New Bankruptcy Opinion: IN THE MATTER OF POSITIVE HEALTH MANAGEMENT – Court of Appeals, 5th Circuit, 2014

In the Matter of: POSITIVE HEALTH MANAGEMENT, Debtor.

RANDY W. WILLIAMS, Chapter 7 Trustee, Appellant,

v.

FEDERAL DEPOSIT INSURANCE CORPORATION, as Receiver for First National Bank, Appellee.

No. 12-20687.

United States Court of Appeals, Fifth Circuit.

Filed: October 16, 2014.

Before: STEWART, Chief Judge, and WIENER and COSTA, Circuit Judges.

GREGG COSTA, Circuit Judge.

The Bankruptcy Code allows a trustee to recover fraudulent transfers made by the debtor prior to bankruptcy. 11 U.S.C. § 548(a). An innocent recipient of such a fraudulent transfer is not without a defense, however. The Code allows a transferee that takes in good faith to retain what it received from the debtor in a fraudulent transfer “to the extent that such transferee . . . gave value to the debtor in exchange for such transfer.” 11 U.S.C. § 548(c). This appeal from a bankruptcy court decision that allowed the innocent recipient of fraudulent transfers to retain all the funds it received under the affirmative defense in section 548(c) turns on the meaning of “value” in this statute. We have already held that this value must be assessed from the perspective of what the transferee gave up rather than what the debtor received. Jimmy Swaggart Ministries v. Hayes (In re Hannover Corp.), 310 F.3d 796, 799-802 (5th Cir. 2002) . The unresolved question we must now decide is what happens when a transferee gave less value to the debtor than it received. Is the transferee allowed to keep all that it received so long as it gave “reasonably equivalent” value in exchange? Or is netting required so that the transferee keeps only the value that it gave to the Debtor?

I.

Ronald T. Ziegler was the president and sole shareholder of Positive Health Management, Inc., which operated pain management clinics in Texas. In 2005, First National Bank made a refinance loan to a separate corporate entity owned by Ziegler. The loan was secured by a building in Garland, Texas, which Positive Health used for office space from September 2006 to March 2008. Despite having no direct obligations under the loan, Positive Health made a series of payments to First National totaling $367,681.35. The payments, which began in February 2007 and ended in March 2008, were listed on Positive Health’s tax returns as rent. When the payments stopped, First National foreclosed on the Garland property.

After Positive Health filed a bankruptcy petition, trustee Randy Williams brought an adversary proceeding to recover the payments to First National as fraudulent transfers under 11 U.S.C. § 548. The bankruptcy court conducted a three-day trial on the claim, after which it submitted Proposed Findings of Fact and Conclusions of Law.

The bankruptcy court first addressed whether Williams could prove a constructive fraudulent transfer, which requires that the debtor “received less than a reasonably equivalent value in exchange for such transfer or obligation.” 11 U.S.C. § 548(a)(1)(B). The court found that Positive Health received at least reasonably equivalent value for the $367,681.35 in transfers to First National on two alternative grounds. First, the court cited First National’s forbearance from foreclosing on the Garland property, which allowed Positive Health to continue “running its operations and generating cash flow in the millions.” Second, the court cited the “reasonable rent” for the office space that the payments enabled Positive Health to continuing using, which the court determined was $253,333.33 based on an appraisal conducted in 2006. Because Positive Health received value at least “reasonably equivalent” to the amount of the transfers, the court held that Williams could not prevail on the constructive fraudulent transfer claim.

Nonetheless, for reasons not seriously challenged in this appeal, [1] the bankruptcy court concluded that Positive Health made the transfers “with actual intent to hinder, delay, or defraud,” and therefore that Williams had established actual fraud. 11 U.S.C. § 548(a)(1)(A). The court made this finding pursuant to the multifactor test identified in Soza v. Hill (In re Soza), 542 F.3d 1060, 1067 (5th Cir. 2008), and noted Positive Health’s deteriorating financial condition and the fact that it faced lawsuits and judgments around the time of the transfers.

The bankruptcy court then analyzed whether First National could establish the affirmative defense that it took the payments in good faith and gave value in return. 11 U.S.C. § 548(c). Relying on its discussion of “reasonably equivalent value” under the constructive fraudulent transfer analysis, the court determined that First National “gave value in exchange for the transfers” and acted in good faith. It therefore found that First National was entitled to the defense and could keep the funds.

After the district court adopted the bankruptcy court’s proposed order, Williams filed a motion to amend the judgment, arguing that the affirmative defense had not been adequately pleaded and that the testimony concerning the market value of the rent was unreliable. The district court referred the motion back to the bankruptcy court, which held an additional hearing on First National’s section 548(c) affirmative defense. At the hearing, Williams called his own expert witness, who testified that the testimony of First National’s witness was not reliable for the purposes of determining rent in 2007 and 2008. The bankruptcy court noted in response that Williams “offered no evidence on the rental value of the Garland Property,” so its initial finding of market rent was uncontroverted. The district court again adopted the bankruptcy court’s recommendation, noting that First National “`gave value’ to the debtor beyond the rental value of the property.” This appeal followed. [2]

II.

“In reviewing the rulings of the bankruptcy court on direct appeal and the district court sitting in bankruptcy, we review findings of fact for clear error and conclusions of law de novo. We review mixed questions of law and fact de novo.” TMT Procurement Corp. v. Vantage Drilling Co. (In re TMT Procurement Corp.), 764 F.3d 512, 519 (5th Cir. 2014) (per curiam) (internal citations omitted); see also Hannover, 310 F.3d at 799-800 . A bankruptcy court’s valuation “is largely a question of fact, as to which considerable latitude must be allowed to the trier of the facts.” Hannover, 310 F.3d at 801 (internal quotation marks omitted). However, “we review de novo the methodology employed by the bankruptcy court in assigning values to the property transferred and the consideration received.” Id. (internal quotation marks and citation omitted).

III.

Under 11 U.S.C. § 548(a), the trustee of a bankruptcy estate may avoid certain transfers made by the debtor before bankruptcy proceedings if the transfer was made with actual or constructive fraudulent intent. But even when a debtor has made a fraudulent transfer under that provision, an innocent recipient of that transfer is able to retain what it received if the conditions set out in section 548(c) are met:

[A] transferee or obligee of such a transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.

The provision is “perfectly complementary” with section 548(a), which allows trustees to claw back fraudulent transfers. Hannover, 310 F.3d at 802 . Section 548(a) “affords creditors a remedy for the debtor’s fraudulence or, as the case might be, mere improvidence,” whereas section 548(c) “protects the transferee from his unfortunate selection of business partners.” Id.

To establish its entitlement to the section 548(c) defense, a transferee must prove that it “provided value in good faith” for the transfer. In re Am. Hous. Found., 544 F. App’x 516, 520 (5th Cir. 2013) (per curiam). A transferee provides value when it receives the transfer in question in exchange for “property, or satisfaction or securing of a present or antecedent debt of the debtor.” 11 U.S.C. § 548(d)(2)(A). Williams does not dispute that First National acted in good faith when it accepted funds from Positive Health as payments on a loan made to another Ziegler entity, but contends that First National failed to prove that it provided value. He attacks both grounds upon which the bankruptcy court found value. First, he contends that finding value based on the benefit to Positive Health of its extended ability to use the Garland property did not assess value from the perspective of First National as transferee. Second, Williams questions the evidence presented on the reasonable rental value of the property: he agrees that the court properly evaluated this “value” from the transferee’s perspective, but he challenges its reliability.

This court’s decision in Jimmy Swaggart Ministries v. Hayes (In re Hannover Corp.), 310 F.3d 796 (5th Cir. 2002), clarified the meaning of “value” under section 548(c). In that case, prior to the bankruptcy proceedings, Sam J. Recile was found in violation of the securities laws for operating a Ponzi scheme. Id. at 798, 802. The trustee brought an action to recover funds from Jimmy Swaggart Ministries, which received them from Recile’s enterprise in exchange for short-term call options for the purchase of a tract of land. Id. at 798-99. In response, Jimmy Swaggart Ministries asserted the section 548(c) defense. Id. at 799. The trustee argued that the options were valueless because the fraudulent nature of Recile’s enterprise meant that it lacked the resources to pay anything close to the land’s $11.25 million purchase price set forth in the option agreement, and thus that Jimmy Swaggart Ministries did not “give value” in exchange for the transfers it received. Id. at 801-02.

This court rejected that argument, holding that “value” under section 548(c) is measured from the transferee’s perspective, and therefore that whether the options had any actual value to Recile’s enterprise was irrelevant:

Instead of inquiring into the possibility and extent of the debtor’s loss, [section 548(c)] provides a means by which the unwitting trading partner can protect himself. Received property can be retained “to the extent” that the “transferee . . . gave value to the debtor.” The provision looks at value from the perspective of the transferee: How much did the transferee “give”? The concern here, quite properly, is for the transferee’s side of the exchange, not the transferor’s gain.

Id. at 802. The court thus found that the option to buy the property was “a very valuable asset” from the perspective of Jimmy Swaggart Ministries, the transferee, because it tied up its ability to sell to other willing buyers. Id. at 803-04.

In measuring “value” under section 548(c), therefore, this court looks not to “the transferor’s gain,” but rather to the value that the transferee gave up as its side of the bargain. [3] In this case, First National as transferee argues that the estate cannot recover the payments because the value of First National’s forbearance—which the bankruptcy court noted was the potential for Positive Health to generate cash flow from ongoing operations that ultimately earned the company over $4 million in revenue—exceeds the $367,681.35 that First National received. But just as it was irrelevant in Hannover whether Recile’s operation received any real value from options it could not exercise, it is irrelevant that Positive Health received outsized benefits from First National’s forbearance. Both examples fail to follow Hannover’s instruction that value given up should be measured from the transferee’s perspective—instead, they measure the value of the transferee’s consideration as the transferor would. [4]

The alternative form of value found by the bankruptcy court, market rent, does analyze value from the correct perspective. Just as tying up land was costly to the transferee in Hannover, allowing Positive Health to stay in the Garland property was costly to First National. By giving up the chance to foreclose and find a new tenant, First National incurred an opportunity cost in the form of foregone market rent. [5]

Because First National received the loan payments in lieu of rent it could have otherwise earned, it gave value within the meaning of section 548(c). Although the rent measure properly assesses value from the standpoint of the transferee, Williams contends that the bankruptcy court erroneously calculated the market rent because it relied on an appraisal of the Garland building from January 2006 when the transfers occurred in 2007 and 2008. It is true that “for purposes of § 548 the value of an investment . . . is to be determined at the time of purchase.” Hannover, 310 F.3d at 802 . The bankruptcy court, however, did determine that “the reasonable rental rate from September 2006 to March 2008″—which includes the entire period in question—”was $253,333.33.” It was not clearly erroneous based on the record in this case to use the January 2006 appraisal—the only evidence offered for market value—to assess rental value for the 27 months that followed the appraisal. To hold otherwise would present significant practical problems for trial judges who often must make findings of fact based on imperfect evidence. There is no reason to question the bankruptcy court’s finding, particularly given the “considerable latitude” we must give it in this situation. See Hannover, 310 F.3d at 801 . We therefore affirm the finding that First National was entitled to the section 548(c) defense because it acted in good faith and provided value in return.

IV.

This brings us to the “netting” question identified at the outset. Williams contends that even if the affirmative defense applies, section 548(c) requires this court to reduce the value of the fraudulent transfers ($367,681.35) by the value of the market rent ($253,333.33), and to award the estate the $114,348.02 difference. This argument is based on the text of section 548(c), which provides that if a transferee shows it has taken in good faith and for value, then it “may retain any interest transferred . . . to the extent that such transferee . . . gave value to the debtor in exchange for such transfer or obligation.” 11 U.S.C. § 548(c) (emphasis added). The bankruptcy court took a looser approach, finding (in the alternative) that First National was entitled to keep the entirety of the transfers because the rental value was “reasonably equivalent” to the amount of the transfer. Although the district court appeared to recognize that netting may be appropriate in some situations, emphasizing section 548(c)’s “to the extent” language, it found that First National “`gave value’ to the debtor beyond the rental value of the property,” and therefore that netting was not necessary in this case. It reached this conclusion based on the value that Positive Health received from continuing operations in the Garland office, an assessment that we have already concluded is at odds with Hannover.

First National rejects what it terms a “rigid `netting’ approach,” arguing instead that a transferee is allowed to keep all of the fraudulent transfers when it establishes the section 548(c) defense so long as the values exchanged are “reasonably equivalent.” The term “reasonably equivalent value” appears in section 548(a)(1)(B)(i) as a factor in the determination of constructive fraudulent transfer. It does not appear in section 548(c). Nonetheless, the bankruptcy court equated the two terms, citing Hannover: “In analyzing whether a transferee gave value, the Fifth Circuit adopted the analysis of reasonably equivalent value under § 548.” Although a number of bankruptcy courts have similarly cited Hannover for the proposition that “value” under section 548(c) means “reasonably equivalent value,” [6] this reading is mistaken. Hannover only held that “the standard for appellate review of trial court determinations of `value’ under § 548(c)” is the same as “this court’s approach to the review of trial court determinations of `reasonably equivalent value'” under section 548(a). 310 F.3d at 801 (emphasis added). Nonetheless, even some courts that do not rely on this “standard of review” language from Hannover have held that section 548(c) “value” means “reasonably equivalent value.” See, e.g., Balaber-Strauss v. Sixty-Five Brokers (In re Churchill Mortg. Inv. Corp.), 256 B.R. 664, 677 (Bankr. S.D.N.Y. 2000), aff’d sub nom. Balaber-Strauss v. Lawrence, 264 B.R. 303 (S.D.N.Y. 2001) .

This is not, however, the only conclusion reached by courts that have considered the issue. Others have treated “value” and “reasonably equivalent value” as having distinct meanings. See Leonard v. Coolidge (In re Nat’l Audit Def. Network), 367 B.R. 207, 223 (Bankr. D. Nev. 2007) ; cf. Salven v. Munday (In re Kemmer), 265 B.R. 224, 234-35 (Bankr. E.D. Cal. 2001) (noting, in the context of 11 U.S.C. § 550(a), which sets out a trustee’s right of recovery from an avoided fraudulent transfer, that “value” “is not necessarily synonymous with either `reasonably equivalent value’ [under section 548(a)(1)(B)] or `fair market value'”). The Collier treatise also takes the view that “value” in section 548(c) is different than “reasonably equivalent value.” In comparing section 548(c) with the corresponding provision of the Uniform Fraudulent Transfer Act, the treatise provides a helpful comparison:

[A]ssume that a debtor [sold his brother a car worth $12,000 for $11,000] to put the car out of the reach of the debtor’s creditors, but the brother did not know of the fraud or of his brother’s financial condition. . . . Under [section 548(c)], the transaction is. . . set aside, but the brother has a lien on the car to the extent of $11,000; under state law, assuming that $11,000 is reasonably equivalent value for a $12,000 car, the brother has a complete defense to avoidance.

5 COLLIER ON BANKRUPTCY ¶ 548.09[5] (16th ed. 2014) (quoting Nat’l Audit Def. Network, 367 B.R. at 233 ).

We agree with Collier’s reading of section 548(c). It is unlikely that the drafters of the Bankruptcy Code intended “value” under section 548(c) to mean “reasonably equivalent value” when the latter term is explicitly used in another subsection of the same statute (section 548(a)’s provision for constructive fraudulent transfers). See Sosa v. Alvarez-Machain, 542 U.S. 692, 711 n.9 (2004) (“[W]hen the legislature uses certain language in one part of the statute and different language in another, the court assumes different meanings were intended.”). And the exclusion of these words is particularly telling in light of the Uniform Fraudulent Transfer Act’s use of “reasonably equivalent value” in its corresponding affirmative defense to avoidance of a fraudulent transfer. [7] See 5 COLLIER, supra, ¶ 548.09[5] (comparing the Bankruptcy Code and UFTA, and noting that only the latter gives the transferee “a complete defense” if it “gave reasonably equivalent value for the exchange” (emphasis added)); In re Nat’l Audit Def. Network, 367 B.R. at 223 (same); Jack F. Williams, Revisiting the Proper Limits of Fraudulent Transfer Law, 8 BANKR. DEV. J. 55, 111 (1991) (noting that when a transferee gives “reasonably equivalent value” that is less than actual value, the transferee “is afforded additional protection under Section 8(a) of the UFTA beyond that provided under Section 548(c) of the Code”).

Apart from the need to give different meanings to different terms used in the same statute, even viewed on its own the text of section 548(c) supports the netting approach. The last clause of the statute, beginning with “to the extent,” makes clear that a transferee is entitled to keep only the amount of a fraudulent transfer that equals the amount it gave up in exchange. See Hannover, 310 F.3d at 802 (noting that “[r]eceived property can be retained `to the extent’ that the `transferee . . . gave value to the debtor'”). And if, as the bankruptcy court implicitly found, netting is not appropriate because “value” means “reasonably equivalent value,” this reads the “to the extent” clause out of section 548(c) as establishing reasonably equivalent value under the first clause would be all that a transferee needs to show. See 11 U.S.C. § 548(c) (“[A] transferee . . . that takes for value and in good faith . . . may retain any interest transferred . . . to the extent that such transferee . . . gave value.” (emphasis added)).

First National argues that a “rigid netting approach” is not appropriate because “for more than four hundred years, the good faith and `value’ defense merely required `good consideration’ rather than some precise mathematical equivalence of value.” But it is because transferees who merely give “good consideration” in exchange for fraudulent transfers are entitled to the defense that netting is necessary. Consideration need not be “reasonably equivalent” to be valid. See Scholes v. Lehmann, 56 F.3d 750, 756 (7th Cir. 1995) (“[O]rdinarily a court will not even permit inquiry into the adequacy of the consideration for a promise or a transfer.”). And because consideration may be disproportionately small, to hold that a transferee who merely gives “good consideration” in exchange for a fraudulent transfer may keep the entire amount would allow it to benefit at the expense of the debtor’s creditors based on the fortuity that it received a fraudulent transfer. [8]

Courts have thus netted the amounts received in a fraudulent transfer against the value given to the debtor. See, e.g., Clark v. Sec. Pac. Bus. Credit, Inc. (In re Wes Dor, Inc.), 996 F.2d 237, 243 (10th Cir. 1993) (“[T]he Bank was the transferee of a fraudulent transfer from the Debtor. As such, it became liable to the bankruptcy estate for the amount of the transfer less any value it extended to the Debtor in exchange for that transfer.”); In re Telesphere Comm’ns, Inc., 179 B.R. 544, 559 (Bankr. N.D. Ill. 1994) (for the purposes of comparing a settlement to the likely outcome of litigation, netting a $92.7 million fraudulent transfer with the $38.9 million value given by the transferee). The netting issue often arises in Ponzi scheme cases. The trustee of a bankrupt Ponzi scheme typically files fraudulent transfer claims against “net winner” investors to claw back profits they have received. The “general rule” is that while transfers to innocent investors are fraudulent, the “defrauded investor gives `value’ to the Debtor in exchange for a return of the principal amount of the investment, but not as to any payments in excess of principal.” [9] Perkins v. Haines, 661 F.3d 623, 627 (11th Cir. 2011) ; see also Janvey, 2014 WL 4627972, at *6-8; Donell v. Kowell, 533 F.3d 762, 770 (9th Cir. 2008) ; Scholes, 56 F.3d at 757-58 .

The language of the Bankruptcy Code and the policies it embodies therefore lead us to the following conclusion: A good faith transferee is entitled to the protections of section 548(c) when it gives any value in return, but only to the extent of that value. When a transferee receives a fraudulent transfer the value of which exceeds the consideration it gave up in return, section 548(c) requires netting.

We recognize that not all cases will lend themselves to valuation at a precise dollar amount, such as the rental value determined by the bankruptcy court in this case. But this presents less of a problem than First National suggests. Many section 548 transfers to which the good faith defense applies involve the purchase of an asset at its fair market price. [10] This is the reason Hannover did not present the netting issue; there was no reason to doubt that the option to purchase the land was acquired at a market price that accurately reflected the value of that option. But in more unusual transfers, such as the one in this case and as in the Ponzi context, dollar-for-dollar netting is both practicable and important in balancing the interests of creditors with the interests of transferees. Bankruptcy courts may simply continue applying the tools they use to determine the value of assets in many contexts to determine value under section 548(c).

We therefore hold that Williams, as trustee of the bankruptcy estate, is entitled to recover the $114,348.02 difference between the payments First National received and the value it gave in return.

* * *

For these reasons, we AFFIRM the district court’s finding of fraudulent transfer under section 548(a)(1)(A) to the extent First National challenges it on appeal. We also AFFIRM the district court’s conclusion that First National is entitled to the section 548(c) defense, but REVERSE its take-nothing judgment in favor of First National. Instead, judgment is RENDERED in favor of Williams in the amount of $114,348.02.

