The district judge referred the appeal to a magistrate judge, who issued a report and recommendation on September 3, 2013 (R&R). Aplt. App. 1212. The R&R largely disagreed with the bankruptcy court’s legal conclusions and recommended reversal. The district court agreed and therefore adopted and incorporated the magistrate’s recommendations.

The district court held that the Participants had perfected security interests in the FLAC stock and that such interests were superior to Citizens’ interest in the same. It reasoned that application of Kan. Stat. Ann. § 84-9-310(c), which the bankruptcy court “fail[ed] to apply,” was outcome determinative. S. Fid. Managing Agency, LLC, 2014 WL 129336, at *2. That section provides:

Assignment of perfected security interest. If a secured party assigns a perfected security interest or agricultural lien, a filing under this article is not required to continue the perfected status of the security interest against creditors of and transferees from the original debtor.

Kan. Stat. Ann. § 84-9-310(c). The district court reasoned that because the Participation Certificates employ express language of assignment in transferring a perfected security interest in FLAC stock, the Participants were not required to take additional steps to protect their interests. The district court rejected Citizens’ argument that recharacterization of the Participation Certificates as loans rendered § 84-9-310(c) inapplicable.

The district court likewise rejected Citizens’ argument that, even if § 84-9-310(c) applies, the Participants are not perfected as against Citizens. Citizens maintains that assignees of perfected security interests are not perfected against creditors and transferees of the lender (here, BCA). [3] According to Citizens, Citizens became a transferee of BCA when those two parties executed the Payment Agreement, transferring BCA’s rights to receive the FLAC sale proceeds. Thus, even if § 84-9-310(c) did apply, the Participants were required to take additional steps to perfect against Citizens, as transferee of BCA. Looking to the transactions and the plain language of § 84-9-310(c), however, the district court concluded that Citizens was simply a creditor of the original debtor (BCC), not a transferee of BCA. As such, the Participants could rely upon § 84-9-310(c) and BCA’s perfection.

On appeal, Citizens argues that (1) both the magistrate judge and the district judge failed to account for the consequences of recharacterization vis-a-vis the collateral and its proper perfection, (2) Kan. Stat. Ann. § 84-9-310(c) does not apply to this case, and (3) the Payment Agreement was effective against the Participants. Discussion

In essence, this appeal involves three distinct, but interrelated, issues:

(1) What effect, if any, does recharacterization have on the Participation Certificates and the security interests purportedly assigned therein?

(2) Are the Participants perfected as against Citizens pursuant to Kan. Stat. Ann. § 84-9-310(c), or is Citizens a “transferee” of BCA such that the Participants needed to take additional steps to perfect against them?

(3) What is the effect, if any, of the Payment Agreement on the rights of the parties?

Because we agree with Citizens that recharacterization of the Participation Certificates from true participations to loans renders Kan. Stat. Ann. § 84-9-310(c) inapplicable, we reach only the first of these questions.

We review the legal conclusions of both the district court and the bankruptcy court de novo. In re Paige, 685 F.3d 1160, 1178 (10th Cir. 2012) ; In re Peterson Distrib., Inc., 82 F.3d 956, 959 (10th Cir. 1996) . We overturn the bankruptcy court’s findings of fact only if clearly erroneous. In re Paige, 685 F.3d at 1178 . Despite the fact that the parties quarrel over inferences to be drawn from the bankruptcy court’s findings of fact, neither party challenges the facts as set forth above.

A. Recharacterization and Perfection of Security Interests Under Revised Article 9 of the U.C.C.

Central to this appeal is the concept of recharacterization. The bankruptcy court determined in its final order that the alleged participations should be recharacterized as loans. In re Brooke Capital Corp., 2012 WL 4793010, at *15-16. The Participants challenged this ruling on appeal to the district court, but that court found that, recharacterized or not, the Participants had perfected security interests in the FLAC stock pursuant to Kan. Stat. Ann. § 84-9-310(c). In their briefing before this court, the Participants no longer argue that recharacterization was improper; rather, they argue that the recharacterization has no effect on whether BCA’s security interest in FLAC was assigned. Indeed, as the briefs make clear, the present dispute is not over the issue of recharacterization itself, but rather concerns only the consequences of recharacterization. We therefore proceed to the issue of what effect, if any, recharacterization has on the Participants’ ability to attain automatic perfection pursuant to Kan. Stat. Ann. § 84-9-310(c).