[1] First National argues that “the payments from Positive Health to First National could not constitute fraudulent transfers at all.” But it does not challenge the court’s finding of fraudulent transfer beyond an unsupported assertion that Williams offered “no proof whatsoever.” We therefore conclude that any challenge to the fraudulent transfer finding is waived. See Cavallini v. State Farm Mut. Auto Ins. Co., 44 F.3d 256, 260 n.9 (5th Cir. 1995) (“[T]he failure to provide any legal or factual analysis of an issue results in waiver of that issue.”). In any event, the reasons cited by the bankruptcy court were sufficient to support its finding of fraud.

[2] The Federal Deposit Insurance Corporation was appointed receiver of First National in September 2013, and was substituted as the defendant in this appeal. For clarity, and because First National was the defendant at the time of briefing and the trial court proceedings, this opinion will refer to the defendant as First National.

[3] In cases brought under state fraudulent transfer law, we have focused instead on the value of the consideration to the transferor. In Janvey v. Brown, ___ F.3d ___, 2014 WL 4627972, at *7-8 (5th Cir. Sept. 11, 2014), for example, we held that the trustee of a bankrupt Ponzi scheme could claw back interest payments to innocent investors. Janvey rejected the investor-defendants’ argument that the debtor’s use of their money established that they gave value in exchange for the interest payments. Id. at *7. The court noted that “[t]he primary consideration in analyzing the exchange for value for any transfer is the degree to which the transferor’s net worth is preserved” because “creditors are not . . . defrauded if all that happens is the exchange of an existing asset of the debtor for a different asset of equal value.” Id. at *8 (alterations in original) (quoting Warfield v. Byron, 436 F.3d 551, 560 (5th Cir. 2006), and Scholes v. Lehmann, 56 F.3d 750, 753 (7th Cir. 1995) ) Because the Ponzi scheme’s financial condition was only worsened by the interest payments, the investors had not given value in exchange for the interest payments. Id. As the Hannover decision makes clear, however, we focus on the value of the exchange to the transferee for the purposes of section 548(c) of the federal Bankruptcy Code.

[4] In fact, the bankruptcy court’s finding of value under section 548(c) simply incorporated its finding of value under section 548(a)(1)(B). Under the latter provision, unlike the former, value is properly determined from the transferor’s perspective. See Butler Aviation Int’l Inc. v. Whyte (In re Fairchild Aircraft Corp.), 6 F.3d 1119, 1127 (5th Cir. 1993) (“[T]he recognized test is whether the investment conferred an economic benefit on the debtor.”).

[5] Contrary to First National’s argument, the two valuations offered by the bankruptcy court are not two independent forms of value that the bank gave to Positive Health. Rather, they are two different ways of analyzing the value of First National’s forbearance. Because only the rental value of the property measures value from First National’s own perspective, it is the appropriate measure in this case.

[6] See Dobin v. Hill (In re Hill), 342 B.R. 183, 203 (Bankr. D.N.J. 2006) ; Satriale v. Key Bank USA, N.A. (In re Burry), 309 B.R. 130, 136 (Bankr. E.D. Pa. 2004).

[7] See UNIF. FRAUDULENT TRANSFER ACT § 8(a) (“A transfer or obligation is not voidable. . . against a person who took in good faith and for a reasonably equivalent value.”).

[8] In trying to defend the equity of retaining the full transfer, First National claims that it was “entitled” to repayment of the loan it made. That is true, but beside the point. Positive Health’s other creditors were also entitled to compensation—that is what makes them creditors—and allowing First National to keep the full amount of the transfers reduces their potential recovery.

[9] The defrauded investor will be found to have given value to the enterprise in the form of the surrender of her fraud claim against the debtor. Janvey, 2014 WL 4627972, at *8 (“[T]he principal payments were payments of an antecedent debt, namely fraud claims that the investor-defendants have as victims of the Stanford Ponzi scheme.”). Anything above that (or in some cases, above the principal plus interest payments, see In re Carrozzella & Richardson, 286 B.R. 480, 492 (D. Conn. 2002) ), “exceed[s] the scope of the investors’ fraud claim and may be subject to recovery by a plan trustee.” Perkins, 661 F.3d at 627 .

[10] When there is a vast imbalance in the values exchanged that would be apparent to the transferee, it may be difficult to establish the good faith requirement.

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New Bankruptcy Opinion: US v. State Street Bank and Trust Co. – Bankr. Court, D. Delaware, 2014

UNITED STATES OF AMERICA, et al., Plaintiffs,

v.

STATE STREET BANK AND TRUST CO., As Trustee for Junior Subordinated Secured PIK Notes, et al., Defendants

Adv. No. 01-4605 (KJC).

United States Bankruptcy Court, D. Delaware.

October 15, 2014.

OPINION [1]

KEVIN J. CAREY, Bankruptcy Judge.

Before the Court is an adversary complaint in which the United States of America, on behalf of the Internal Revenue Service (the “Government” or “IRS”), asks this Court to recharacterize or equitably subordinate certain secured notes issued in 1996 as part of a chapter 11 reorganization plan. The secured notes were issued to two classes of creditors and known as Series A Junior PIK Notes and Series B Junior PIK Notes. For the reasons that follow, the request to recharacterize the Series A Junior PIK Notes is denied, but the request to equitably subordinate the Series A Junior PIK Notes is granted. The requests to recharacterize or equitably subordinate the Series B Junior PIK Notes are both denied.

I. BACKGROUND

Scott Cable Communications, Inc. (the “Debtor” or “Scott Cable” or the “Company”) filed a chapter 11 bankruptcy petition in the United States Bankruptcy Court for the District of Connecticut (Bridgeport) (the “Connecticut Bankruptcy Court) on October 1, 1998 (the “1998 Bankruptcy Case”). This 1998 Bankruptcy Case followed closely on the heels of a 1996 chapter 11 bankruptcy filing by Scott Cable and its affiliated holding companies in the United States Bankruptcy Court for the District of Delaware (the “1996 Bankruptcy Case”).

The 1998 Bankruptcy Case included a prepackaged liquidation plan and contemplated a sale of substantially all of the Debtor’s assets. On December 11, 1998, the Connecticut Bankruptcy Court denied confirmation of the prepackaged liquidation plan after determining that (i) the capital gains tax owing to the Internal Revenue Service as a result of the proposed sale (which was scheduled to occur post-confirmation) was an administrative expense claim; and (ii) that the principal purpose of the prepackaged plan was to avoid payment of taxes. See In re Scott Cable Commc’n, Inc., 227 B.R. 596 (Bankr.D.Conn. 1998) .

On November 19, 1998, the Government filed an adversary complaint in the Connecticut Bankruptcy Court against State Street Bank & Trust Co., as Indenture Trustee to the holders of Junior Subordinated Secured PIK Notes (the “Junior PIK Notes”), seeking to disallow the Indenture Trustee’s secured claim under Bankruptcy Code §502(a) on the grounds of recharacterization or, in the alternative, equitable subordination. [2] In 2001, the Connecticut Bankruptcy Court transferred the adversary proceeding to the Delaware Bankruptcy Court. United States v. State Street Bank and Trust Co. (In re Scott Cable Commc’n, Inc.), 263 B.R. 6 (Bankr.D.Conn. 2001).

Some holders of the Junior PIK Notes moved to intervene as defendants in the adversary proceeding, including Media/Communications Partners, L.P., Chestnut Street Partners, Inc., Milk Street Partners, Inc., TA Investments, and Allstate Insurance Company. [3] Scott Cable also intervened as a defendant (United States v. State Street Bank & Trust Co. (In re Scott Cable Commc’n, Inc.), 2002 WL 417013 (Bankr.D.Del Mar. 4, 2002)), but after the 1998 Bankruptcy Case was converted to a chapter 7 case, the chapter 7 trustee filed a motion to, among other things, substitute himself for the Debtor in the adversary proceeding and realign himself as a plaintiff. The chapter 7 trustee’s motion was granted, in part, allowing the trustee to be realigned as a plaintiff in this litigation.

This adversary case has been in the hands of four judges and three courts in two jurisdictions. There have been years of discovery and countless motions. A bench trial was held, spanning approximately 34 days over the course of nine months. A lengthy post-trial briefing process and numerous post-trial motions followed. The record is complete and this matter is ripe for adjudication.

II. JURISDICTION

This Court has jurisdiction over this adversary proceeding pursuant to 28 U.S.C. §1334(b) and §157(a). The Government’s claims for recharacterization and equitable subordination of claims against the Debtor’s bankruptcy estate are core matters pursuant to 28 U.S.C. §157(b)(2)(B), the equitable subordination claim directly arises under Bankruptcy Code §510(c), and both claims require this Court to determine the priority among entities asserting claims against a bankruptcy estate. Resolution of such claims by final order are integral to the objectives set by Congress when enacting the Bankruptcy Code. [4]

III. FINDINGS OF FACT

A. The Leveraged Buyout of Scott Cable

Scott Cable, founded by Jim Scott, was a multi-system cable operator (“MSO”) that was publicly traded before it was acquired in a leveraged buyout (“LBO”) in 1988. (Government Negotiated Facts, D.I. 739, (“Stip. Facts – Gov.”) ¶ 1.) [5] In 1984, the federal government deregulated the rates that MSOs and other cable operators could charge their subscribers, which had been previously regulated at the local level. (Pl. Ex. 114 at 1317.) The deregulation of these rates made MSOs like Scott Cable more enticing to investors.

One such investor was Steven Simmons (“Simmons”), owner and officer of Simmons Communications, Inc., an entity that acquired and operated cable television companies. Simmons sought to acquire underperforming MSOs, expecting to increase their value by offering a greater selection of programs, improving management and marketing, and increasing the customer base. (Stip. Facts – Gov. ¶¶ 21-23.) The capital that Simmons Communications used to acquire cable systems was supplied primarily by investment funds and institutional investors. (Id. at ¶24.)

On April 17, 1987, Simmons sent a letter about his interest in acquiring Scott Cable to Richard Churchill (“Churchill”) of T.A. Associates. (Pl. Ex. 2 at 871.) T.A. Associates was a venture capital firm that invested in technology oriented companies and media or communications companies. (Tr. 10/27/06, D.I. 777 (“Tr. D.I. 777″) at 8:21-9:3 (Churchill Test.)). [6] On June 4, 1987, Churchill sent a letter to Simmons containing a prospective term sheet for T.A. Associates’ and Allstate Insurance Company’s (“Allstate”) commitment to provide $22.5 million for the acquisition of the stock of Scott Cable. (Def. Ex. 1.) The financing would be divided into two parts: $18 million to be invested in a junior subordinated note with an interest rate of 15 5/8%, and $4.5 million to be invested as equity through Class B non-voting stock. Id. The junior subordinated notes would be subordinate to all other debt raised as part of the LBO.

On September 25, 1987, Scott Cable filed a Proxy Statement with the Securities and Exchange Commission (the “SEC”), which provided notice that a Special Meeting of Shareholders was to be held on October 23, 1987, to consider and vote on a proposal to approve the Agreement and Plan of Merger, dated as of June 12, 1987, as amended (the “Merger Agreement”), pursuant to which Simmons Communications Merger Corp. (“SCM” or the “Merger Corp.”), a Texas corporation formed for the purpose of acquiring Scott Cable, would be merged with and into Scott Cable. (Pl. Ex. 15 at 2.) The Proxy Statement provided that the transaction would be structured as a sale of stock, stating, in part, as follows:

The Company’s investment bankers had requested that bidders submit proposed definitive agreements and that the agreements be structured in such a way as to involve the sale of all the capital stock of the Company.

. . . .

After considering the prices, financing, compliance with the bidding process, timing, prospects for closing and all other relevant matters, the Board concluded that the terms of the Merger with SCM offered the alternative that was in the best interests of the Company’s shareholders because the SCM bid offered more favorable terms, including a higher per share consideration for the shareholders, and that the Company should pursue the SCM offer. The proposal from the unsuccessful group involved structuring the transaction as an asset sale which, because of the taxes that would have been incurred by the Company upon the sale, would have resulted in less cash available for distribution to the Company’s shareholders. After further negotiations with SCM involving the price and terms of the Merger, the Merger Agreement was executed on June 15, 1987.

(Pl. Ex. 15 at 12.)

The Proxy Statement stated that the debt of Scott Cable, post-merger, would be increased significantly, and “in order to generate sufficient funds to satisfy its obligations, including interest and principal payments, and to meet its working capital and capital expenditure requirements, the Company will have to improve its results of operations and cash flow significantly above historical levels.” (Id. at 28.) The Proxy Statement also stated that the proposed financing included, among other sources, $18,000,000 in Junior Subordinate Notes and $4,500,000 of equity contributions, essentially identical to the proposed term sheet between Churchill and Simmons. (Id. at 25.)

In 1987, some bondholders of old Scott Cable, whose bonds were to be assumed by the new, post-merger Scott Cable, filed a lawsuit in the United States District Court for the Southern District of New York, 87 CIV 7369, seeking to enjoin the proposed merger/acquisition of Scott Cable, alleging, among other things, “if the merger is consummated, the immediate effect thereof will be to render Scott Cable insolvent, undercapitalized, or otherwise unable to pay the amount due and owing by Scott Cable to plaintiffs and others under the indenture and the debentures. . . .” (Stip. Facts – Gov. ¶42.) The lawsuit was settled with a payment by Scott Cable to the bondholders, including payment of the bondholders’ attorney fees and other professional fees associated with the lawsuit. (Id. at ¶43.) The lawsuit was dismissed with prejudice and no injunction was entered. (Id.)

The LBO was consummated on January 19, 1988, at which time Scott Cable was merged into Merger Corp which, subsequently, was renamed Scott Cable Communications, Inc. (Defendants’ Negotiated and Agreed Facts, D.I. 713, “Stip. Facts – Def.,” ¶ 3.) [7] The financing for the merger transaction involved approximately $4.5 million of securities issued in the form of stock, and several tranches of securities issued in the form of debt instruments. (Stip. Facts – Gov. ¶63.) The debt securities, in the approximate amounts and order of priority, were as follows:

Senior Bank Revolving Credit Agreement $ 56,767,000 [8]

Series A Zero Coupon Senior Secured Notes due 1/31/93 $ 23,000,000

Series B Zero Coupon Senior Secured Notes due 1/31/93 $ 7,000,000

Series C Zero Coupon Senior Secured Notes due 1/31/93 $ 3,000,000

Series D Senior Secured Notes due 1/31/93 $ 14,000,000

Senior Subordinated Zero Coupon Notes due 7/31/93 $ 8,000,000

Zero Coupon Note due 8/15/93 $ 5,000,000 [9]

Subordinated Debentures due 4/15/01 $ 50,000,000 [10]

Junior Subordinated Notes due 12/31/95 $ 18,000,000
_____________
$184,767,000

(Stip. Facts – Gov. ¶64; Stip. Facts – Def. ¶4.) A security agreement providing a first priority lien on all assets of Scott Cable was provided to the Banks and to the holders of the Series A, B, C, and D Zero Coupon Senior Secured Notes. [11] (Stip. Facts – Gov. ¶67.) Another security agreement providing a second priority lien on all assets of Scott Cable was provided to the Senior Subordinated Zero Coupon Notes due 7/31/93. [12] (Id.) The remaining notes issued in 1988 were unsecured. (Stip. Facts – Gov. ¶70).

Post-merger, the stock of Scott Cable was owned by six intermediate holding companies: Simmons Communications U.S., Inc.; Simmons Communications of Texas, Inc.; Simmons Communications Central, Inc.; Simmons Communications East, Inc.; Simmons Communications West, Inc.; and Simmons Communications South, Inc. (together the “Holding Companies”). [13] (Pl. Ex. 160; Stip. Facts – Def. ¶34.) The Holding Companies, in turn, were wholly owned by Simmons Communications Texas Acquisition Corporation (“Acquisition Corp.”). (Pl. Ex. 160; Stip. Facts – Def. ¶35.) The Class A common stock of Acquisition Corp. was held by Simmons Communications, which represented 100% of Acquisition Corp.’s voting stock. (Stip. Facts – Def. ¶38). In return for the investment of approximately $4,500,000, Allstate and MC Partners received non-voting Class B stock in Acquisition Corp. (Stip. Facts – Def. ¶ 36, ¶37.)

Because the LBO was structured as a stock purchase, and not an asset purchase, post-LBO Scott Cable inherited an adjusted tax basis in the assets of old Scott Cable that had been reduced to take into account depreciation deductions that had been claimed previously. (Stip. Facts – Gov. ¶86.) If the assets were sold subsequently at a price in excess of the adjusted tax basis, the sale would produce a taxable gain. (Id. at ¶87.)

B. Terms of the 1988 Junior Subordinated Notes

As was originally proposed in the term sheet between Churchill and Simmons, the Junior Subordinated Notes issued in 1988 (the “1988 Junior Notes”) had an aggregate principal value of $18 million, received from the following purchasers:

Purchaser Note Amount

MC Partners $10,440,000

Allstate $6,000,000

Chestnut Street $500,000

TA Investors $480,000

NE Ventures $400,000

Milk Street $180,000

(the “Junior Noteholders”). [14] (Stip. Facts – Gov. ¶ 81.) The 1988 Junior Notes had a maturity date of December 31, 1995, and a fixed interest rate of 10%. (Stip. Facts – Def. ¶26.) Payment of interest was deferred until the maturity date. On each anniversary of the issuance of the 1988 Junior Notes, all accrued interest was added to the principal amount of the notes. (Stip. Facts – Gov. ¶71, ¶73; Pl. Ex. 26 at CT0074.) The 1988 Junior Notes also contained a contingent interest feature, providing for an additional payment on the notes’ maturity date based on a percentage of the increase in fair market value of Scott Cable, if any, above a certain floor, but capped at a certain amount. (Stip. Facts – Gov. ¶77; Pl. Ex. 26 at CT0074). The 1988 Junior Notes were the most junior note instruments, expressly subordinated to all other notes, and, therefore, bore the greatest risk of repayment among the debt instruments issued by Scott Cable. (Stip. Facts – Gov. ¶75.)

The Junior Subordinated Note Purchase Agreement dated January 19, 1988 between Scott Cable and the Junior Noteholders (Pl. Ex. 26) (the “Junior Note Agreement”) placed certain restrictions upon Scott Cable. For example, the Junior Note Agreement restricted Scott Cable’s ability to incur future debt, future liens on its property, or future contingent liabilities. (Stip. Facts – Def. ¶17 – ¶19.) The Junior Note Agreement also restricted Scott Cable’s ability to (i) make investments, loans and advances; (ii) enter into any transaction of merger, acquisition or consolidation; (iii) liquidate, sell, convey, lease, trade, exchange, or otherwise dispose of its assets or business; or (iv) enter into certain transactions with any officer, director or shareholder. (Id. at ¶20 – ¶22.) The Junior Notes Agreement also required Scott Cable to notify the Junior Noteholders if Scott Cable was in default under any other credit agreement for an amount in excess of $250,000. (Id. at ¶16.) The Agreement set forth fourteen “Events of Default.” (Id. at ¶ 23.)

C. Management of Scott Cable

On the same date that the LBO was completed (January 19, 1988), Scott Cable, its subsidiaries, and the Holding Companies entered into a Management Agreement with Simmons Cable TV Management, Inc. (“Simmons Management”). (Stip. Facts – Def. ¶ 40; Def. Ex. 3.) The Management Agreement provided that Simmons Management would be responsible for the day-to-day operations of all of the community antenna television systems (the “Systems”) owned by Scott Cable, its subsidiaries, or the Holding Companies, including, without limitation, management of personnel, maintenance, fee collection, marketing, purchases of goods and services, and all policy decisions with respect to the operation of the Systems (including financial planning, establishing rates and prices, subscriber growth, advertising, programming, and representation before governmental or regulatory agencies). (Stip. Facts – Def. ¶¶ 41-42; Def. Ex. 3).

Post-LBO, none of the Junior Noteholders had any direct management oversight with respect to Scott Cable (Tr. 10/19/06, D.I. 760, (“Tr. D.I. 760″) at 49:2-5 (Wade Test.)), nor did they hold any seats on Scott Cable’s Board of Directors (Stip. Facts – Def. ¶43-¶44).

D. Performance of Scott Cable Post-LBO

The exit strategy of the Junior Noteholders and Simmons Communications in acquiring Scott Cable was to increase the Company’s cash flow (which they anticipated would lead to an increase in its fair market value), and liquidate their investment in four to eight years. (Stip. Facts – Gov. ¶94.) Post-LBO through 1992, Scott Cable experienced solid growth in system revenue and cash flow. (Pl. Ex.114 at 1318.) Independent audits of Scott Cable performed by Deloitte & Touche, LLP (“Deloitte”) confirmed a positive operating cash flow. [15] (Def. Exs. 34-40; Stip. Facts – Def. ¶¶ 49-50.) Further, on June 1, 1989, Scott Cable sold cable television systems in King City and Greenfield, California for approximately $8.5 million and, on April 30, 1992, Scott sold its San Angelo and Andrews cable television systems for aggregate net proceeds of $53.7 million. (the “Post-LBO System Sales”). Scott Cable used the sale proceeds to reduce its secured debt. (Stip. Facts – Def. ¶46 – ¶48.)

However, changes in regulations related to the banking and cable industries reduced cable company values and thwarted the investors’ goal. In 1989, the Comptroller of the Currency instituted changes in regulations adversely affecting “highly leveraged transactions.” (Pl. Ex. 114 at 1317.) Because financing in the cable industry tended to be highly leveraged, the regulatory changes created a credit crunch for the cable industry, which, in turn, led to a decline in the value of cable systems. (Id.; Stip. Facts – Gov. ¶111). Also, beginning in 1990, the market for small cable systems began to suffer under the threat of a return to federal regulation of cable subscriber rates. (Pl Ex. 114 at 1317; Stip. Facts – Def. ¶52.) In 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the “1992 Cable Act”), restricting the rates cable companies could charge and leading to a decrease in the prices at which cable systems were bought and sold. (Def. Neg ¶ 53.) Beginning in March 1993, cable operators were effectively required to freeze their subscriber rates, followed by rate reductions in September 1993 and, again, in August 1994. (Id.)

The managers overseeing MC Partners’ and Allstate’s investments in Scott Cable maintained open and regular communications with Scott Cable about the Company’s financial condition and performance. (Stip. Facts – Gov. ¶96 – ¶102.) Internal memoranda and testimony of representatives of MC Partners and Allstate show that the Junior Noteholders were concerned about a decrease in the value of Scott Cable. (Stip. Facts – Gov. ¶120-¶125; ¶130-¶133.) In July 1990, Simmons noted in a letter to Allstate that the Public Debentures were trading at the reduced price of approximately $.60 on the dollar and proposed that Scott Cable buy back the Public Debentures to reduce interest payments and total outstanding debt. (Stip. Facts – Gov. ¶113-¶116.) However, Scott Cable did not purchase the Public Debentures. (Stip. Facts – Gov. ¶118.)

As concern mounted over the Company’s ability to pay its debt instruments that were due to mature in 1993, Scott Cable hired First Boston Corporation, an investment banking company, to assist in developing strategies to meet the Company’s obligations, either through a sale of assets or refinancing. (Stip. Facts – Gov. ¶119-¶120, ¶126.) Simmons and the Junior Noteholders recognized that the first option — a sale of Scott Cable’s assets — would not generate sufficient funds to pay the 1988 Junior Notes. In a report issued in October 1991, First Boston noted that the value of Scott Cable’s assets might be sufficient to pay senior debt, but not to pay the Public Debentures and original equity, including the 1988 Junior Notes, which were listed in the report under the category of “Total Equity and Equivalents.” (Stip. Facts – Gov. ¶146, ¶150-¶152.) An internal Allstate memo dated October 11, 1991 reached the same conclusion. (Stip. Facts – Gov. ¶128-¶133.)

The First Boston report also discussed that “[t]axes will have to be paid on any gain from asset sales with the amount dependent upon the Company’s use of the mirror subsidiaries, the relevant stock or assets bases and the amount of existing NOLs.” [16] (Stip. Facts – Gov. ¶153; Pl Ex. 35 at MC 09193.) Because Scott Cable had used the majority of its existing net operating losses (“NOLs”) to offset the gains received from the Post-LBO System Sales, additional asset sales would create significant tax liabilities. (Stip. Facts – Gov.¶202; Pl. Ex. 50 at A011210.) As discussions continued through 1992, Simmons, MC Partners and Allstate understood that, due to depressed cable system values and potential capital gains tax liability, a sale of Scott Cable’s assets would be insufficient to pay the 1988 Junior Notes. (Stip. Facts – Gov. ¶211-¶214.)

The October 1991 First Boston report also discussed the option of a restructuring in which the equity holders would purchase the Public Debentures and/or the Scott Note at a discount. (Stip. Facts – Gov. ¶149.) Notes of internal discussions at MC Partners over a purchase of the Scott Note reflected concerns that the Public Debenture Holders might seek to equitably subordinate any payment of the Scott Note to the Public Debentures, or senior lenders might seek to require the Junior Noteholders to make an equity infusion, rather than purchase the Scott Note. (Id. at ¶156-¶157, ¶179-¶180.) In a May 1992 report, First Boston proposed “that all existing lenders and investors participate in an intermediate term recapitalization which will allow [the Company] to reduce leverage and better position itself for refinancing or sale at the end of 1995.” (Pl Ex. 50 at A011207.) Subsequent discussions among First Boston, Simmons and the Junior Noteholders again proposed that the Junior Noteholders purchase the Scott Note due to concerns that, under the intercreditor agreement, Scott could block interest payments to the Public Debentures and “bring the house of cards down.” (Stip. Facts – Gov. ¶189-194.) Moreover, a default on the Scott Note would trigger cross-defaults on the Public Debentures and, indirectly, in certain senior secured notes. (Id. at ¶229; Pl. Ex. 58 at A011405.)

MC Partners, Allstate and the management of Scott Cable determined that Scott Cable should remain as a going concern in the hope that, over the course of two or three years, cable system values would appreciate and a later refinancing or liquidation would provide a favorable recovery. (Id. at ¶215). In an internal memo dated June 17, 1993, prepared for the Allstate Venture Capital Division, Richard Doppelt (an Allstate investment manager) noted that Allstate had no choice but to agree to a recapitalization plan involving an extension of the maturity date for the 1988 Junior Notes and committing additional funds to purchase the Scott Note; otherwise, Allstate risked losing its investment. (Id. at ¶245-¶251.) Likewise, MC Partners’ goal during the 1993 restructuring was “to do the minimum amount necessary to keep senior lenders at bay in hopes that, as market conditions improved . . . over the next couple of years, that would enable us to then refinance” remaining debt without the need for additional asset sales or liquidating the company. (Id. at ¶259 quoting Churchill Dep. at 157.)

E. The 1993 Restructuring of Scott Cable

On or about June 30, 1993, Scott Cable entered into a series of agreements to restructure Scott Cable’s finances (the “1993 Restructuring”). As part of the 1993 Restructuring, the maturity dates on the Bank Loan and the Senior Secured Notes were extended until November 15, 1995, and the maturity dates on the Senior Subordinated Notes were extended until January 15, 1996. (Stip. Facts – Def. ¶ 55.) The Junior Noteholders and Simmons Communications purchased a portion of the Scott Note. (Pl. Ex. 69 at 2074.) Sandler Capital Management (“Sandler Capital”), a holder of a portion of the Public Debentures, also purchased a portion of Scott Note. (Pl. Ex. 100 at 2.)

The Junior Note Agreement was also amended. (Pl. Ex. 70.) The amendment extended the maturity date of the 1988 Junior Notes to November 15, 2003. (Stip. Facts – Def. ¶ 55.) Scott Cable replaced the 1988 Junior Notes with Junior Subordinated Notes Due 2003 (the “1993 Junior Notes”) in the aggregate principal amount of $30,285,640.55, which reflected the original principal amount due to the Junior Noteholders and accrued interest due under the terms of the 1988 Junior Notes. No cash interest was paid on the 1988 Junior Notes. (Stip. Facts – Gov. ¶265.) No new money was required to be paid by holders of the 1988 Junior Notes for the 1993 Junior Notes. (Stip. Facts – Gov. ¶266.)

The Junior Noteholders also entered into a “Voting Agreement” with the Banks and the Senior Secured Noteholders dated June 30, 1993, which provided that if Scott Cable subsequently filed bankruptcy, the Junior Noteholders would vote only in favor of a proposed plan of reorganization that the Banks and the Senior Secured Noteholders favored. (Stip. Facts – Def. ¶59 – ¶60.) Otherwise, the Junior Noteholders were required to vote against any proposed plan of reorganization to which the Banks and Senior Secured Noteholders were opposed. (Id.). The Junior Noteholders entered into a similar Voting Agreement with the Subordinated Secured Noteholders. (Id. at ¶61.)

F. The 1993 Management Incentive Agreement; Management Transition

During the time leading up to the 1993 Restructuring, Simmons suggested the possibility of SCC Management entering into an incentive agreement with the Junior Noteholders. (Tr. 10/30/06, D.I. 778, 139:21-24 (Churchill Test.) (“Tr. D.I. 778″).) On June 30, 1993, the same date the Junior Note Agreement was amended, the Junior Noteholders and Simmons Management entered into a management incentive agreement (the “1993 Management Incentive Agreement”) pursuant to which the Junior Noteholders granted Simmons Management a portion of any recovery obtained on the 1993 Junior Notes. (Stip. Facts – Def. ¶ 67; Pl Ex. 68.) When negotiating the 1993 Management Incentive Agreement, the parties had no discussions about granting a security interest to the Junior Noteholders. (Tr. D.I. 778 at 139:25-140:8.) Rather, the agreement states that it was created because “the parties desire to provide for an incentive to the Manager to enhance the value of the cable television systems owned by Scott [Cable].” (Pl. Ex. 68 A0001; Stip. Facts – Def. ¶ 68.)

In November 1993, Simmons, who was the chief executive officer (“CEO”), chairman and a director of Scott Cable, as well as the president, CEO, and a director of Simmons Management, decided to retire. (Tr. D.I. 778 at 140:9-25; Pl Ex. 74.) Bruce Armstrong (“Armstrong”), who was then a director, president and chief operating officer of Scott Cable, was selected to be the new CEO, chairman and president of Scott Cable, and the new president and CEO of Simmons Management, with the approval of the Banks, Senior Secured Noteholders, and Senior Subordinated Noteholders. [17] (Pl. Ex. 74; Stip. Facts – Def. ¶ 72.) The Junior Noteholders also approved the replacement of Simmons with Armstrong, as required by the Junior Note Agreement. (Stip. Facts – Gov. ¶282A.)

Armstrong and Simmons entered into an agreement in which Simmons transferred his interests in Simmons Communications and Scott Cable to Armstrong. [18] (Stip. Facts – Gov. ¶283; Pl. Ex. 75.) The 1993 Management Incentive Agreement was amended to provide that Armstrong and Simmons would each receive a portion of any recovery on the 1993 Junior Notes. (Stip. Facts – Gov. ¶286; Pl. Ex. 76.) The transition was effective on January 31, 1994. (Stip. Facts – Def. ¶73.)

G. Efforts to Sell and Further Restructure Scott Cable post-1993 Restructuring

In September 1994, Armstrong hired HPC Puckett & Company (“HPC”), a cable television broker, to find a buyer for Scott Cable. (Stip. Facts – Gov. ¶295; Pl. Ex. 89 at 8238.) In a report dated January 26, 1995, HPC advised that it had entered into confidentiality agreements with 10 prospective purchasers and provided details of its discussions with a few of those MSOs about a potential stock purchase, merger, or other business venture with Scott Cable. (Stip. Facts – Gov. ¶¶ 299; Pl. Ex.79 at 11121, 11126, 11181.) However, a pattern developed in which any potential buyers’ interests waned after learning about the geographic spread of the systems and the low tax basis in the assets. (Pl. Ex. 89 at SCCB 8238.) For example, one operator, Classic Cable, initially offered to purchase Scott Cable for $120 million; but, after a more complete understanding of Scott Cable’s tax situation, Classic Cable lowered its offer to $95 million. (Stip. Facts – Gov. ¶300-¶302; Pl. Ex. 89 at SCCB 8238.) Other offers were made in the range of $95-$100 million, but with a debt load of $148 million, the offers would result in no return to Junior Noteholders and an impaired return to Public Debenture Holders, and were rejected. (Pl. Ex. 89 at SCCB 8239.)

Scott Cable sold off separate cable systems to enable it to make principal payments to the Banks and the Insurance Companies, as required by the 1993 Restructuring. (Stip. Facts – Def. ¶75; Pl. Ex. 114 at 1318.) In January 1994, Scott Cable sold its cable system in Rancho Cucamonga, California for approximately $23 million. (Stip. Facts – Def. ¶75.) In February 1995, Scott Cable sold certain cable systems in Texas, Oklahoma and Missouri for $12.7 million. (Id. at ¶76.) The proceeds of those sales resulted in $33 million in principal payments to the Banks and Insurance Companies. (Id.)

As a result of the 1993 Restructuring, the Bank Loans and Senior Secured Notes were scheduled to mature on November 15, 1995, and the Senior Subordinated Notes were scheduled to mature on January 15, 1996. (Id. at ¶78.) By Spring 1995, Scott Cable had no potential buyer for the Company as a whole. Around that time, Armstrong was discussing potential tax consequences of a sale with the secured creditor of a different cable company. The secured creditor told Armstrong that, due to his secured status, he was not concerned about the tax consequences of a sale. (Tr. 10/25/06, D. I. 775, at 27:6-28:2 (Armstrong Test.).) Around May of 1995, Armstrong began to meet with attorneys Michael Blumenthal (“Blumenthal”) and Stanley Bloch (“Bloch”), to discuss potential sales or a restructuring. [19] (Pl. Ex. 80.) At these meetings, the possibility of granting a security interest to the Public Debenture Holders and Junior Noteholders arose, and the attorneys began to research this issue as part of an overall restructuring. (Tr. 10/26/06, D.I. 776 (“Tr. D.I. 776″) at 132:13-132:25 (Armstrong Test.); Bloch Dep. 3/10/04 at 264:23-265:16.) (See also Pl. Ex. 80 at SCP5724: “What we are trying to do is put the present creditors in a position of getting paid and avoiding income taxes on the sales from eating up a good part of the proceeds. Please note that because the assets have a very low basis the income taxes could be as high as an aggregate of about $50,000,000.”) Bloch questioned whether granting a security interest to subordinated debt holders, thereby allowing them to be paid before taxes in the event of an asset sale, would result in the government pursing payment from Scott Cable’s officers or management, individually. (Stip. Facts – Gov. ¶309; Bloch Dep.at 196:14-198:22.) Further research and discussions were held about whether granting a security interest in a chapter 11 bankruptcy case would resolve the personal liability issues. (Stip. Facts – Gov. ¶329, ¶335; Bloch Dep. at 199:12-200:10.) The attorneys’ research at that time indicated that no personal liability for officers or directors should result from the granting of a lien in a chapter 11 reorganization. (Bloch Dep. at 268:6-268:25.)

On October 15, 1995, Scott Cable defaulted on an interest payment due to the Public Debenture Holders. (Stip. Facts – Gov. ¶338).

Scott Cable retained investment bankers Donaldson, Lufkin & Jenrette (“DLJ”) as restructuring advisors. (Pl. Ex. 89 at SCCB 8239.) On November 2, 1995, Scott Cable met with its senior lenders and began negotiations to restructure and refinance the senior debt due to mature on the 15th of that month. (Pl. Ex. 93 at SCCB 8412.) The senior lenders agreed to a 90-day standstill agreement that postponed, until February 15, 1996, the lenders’ exercise of their rights upon an event of default. (Id. at SCCB 8412.) The terms of the standstill agreement required Scott Cable: (1) to make a cash payment of $3 million; (2) to pay the previous quarter’s interest in cash; (3) to pay, in cash and in advance, any interest that would be incurred during the standstill period; and (4) to obtain approval from senior lenders before paying any management fees during the standstill period. (Id. ) The Junior Noteholders were not part of the negotiations and were told of the standstill agreement on November 8, 1995. (Id.) On November 15, 1995, with the standstill agreement in place, Scott Cable defaulted on its senior debt by failing to make the required payment. On November 16, 1995, Scott Cable notified the holders of the Public Debentures of the various defaults, the standstill agreement, and the Company’s restructuring efforts. (Pl. Ex. 94; Stip. Facts – Gov. ¶371-¶372.)

Armstrong, Scott Cable’s CEO, acknowledged that if the Company was liquidated in late 1995, the sale proceeds would be insufficient to pay all of the notes. (Stip. Facts – Gov. ¶410.) DLJ issued a report dated November 1995 (the “DLJ Report”) that was provided to the unsecured noteholders. (Stip. Facts – Gov. ¶ 353.) In the report, DLJ estimated Scott Cable’s value at $126.7 million, based upon a cash flow multiple of 8.5. (Pl Ex. 90 at SCCB 8045.) Using the same multiple, DLJ projected that Scott Cable’s value would reach $210.8 million by 2000. (Id.) As a result, while a sale of Scott Cable in 1995 would not allow for full recovery to the unsecured noteholders, there was a potential for 100% recovery in 2000. (Id.) The DLJ Report proposed a restructuring plan that required: (i) raising $75 million new debt capital to refinance all secured debt and zero coupon subordinated notes; (ii) using excess cash to redeem partially the Public Debentures; and (iii) restructuring the balance of the Public Debentures and the 1993 Junior Notes as secured debt of a holding company of Scott Cable, with varying lien priorities. (Id. at SCCB 8021; Stip. Facts – Gov. ¶360.) Discussion between DLJ and the Junior Noteholders about the November 1995 DLJ Report included a plan or strategy to provide a security interest in the assets of Scott Cable to Junior Noteholders to put them in a position to be paid before any capital gains tax that would result from a future sale of Scott Cable’s assets. (Stip. Facts – Gov. ¶404.)

H. Negotiations with the Public Debenture Holders

An informal committee, consisting of the larger holders of the Public Debentures and Sandler Capital, which held a number of Public Debentures and a portion of the Unsecured Zero Coupon Notes (the “Informal Bondholders Committee”), was created to negotiate with Scott Cable. [20] (Pl. Ex. 100 at 2; Stip. Facts – Gov. ¶375.) The Informal Bondholders Committee hired Brown & Wood as its legal counsel, and Chanin and Company as its financial advisor. (Stip. Facts – Gov. ¶376-¶377). Scott Cable proposed a restructuring plan as set forth in the DLJ Report. On January 25, 1996, the Informal Bondholders Committee responded by proposing (i) that the senior debt would be exchanged for $50 million senior secured notes having a first lien on Scott Cable’s assets; (ii) Sandler Capital’s share of the Unsecured Zero Coupon Notes would be exchanged for a proportional share of senior payment-in-kind (“PIK”) notes, secured by a second lien on Scott Cable’s assets; (iii) the Public Debentures would be exchanged for a share of the second lien secured senior PIK notes, 100% common stock of Scott Cable, and 75% of junior PIK notes, secured by a third lien on Scott Cable’s assets; (iv) the 1993 Junior Notes would be exchanged for 25% of the third lien secured junior PIK notes; and (v) the restructuring would be accomplished through confirmation of a pre-packaged chapter 11 plan of reorganization. (Def. Ex. 90 at A000482; Pl. Ex. 100 at 3.)

On February 1, 1996, Scott Cable responded to the Informal Bondholders Committee’s counter-proposal suggesting, among other things, changes to proposed interest rates and maturity dates. (Pl. Ex. 100, Att. C.) Scott Cable’s response also proposed keeping Sandler Capital’s interest in the Unsecured Zero Coupon Notes as part of the senior debt, granting second lien noteholders two of the five seats on the Board of Directors and the right to compel Scott Cable to sell after a period of four years. (Id. at 2.) On February 6, 1996, the Informal Bondholders Committee responded to Scott Cable’s proposal, rejecting some parts and revising others. (Def. Ex. 91.) However, Scott Cable and the Informal Bondholders Committee could not agree upon a restructuring plan prior to the expiration of the standstill agreement on February 15, 1996.

I. Scott Cable’s 1996 Bankruptcy Case

On February 14, 1996, Scott Cable and the Holding Companies, now named ACE – Central, Inc, ACE – East, Inc., ACE – South, Inc., ACE – Texas, Inc., ACE – U.S., Inc., and ACE – West, Inc., (collectively the “Debtors”) filed chapter 11 bankruptcy petitions in the Delaware Bankruptcy Court (the “1996 Bankruptcy Case”). (Stip. Facts – Def. ¶ 85.) An Official Committee of Unsecured Creditors (the “Creditors Committee”) was formed, consisting of Home Box Office and holders of the Public Debentures (some of whom had served on the Informal Bondholders Committee. (Pl. Ex. 199 ¶ 4 n. 1; Stip. Facts – Def. ¶90.) No Junior Noteholder or representative thereof was a member of the Creditors Committee. (Stip. Facts – Def. ¶92.)

Scott Cable’s debt structure in 1996 was as follows:

Senior Secured Bank debt: $ 8.3 million

Senior Secured Notes: $ 23.1 million

Senior Subordinated Notes: $ 17.6 million

Unsecured Zero Coupon Notes: $ 13.3 million

Public Debentures: $ 55.0 million

1993 Junior Notes: $ 38.9 million

Trade Debt: $ 1.4 million
______________
$157.6 million

(Pl. Ex. 114 at 1311-1314.) A letter dated April 19, 1996 from the Creditors Committee’s counsel to the Committee’s members attached a chart showing the enterprise value of Scott Cable falling within a range of $105 million to $142.5 million. (Stip. Facts – Gov. ¶419, Pl. Ex. 103.) With Court approval, Scott Cable retained Waller Capital Company (“Waller Capital”) as appraisers to determine the fair market value of the Company. (Pl Ex. 114 at 1346.) Waller Capital determined that the fair market value of Scott Cable’s cable television systems as of June 30, 1996 was $142,251,000.00 (Id.)