Citizens argues that there are two important consequences of recharacterization. First, the terms of the Participation Certificates are recast as lending terms to reflect the true nature of the transaction. Second, the Participants, now treated as creditors, must perfect in some asset or assets of BCA. Thus, Citizens contends the Participation Certificates represent lending transactions whereby the Participants received either a security interest (1) in BCA’s right to receive payments from BCC (a payment intangible), or (2) in BCA’s security interest in the FLAC stock (a security interest in a security interest—a general intangible). Aplt. Br. 44. According to Citizens, there was no true assignment of BCA’s security interest in FLAC.

Both the district court and the Participants reject Citizens’ view of how recharacterization affects the outcome of this case. According to the Participants, “BCA did not merely grant Participants a security interest in the FLAC stock. BCA expressly assigned its security interest in the FLAC stock to the Participants.” Aplee. Br. 19-20. Participants then argue that they are entitled to the benefits of automatic perfection pursuant to § 84-9-310(c). The core of this dispute, then, is on what the Participation Certificates did or did not transfer. As we shall explain in more detail below, we reject the Participants’ attempt to place near dispositive reliance on the assignment provisions in the agreements without regard to the economic substance of the transactions. It is clear that in a transaction such as this, what the agreement assigned or did not assign must be evaluated against a backdrop of the economic and commercial reality of the transactions.

We begin our analysis by setting forth the nature of the lending transactions that led to this dispute. In the BCA Loan, BCC is the debtor and BCA is the creditor. The collateral is the FLAC stock. Thereafter, the Participants loaned funds to BCA. [4] In this transaction, BCA is the debtor and the Participants are the (secured) creditors. Thus, we have two different debtors in the two transactions.

For a secured party’s interest to be enforceable against the debtor and third parties, the debtor must have had “rights in the collateral or the power to transfer rights in the collateral.” Kan. Stat. Ann. § 84-9-203(b). Here, BCA had a security interest in the FLAC stock. We do not doubt that BCA could validly sell or assign that interest. However, it is also clear that if there was anything short of a true sale or assignment, BCA could not grant a security interest in the FLAC stock itself because BCA did not own the stock (BCC did), and BCC was not the debtor vis-a-vis the Participants (BCA was). But this does not mean that BCA could not grant the Participants a security interest in something else. Short of a true sale or assignment, there are two types of collateral or property in which BCA might grant a security interest. The first is a payment intangible, the right to receive payments from BCC under the BCA loan. [5] See Kan. Stat. Ann. § 84-9-102(a)(61). The second is BCA’s security interest in the FLAC stock, which is a general intangible. See id. § 84-9-102(a)(42). As the cases below illustrate, the Participation Certificates grant the Participants a security interest in something other than the FLAC stock.

In Castle Rock Industrial Bank v. S.O.A.W. Enterprises, Inc. (In re S.O.A.W. Enters., Inc.), S.O.A.W. purchased large tracts of land, subdivided those tracts, and sold the smaller tracts under “Agreements for Deed.” 32 B.R. 279, 281 (Bankr. W.D. Tex. 1983). The buyers of the subdivided tracts remitted payments to S.O.A.W. until the purchase price was fully paid. To generate operating capital, S.O.A.W. executed a “Participation Agreement” with Castle Rock. Id. Under the Agreement, S.O.A.W. purported to sell the Agreements for Deed to Castle Rock. In reality, however, Castle Rock was only entitled to 30% of each agreement for deed’s overall purchase price. Castle Rock would simply retain possession of the “purchased” agreements for deed and, until it received its 30% interest, was entitled to all payments made by the original purchasers. Id.

When S.O.A.W. filed for bankruptcy, Castle Rock asserted its rights as the owner of the Agreements for Deed. The bankruptcy court recharacterized the Participation Agreement as a loan agreement “secured by collateral.” Id. at 283. The collateral, however, was not the agreements for deed. Rather, the security interest was “essentially the right to collect all sums due from vendees under the various Agreements for Deed,” a “general intangible” under the pre-Revised Article 9 U.C.C. Id. at 283-84. Once the court established that Castle Rock had a security interest in general intangibles, the court considered whether that interest was perfected under the U.C.C. Id. at 285. The court determined that, because Castle Rock had failed to file a financing statement, it “was an unperfected secured creditor.” Id.