After filing its bankruptcy case, Scott Cable began a campaign to refinance certain existing indebtedness. (Pl. Ex. 114 at 1321.) Initially, Scott Cable sought $65 million to replace all of the secured debt and the Unsecured Zero Coupon Notes on the effective date of a plan of reorganization. (Id.) The remaining indebtedness, including the Public Debentures and 1993 Junior Notes, would be restructured in a plan of reorganization. (Id.) After receiving inquiries from seven financial institutions, Scott Cable began negotiations with two institutions that expressed a strong interest in providing refinancing. (Id. at 1322.) At the conclusion of the process, Scott Cable obtained a commitment letter from Finova Capital Corporaiton (“Finova”) dated September 19, 1996, in which Finova agreed to provide Scott Cable with a term loan of $57.5 million and a revolving loan of $10 million, with a term of five years from the date of closing, secured by a first lien on all of the assets of reorganized Scott Cable and a lien on the New Common Stock of reorganized Scott Cable. (Id. at 1322-23.)

J. Post-filing negotiations with the Creditors Committee

The Creditors Committee and the Debtors engaged in restructuring negotiations, following closely along the lines of the pre-bankruptcy negotiations between the Informal Bondholders Committee and Scott Cable. (Def. Ex. 95.)

Around May of 1996, DLJ prepared a presentation discussing the competing proposals between the Creditors Committee and the Debtors, and a proposed cram-down scenario for the Debtors. (Def. Ex. 98.) Each of the proposals assumed 1999 as the exit year in which Scott Cable would be sold. (Id.) The recovery analysis under the Creditors Committee’s proposal predicted no recovery for the 1993 Junior Noteholders in the event of a stock sale in 1999, and limited recovery in the event of an asset sale in 1999. (Def. Ex. 98.)

In a letter to Creditors Committee dated April 19, 1996, counsel to the Creditors Committee recommended the following:

The equity and the holders of the [1993 Junior Notes] want to preserve any upside potential and are unwilling to eliminate any of their debt because to do so will only transfer value to the taxing authorities. In light of these facts and the real ability of both the Senior Lenders and the holders of the [1993 Junior Notes] to oppose confirmation, it appears that the best way to proceed is to propose a compromise plan that will give each group some of what it wants.

(Stip. Facts – Gov. ¶420; Pl Ex. 103 at 7.)

K. Scott Cable’s 1996 Plan and Disclosure Statement

(1) Plan Negotiations

After receiving two extensions of the exclusive period in which only the Debtors can file a plan of reorganization and solicit acceptances, the Debtors filed a Disclosure Statement and Joint Plan of Reorganization on August 29, 1996 (the “Initial Plan”). (Pl. Ex. 109.) The cornerstone of the Initial Plan was the $67.5 million in refinancing provided by Finova, which would be used to pay the Senior Bank Loan, the Senior Secured Notes, the Senior Subordinated Notes, and the Unsecured Zero Coupon Notes in full on the plan’s effective date. (Pl. Ex. 109 at 1477; Pl Ex. 115 at 2:21-2:24.) The Initial Plan provided that the Public Debenture Holders would receive restructured notes in the full amount of their allowed claims, secured by a second priority lien on Scott Cable’s assets that was subordinate to the lien granted to Finova pursuant to the post-confirmation credit facility. (Pl. Ex. 109 at 1486.) The 1993 Junior Noteholders would receive restructured notes in the principal amount of $35 million, secured by a third priority lien on Scott Cable’s assets that was subordinate to the liens granted to Finova and the Public Debenture Holders. (Id. at 1487.) The Initial Plan’s treatment of the Public Debenture Holders and the 1993Junior Noteholders was not consensual. (Tr. D.I. 778 at 165:12-165:20.)

Negotiations with the Creditors Committee intensified, not only between the Debtors and the Creditors Committee, but also between representatives of the 1993 Junior Noteholders and the Creditors Committee. (Pl. Ex. 114 at 1324; Tr. D.I. 778 at 165:17-165:20.) Points of negotiation included the Public Debenture Holders’ requests for a current cash payment upon confirmation, input into post-confirmation corporate governance, and a deadline for the occurrence of a post-confirmation “transaction event” (such as a merger or sale of reorganized Scott Cable) (Id. 165:21-166:11). In addition, the Public Debenture Holders sought a share of the third priority secured notes to be issued post-confirmation to the 1993 Junior Noteholders. (Id. 166:16-167:4.)

(2) The 1996 Plan and Disclosure Statement

The parties reached an agreement that was reflected in the Debtors’ First Amended Disclosure Statement and First Amended Joint Plan of Reorganization dated October 22, 1996. (Pl. Ex. 114 at 1324; Pl. Ex. 113.) On the same day that the hearing for approval of the Disclosure Statement was set, the Debtors filed the Second Amended Disclosure Statement (the “1996 Disclosure Statement”) and Second Amended Joint Plan of Reorganization dated October 31, 1996 (the “1996 Plan”) to incorporate comments received from secured lenders and, primarily, from the Creditors Committee. (Pl. Ex. 115 at 3:11-3:17.)

(a) Treatment of certain creditors

The terms of the 1996 Plan provided that certain creditors would be treated as follows:

(1) all administrative claims, tax claims, priority claims, senior secured debt, subordinated secured debt, the Unsecured Zero Coupon Notes and “other” unsecured debt [21] would be paid in full on the plan’s effective date with funds received from $67.5 million credit facility between Finova and reorganized Scott Cable that would be secured with a first priority lien on all of the assets of reorganized Scott Cable and all of the new common stock issued under the plan;

(2) each Public Debenture holder would receive:

(a) its share of (i) the Public Subordinated Interest Payment (in the total amount of $5,087,153), (ii) the Public Subordinated Principal Payment (in the total amount of $500,000), and (iii) the Public Subordinated Refinancing Fee (in the total amount of $500,000) in cash on the plan’s effective date;

(b) a negotiable certificate representing each holders’ share of its undivided interest in the New Restructured Second Secured PIK Notes (the “Senior PIK Notes”) [22] and all of the New Class C Common Stock; and

(c) a negotiable certificate representing each holders’ share of its undivided interest in fifteen percent of the New Restructured Third Secured PIK Notes.

(3) each 1993 Junior Noteholder would receive:

(a) a negotiable certificate representing each holders’ share of its undivided interest in 85% of the New Restructured Third Secured PIK Notes (the “Junior PIK Notes”); [23] and

(b) its share of all New Class B Common Stock.

(Pl. Ex. 114 at 1306-07, 1327-31; 1385-87.)

The 1996 Disclosure Statement explains that no dividends are expected to be paid on the common stock issued according to the 1996 Plan. (Pl Ex. 114 at 1344.) Further, the Senior PIK Notes and the Junior PIK Notes would pay interest through the issuance of additional payment-in-kind (“PIK”) notes. (Id.) The Debtors planned to offer notes with a PIK feature because they projected that Scott Cable would not have sufficient cash flow to make payments on those notes after paying operating expenses, capital expenses and interest payments to Finova. (Tr. D.I. 775 at 160:4-160:12.) Therefore, except for the cash payment made to Public Debenture Holders on the effective date of the plan, no payments were expected to be made to the Public Debenture Holders or the 1993 Junior Noteholders on account of the reorganization securities received under the Plan until the notes mature. (Id.)

Section VII.E. of the 1996 Disclosure Statement (which appeared only in the Second Amended Disclosure Statement) further provided:

The Debtors expect that the [Senior PIK Notes] and [Junior PIK Notes] will be paid from the proceeds of a subsequent refinancing of Reorganized Scott’s indebtedness or from the proceeds of a “Transaction Event” which is defined in the Plan as (i) the merger, consolidation, liquidation, reorganization or dissolution of Reorganized Scott; (ii) the sale of all of the cable television systems currently owned by Scott, and (iii) any similar transaction including, without limitation, the reclassification of the capital stock of Reorganized Scott or the dividend or other distribution of any corporate asset to shareholders. [footnote in original: The maturity of both the [Senior PIK Notes] and [Junior PIK Notes] will accelerate upon the occurrence of a Transaction Event.] The Debtors expect that the financing or a Transaction Event will occur before January 1, 2000. . . .

Regardless of when a refinancing or Transaction Event occurs, there is no assurance that Reorganized Scott will be able to realize the value necessary to pay the [Senior PIK Notes] (which are subordinated to the Post-Confirmation Credit Facility) or the [Junior PIK Notes] (which are subordinated to both the Post-Confirmation Credit Facility and the [Senior PIK Notes]. . . . In the event the [Senior PIK Notes] and [Junior PIK Notes] cannot be paid off in full at maturity, it may be necessary for Reorganized Scott to commence another case under the Bankruptcy Code, in which event the claims represented by the [Senior PIK Notes] and [Junior PIK Notes] should be secured claims (to the extent the value of their collateral is equal to or exceeds the amount of the debt) as opposed to the unsecured status of Classes 6 [Public Debentures] and 7 [1993 Junior Notes] under the Plan.

(Pl. Ex. 114 at 1344-45.)

(b) New common stock and post-confirmation corporate governance

The officers of Scott Cable would continue as officers in reorganized Scott Cable, including retaining Bruce Armstrong as the Chief Executive Office of reorganized Scott Cable. (Pl. Ex. 114 at 1336.) Post-confirmation, the common stock of reorganized Scott Cable would be held by the Manager, i.e., Scott Cable Management Co., Inc. (New Class A Common Stock); the Junior PIK Noteholders (New Class B Common Stock); and the Senior PIK Noteholders (New Class C Common Stock). The five-member board of directors of reorganized Scott Cable would be elected annually as follows: two directors elected by the Manager, one director elected by the Junior PIK Noteholders, and two directors elected by the Senior PIK Noteholders. . (Pl. Ex. 114 at 1399.)

On the earlier of December 31, 1999 or the occurrence of a “Transaction Event,” the New Class C Common Stock held by the Senior PIK Noteholders would automatically convert to new Class A Common Stock, which would give the Senior PIK Noteholders control of the Board of Directors. [24] (Pl. Ex. 114 at 1400.)

(c) Valuation and Liquidation Analyses

The 1996 Disclosure Statement advised that DLJ estimated the enterprise value of Scott Cable as a whole fell within a range between $140 and $160 million. (Pl. Ex. 114 at 1346.) The 1996 Disclosure Statement also discussed the appraisal performed by the Debtors’ court-approved appraiser, Waller, which determined that the fair market value of Scott’s cable television systems as of June 30, 1996 was $142.251 million. (Id.) The Debtors believed the two appraisals were consistent. (Id.)

The Debtors asserted that the 1996 Plan met the Bankruptcy Code’s “best interests” test, which the Debtors described as requiring “the Bankruptcy Court [to] find that the Plan provides to each member of each impaired Class of Claims and Interests a recovery which has a present value of the distribution which each such person would receive from its respective debtor if that debtor were instead liquidated under chapter 7 of the Bankruptcy Code.” (Id. at 1348.) Exhibit C to the 1996 Disclosure Statement set forth a Liquidation Analysis to demonstrate that the distributions made to impaired creditors under the plan were greater than the distributions — if any — that those creditors would receive in a chapter 7 liquidation. (Id. at 1420-21.)

The Initial Plan and Disclosure Statement did not attach a Liquidation Analysis, but only included an Exhibit C stating that a Liquidation Analysis would be provided. (Pl. Ex. 109 at 1575.) The Liquidation Analysis attached to the First Amended Disclosure Statement described the distribution of “PreTax” Liquidation Proceeds to unsecured creditors as follows:

Amount Available for Percent Recovery in Percent Recovery
Unsecured Creditors (PreTax*) Liquidation (PreTax) under Plan

Class 6 (Zero Coupon) 100% 100%

Class 7 [Public Indentures] 100% 100%

Class 8 [1993 Junior Notes] 14% 100%

Class 9 Other Unsecured 69% 100%

*Taxes arising from the sale of the systems would be substantial. The payment of such taxes
would significantly reduce the amount of cash available for Unsecured Creditors.
(Pl. Ex. 113 at 0997.)

The Liquidation Analysis attached as Exhibit C to the final 1996 Disclosure Statement changed significantly, providing as follows:

LIQUIDATION ANALYSIS

I. Liquidation Value of Assets of Scott

A. Proceeds from Sale of Operating Businesses $142,251,000 [a]

Before Applicable Discount 21,337,000 [b]
_____________
Less: Applicable Discount $120,914,000

Cash on Hand 10,900,000 [c]
_____________
$131,814,000

B. Costs and Fees of Scott Liquidation $ 1,800,000 [d]

Selling Transaction Fees 1,500,000 [e]
_____________
Chapter 7 Expenses $ 3,300,000
_____________
C. Liquidation Proceeds Available to Scott Creditors $ 128,514,000

II. Recovery By Scott Creditors

A. Liquidation Proceeds Available $128,514,000

B. Scott Liabilities

Secured Creditors 50,000,000

Administrative Expenses 2,000,000 [f]

Tax Claims 43,965,000 [g]
_____________
$ 32,549,000

C. Amount Available for Unsecured Creditors $ 32,549,000

Class 5 (Zero Coupon) ($13,307,105) $ 13,307,105

Class 6 [Public Debentures] ($55,087,153) $ 18,899,895

Class 7 [1993 Junior Notes] ($38,925,797) $ -0-

Class 8 (Other Unsecured) (1,140,000) $ 342,000

Total Unsecured Claims ($108,460,055) $ 32,549,000

The percent of recovery for unsecured creditors included in the 1996 Disclosure Statement’s Liquidation Analysis was as follows:

Percent Recovery in Percent Recovery
Liquidation under Plan

Class 5 (Zero Coupon) 100% 100%

Class 6 [Public Debentures] 34% 100%

Class 7 [1993 Junior Notes] -0- 85%

Class 8 (Other Unsecured) 30% 100%

(Pl. Ex. 114 at 1420-21.) (Final footnotes omitted.)

(d) Tax Provisions

The Initial Plan provided for full payment of priority tax claims, but noted that the Debtors were unaware of the existence of any holders of Allowed Priority Tax Claims. (Pl. Ex. 109 at 1482, 1548.) The Initial Plan also included a section for “Certain Federal Income Consequences of the Plan,” which provided — in all capital letters — and in part:

THE TAX CONSEQUENCES OF CERTAIN ASPECTS OF THE PLAN ARE UNCERTAIN DUE TO THE LACK OF APPLICABLE LEGAL PRECEDENT AND THE POSSIBILITY OF CHANGES IN THE TAX LAW. NO RULINGS WILL BE SOUGHT FROM THE INTERNAL REVENUE SERVICE (THE “IRS”) WITH RESPECT TO ANY OF THE TAX ASPECTS OF THE PLAN, AND NO OPINION OF COUNSEL HAS BEEN REQUESTED OR OBTAINED WITH RESPECT TO ANY SUCH ASPECTS. THERE CAN BE NO ASSURANCE THAT THE IRS WILL NOT CHALLENGE ANY OR ALL OF THE TAX CONSEQUENCES OF THE PLAN, INCLUDING THE UTILITZATION OF THE DEBTORS’ TAX ATTRIBUTES, OR THAT SUCH A CHALLENGE, IF ASSERTED, WOULD NOT BE SUSTAINED.

(Pl. Ex. 109 at 1505-06.) The 1996 Disclosure Statement did not change with respect to its treatment of priority tax claims, except to estimate that Allowed Priority Tax Claims paid on the Effective Date were expected to be less than $100,000.00 (Pl. Ex. 114 at 1327.) The language in the section for Certain Federal Income Consequences of the Plan, as quoted above, did not change. (Pl. Ex. 114 at 1351.)

L. The Government’s Actions During the 1996 Bankruptcy Case

At the time the petition was filed in the 1996 Bankruptcy Case, it was the practice of the U.S. Attorney’s Office in Wilmington, Delaware to monitor chapter 11 filings for “large dollar cases,” meaning those cases that involved assets of $50 million or more. (Tr. 11/3/2006, D.I. 782 (Tr. D.I. 782) at 30:1-30:19.) The 1996 Bankruptcy Case satisfied the “large dollar case” criterion and on February 26, 1996, the U.S. Attorney’s Office opened a file for the 1996 Bankruptcy Case. (Id. at 30:25-31:16; Def. Ex. 193, 194.) On February 28, 1996, an Assistant United States Attorney (“AUSA”), filed a Notice of Appearance, Request for Matrix Entry and Request for Service of Notices and Documents on behalf of the Government. (Def. Ex. 9; Stip. Facts – Def. ¶ 93.)

Also on February 28, 1996, the AUSA sent a letter to the Internal Revenue Service Special Procedures Office in Wilmington, Delaware (the “Wilmington IRS Office”) to advise that the 1996 Bankruptcy Case was filed and that it was the responsibility of that IRS office to file a timely proof of claim. (Def. Ex. 191.) On the same date, the AUSA sent a letter to the Assistant District Counsel in the IRS District Counsel’s office in Washington, D.C. to advise that the 1996 Bankruptcy Case was a “large dollar case” filing. (Def. Ex. 192.)

On March 4, 1996, the Wilmington IRS Office opened a case on its Automated Insolvency System (“AIS”) for the 1996 Bankruptcy Case. (Def. Ex. 25 at 627.) On June 8, 1996, Elizabeth Hennessey (“Hennessey”), a bankruptcy specialist with Wilmington IRS Office, noted in the AIS that the Debtors “were in full compliance pre-petition.” (Def. Ex. 25 at 633.) On or about August 14, 1996, Hennessey noted that there was no reason to ask for an extension of the claim bar date. (Id.)

The AUSA began a leave of absence in June 1996 and, on June 12, 1996, filed a separate Notice of Appearance in the 1996 Bankruptcy Case on behalf of Miriam Howe, (“Howe”), an attorney with the District Counsel Office of the IRS in Washington, D.C. (Tr. D.I. 782 at 61:21-62:10; Def. Ex. 11.) Howe was transferred and, eventually, responsibility for the 1996 Bankruptcy Case was transferred to Sandra Jefferson, a Senior Attorney in the Office of Chief Counsel, Tax Exempt and Governmental Entities Division, located in Baltimore, Maryland. (Tr. D.I. 782 at 127:6-128:14; 129:9-130:13 (Jefferson Test.)) After speaking with Hennessey, on August 21, 1996, Jefferson wrote a memorandum to the District Director, Delaware-Maryland, and to William Spatz (“Spatz”), in the office of Assistant Chief Counsel, Washington, D.C. (the “IRS National Office”), to advise that the debtor entities did not owe any outstanding taxes and, therefore, the case would not be transferred to the Department of Justice to request an extension of the bar date. (Def. Ex. 12 and 13.)

On August 29, 1996, Debtors’ counsel served a copy of the Initial Plan upon the service list for Government Agencies that included the AUSA, the Wilmington IRS Office, an IRS office in Philadelphia, PA, and the Secretary of the Treasury, Washington, D.C., among others. (Def. Ex. 111.) Jefferson received a copy of the Initial Plan and Disclosure Statement on September 9, 1996, and forwarded a copy of those documents to Spatz on the same day. (Def. Ex. 14.) In her cover memorandum, Jefferson pointed out that that the IRS did not have any priority tax claims, but noted that such claims were not impaired under the Initial Plan. (Id.)

At that time, Spatz was already responsible for many other assignments, so Kathryn Zuba (“Zuba”), Spatz’s supervisor at the National Office, assigned the 1996 Bankruptcy Case to Carol Campbell (“Campbell”). (Tr. 1/19/07, D.I. 787 (Tr. “D.I. 787″) at 22:23-23:20 (Campbell Test.)) Campbell had never reviewed a large dollar bankruptcy case before the 1996 Bankruptcy Case. (Id at 49:13-14.) On September 13, 1996, after reviewing Initial Plan and Disclosure Statement, Campbell prepared a brief memo, signed by Zuba, to other divisions of the IRS National Office, including Corporate, Financial Instruments and Products (“FI&P”), and Income Tax and Accounting (“IT&A”). (Def. Ex. 16.) In the memo, Campbell advises that no claim was filed because it was determined that the Debtors did not owe any taxes, points out sections of the Initial Plan and Disclosure Statement addressing “Federal Tax Consequences” and treatment of priority claims, and asks the divisions to provide any comments on the documents directly to Jefferson. (Id.) Neither Campbell nor Jefferson recall ever being contacted by another IRS division regarding the Initial Plan and Disclosure Statement. (Tr. D.I. 787 at 45:14-46:20 (Campbell Test.); Tr. 12/11/2006, D.I 783 (“Tr. D.I. 783″) at 28:2-29:9 (Jefferson Test.))

On October 16, 1996, Jefferson wrote a memorandum to Campbell advising that October 27, 1996 was the deadline for filing objections to the Initial Plan. [25] (Def. Ex. 17.) This memo explained that the IRS Wilmington Office did not intend to file an objection because “the Plan is unobjectionable and the IRS has not filed a proof of claim.” (Id.)

On October 23, 1996, Debtors’ counsel served notice and a copy of the First Amended Disclosure Statement and Plan on Howe, at the Washington, D.C. address, and on the same Government Agencies service list, including the AUSA, the Wilmington IRS Office, an IRS Office in Philadelphia, PA, and the Secretary of the Treasury in Washington, D.C., among others. [26] (Def. Ex. 119.) Although she received the documents, Jefferson did not review the First Amended Disclosure Statement and Plan. (Tr. D.I. 783 at 242:19-25), nor did she send a copy to the IRS National Office believing there had been no changes between the Initial Plan and the First Amended Plan that affected the Government. (Id. at 52:25-53:8.)

On November 7, 1996, the Debtors served copies of the Second Amended Disclosure Statement, Second Amended Plan, Notice of Order approving the Second Amended Disclosure Statement and setting deadlines for voting, objections to confirmation and the confirmation hearing; and ballots upon Howe at the Washington, D.C. address, the Wilmington IRS Office, an IRS Office in Philadelphia, PA, and the Secretary of the Treasury in Washington, D.C., among others. (Def. Ex. 120.) In November 1996, Jefferson sent a memo and copy of the Second Amended Disclosure Statement and Plan to Campbell, advising that objections to plan confirmation had to be filed by November 27, 1996. (Def. Ex. 21.) The memo also advised that “[w]e do not intend to file objections since the Plan is unobjectionable and the IRS has not filed a proof of claim. However, we would still like the National Office’s views concerning the future tax consequences of the Plan.” (Id.) Campbell had no specific recollection of receiving the memorandum and documents, but assumed she did receive them. (Tr. D.I. 787 at 77:20 – 78:1.)

M. The 1996 Plan is Confirmed and Becomes Effective

On December 6, 1996, the Court held a hearing on the confirmation of the Debtors’ 1996 Plan. (Pl. Ex. 119.) At the hearing, Debtors’ counsel advised the Court that the 1996 Plan was “overwhelmingly accepted by all classes entitled to vote on the plan.” (Pl. Ex. 119 at 2:11-14; 3:22-4:1.) Debtors’ counsel advised that three objections to the 1996 Plan had been filed: one by a Texas state controller (which was withdrawn), and two by creditors who would be paid in full on the Plan’s effective date. (Pl. Ex. 19 at 4:2-14.) In response to the Court’s request to run through the requirements of §1129, Debtors’ counsel read a proffer of Armstrong’s testimony (Id. at 12-18), which included a proffer that the primary purpose of the plan was not the avoidance of taxes, but rather “to preserve and protect Scott’s viable business operations, to maximize distributions to creditors, and to allow creditors to participate in distributions in excess of those which would be available if the chapter 11 cases were converted to cases under chapter 7 of the Bankruptcy Code” (Id. at 14:8-9) and a proffer that confirmation of the plan was not likely to be followed by the liquidation or need for further financial reorganization (Id. at 17:10-24). After careful consideration of the objections to the 1996 Plan, the Court ordered that certain language be added to the proposed confirmation order to address his ruling on the objections. [27] An Order confirming the 1996 Plan was entered that same date. (Pl. Ex. 120.)

The 1996 Plan became effective on December 18, 1996. (Pl. Ex. 148 at CTO975.) On the effective date, the following events occurred pursuant to the 1996 Plan: (i) Scott Cable closed on the $67.5 million credit facility with Finova; (ii) the Senior Secured Debt, Subordinated Secured Debt and the Unsecured Zero Coupon Notes were paid in full; (iii) holders of unsecured trade debt were paid in full; (iv) Scott Cable made certain payments to the Public Debenture Holders; (v) Scott Cable issued the Senior PIK Notes and the Junior PIK Notes; (vi) existing common stock was cancelled and the following new stock was issued: Class A common stock representing 1% of equity was issued to management; Class B common stock representing 24% of equity was issued to the 1993 Junior Noteholders; and Class C common stock representing 75% of equity was issued to the Public Debenture Holders. (Id. at CTO975, CTO978-79.) Neither the Public Debenture Holders, the 1993 Junior Noteholders nor management provided any new cash or assets to Scott Cable in exchange for the Senior PIK Notes, Junior PIK Notes or new stock. (Tr. D.I. 776 at 41:7-41:15.)

On December 18, 1996, the Indenture Trustee for the Junior PIK Notes, and Scott Cable executed an Indenture, a Security Agreement, as well as Subordination Agreements, with respect to the Junior PIK Notes. (Pl. Exs. 121, 123-126.) The Junior PIK Notes were divided into two groups: “Series A,” consisting of 85% of the total amount available for payment, and “Series B,” consisting of the remaining 15% of the total amount available for payment. (Pl. Ex. 126 at 3397.) Consistent with the 1996 Plan, the Series A Junior PIK Notes were distributed to the prior 1993 Junior Noteholders, and the Series B Junior PIK Notes were distributed to the prior holders of the Public Debentures. [28]

After the effective date, Scott Management remained as management of Scott Cable, with Armstrong remaining as CEO. (Pl. Ex. 114 at 1336, 1377.) On the Effective Date, Scott Management and the Series A Junior PIK Noteholders entered into a new management incentive agreement (the “1996 Management Incentive Agreement”). (Pl. Ex. 122.) Under the terms of the 1996 Management Incentive Agreement, the Series A Junior PIK Noteholders agreed to allocate to Scott Management 21½ % of any recovery on the Series A Junior PIK Notes or Class B stock. (Id.)

N. Scott Cable after the 1996 Bankruptcy Case

In June 1995, the Federal Communications Commission extended regulatory rate relief to small cable operators, which allowed for greater flexibility in establishing and increasing rates. (Pl. Ex. 148 at CT0983.) In February 1996, Congress enacted the Telecommunications Act of 1996 (the “1996 Act”) which, among other things, deregulated service, but also intended to foster competition by allowing direct broadcast satellite television. (Tr. D.I. 776 at 34:15-36:20.)

After the 1996 Bankruptcy Case, Scott Cable, through its CEO Armstrong, again hired HPC to market the Company. (Id. at 67:21-68:2.) In the summer of 1997, HPC learned that Interlink Communications Partners, LLP (“Interlink”) was interested in purchasing substantially all of the assets of Scott Cable. (Id. at 68:3-9; Pl. Ex. 147 at 10796.) Interlink offered initially to purchase Scott Cable’s assets in a price range between $136 million and $143 million. (Pl. Ex. 196 at 8:25-9:6.) That offer was rejected as insufficient. (Id.) In October 1997, HPC returned with an offer of $150 million from Interlink, and Scott Cable’s board of directors found the price sufficient to start negotiations in earnest. (Id. at 9:7-12.) Due to changes in the market around that time, the Company’s board of directors decided that even Interlink’s revised offer was too low, and decided to set the price for Scott Cable at $165 million. (Pl. Ex. 196 at 9:13-25.) In acknowledgement of Interlink’s investment in the process, Scott Cable offered that price to Interlink prior to starting another marketing campaign, and Interlink accepted. (Id. at 10:1-14.)

Armstrong was aware that the proceeds from the sale to Interlink were not enough to pay the Junior PIK Notes and the tax obligations resulting from the sale. (Tr. D.I. 776 at 69:1-10.) As an officer of Scott Cable, Armstrong was concerned that he and other officers could be held personally liable for authorizing payment of the Junior PIK Notes rather than the taxes. (Id. at 69:1-70:8.) As a result, Armstrong considered a second bankruptcy filing to obtain a court order approving the sale and the payments. (Id.).

In April 1998, Scott Cable’s board of directors met with bankruptcy counsel to review plan of reorganization alternatives that could, among other things, provide for closing of the purchase agreement with Interlink after entry of the confirmation order “to insure that tax liability triggered by the sale is not an administrative claim,” and include “releases (and injunctive protections) for all officers and directors from all liability including, without limitation, claims of the Internal Revenue Service and state and local taxing authorities relating to tax liability triggered by the sale of assets.” (Pl. Ex.142.)

On July 10, 1998, Scott Cable and Interlink entered into an Asset Purchase Agreement (the “APA”) pursuant to which Interlink agreed to purchase substantially all of Scott Cable’s cable television systems and related assets for $165 million. (Pl. Ex. 147 at 10797, 10879-10948.) The APA provided that Scott Cable would seek to complete the sale through a chapter 11 bankruptcy plan. (Id. at 10922-24.) The APA provided that closing on the sale would occur “no sooner than sixty (60) days after the entry of the Confirmation Order.” (Id. at 10902.)

On August 17, 1998, Scott Cable solicited approval of a pre-packaged liquidating chapter 11 plan by distributing a disclosure statement (the “1998 Disclosure Statement”) and ballots to creditors in Class 1 (Finova), Class 2 (Senior PIK Notes) and Class 3 (Junior PIK Notes). (Id. at 10782-83.) The proposed plan of liquidation incorporated the terms, provisions and conditions of the APA, including the requirement that closing of the sale occur after the entry of a Confirmation Order. (Id. at 10865 ¶8.17.) The 1998 Disclosure Statement also provided notice of the non-payment of claims including taxes that would arise after the bankruptcy filing, as follows:

BECAUSE THE SECURED CLAIMS AGAINST THE COMPANY EXCEED THE VALUE OF THE COMPANY’S ASSETS, FOLLOWING THE SALE AND LIQUIDATION OF THE COMPANY CONTEMPLATED BY THE PLAN THERE WILL BE NO FUNDS AVAILABLE TO PAY LIABILITIES ARISING ON OR AFTER THE CONFIRMATION DATE, EXCEPT AS EXPRESSLY PROVIDED IN THE PLAN. SPECIFICALLY, THERE WILL BE NO FUNDS AVAILABLE TO PAY FEDERAL, STATE OR LOCAL INCOME OR SIMILAR TAXES ARISING AS A RESULT . . . OF THE SALE ASSETS, AND SUCH TAX CLAIMS WILL BE BARRED FROM RECOVERY AGAINST THE PURCHASER, THE SALE ASSETS, THE PROCEEDS, THE EXCLUDED ASSETS, THE COMPANY, ITS AFFILIATE, OFFICERS AND DIRECTORS, THE OFFICERS AND DIRECTORS’ INDEMNITY ESCROW FUND AND ITS AGENT, THE ADMINISTRATIVE TRUST AND ITS TRUSTEE, OR HOLDERS OF CLAIMS OR INTERESTS. . . .

(Id. at 10786-87.) In Section VIII titled “Tax Consequences To Debtor Arising From the Sale of the Sale Assets,” the disclosure statement further explained that the sale of the Debtor’s assets to Interlink would give rise to approximately $37.4 million of federal and state income tax liabilities that would not be paid. (Id. at 10834.) The 1998 Disclosure Statement also provided that, upon effective date of the plan, certain parties, generally, and taxing authorities, specifically, would be enjoined from bringing any action against the Debtor, its officers and directors, and that certain third party releases would be granted. (Id. at 10813-14.)

O. Scott Cable Files a Second Bankruptcy Case

On October 1, 1998, Scott Cable filed a chapter 11 bankruptcy petition in the Bankruptcy Court for the District of Connecticut (the “1998 Bankruptcy”) together with the 1998 Disclosure Statement and the prepackaged plan of liquidation (the “1998 Plan”). At a hearing on November 13, 1998, the Connecticut Bankruptcy Court approved the asset sale to Interlink, free and clear of all liens and encumbrances, under Bankruptcy Code §363. (Pl. Ex. 196.)

The IRS objected to confirmation of the 1998 Plan, arguing that the plan failed to provide for payment of the capital gains tax arising from the sale as an administrative expense, provided for an injunction in violation of the Anti-Injunction Act (26 U.S.C. §7421(a)) and because the 1998 Plan’s principal purpose was to avoid taxes. In re Scott Cable Commc’n, Inc., 227 B.R. 596, 599 (Bankr.D.Conn. 1998) (“Scott I”) . At a hearing on November 23, 1998 on the prepackaged plan and disclosure statement, the Connecticut Bankruptcy Court approved (without objection) the 1998 Disclosure Statement, but — based on the significant objections raised by the IRS — reserved judgment on the 1998 Plan. (Pl. Ex. 197 at 8.)

On December 11, 1998, the Connecticut Bankruptcy Court issued a memorandum opinion and order denying confirmation of the1998 Plan. Scott I, 227 B.R. at 604 . The Court’s main reasoning for denying confirmation of the plan was that it failed to satisfy the requirement under Bankruptcy Code §1129(d), which provides that a Court may not confirm a plan if the principal purpose of the plan is the avoidance of taxes. Id. at 601. The Court wrote:

The Debtor has conceded that “[t]he principal purpose of the Plan . . . has always been to structure a sale . . . that is acceptable to the [Junior PIK Noteholders]. . . .” Debtor’s Response at 1-2. It is apparent that in order for that group to benefit from the Sale, the Plan would have to structure the Sale so that there would be no administrative capital gains tax and no future tax liability for the Jr. PIK Note Holders, and that is its principal purpose. Accordingly, the Plan does not escape the §1129(d) prohibition, and it cannot be confirmed.

Id. at 604. The Court further held that the 1998 Plan could not be confirmed because its release provisions would prevent the IRS and other taxing authorities asserting claims for unpaid taxes against officers, directors and others defined as “Company Releasees” in violation of 26 U.S.C. § 7421, the Anti-Injunction Act. Id. at 602.

P. The Sale of Scott Cable’s Assets

Failure to obtain confirmation of the 1998 Plan also meant that Scott Cable failed to satisfy a condition precedent to closing the APA. However, Scott Cable and Interlink agreed to extend the sale’s closing date and, on January 7, 1999, entered into an amended APA. (Pl. Ex 197 at 10:24-11:5.) On January 14, 1997, the Connecticut Bankruptcy Court approved the Debtor’s motion for authority to sell essentially all of its assets to Interlink pursuant to Bankruptcy Code §363. (Pl. Ex. 197 at 32:8-33:3.)

The sale to Interlink closed on February 12, 1999, and the proceeds paid to Finova and the Senior PIK Notes. (Tr. D.I. 776 at 76:23-77:12; 78:12-24.) See also United States v. State Street Bank and Trust Co. (In re Scott Cable Commc’n, Inc. (“Scott II”)), 259 B.R. 536, 542 (D. Conn. 2001). The remaining proceeds (approximately $30,291,296.00) were placed into an interest-bearing escrow account. The claims of the IRS (approximately $37.4 million) and the Junior PIK Noteholders (more than $49 million) remained unpaid. (Scott II, 259 B.R. at 541, 542.)

Q. The IRS’s Adversary Proceeding

(1) The Adversary Proceeding before the Connecticut Courts

On November 19, 1998, the Government filed the instant adversary proceeding against the Indenture Trustee for the Junior PIK Notes seeking to recharacterize the Junior PIK Notes as equity. On December 17, 1998, the Government filed an amended complaint adding a claim for equitable subordination of the claims of the Junior PIK Noteholders to the claim of the IRS.

On December 14, 1998, Scott Cable filed a motion to intervene and a Rule 12(c) motion for judgment on the pleadings. On January 4, 1999, the Indenture Trustee filed a motion to dismiss the amended complaint. The Connecticut Bankruptcy Court determined that the Government’s adversary proceeding was barred by the res judicata effect of the order confirming the 1996 Plan, but that decision was reversed by the Connecticut District Court. United States v. State Street Bank and Trust Co. (In re Scott Commc’n, Inc.), 232 B.R. 558 (Bankr. D.Conn. 1999) rev’d Scott II, 259 B.R. 536. The Connecticut District Court held that the Government’s adversary proceeding was not barred by res judicata, deciding:

[T]he circumstances in the Delaware Proceeding [i.e., the 1996 Bankruptcy Case] were such that the IRS did not hold a claim and thus was not a creditor relying on the claims allowance procedures and the information conveyed to the IRS tended to suggest that the IRS was not affected by the [1996 Plan]; that the information conveyed to the IRS tended to suggest that all tax claims were being paid; that the relevant law which would have informed the IRS’s understanding of the information being conveyed to it should not have caused the IRS to see any particular “red flags”; that the discussion, in the information conveyed to the IRS, about the implications of the conversion to secured creditor status of the holders of the [Junior PIK Notes] was suggestive of other concerns; that, in the information conveyed to the IRS, there was no clear, limited set of possibilities; and that the IRS was entitled to assume it would receive full and fair disclosure. It is true that the IRS should be deemed to be sophisticated. It is also true that a thorough analysis of all the scenarios that were possible as a result of confirmation of the Delaware Plan would have revealed to the IRS that its pecuniary interests could be adversely affected under certain scenarios. However, where it is the common understanding that what the law requires is full and fair disclosure, where the circumstances tended to indicate that confirmation of the plan would not adversely affect any pecuniary interest of the IRS, and where nothing in the Delaware Plan and the Delaware Disclosure Statement explicitly stated or even suggested that, in fact, the IRS’s pecuniary interests could be adversely affected, it can not be said that the plan or the disclosure statement was reasonably calculated to inform even a sophisticated party in interest like the IRS that its pecuniary interests could be affected. Notice, given in such a way that a thorough analysis of all possible scenarios is required before the recipient can discern that its pecuniary interests could be adversely affected, is not notice given by a “means . . . such as one desirous of actually informing the absentee might reasonably adopt to accomplish it,” . . . nor does it appear to satisfy the requirement that there be disclosed “information of a kind, and in sufficient detail,” . . . as would enable a person to make an informed judgment about the plan.

Scott II, 259 B.R. at 547-48 (citations omitted).

The Connecticut District Court remanded the adversary proceeding to the Connecticut Bankruptcy Court for further proceedings, and the Connecticut Bankruptcy Court, sua sponte, issued an order to show cause why the venue of the adversary proceeding should not be transferred to the Delaware Bankruptcy Court. United States v. State Street Bank and Trust Co. (In re Scott Cable Commc’n, Inc. (“Scott III”)), 263 B.R. 6 (Bankr. D. Conn. 2001). [29] The Government opposed the transfer, but the Connecticut Bankruptcy Court held that the Delaware Bankruptcy Court was the appropriate forum to determine the proceeding, after considering that determination of the adversary proceeding required “interpretation of the effect of the Delaware Plan, of which the IRS had inadequate notice,” and “an examination of the [1996 Bankruptcy Case] record.” Scott III, 263 B.R. at 9. Thus, on June 7, 2001, the Connecticut Bankruptcy Court transferred the instant adversary proceeding to the Delaware Bankruptcy Court. Id.

(2) The Adversary Proceeding before the Delaware Bankruptcy Court

On March 20, 2002, the Indenture Trustee moved for Joinder of Persons Needed for Just Determination seeking to join all Junior PIK Noteholders as defendants to the instant adversary proceeding (the “Joinder Motion”). (D.I. 77.) Before the Joinder Motion was decided, on August 28, 2002, MC Partners, Chestnut Street, Milk Street and TA Investors moved to intervene. (D.I. 100.) On October 4, 2002, the Court entered an order allowing the intervention. (D.I. 116.)

On December 6, 2002, the Court denied the Joinder Motion. (D.I. 160 at 6:14-18.) Instead of joining each Junior PIK Noteholder as a defendant to the adversary, the Court directed that notice of the adversary proceeding be given to the record holders of the Junior PIK Notes, along with the request that the notice be forwarded on to the beneficial owners of the Junior PIK Notes. (Id. at 7:13-10:2.) The Court directed that the notice should (i) attach a copy of the amended complaint; (2) identify the substantial noteholders who had intervened in the case; (iii) briefly explain the two causes of action; (iv) explain that the interests of all Junior PIK Noteholders in defending the action, especially with respect to Count 2 seeking equitable subordination, may not be identical; and (v) advise that individual Junior PIK Noteholders have the option of moving to intervene in the adversary. (Id.) The Indenture Trustee sent notices regarding this adversary proceeding to the record holders and encouraged Series B Junior PIK Noteholders to intervene. (Tr. 12/14/2006, D.I. 786 at 154:21-155:6; 185:21-186:3.)

The Indenture Trustee moved for summary judgment, arguing, in part, that the relief sought in the complaint was barred by the Court’s final order confirming the 1996 Plan. By Memorandum and Order dated December 12, 2003, the Court denied the Indenture Trustee’s motion for summary judgment (D.I. 239, D.I. 240.)

Next, the Government moved for summary judgment. (D.I. 267.) After many extensions of the briefing schedule and the filing of cross-motions for summary judgment and other related motions, a “Notice of Completion of Briefing of Dispositive and Related Motions” was filed June 15, 2005. (D.I. 315.) At a hearing on July 22, 2005, my colleague, the Honorable Peter J. Walsh, held that the claims required a fact-intensive analysis and did not lend themselves to summary judgment. (D.I. 318.) He ordered that the matter be scheduled for a trial on the merits. (Id.)