Likewise, in In re Commercial Money Center, Inc., debtor Commercial Money Center (CMC) “packaged groups of leases together and assigned its contractual rights to future lease payments” to participant, NetBank. 350 B.R. 465, 469 (B.A.P. 9th Cir. 2006) (emphasis added). NetBank was also granted a security interest in the underlying leases. Notably, the agreements expressly provided that the parties “intend that each assignment and transfer herein contemplated constitute a sale and assignment outright.” Id. at 470.

Similar to this case, the court set out to answer the following questions: (1) was the transaction a true sale or a mere loan; (2) what interests did NetBank obtain in the transactions; and (3) had NetBank perfected its interests. Id. at 473.

The bankruptcy appellate panel (BAP) determined that the purported sales transactions were in fact loans. Id. at 481-82. More important for our present purposes, the BAP considered NetBank’s arguments that it held perfected security interests in either chattel paper (the underlying leases) or payment intangibles. The BAP rejected the bankruptcy court’s finding that NetBank had a perfected interest in “chattel paper” by possession or filing. Critically, in discerning the nature of the interest, the BAP examined the U.C.C. definition of chattel paper and the financial reality of what NetBank received under the agreements. Id. at 475-77.

The BAP concluded that what NetBank actually received were carved out payment streams—in essence, monetary obligations. Based on this determination, the BAP held that NetBank was granted a security interest in a payment intangible. Id. at 476. Under Revised Article 9, a payment intangible is defined as “a general intangible under which the account debtor’s principal obligation is a monetary obligation.” Kan. Stat. Ann. § 84-9-102(a)(61). As the official comments to that section advise, “[i]n classifying intangible collateral, a court should begin by identifying the particular rights that have been assigned.” Id. cmt. 5. CMC’s principal obligation to NetBank was indeed a monetary one.

We agree with the analysis in the foregoing cases that, upon recharacterization, a court must look beyond the language of the agreement to determine the true nature of the interest granted. See Fireman’s Fund Ins. Co. Grover (In re Woodson Co.), 813 F.3d 266, 272 (9th Cir. 1987). In this case, the district court gave near dispositive weight to the fact that the Participation Certificates employed language of sale and assignment. S. Fid. Managing Agency LLC, 2014 WL 129336, at *5-6. But, as we have just seen, recharacterization requires us to look at substance over form. Participants’ argument that the recharacterization cases, In re S.O.A.W. and In re Commercial Money Center, are inapposite because they involved different ultimate issues is unavailing. Aplee. Br. 20. Merely asserting that these cases are inapplicable because they considered whether certain collateral was property of the bankruptcy estate under 11 U.S.C. § 541(d) is not a sufficient basis to brush aside the applicable legal reasoning therein. In each of these cases, the court’s determination of the nature of interest was essential to the court’s determination of priority. The district court failed to adequately consider the security interests the Participants received in the recharacterized transactions.

Employing the approach of In re S.O.A.W. and In re Commercial Money Center, we hold that Participants received security interests in both a payment and general intangible. When we look to the “particular rights that have been assigned,” Kan. Stat. Ann. § 84-9-102(a)(61) cmt. 5, it is clear that BCA’s “principal obligation” to the Participants is a monetary obligation. Id. § 84-9-102(a)(61). The recharacterized agreements obligate BCA to repurchase the Participants’ interests at the end of a six-month term (initially, three months). The Participation Certificates call for BCA to administer and service the BCA Loan, and do not grant Participants any right to share in borrower fees. Perhaps most significantly, the Participants’ security interests terminate when BCA fully pays off the Participants’ loans. See, e.g., Aplt. App. 164. Participants do not retain any interest, security or otherwise, in the FLAC stock. What, then, did Participants get? In return for their loans, Participants obtained security interests in “a general intangible under which [BCA’s] principal obligation is a monetary obligation.” Kan. Stat. Ann. § 84-9-102(a)(61); see, e.g., Aplt. App. 164 (“Payments received by [BCA] under the [BCA Loan] will be held for the benefit of [BCA] and [Participant] until the payments are actually paid to and received by the [Participant].”). Thus, the district court improperly focused on the form of the agreements and erroneously concluded that Participants’ security interests are security interests in the FLAC stock. The Participation Certificates granted Participants security interests in payment and general intangibles.

B. Perfection and Priority

Having concluded that the recharacterized transaction only involves a security interest in a payment intangible (BCA’s right to receive payments from BCC under the BCA loan) and a security interest in a general intangible (BCA’s security interest in the FLAC stock), we must consider who has priority.