On December 23, 2005, the Government moved that Judge Walsh, who had entered the Order confirming the 1996 Plan, should recuse himself from this case. (D.I. 321.) In its motion, the Government did not allege any bias on the part of Judge Walsh; rather, the Government argued that recusal was appropriate “at least to avoid the appearance of partiality under 28 U.S.C. §455(a), due to actual and implicit findings in confirming the [1996 Plan] giving rise to the present debtor, Scott Cable Communications, Inc. — and possibly also because of personal knowledge of disputed evidentiary facts within the purview of §455(b)(1).” (D.I. 322 at 1.) The Defendants opposed the recusal request. (D.I. 323, 324.) Although Judge Walsh determined that the recusal motion was untimely and without merit, he transferred the adversary proceeding to me, concluding that it was in the interest of judicial economy to remove a possibility for appeal and due to scheduling conflicts on his calendar for the start of the trial. (D.I. 328 at 2.) By order entered on January 27, 2006, the case was transferred to me. (D.I. 329.)

The Government then filed a motion to re-transfer venue of the adversary proceeding back to the Connecticut Bankruptcy Court (D.I. 331), which was denied by Order dated April 11, 2006 (D.I. 410).

(3) Trial

After numerous discovery motions and pre-trial motions, trial began on October 16, 2006, and continued on the following dates: October 17, 18, 19, 20, 23, 25, 26, 27, 30, 31, 2006; November 1, 2, 3, 2006; December 11, 12, 13, 14, 2006; January 19, 2007; February 12, 28, 2007; March 1, 2, 5, 6, 30, 2007; April 23, 2007; and May 10, 22, 23, 24, 25, 2007. Closing arguments were completed on June 22, 2007. Thereafter, the parties began their post-trial briefing, which introduced more rounds of motions. A certification that the record was complete was filed September 2, 2008. (D.I. 801.)

(4) The Chapter 7 Trustee

On March 10, 2009, approximately two years after the trial for the instant adversary proceeding had ended, the Connecticut Bankruptcy Court converted the 1998 Bankruptcy Case to chapter 7 and appointed Ronald Chorches as chapter 7 Trustee (the “Trustee”). (D.I. 804 at 2.) The Trustee filed a motion to substitute himself in the adversary proceeding in place of the Debtor, to realign himself as a plaintiff, to supplement the record, and to amend the Complaint to assert a fraudulent conveyance claim. (D.I. 839). The Trustee’s motion was granted, in part, to allow the Trustee to be realigned as a plaintiff in this adversary proceeding, and to admit certain documents. However, the Trustee’s request to amend the complaint to assert a fraudulent conveyance claim was denied. (D.I. 911).

On June 8, 2009, the Trustee filed an Objection to the Proof of Claim filed by State Street Bank and Trust Company, as Indenture Trustee for the Junior Subordinated PIK Notes (the “Claim Objection”) in the Connecticut Bankruptcy Court. On June 25, 2009, U.S. Bank filed a motion to strike the Claim Objection (the “Motion to Strike”). The Trustee filed a Second Amended Claim Objection on November 5, 2009 (the “Amended Claim Objection”).

On March 8, 2011, the Connecticut Bankruptcy Court approved an Agreed Order among the Trustee, U.S. Bank and the IRS to transfer the Claim Objection, Amended Claim Objection and Motion to Strike and related pleadings (the “Claim Objection Proceeding”) to this Court for disposition. The Claim Objection Proceeding was docketed as Miscellaneous Proceeding 11-00105 in the Delaware Bankruptcy Court on March 16, 2011.

On March 29, 2011, without conceding the necessity of an adversary proceeding, the Trustee filed an adversary complaint in the Connecticut Bankruptcy Court asserting that the Debtor’s granting of a lien to secure the Junior PIK Notes was a fraudulent conveyance pursuant to 11 U.S.C. §544(b) and applicable New York state law. The adversary complaint was amended on March 31, 2011 (the “Amended Complaint”).

On May 17, 2011, the Connecticut Bankruptcy Court entered a Consent Order to transfer the Amended Complaint to the Delaware Bankruptcy Court. The Amended Complaint was docketed as Miscellaneous Proceeding 11-00106 in the Delaware Bankruptcy Court on June 2, 2011.

By Memorandum and Order issued simultaneously with this Opinion, I granted the Motion to Strike the Trustee’s Claim Objection and granted the Motion to Dismiss the Trustee’s Amended Complaint.

IV. CONCLUSIONS OF LAW

The Government’s Amended Complaint seeks a determination of the validity, priority and extent of the Junior PIK Noteholders’ lien against Scott Cable’s assets. The Amended Complaint contains two counts: Count One seeks to recharacterize the Junior PIK Notes as preferred equity instruments of Scott Cable, with no lien against Scott Cable’s assets; and Count Two seeks to equitably subordinate the Junior PIK Noteholders’ claim to the administrative claims of federal and state taxing authorities.

Recharacterization and equitable subordination are similar causes of action “grounded in bankruptcy courts’ equitable authority to ensure `that substance will not give way to form, that technical considerations will not prevent substantial justice from being done.'” Cohen v. The KB Mezzanine Fund II, L.P. (In re SubMicron Sys. Corp.), 432 F.3d 448, 454 (3d Cir. 2006) (quoting Pepper v. Litton, 308 U.S. 295, 305, 60 S.Ct. 238, 84 L.Ed. 281 (1939) ). Although similar, each cause of action is distinct and must be treated separately. Id. “In a recharacterization action, someone challenges the assertion of a debt against the bankruptcy estate on the ground that the `loaned’ capital was actually an equity investment.” In re Insilco Techs., Inc. 480 F.3d 212, 217 (3d Cir. 2007) . In other words, recharacterization is a determination as to “whether a debt actually exists.” SubMicron, 432 F.3d at 454 . An equitable subordination analysis, on the other hand, requires the court to review whether an otherwise “legitimate” creditor has engaged in inequitable conduct. Bayer Corp. v. MascoTech, Inc. (In re Autostyle Plastics, Inc.), 269 F.3d 726,749 (6th Cir. 2001) .

A. Threshold Matters

The Defendants argue that the Government’s claims are barred under a number of legal theories. I will address these threshold matters before addressing the merits of the case.

1. Res Judicata

Attempting to resurrect one of their oldest arguments, the Defendants contend that the doctrine of res judicata bars the Government from bringing this adversary proceeding. The Defendants argue that the IRS, as a party in interest in the 1996 Bankruptcy Case, is bound by the order confirming the 1996 Plan and cannot challenge the issuance of the Junior PIK Notes. In response, the Government argues that the law of the case doctrine precludes the Defendants from re-raising the res judicata defense. In Scott II, the Connecticut District Court determined that the principles of res judicata did not bar the IRS from bringing the adversary proceeding because the IRS did not receive notice reasonably calculated, under the circumstances, to inform it that its rights might be affected by the 1996 Plan. Scott II, 259 B.R. at 548. The IRS asserts that the Connecticut District Court’s decision is the law of the case on this issue.

“The law of the case doctrine `limits relitigation of an issue once it has been decided’ in an earlier stage of the same litigation.” Hamilton v. Leavy, 322 F.3d 776, 786-87 (3d Cir. 2003) quoting In re Continental Airlines, Inc., 279 F.3d 226, 232 (3d Cir. 2002) . “The purpose of this doctrine is to promote the `judicial system’s interest in finality and in efficient administration.'” Hayman Cash Register Co. v. Sarokin, 669 F.2d 162, 165 (3d Cir. 1982) quoting Todd & Co., Inc. v. S.E.C., 637 F.2d 154, 156 (3d Cir. 1980) .

“[T]he law of the case doctrine does not restrict a court’s power but rather governs its exercise of discretion.” In re City of Philadelphia Litig., 158 F.3d 711, 718 (3d Cir. 1998) citing Public Interest Research Group of New Jersey, Inc. v. Magnesium Elektron, Inc., 123 F.3d 111, 116 (3d Cir. 1997) . Courts have recognized that the law of the case doctrine will not prevent reconsideration of previously decided issues in extraordinary circumstances when: (i) new evidence is available; (ii) a supervening new law has been announced; or (iii) the earlier decision was clearly erroneous and would create manifest injustice. Philadelphia Litig., 158 F.3d at 718 .

The Defendants argue that the law of the case doctrine does not prevent this Court from reconsidering their res judicata defense due to (1) new facts uncovered during discovery and at the trial; (2) new defendants who intervened in this adversary after the Scott II decision; and (3) new facts which establish that the Connecticut District Court’s opinion in Scott II is manifestly unjust.

(a) Newly Discovered Facts

The Defendants argue that the Scott II Court decided the res judicata issue on a motion for summary judgment, without a fully developed factual record. As a result of the extensive discovery process and testimony of IRS employees at the trial, more detailed information has come to light regarding the Government’s review of the 1996 Plan documents. The Defendants contend that the newly discovered facts require a new analysis of the res judicata defense.

The new facts that the Defendants ask the Court to consider include: (i) the number of Government employees who were forwarded copies of the various versions of Scott Cable’s plans and disclosure statements during the 1996 Bankruptcy Case for review and comment; (ii) internal memos noting that the IRS did not intend to file an objection to the 1996 Plan because it was “unobjectionable” and the IRS had not filed a proof of claim; and (iii) internal IRS manuals, which instruct IRS lawyers to assess whether a bankruptcy case raises “postconfirmation issues” or whether a plan could create “adverse tax consequences.” The inference the Defendants want the Court to draw from the new facts is that the IRS understood the future tax consequences of the 1996 Plan and found the plan “unobjectionable.” I do not agree that such an inference arises here.

The Defendants further argue that the new facts change the res judicata analysis because those facts show that the IRS should have known that adverse tax consequences could arise from the 1996 Plan and should have objected prior to confirmation of the 1996 Plan. However, I disagree with the Defendants’ assertion that the new facts concerning the IRS’s conduct, if they had been available to Connecticut District Court, would have changed the outcome of the previous decision.

After a close review of the 1996 Plan and 1996 Disclosure Statement, the Scott II Court held, as a matter of law, that those documents failed to provide the IRS with the requisite notice that the 1996 Plan could affect the IRS’s future pecuniary interests. The Connecticut District Court determined that the documents did not disclose “that an intended or possible consequence of the plan was that under certain scenarios the IRS would be precluded from, or limited in any way in, pursuing a claim against Reorganized Scott once the [1996 Plan] was confirmed.” Scott II, 259 B.R. at 546. The Scott II Court noted that the 1996 Disclosure Statement purported to describe “certain federal income tax consequences of the plan,” but made no mention of those intended or potential tax consequences, and, in particular, did not include a disclaimer that the tax consequences of Transaction Events were not being addressed. Id. In short, either Scott Cable was aware of the potential consequences of its plan, but failed to provide full and fair disclosure of that consequence, or Scott Cable was unaware of the potential consequence, in which case “it is difficult to see how the IRS could be expected to have discerned that its pecuniary interest could be adversely affected.” Scott II, 259 B.R. at 546, n. 1.

Regardless of the Government’s actions or inactions, the Scott II Court concluded that the 1996 Plan and Disclosure Statement were not reasonably calculated to inform even a sophisticated party-in-interest like the IRS that its pecuniary interests could be affected by the 1996 Plan. The “new facts” cited by the Defendants do not change this conclusion of law.

(b) New Defendants

The Defendants argue that those Defendants who intervened after Scott II was decided are not bound by that decision, relying on the Third Circuit Court’s decision in Hamilton, 322 F.3d at 787 (“the law of the case doctrine should not be read so rigidly that it precludes a party from raising an argument that it had no prior opportunity to raise” (internal quotations omitted)). Hamilton, however, is distinguishable. In Hamilton, the plaintiff amended the complaint to add new defendants after the court ruled that the earlier-named defendants had violated the plaintiff’s Eighth Amendment rights. The Third Circuit determined that the law of the case did not prevent the new defendants from arguing that they did not violate the plaintiff’s Eighth Amendment rights. Id. The issue was a factual one particular to each defendant.

In contrast, the intervening defendants here seek to re-litigate a previously decided legal issue and the result does not change with respect to individual defendants. “[P]ermission to intervene does not carry with it the right to relitigate matters already determined in the case, unless those matters would otherwise be subject to reconsideration.” Arizona v. California, 460 U.S. 605, 615, 103 S.Ct. 1382, 1389, 75 L.Ed.2d 318 (1983) . See also Galbreath v. Metropolitan Trust Co. of Calif., 134 F.2d 569, 570 (10th Cir. 1943) (“[O]ne who intervenes in a suit in equity thereby becomes a party to the suit, and is bound by all prior orders and adjudications of fact and law as though he had been a party from the commencement of the suit.”)

(c) Manifest Injustice

Finally, the Defendants argue that the law of the case should not be applied here because the new facts show that Scott II was clearly erroneous and, if allowed to stand, would be manifestly unjust. See Philadelphia Litig., 158 F.3d at 718 . However, for the reasons stated above, the decision of the Scott II Court was a legal determination about the lack of adequate notice to the IRS in the 1996 Plan and 1996 Disclosure Statement. Additional facts in the record before this Court do not alter this legal conclusion and do not render the decision “clearly erroneous” or “manifestly unjust.”

(d) Other defenses

Because the Scott II Court’s decision regarding the lack of reasonable notice given to the IRS is the law of the case, other defenses raised by the Defendants that are grounded on the Government’s failure to object to the 1996 Plan — in particular, waiver, equitable estoppel, and laches — must also be rejected.

The Defendants further claim that the Government’s proceeding should be barred by the doctrine of unclean hands, arguing that the Government (i) presented an incomplete and highly misleading picture to the Connecticut Courts regarding its activity in the 1996 Bankruptcy Case; and (ii) failed to disclose that the IRS’s internal manuals required the employees to review all versions of disclosure statements and plans to determine whether they raise pre-confirmation or post-confirmation tax problems.

“To prevail on an `unclean hands’ defense, the defendant must show fraud, unconscionability, or bad faith on the part of the plaintiff.” Sonowo v. U.S., 2006 WL 3313799, 3 (D.Del. Nov. 13, 2006) citing S&R Corp. v. Jiffy Lube Int’l, Inc., 968 F.2d 371, 377 n. 7 (3d Cir. 1992) . The Third Circuit Court of Appeals has recognized that “the primary principle guiding application of the unclean hands doctrine is that the alleged inequitable conduct must be connected, i.e., have a relationship, to the matters before the court for resolution.” New Valley Corp. v. Corporate Prop. Assoc. 2 and 3 (In re New Valley Corp.), 181 F.3d 517, 525 (3d Cir. 1999). “As an equitable doctrine, application of unclean hands rests within the sound discretion of the trial court.” Id.

This record does not reflect conduct that would support a finding of fraud, unconscionability or bad faith by the IRS in Scott II. Further, the Scott II Court’s decision of inadequate notice was not based upon the actions or inactions of the IRS, but upon the 1996 Plan documents’ failure to provide full and fair disclosure.

2. Bankruptcy Code §1144

The Defendants also contend that the Government’s adversary proceeding is a collateral attack to revoke the order confirming the 1996 Plan which, pursuant to Bankruptcy Code §1144, is untimely. Bankruptcy Code §1144 provides:

On the request of a party in interest at any time before 180 days after the date of the entry of the order of confirmation, and after notice and a hearing, the court may revoke such order if and only if such order was procured by fraud. An order under this section revoking an order of confirmation shall —

(1) contain such provisions as are necessary to protect any entity acquiring rights in good faith reliance on the order of confirmation; and

(2) revoke the discharge of the debtor.

11 U.S.C. §1144 (emphasis added). [30] “While on its face, §1144 appears to apply only to express efforts to revoke a confirmation order, courts have applied the bar in §1144 when the complaint in question appears `to do indirectly what [the plaintiffs] no longer may do directly’ because of that statutory bar.” In re Genesis Health Ventures, Inc., 340 B.R. 729, 733 (D.Del. 2006) . In Genesis, the plaintiffs (consisting of 275 former debenture holders of the debtor, Genesis Health Ventures (“Genesis”)) alleged that Genesis and non-debtor co-defendants committed fraud or made grossly negligent misrepresentations to the plaintiffs regarding the value of Genesis during the bankruptcy case. Id. at 731. The District Court held that the Bankruptcy Court did not commit error when it dismissed the claim against the debtor, but remanded the case to determine whether the claims asserted against the non-debtor co-defendants were “independent” and not barred by §1144. Id. The Genesis Court wrote:

A claim is not independent where it is simply an attempt to redivide the pie by a disgruntled participant in the Plan. An independent cause of action can be maintained, however, at least where the alleged fraud could not have been asserted in the bankruptcy proceedings, the underlying factual claims were not actually adjudicated, and the relief sought would not upset the confirmed plan of arrangement.

Id. at 733 (citations and internal quotations omitted). On remand, the bankruptcy court in Genesis held that §1144 did not bar the fraud claims against the non-debtor co-defendants, noting: “there ought to be a remedy to redress the harms suffered and a mechanism to divest the alleged tortfeasors of their ill-gotten gains, at least where doing so would not affect innocent parties.” In re Genesis Health Ventures, Inc., 355 B.R. 438, 445 (Bankr.D.Del. 2006) .

The Government was not a plan participant in the 1996 Bankruptcy Case. The Government did not name Scott Cable as a defendant to its action (although it later intervened) and, further, is not trying to “redivide” the pie created by the 1996 Plan. The Government’s claims contest the priority of payments among competing creditors in the 1998 Bankruptcy Case. As discussed above, the Connecticut District Court has held that the Government did not have adequate notice of the 1996 Plan’s possible future effect on its pecuniary interests and, therefore, the matter was not adjudicated as part of the confirmation of the 1996 Plan. [31]

Moreover, the relief sought by the Government does not disturb the 1996 Plan distributions to any plan participants. The confirmed 1996 Plan constitutes an enforceable contract between Scott Cable and its creditors, equity security holders and others. See In re Accuride Corp., 439 B.R. 364, 367 (Bankr.D.Del. 2010) citing 11 U.S.C. §1141(a). The Debtors complied with that contract by distributing Junior PIK Notes to the 1993 Junior Noteholders and the Public Debenture Holders. The Government’s current challenge to the Junior PIK Noteholders’ liens is similar to challenging a pre-bankruptcy security agreement granted by a debtor to a secured creditor. Because this adversary proceeding involves a 1998 plan participant questioning priorities under the 1998 Plan, I conclude that Bankruptcy Code §1144 is not applicable. [32]

3. Equitable Mootness

The Defendants next argue that the Government’s claims are equitably moot, since it would be inequitable to reverse all of the distributions made pursuant to the order confirming the1996 Plan. The Government reiterates that the relief it seeks does not include revoking the 1996 Plan confirmation order or undoing transactions made to other classes of creditors under the 1996 Plan.

The equitable mootness doctrine states that an action should “be dismissed as moot when, even though effective relief could conceivably be fashioned, implementation of that relief would be inequitable.” In re Continental Airlines, Inc., 91 F.3d 553, 559 (3d Cir. 1996) (“Continental I”). “Equitable mootness . . . does not ask whether a court can hear a case, but whether it should refrain from doing so because of the perceived disruption and harm that granting relief would cause.” Samson Energy Resources Co. v. Semcrude, L.P. (In re Semcrude, L.P.), 728 F.3d 314, 316 (3d Cir. 2013) . “[E]quitable mootness is most often applied in the context of an appeal, but it applies with equal force to actions brought to revoke a plan of reorganization.” Almeroth v. Innovative Clinical Solutions, Ltd. (In re Innovative Clinical Solutions, Ltd.), 302 B.R. 136, 141 (Bankr. D. Del. 2003) .

The Third Circuit has decided that an equitable mootness analysis should consider (i) whether a confirmed plan has been substantially consummated; and (ii) if so, whether granting the relief requested in the appeal will (a) fatally scramble the plan and/or (b) significantly harm third parties who have justifiably relied on plan confirmation. Semcrude, 728 F.3d at 321 . The Defendants argue that the 1996 Plan was substantially consummated and that it is too late to “unscramble the egg” and all of the transactions completed years ago with a number of parties not before this Court. The Defendants also assert that application of the equitable mootness doctrine is particularly relevant in this matter to preserve of the finality of confirmation orders.

The relief sought in this adversary proceeding is not barred by the equitable mootness doctrine. As discussed above, the Government’s claims do not seek to unravel the entirety of distributions made pursuant to the 1996 Plan. The outcome of this adversary affects the lien given to one series of notes issued under the 1996 Plan, and the holders of those notes are Defendants before the Court, or received notice and an invitation to intervene in this proceeding. Semcrude, 728 F.2d at 321 (If a plan is substantially consummated, a court should next consider “whether granting relief will require undoing the plan as opposed to modifying it in a manner that does not cause its collapse.”) The equities in this case do not favor dismissal. [33]

4. Standing

The Defendants next argue that the Government lacks standing to bring the instant proceeding, arguing that claims for recharacterization or equitable subordination are generally brought by a debtor or other estate representative. See Bezanson v. Bayside Enter., Inc. (In re Medomak Canning), 922 F.2d 895, 902 (1st Cir. 1990) (“The Trustee is ordinarily the appropriate party to seek equitable subordination on behalf of the estate and unsecured creditors. Generally, an unsecured creditor may assert equitable subordination only where the Trustee has refused to do so and the court grants an unsecured creditor leave to contest a claim.”) The Defendants point out that the Government did not seek permission to pursue its claims.