The default rule is that a secured party must file a financing statement to perfect its security interest. See Kan. Stat. Ann. § 84-9-310(a). The filing requirement, however, is subject to numerous exceptions and carve-outs. For example, sales of loans or payment intangibles are generally automatically perfected and filing is not required. See id. §§ 84-9-309(3) & (4), 84-9-310(b)(2). Additionally, § 84-9-310(c) provides for automatic perfection where a secured party, like BCA, assigns a perfected security interest.

In this case, the Participants are not perfected pursuant to any of these provisions. To reap the benefits of these provisions there had to be either (a) a true sale, or (b) a true assignment of a perfected security interest. See In re Commercial Money Ctr., 350 B.R. at 485 (holding that, because the underlying transaction was a loan and not a true sale, creditor’s interest in a payment intangible was not automatically perfected under U.C.C. § 9-309(3)). Neither happened in this case. The former situation never occurred because, as we have already discussed, the transaction between BCA and the Participants is a loan, not a sale. As to the latter of the two situations, the Participants cannot rely on § 84-9-310(c) because, for the reasons discussed above, BCA granted Participants security interests in payment and general intangibles, and did not truly assign its own security interest in FLAC. And although § 84-9-309(2) suggests that an assignment of a payment intangible may be automatically perfected when the assignment does not transfer a significant part of the assignor’s outstanding accounts or payment intangibles, no party has raised this and we decline to consider it. Finally, Participants similarly failed to perfect a security interest in a general intangible—BCA’s security interest in the FLAC stock—because filing is required to perfect that type of interest. See id. § 84-9-310(a).

We therefore conclude that the underlying transactions granted the Participants only unperfected security interests. [6] The record before us makes clear—and neither party disputes the fact—that Citizens held a perfected security interest in the FLAC stock. Accordingly, in this priority dispute over the sale proceeds of FLAC, Citizens must win.


[*] This order and judgment is not binding precedent, except under the doctrines of law of the case, res judicata, and collateral estoppel. It may be cited, however, for its persuasive value consistent with Fed. R. App. P. 32.1 and 10th Cir. R. 32.1.

[1] The initial repurchase date was June 20, 2008. The date was later extended pursuant to signed addenda. See Aplt. App. 166, 171, 192.

[2] In general, we refer to BoK separately from Participants. Unlike Participants, BoK is not a party to this appeal. BoK initially appealed but, on October 23, 2012, an amended notice of appeal was filed that removed BoK as an appellant. Citizens has not cross-appealed from that part of the bankruptcy court’s order ruling on BoK’s interests. Citizens indicated that it has settled with BoK. Aplt. Br. 42.

[3] The comment to § 84-9-310 explains:

Subsection (c) applies not only to an assignment of a security interest perfected by filing but also to an assignment of a security interest perfected by a method other than by filing, such as by control or by possession. Although subsection (c) addresses explicitly only the absence of an additional filing requirement, the same result normally will follow in the case of an assignment of a security interest perfected by a method other than by filing. For example, as long as possession of collateral is maintained by an assignee or by the assignor or another person on behalf of the assignee, no further perfection steps need be taken on account of the assignment to continue perfection as against creditors and transferees of the original debtor. Of course, additional action may be required for perfection of the assignee’s interest as against creditors and transferees of the assignor.

Kan. Stat. Ann. § 84-9-310, cmt. 4 (emphasis added).

[4] Were this a true sale or loan participation, the Participants’ argument that they had a perfected security interest in collateral securing the BCA Loan, the FLAC stock, would be more persuasive given Kan. Stat. Ann. § 84-9-309(3) (automatic perfection). Again, however, the Participants make no argument that recharacterization is improper.

[5] We note that once a security interest attaches to the payment intangible, so too does a security interest in its underlying collateral. See Kan. Stat. Ann. § 84-9-203(g).

[6] We also reject the Participants’ argument that BCA was precluded, by the express terms of the Participation Certificates, from relinquishing rights in the collateral. Kan. Stat. Ann. § 84-9-401(b) provides: “An agreement between the debtor and the secured party which prohibits a transfer of the debtor’s rights in collateral or makes the transfer a default does not prevent the transfer from taking effect.” The Participants’ remedy may be against BCA for breach, but the transfer was effective.

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