The Government argues, in response, that an individual creditor may bring an action for equitable subordination under Bankruptcy Code §510(c) which, unlike §§544(b), 545, 547, 548 and 549, does not grant such powers to a trustee. See Matter of Vitreous Steel Products Co., 911 F.2d 1223, 1231 (7th Cir. 1990) (deciding that a creditor has standing under §510(c) since, in some instances, equitable subordination will not benefit all unsecured creditors equally.)

At this point in the litigation, however, a chapter 7 trustee has been appointed and has joined the litigation as a plaintiff. The standing argument is rejected as moot.

I conclude that the Defendants’ threshold defenses and objections have no merit and, therefore, I will consider the Government’s claims for recharacterization and equitable subordination.

B. Recharacterization

The recharacterization of debt to equity is a fact-specific inquiry, and many courts have relied upon multi-factor tests to analyze the issue. SubMicron, 432 F.3d at 455-56 . Often the tests are borrowed from tax cases seeking to recharacterize debt as equity for tax liability purposes, such as the 11-factor test used by the Sixth Circuit Court of Appeals. [34] Id. at 455, n.8 citing Roth Steel Tube Co. v. Comm’r, 800 F.2d 625 (6th Cir. 1986) ; Bayer Corp. v. Masco Tech, Inc. (In re AutoStyle Plastics, Inc.), 269 F.3d 726 (6th Cir. 2001) . The Eleventh and Fifth Circuits have identified a 13-factor test. [35] SubMicron, 432 F.3d at 455, n.8 citing Stinnet’s Pontiac Serv., Inc. v. Comm’r, 730 F.2d 634, 638 (11th Cir. 1984) ; Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972) . The District Court in SubMicron relied on a seven-factor test. [36] SubMicron, 432 F.3d at 456 . In this case, the Government, never at a loss for exhaustive arguments, asks the Court to rely upon its proposed 23-factor test, drawn from a variety of decisions on recharacterization in both the bankruptcy and tax arenas. [37]

The Third Circuit recognized that the multi-factor tests include pertinent factors, but determined that “[n]o mechanistic scorecard suffices” for a recharacterization inquiry. SubMicron, 432 F.3d at 456 . Instead, the Third Circuit decided that:

[The factors] devolve to an overarching inquiry: the characterization as debt or equity is a court’s attempt to discern whether the parties called an instrument one thing when in fact they intended it as something else. That intent may be inferred from what the parties say in their contracts, from what they do through their actions, and from the economic reality of the surrounding circumstances. Answers lie in facts that confer context case-by-case.

. . . .

Which course a court discerns is typically a commonsense conclusion that the party infusing funds does so as a banker (the party expects to be repaid with interest no matter the borrower’s fortunes; therefore the funds are debt) or as an investor (the funds infused are repaid based on the borrower’s fortunes; hence, they are equity). Form is no doubt a factor, but in the end it is no more than an indicator of what the parties actually intended and acted on.

SubMicron, 432 F.3d at 456 (emphasis added). See also Friedman’s Liquidating Trust v. Goldman Sachs Credit Partners, L.P. (In re Friedman’s Inc.), 452 B.R. 512, 519 (Bankr.D.Del. 2011) (reading SubMicron to require a recharacterization analysis to focus on the overarching inquiry of the parties’ intent, rather than a multi-factor test).

The Government seeks to recharacterize the Junior PIK Notes as equity and asks the Court to consider the facts surrounding the issuance of those notes upon confirmation of the 1996 Plan. The Defendants disagree, however, and assert that the Court should review the circumstances occurring at the outset of the financial relationship between the parties which, for the Series A Junior PIK Notes, was initial issuance of the Junior Notes as part of the 1988 LBO, and, for the Series B Junior PIK Notes, was the issuance of the Public Debentures.

In SubMicron, the Third Circuit determined that “the focus of the recharacterization inquiry is whether `a debt actually exists,’ . . . or, put another way, we ask what is the proper characterization in the first instance of an investment.” SubMicron, 432 F.3d at 454 quoting AutoStyle Plastics, 269 F.3d at 748 (emphasis added). In this context, the SubMicron Court noted, the term recharacterization is actually misleading. Id. at n. 7 citing Citicorp Real Estate, Inc. v. PWA, Inc. (In re Georgetown Bldg. Assocs. Ltd P’ship), 240 B.R. 124, 137 (Bankr. D.D.C. 1999) (“The debt-versus-equity inquiry is not an exercise in recharacterizing a claim, but of characterizing the advance’s true character.”) (emphasis in original); In re Cold Harbor Assocs., L.P., 204 B.R. 904, 915 (Bankr. E.D. Va. 1997) (“Rather than recharacterizing the exchange from debt to equity, . . . the question before this Court is whether the transaction created a debt or equity relationship from the outset.”). Accordingly, in characterizing an instrument as debt or equity, a court must focus its inquiry to a point at the very beginning of the parties’ relationship. See AutoStyle, 269 F.3d at 748-49 (“Recharacterization is appropriate where the circumstances show that a debt transaction was actually an equity contribution ab initio”) (internal quotations omitted).

The Government argues that the Junior PIK Notes issued pursuant to the 1996 Plan were an entirely new transaction between the parties because, unlike the 1993 Restructuring that simply amended an already-existing agreement, the 1996 Plan provided creditors with a new instrument subject to a new agreement. In those terms, the Government is correct, but only in form, not substance.

Consistent with the Court’s direction in SubMicron, I conclude that a recharacterization analysis of the 1996 Junior PIK Notes must be considered in light of the entire relationship of the parties, with particular emphasis on parties’ intent at the initial funding. For the Series A Junior PIK Notes, the focus of the recharacterization analysis is on the initial issuance of the Junior Notes as part of the 1988 LBO. For the Series B Junior PIK Notes, the recharacterization analysis will focus on the issuance of the original Public Debentures. There has been no challenge to the characterization of the original Public Debentures as debt of Scott Cable. Therefore, I conclude that the Government’s claim for recharacterization of the Series B Junior PIK Notes must be denied. The remaining recharacterization analysis will be limited to the Series A Junior PIK Notes. As directed by SubMicron decision, the recharacterization analysis seeks to divine the parties’ true intent at the outset of the parties’ relationship, i.e., the issuance of the 1988 Junior Notes, by considering pertinent factors found in the multi-factor tests, particularly the parties’ contract, actions and the economic reality of the circumstances surrounding the 1988 LBO.

1. The Parties’ Contract

The 1988 Junior Notes and the Junior Note Agreement included many provisions that are typical for debt instruments. The 1988 Junior Notes had a fixed maturity date and fixed rate of interest. The Junior Note Agreement specified a number of events of default. Should certain events of default occur, the Junior Note Agreement provided that the notes immediately became due and payable and the Junior Noteholders could exercise all rights and remedies provided for in the Notes, the Junior Note Agreement or at law or equity. The Junior Note Agreement also restricted some of Scott Cable’s actions; for example, Scott Cable’s ability to incur future debt or future liens, to enter into any transaction of merger, acquisition or consolidation, or to enter into certain transactions with any officer, director or shareholder — all of which are ordinary protections for a lender.

The documents also include provisions that sometimes tend to indicate funding is equity, rather than debt. For example, the 1988 Junior Notes deferred payment of interest until maturity. Compare Off’l Comm. v. Highland Capital Mgmt. L.P. (In re Moll Indus., Inc.), 454 B.R. 574, 582 (Bankr.D.Del. 2011) (a transaction that defers repayment of interest indicates a transaction may be intended as equity) with AutoStyle, 269 F.3d at 750-51 (deferral of interest payments on its own does not prove the parties intended the debt transaction to be equity). In addition to payment of interest at a fixed rate, the 1988 Junior Notes had a contingency interest feature that provided for an additional payment on the notes’ maturity based upon a percentage of the increase in fair market value of Scott Cable, if any, but the contingent interest was capped at a certain amount. Courts have also viewed the absence of a sinking fund for repayment to be evidence that funds were capital contributions. AutoStyle, 269 F.3d at 753 . Furthermore, an agreement to subordinate repayment of funds to claims of all other creditors indicates that advances were equity, rather than debt. AutoStyle, 269 at 752.

The general form and overall content of the 1988 Junior Notes and the Junior Note Agreement weigh in favor of finding that the Junior Notes represent debt of Scott Cable. The deferred interest rate and subordination provisions indicate that the Noteholders were understood to be at the end of the line, but that they expected repayment pursuant to fixed terms on or before the maturity date. Even the contingency interest feature supports this finding — rather than tying repayment of the Notes to an uncertain future date based on the fortunes of the business, the contingency interest provides extra payment on the fixed maturity date — only the amount of the extra payment is contingent. See AutoStyle, 269 F.3d at 751 (deciding that if repayment depended solely on the success of the borrower’s business, the transaction has the appearance of an equity contribution). The 1988 Junior Notes were subordinated and risky and, as a practical matter, repayment depended on the success of the new owner’s plan to boost performance and increase revenues. However, all extensions of credit depend on a company’s success, and that risk alone — without more — does not indicate that they are capital contributions. Joseph v. Feit (In re Liberty Brands, LLC), No. 07-10645, Adv. No. 09-50965, 2014 WL 4792053, *4 (Bankr.D.Del. Sept. 25, 2014).

2. The Parties’ Actions

The Government argues that the Defendants’ actions contradicted any “debt” provisions in the documentation. For example, despite being labeled as “notes,” there is evidence that internal reports of the noteholders or of consultants to Scott Cable included the 1988 Junior Notes (and the 1993 Junior Notes) in categories labeled “equity” or “equity and equivalents.” These internal reports are not controlling on this issue. Documentation available to outsiders, for example the annual Deloitte & Touche, LLP audited financials, always included the 1988 Junior Notes under “Notes and Loans Payable.”

The Government also argues that the maturity date in the 1988 Junior Notes was meaningless, since it was continually extended without payment. A willingness to postpone repayment of the indebtedness has been viewed by some courts as a characteristic of equity. See Slappey Drive Ind. Park v. U.S., 561 F.2d 572, 582 (5th Cir. 1977) (Failure to insist upon timely repayment or satisfactory renegotiation indicates an expectation to recover more than the announced interest rate); Flint Indus., Inc. v. Comm’r, 82 T.C.M. (CCH) 778, 2001 WL 1195725, *12 (U.S. Tax Ct. 2001) (“Evidence that a creditor did not intend to enforce payment or was indifferent as to the exact time the advance was to be repaid belies an arm’s-length debtor-creditor relationship”); Aquino v. Black (In re AtlanticRancher, Inc.), 279 B.R. 411, 437 (Bankr.D.Mass. 2002) (Despite proper documentation, the creditor never made any effort to collect the note, thus treating it as an investment).

In the above cases, the creditors chose not to collect the indebtedness, waiting instead until the company had “plenty of cash” ( Slappey, 561 F.2d at 582 ) or deciding not to foreclose and collect, because doing so would put the company out of business (AtlanticRancher, 279 B.R. at 437 ). In this case, the evidence shows that demanding payment at the point of maturity would have been futile since Scott Cable had insufficient funds or value available to pay the subordinated debt. At that point, the Defendants had only a Hobson’s Choice: extend the maturity date and possibly recover funds in the future or force a liquidation and, most likely, receive no payment. The evidence in this case also shows that — at the time the 1988 Junior Notes were issued — Simmons Communications and the 1988 Junior Noteholders expected that internal changes would increase the Company’s revenues and allow the 1988 Junior Noteholders to obtain full payment on the Notes in four to eight years. Outside forces, such as increased regulation of cable companies in 1992, prevented the parties from realizing that goal.

The Government also argues that evidence demonstrated that the Junior Noteholders (later, the Series A Holders) had influence over management and participated in Scott Cable’s board decisions, thus indicating that the Junior Notes were capital contributions. “If a creditor receives a right to participate in the management of a business in consideration for an advance to the business, such participation tends to demonstrate that the advance was not a bona fide debt but rather was an equity investment.” Flint, 2001 WL 1195725 at *13. The Government points out that some of the larger 1988 Junior Noteholders, namely, MC Partners and Allstate, obtained shareholder interests in Scott Cable as part of the 1988 LBO. However, the stock acquired in the 1988 LBO was Class B non-voting stock. The evidence showed that the Scott Cable’s management had frequent communications with the Junior Noteholders, particularly Mr. Churchill of T.A. Associates. Scott Cable provided extensive financial information and discussed strategies for repayment with Mr. Churchill. However, none of these activities show involvement in the day-to-day business operations of Scott Cable. Cf. AtlanticRancher, 279 B.R. at 435-36 (deciding a transaction was equity when holder of convertible promissory note had “extraordinary ability to direct the company’s affairs” and “was extremely involved in the daily operations of the [d]ebtor”). The Junior Noteholders did not have the right to elect a member to Scott Cable’s board until confirmation of the 1996 Plan. As recognized in SubMicron, it is not unusual for lenders to participate on a company’s board, particularly when the company is distressed. SubMicron, 432 F.3d at 457-58 ; Off’l Comm. v. Tennenbaum Capital Partners, LLC (In re Radnor Holdings Corp.), 353 B.R. 820, 839-40 (Bankr.D.Del. 2006).

The Government claims that the 1993 and 1996 Management Incentive Agreements created an identity of interest between management and the Junior Noteholders/Series A Holders. Court have considered “identity of interest” as a sign of equity when there is an exact correlation between the ownership interests of the equity holders and their proportionate share of the alleged loan. AutoStyle, 269 F.3d at 751 . Here, there was no such proportionality. “Identity of interest” also occurs when the interests of the shareholder/lenders and the corporation are so entwined that an arm’s-length relationship is unlikely. Fin Hay Realty Co. v. United States, 398 F.2d 694, 698 (3d Cir. 1968) . Any identity of interest created by the Management Incentive Agreements did not exist at the outset of the parties’ relationship.

Overall, the conduct of the Junior Noteholders is consistent with creditors who seek repayment of a debt. As the Company’s finances became distressed, the Junior Noteholders actively sought more information and input to prevent the indebtedness from being wiped out. The subordinated position of the Junior Noteholders caused them to fall within a number of factors that are usually identified with equity, but the Court’s job is to evaluate the factors, not just count them. I conclude that the Junior Noteholders’ conduct throughout the parties’ relationship is consistent with that of a lender — albeit a subordinated lender with no security.

3. The Economic Reality of the Surrounding Circumstances

To determine whether a transaction is debt or equity, a court should also consider the economic circumstances in which the funds were provided to the company. Courts may question whether a prudent lender would have extended credit to the debtor under similar circumstances. Moll Indus., 454 B.R. at 584. See also AutoStyle, 269 F.3d at 752 (“When there is no evidence of other outside financing, the fact that no reasonable creditor would have acted in the same manner is strong evidence that the advances were capital contributions rather than loans.”) This case did not involve a typical lending scenario, but rather an LBO which occurred after a competitive process. Scott Cable had other proposals, but selected the deal with Simmons Communications since it had more favorable terms and a higher per share price. The competitive process indicates that other purchasers were interested in the company, even though the terms may not have been as favorable.

In a debt/equity analysis, courts also consider whether the debtor was undercapitalized when the transaction took place. The Government argues that the Junior Noteholders held equity, not debt, because Scott Cable was undercapitalized when the Junior Noteholders initially obtained their notes upon completion of the LBO, and Scott Cable remained severely undercapitalized through the issuance of the Junior PIK Notes as part of the 1996 Plan. “[W]hen a corporation is undercapitalized, a court is more skeptical of purported loans made to it because they may in reality be infusions of capital.” SubMicron, 432 F.3d at 457 quoting AutoStyle, 269 F.3d at 746-47 . See also Flint, 2001 WL 1195725 at *14 (“Inadequate or `thin’ capitalization is strong evidence of a capital contribution where: (1) [t]he debt-to-equity ratio was initially high; (2) the parties realized that it would likely go higher; and (3) substantial portions of these funds were used for the purchase of capital assets and for meeting expenses needed to commence operations.”) Courts will also examine the proposed source for repayment of interest and principal to a lender.

In general, there are four possible sources: (1) liquidation of the business’ assets, (2) profits, (3) cash flow, and (4) refinancing with another lender. “If repayment of the advances can only be reasonably assured by the chance of profits or from the liquidation of the business, the money is at the risk of the venture.” Scriptomatic, Inc. v. U.S., 397 F. Supp. 753, 764 (E.D. Pa. 1975) . If, however, under the circumstances at the time of the advances, a prudent investor would have had a realistic and reasonable expectation of an adequate cash flow or the presence of outside financing which would enable repayment to be made under the terms of the advance, economic reality would dictate that a valid debt had been created.

Fischer v. U.S., 441 F. Supp. 32, 39 (E.D. Pa. 1977) (emphasis added).

In this case, the record shows that Scott Cable was thinly capitalized after the LBO and the Proxy Statement filed in connection with the transaction noted that the Company needed to improve its operations and cash flow “significantly above historic levels” to meet its obligations. However, the evidence also shows that the parties expected that Scott Cable would experience a growth in system revenue and cash flow to enable the Junior Noteholders to receive payment within four to eight years of the LBO. There was evidence that Scott Cable enjoyed an increase in revenues for a short period post-LBO, but changes in regulations related to the banking and cable industries caused the Company to lose value, jeopardizing payment of subordinated creditors, like the Junior Noteholders.

4. Recharacterization Conclusion for the 1988 Junior Notes

The facts surrounding the issuance of the 1988 Junior Notes as part of the LBO leads me to conclude that the parties intended the Junior Notes to be debt of Scott Cable. The documentation for the Junior Notes and the conduct of the Junior Noteholders reveal an intent to be repaid a fixed amount within a reasonable period of time. Other third-parties were also making offers to acquire Scott Cable in 1988. At that time, the parties reasonably projected that the revenues and cash flow of the Company would increase and be sufficient to repay the indebtedness.

5. Recharacterization Conclusion for the 1996 Junior PIK Notes

The issuance of the Junior PIK Notes in 1996 cannot be viewed as an entirely new transaction, but as a continuance of the Junior Note indebtedness that had its genesis in the 1988 LBO. The Junior PIK Notes reflect all indicia of indebtedness, including the issuance of notes with payment at a fixed interest rate (although payment of interest was deferred) and a maturity date of five years and seven months after the 1996 Plan’s effective date. Moreover, issuance of the Junior PIK Notes was accompanied by the grant of a security interest. On the other hand, the holders of the Junior PIK Notes were also given Class B Common Stock and the ability to elect one member to the Board of Directors. The liquidity crisis faced by Scott Cable in 1996 was clear and known to the parties. The liquidation analysis attached to the final 1996 Plan projected no recovery for Junior Noteholders in the event of a liquidation.

The Government argues that a multi-factor recharacterization analysis supports its position that the1996 Junior PIK Notes should be characterized as equity issued by the reorganized Scott Cable, rather than debt. However, in SubMicron the Third Circuit decided that it was appropriate to review later advances by an existing lender in light of the ongoing relationship and recognizing that “when existing lenders make loans to a distressed company, they are trying to protect their existing loans and traditional factors that lenders consider (such as capitalization, solvency, collateral, ability to pay cash interest and debt capacity ratios) do not apply as they would when lending to a financially healthy company.” SubMicron, 432 F.3d at 457 quoting the District Court SubMicron opinion, 291 B.R. at 325 . This rationale has been followed in subsequent recharacterization cases. Moll Indus., 454 B.R. at 583-84 (citing SubMicron); Radnor Holdings, 353 B.R. at 839 (same).

The Series A Junior PIK Noteholders had the ability to elect one member of a five-member board for reorganized Scott Cable, which is not enough to control the Company. However, the Series B Junior PIK Noteholders (who were also the Senior PIK Noteholders) had the ability to elect two members to reorganized Scott Cable’s five-member board. Presumably, then, the Series A Holders and Series B Holders, together, could control reorganized Scott Cable’s board. However, the SubMicron Court determined that an existing lender’s participation on the board of a distressed company after its loan is in jeopardy does not support an equity characterization. SubMicron, 432 F.3d at 457-58 . See also Radnor Holdings, 353 B.R. at 839-40.

Overall, the circumstances surrounding the issuance of the Junior PIK Notes in the 1996 Plan, especially when viewed in light of the parties’ prior debt relationship, indicate that the Junior PIK Notes remained debt. The Government’s claim for recharacterization of the Series A and Series B Junior PIK Notes will be denied.

C. Equitable Subordination

Alternatively, the Government asks the Court to equitably subordinate the Junior PIK Noteholders’ secured claim to the administrative claims of federal and state taxing authorities for purposes of distributing the proceeds from the 1998 sale of Scott Cable to Interlink. Equitable subordination is a remedy provided in Bankruptcy Code §510(c), which states:

(c) Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may —

(1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or

(2) order that any lien securing such a subordinated claim be transferred to the estate.

11 U.S.C. § 510(c). The Third Circuit has described equitable subordination as “a `remedial rather than penal’ doctrine designed `to undo or to offset any inequality in the claim position of a creditor that will produce injustice or unfairness to other creditors in terms of the bankruptcy results.'” Schubert v. Lucent Tech., Inc. (In re Winstar Commc’n, Inc.), 554 F.3d 382, 411 (3d Cir. 2009) quoting Citicorp Venture Capital, Ltd. v. Comm. of Creditors Holding Unsecured Claims, 323 F.3d 228, 233-34 (3d Cir. 2003) . Courts have further described §510(c) as follows:

For purposes of distribution, Section 510(c) permits a bankruptcy court to subordinate an allowed claim, on equitable grounds, to the claims of other creditors of a debtor’s estate. “In the exercise of its equitable jurisdiction the bankruptcy court has the power to sift the circumstances surrounding any claim to see that injustice or unfairness is not done in administration of the bankruptcy estate.”

In re Mid-American Waste Sys., Inc., 284 B.R. 53, 68 (Bankr.D.Del. 2002) quoting Burden v. United States, 917 F.2d 115, 117 (3d Cir. 1990) in turn, quoting Pepper v. Litton, 308 U.S. 295, 307-08, 60 S.Ct. 238, 245-46, 84 L.Ed. 281 (1939) .

The party seeking to subordinate a claim has the initial burden of coming forward with material evidence to overcome the prima facie validity accorded to proofs of claim. Mid-American Waste, 284 B.R. at 69 . Then, the burden shifts to the claimant to demonstrate the fairness of its conduct. Id. The burden on the claimant is not only to prove the good faith of the parties to the transaction, but also to show the inherent fairness from the point of view of the debtor corporation and those with interests therein. Id.

In Winstar, the Third Circuit adopted the widely-used three-factor test that must be satisfied before deciding whether equitable subordination of a claim is appropriate: (1) the claimant must have engaged in some type of inequitable conduct; (2) the misconduct must have resulted in an injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant; and (3) equitable subordination of the claim must be consistent with the provisions of the Bankruptcy Code. Winstar, 554 F.3d at 411 (internal punctuation omitted) quoting Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692, 699-700 (5th Cir. 1977) . See also, e.g., In re Sentinel Mgmt. Group, Inc., 728 F.3d 660, 669 (7th Cir. 2013) (citing three-factor test); Henry v. Lehman Commercial Paper, Inc. (In re First Alliance Mortg. Co.), 471 F.3d 977, 1006 (9th Cir. 2006) (same); Estes v. N&D Prop., Inc. (In re N&D Prop., Inc.), 799 F.2d 726, 731 (11th Cir. 1986) (same).

In this case, the facts surrounding the grant of security interests to the Series A and the Series B Junior PIK Noteholders are not identical. Therefore, a separate equitable subordination analysis must be undertaken for each sub-group.

(1) The Series A Junior PIK Noteholders

(a) Inequitable Conduct

The type of misconduct that will satisfy the first prong varies depending on whether the alleged bad actor is an “insider” of the debtor. When the claimant is an insider, the standard for finding inequitable conduct is much lower. Mid-American Waste, 284 B.R. at 70 . “A claim arising from the dealings between a debtor and an insider is to be rigorously scrutinized by the courts.” Winstar, 554 F.3d at 412 quoting Fabricators, Inc. v. Technical Fabricators, Inc. (In re Fabricators, Inc.), 926 F.2d 1458, 1465 (5th Cir. 1991) .

The Code defines an “insider” of a corporate debtor as including “(i) director of the debtor; (ii) officer of the debtor; (iii) person in control of the debtor; (iv) partnership in which the debtor is a general partner; (v) general partner of the debtor; or (vi) relative of a general partner, director, officer, or person in control of the debtor.” 11 U.S.C §101(31)(B). A party may also be considered a “nonstatutory insider,” even without actual control of the debtor, when there is a close relationship between debtor and creditor and when transactions between them were not conducted at arm’s length. Winstar, 554 F.3d at 396 -97 citing Anstine v. Carl Zeiss Meditec AG (In re U.S. Medical, Inc.), 531 F.3d 1272, 1277 (10th Cir. 2008) . See also 5-547 Collier on Bankruptcy ¶547.03[6] (Alan N. Resnick & Henry J. Sommer, eds., 16th ed. rev. 2014) (“The consideration of insider status focuses on two factors: (1) the closeness of the relationship between the parties; and (2) whether the transaction was negotiated at arm’s length.”) (discussing “insider” as used in 11 U.S.C. §547(b)(4)(B)).

The Government urges that this Court consider the holders of the Series A Junior PIK Notes “insiders” of Scott Cable, because representatives of MC Partners and Allstate: (i) had regular communications with the management of Scott Cable to learn about the Company’s financial performance; (ii) received financial information, restructuring plans and information about negotiations with other creditors from management that was not available to others; and (iii) generally provided advice to management on Scott Cable’s financial affairs. Moreover, the Government contends that the 1993 and 1996 Management Incentive Agreements provided Scott Cable’s management with an interest in providing for a recovery on the Junior PIK Notes that may not have always aligned with the best interests of the Company. Finally, the Government points out that, after confirmation of the 1996 Plan, the Series A Junior PIK Noteholders obtained the ability to elect a representative to Scott Cable’s Board of Directors.

The Defendants argue that the Series A Holders were not insiders of Scott Cable because activities such as monitoring the Company’s business and attending board meetings are not sufficient to show control over the day-to-day operations. Radnor Holdings, 353 B.R. at 840-41.

I agree that the Series A Holders were not statutory insiders. However, the 1993 and 1996 Management Incentive Agreements created an alignment of interests between Scott Cable’s management and the Series A Holders that provided a closeness that would affect the Company’s dealings with the Series A Holders and prevent a true arm’s-length relationship between the entities. All of the Series A Holders (i.e., MC Partners, TA Investors, Allstate, Milk Street Partners, Chestnut Street Partners and Northeast Ventures II) were parties to the 1993 and 1996 Management Incentive Agreements. (Pl. Ex. 68 and Pl. Ex. 122.) “An arm’s-length transaction is a transaction in good faith in the ordinary course of business by parties with independent interests . . . [that] each acting in his or her own best interest [ ] would carry out. . . .” Winstar, 554 F.3d at 399 quoting In re U.S. Med.,531 F.3d at 1277 n. 4 . The Management Incentive Agreements gave Scott Cable’s management an incentive to act in the best interests of the Series A Holders, rather than independently. Therefore, for purposes of the equitable subordination analysis, the Series A Holders were non-statutory “insiders.”

“Courts have generally recognized three categories of misconduct which may constitute inequitable conduct for insiders: (1) fraud, illegality, and breach of fiduciary duties; (2) undercapitalization; or (3) claimant’s use of the debtor as a mere instrumentality or alter ego.” Mid-American Waste, 284 B.R. at 70 . The Government argues that fraudulent transfer, illegality, aiding and abetting management’s breach of fiduciary duty and undercapitalization are all present in this case. [38] Although the granting of a lien to gain advantage over other creditors has been considered under the first category of inequitable behavior (see Fabricators, 926 F.2d at 1467 ), the foregoing categories are not exclusive in describing inequitable insider conduct. The inability to fit neatly the parties’ actions within a specific heading does not make the misconduct any less inequitable.

The inequitable conduct in this case was the plan between Scott Cable’s management and the Series A Holders to convert the Series A Holders’ subordinated unsecured debt into secured debt by issuing secured notes through the 1996 Plan for the purpose of enabling the Series A Holders to gain an unfair advantage over the IRS by preventing collection of the capital gains tax that all parties knew would arise at a later time since it was already intended that the assets of the Company were expected to be sold. [39] The parties determined to grant this lien in the context of a chapter 11 bankruptcy plan to obtain the comfort of a confirmation order drafted by the parties that would include language to inhibit future challenges to the lien transfer.

Moreover, the chapter 11 plan process allowed the parties to claim that the IRS received notice of the granting of the lien and, further, blame the IRS for not discovering the scheme due to the IRS’s failure to thoroughly review a disclosure statement, which contained — not direct notice — but clues scattered throughout a myriad of sections, in a case in which the IRS was not even a claimant.

The specific factual findings that support this conclusion of inequitable conduct by the Series A Holders (previously, the Junior Noteholders) are as follows:

• At the time of the 1988 LBO, Scott Cable and the Junior Noteholders knew that, due to the low tax basis in the Company’s assets, a large capital gains tax would arise upon the sale of the Company’s assets, which is why the parties structured the LBO as a stock sale, rather than an asset sale.

• At the time Scott Cable was considering strategies to pay the debt instruments that were due to mature in 1993, the Junior Noteholders and management knew a sale of Scott Cable’s assets would not generate sufficient funds to pay all of the Company’s indebtedness, particularly the Public Debentures and the Junior Notes. The Junior Noteholders and management knew that the Company had used most of its existing NOLs to offset gains received from post-LBO system sales and any further asset sales would create significant tax liabilities.

• After the 1993 Restructuring, the Junior Noteholders and management knew that offers received by the Company to purchase its assets were in the range of $95-$100 million, which were not sufficient to pay the outstanding debts, which totaled over $148 million.

• After the 1993 Restructuring, the Junior Noteholders considered the possibility that granting a lien to secure the Junior Notes would enable them to be paid prior to any capital gains tax. The Junior Noteholders began researching whether granting such a lien would create personal liability for Scott Cable’s management and whether a lien could be granted in the context of chapter 11 case to resolve potential liability issues for individuals.

• Scott Cable’s management and the Junior Noteholders acknowledged that a liquidation of the Company in late 1995 would not yield sufficient sale proceeds to pay all of the Company’s indebtedness. The parties began discussions about a restructuring that would grant liens to the unsecured noteholders (both the Public Debentures and the Junior Noteholders) to put them in a position to be paid before any capital gains tax that would arise from a future sale of Scott Cable’s assets.

• The Junior Noteholders and management recognized that the value of Scott Cable’s assets was likely to increase with the enactment of the Telecommunications Act of 1996, which provided for substantial deregulation of rates charged by small system operators, such as Scott Cable. The goal of the Junior Noteholders in the 1996 Bankruptcy Case was to preserve their debt and obtain repayment from a future asset sale based on the increased value; however, the Junior Noteholders needed to obtain a lien to gain an advantage over any capital gains tax that would arise from an asset sale.

• Scott Cable obtained confirmation of the 1996 Plan, which provided for the distribution of secured Junior PIK Notes to the Junior Noteholders (Series A) and the Public Debenture Holders (Series B) that enabled those creditors to gain an advantage over the IRS upon a future sale of the Company’s assets.

The Defendants argue that there is nothing inequitable in obtaining a lien to secure repayment of indebtedness. I agree that obtaining a security interest — without more — is not inequitable conduct. Fabricators, 926 F.2d at 1468 . However, other courts have recognized that obtaining a lien for the purpose of gaining an advantage over other creditors may be inequitable, depending on the circumstances surrounding that act. Fabricators, 926 F.2d at 1468 (finding misconduct, when an insider obtained liens “not merely [as] an isolated act, but one step interconnected with a series of actions by [the insider] to gain an advantage over the position of other creditors.”); Estes v. N & D Prop., Inc. ( In re N & D Prop., Inc.), 799 F.2d 726, 732 (11th Cir. 1986) (finding misconduct based on an insider’s actions to encumber the debtor’s assets and obtain a priority in the impending bankruptcy proceedings was inequitable to consumer creditors); Fluharty v. Wood Prod., Inc. (In re Daugherty Coal Co., Inc.), 144 B.R. 320, 327 (N.D.W.V. 1992) (finding misconduct when an insider obtained liens “without going through the appropriate formalities” covering the only significant assets owned by the debtor, and effectively “leap-frogging” over other creditors); and Rodolakis v. Chertoff (In re 1236 Dev. Corp.), 188 B.R. 75, 84 (Bankr.D.Mass. 1995) (finding misconduct when an insider secured his capital contributions with a lien against the debtor’s assets, thereby gaining an unfair advantage and harming the debtor and its creditors).

The Defendants also argue that the transaction was not inequitable because they provided value to Scott Cable in exchange for the secured Series A Junior PIK Notes in the form of (i) agreeing to receive Junior PIK Notes in an amount that was only 85% of the amount of their allowed claim; (ii) receiving PIK interest; (iii) extending the maturity date for payment; and (iv) the tangible and intangible benefits of agreeing to a consensual plan confirmation. Based upon the evidence in the record regarding the value of the Scott Cable at the time the liens were granted, I cannot agree that the Series A Holders provided anything but minimal value to the Debtors in exchange for the secured Series A Junior PIK Notes. The Junior PIK Notes were in the total amount of the 1993 Junior Noteholders’ claims, but the 1993 Junior Noteholders and the Public Debenture Holders negotiated among themselves to transfer 15% of the Junior PIK Notes to the Public Debenture Holders. Moreover, the Junior Notes had no value. At the time the 1996 Plan was being proposed and confirmed, the 1993 Junior Noteholders and management knew that the value of Scott Cable’s assets was insufficient to pay anything to the 1993 Junior Noteholders. The liquidation analysis attached to the final 1996 Disclosure Statement showed that a liquidation of Scott Cable’s assets, and payment of the capital gains tax, would result in no distribution on the 1993 Junior Notes. Had the IRS received adequate notice regarding the 1996 Plan’s grant of a security interest to displace its ability to collect future capital gains taxes, it could have raised an objection to the 1996 Plan that would have had merit. [40]

(b) Injury to Creditors or Unfair Advantage on the Claimant

The second factor of the equitable subordination analysis requires a finding that the inequitable conduct resulted in an injury to creditors or unfair advantage to the claimant. Here, the misconduct clearly resulted in both. The Government was injured by the attempted impairment of its right to an administrative tax claim based upon the less than arm’s-length negotiations between Scott Management and the Series A Holders. Moreover, the scheme devised by the Series A Holders enabled them to obtain an unfair advantage over the IRS by using the 1996 Bankruptcy Case to “leap-frog” ahead of the IRS’s claim.

“A claim or claims should be subordinated only to the extent necessary to offset the harm which the bankrupt and its creditors suffered on account of the inequitable conduct.” Winstar, 554 F.3d at 413 quoting Mobil Steel, 563 F.2d at 701 . In some equitable subordination cases, it is difficult to quantify the harm caused by the inequitable conduct. In this case, the harm is equal to the amount of the tax claims that lost their priority. Subordinating payment of the Series A Junior PIK Notes to the unpaid administrative tax claims would offset the harm caused by the inequitable conduct.

(c) Consistency with the Provisions of the Code

The final factor in an equitable subordination analysis requires the Court to determine whether subordination of a particular claim is consistent with the Bankruptcy Code. As noted by my colleague, the Honorable Brendan Linehan Shannon:

The leading case on a court’s powers under §510(c) is United States v. Noland, 517 U.S. 535, 116 S.Ct. 1524, 134 L.Ed.2d 748 (1996) . There, the United States Supreme Court held that “the bankruptcy court may not equitably subordinate claims on a categorical basis in derogation of Congress’s scheme of priorities.” Id. at 536, 116 S.Ct. 1524. This means that courts are limited in their ability to reorder express statutory priorities by, for example, subordinating debt to equity. See Winstar, 554 F.3d at 414 . But a court may subordinate the claims of creditors to other creditors. Id.

Elway Co., LLP v. Miller (In re Elrod Holdings Corp.), 421 B.R. 700, 715-16 (Bankr.D.Del. 2010). Here, the Government is asserting its rights as an administrative tax claimant in the 1998 Bankruptcy Case. Subordination of the Series A Junior PIK Notes to the administrative tax claims actually restores the priorities set by Congress by preventing otherwise subordinated unsecured debt from gaining an unfair advantage of prior payment of administrative tax claims. 11 U.S.C. §507(a)(8).

The Defendants argue that equitable subordination of the Junior PIK Notes would be inconsistent with a number of provisions of the Bankruptcy Code: namely, §§ 1101, 1123, 1128, 1129, 1141, 1142, 1144. The Defendants ask this Court to view the adversary proceeding as an attack upon the 1996 confirmation order. For the reasons set forth earlier in this Opinion, I have already held that §1144 is not applicable to this adversary proceeding. The Government’s claims arise in the 1998 Bankruptcy Case. In 1996, the Court had no knowledge of any misconduct. When a fraudulent scheme comes to light, “the necessity of equitable relief against that fraud becomes insistent.” Pepper v. Litton, 308 U.S. 295, 312, 60 S.Ct. 238, 248, 84 L.Ed.218 (1939) . “No matter how technically legal each step in that scheme may have been, once its basic nature was uncovered it was the duty of the bankruptcy court in the exercise of its equity jurisdiction to undo it.” Id.

(d) Conclusion — Equitable Subordination of the Series A Junior PIK Noteholders

The Defendants urge that this Court recognize the unfairness of applying equitable subordination in this case, since the Series A Holders received their secured claims pursuant to a chapter 11 plan that was disseminated to all interested parties (including the IRS) and approved after a hearing before the Bankruptcy Court. They argue that equitable subordination of such notes will chill investments in financially troubled entities. Equitable subordination is a “drastic’ and “unusual” remedy because it means that a court has chosen to disregard an otherwise legally valid transaction.” In re Lifschultz Fast Freight, 132 F.3d 339, 347 (7th Cir. 1997) . The Defendants also point out the Seventh Circuit’s observation that:

Wrongful or unpredictable subordination spawns legal uncertainty of a particular type: the risk that a court may refuse to honor an otherwise binding agreement on amorphous grounds of equity. If a court wrongly subordinates a claim, other investors are sure to take heed. An investor will see that the chance she might not get her money back has gone up slightly. She will be less willing to lend or invest in the future; and the cost of credit will rise for all.

Lifschultz, 132 F.3d at 347 . However, equitable subordination of the Series A Junior PIK Notes to the administrative tax claims is not unpredictable. In this case, the parties invented an artifice to gain an unfair advantage over the IRS and saw their opportunity to do so in the 1996 Bankruptcy Case. At the time they improved their position by obtaining a security interest, the Series A Holders were not “investors” because they did not provide value in return for the security interest. The lien secured prior, unsecured, out-of-the-money debt.

Accordingly, I conclude that the Series A Holders engaged in inequitable conduct in obtaining a lien for their prior debt that enabled the Series A Holders to gain an unfair advantage and priority over another creditor. Namely, this misconduct harmed the IRS (and possibly other taxing authorities) designed to prevent them from collecting any capital gains tax. I also conclude that equitable subordination of the Series A Junior PIK Notes to the administrative tax claims is consistent with the distribution provisions of the Bankruptcy Code.

(2) The Series B Junior PIK Noteholders

The Government argues that the claims of the Series B Junior PIK Noteholders (the “Series B Holders”) also should be equitably subordinated to the administrative tax claims. The Indenture Trustee argues that the Government has not proven that any of the Series B Holders are insiders of Scott Cable or engaged in any misconduct. The Government argues that the facts support equitable subordination of all of the Junior PIK Notes, without regard to the inequitable conduct of individual holders. The Government also argues that facts demonstrate misconduct on behalf of the Series B Holders because the Creditors Committee, consisting mostly of Series B Holders, and their professionals knew about the tax avoidance scheme and negotiated to for “a piece of the action.”

I first address whether the claims of the Series B Holders can be equitably subordinated without a showing of inequitable conduct by the Noteholders. The Government claims that the Series B Holders obtained the 15% interest in the Junior PIK Notes as successors-in-interest to the Series A Holders, whose claims should be equitably subordinated. The Government also contends that the Series B Holders were not holders in due course for value, arguing that the Series B Holders provided no value for their interest in the Junior PIK Notes since they received 100% of their pre-1996 Bankruptcy Case claims on the effective date by receiving a cash payment and the Senior PIK Notes. Further, the Government claims that, by choosing not to intervene, the Series B Noteholders waived any affirmative defenses, such as proving that they had no actual knowledge of the scheme or holder in due course status.

To equitably subordinate the Series B Holders’ claims without a finding of inequitable conduct on their part would be to accept “no-fault” equitable subordination. In the past, the Third Circuit has held that creditor misconduct is not always a prerequisite for equitable subordination. In re Burden v. United States, 917 F.2d 115, 120 (3d Cir. 1990) . In that case, the court subordinated a tax penalty in the absence of government misconduct. SubMicron, 432 F.3d at 462 n. 16 . In United States v. Noland, 517 U.S. 535, 116 S.Ct. 1524, 134 L.Ed.2d 748 (1996), the Supreme Court held that a subordinating a post-petition tax penalty claim “runs directly counter to Congress’s policy judgment that a postpetition tax penalty should receive the priority of an administrative expense.” Id., 517 U.S. at 541, 116 S.Ct. at 1528 . The Nolan Court, however, expressly reserved ruling on whether a bankruptcy court must always find creditor misconduct before a claim may be equitably subordinated. Id., 517 U.S. at 543, 116 S.Ct. at 1528 . More recent Third Circuit cases adopt the 3-prong test for equitable subordination, which requires inequitable conduct. Winstar, 554 F.3d at 411 . See also Moll Indus., 454 B.R. at 585 (reading Winstar as adopting inequitable conduct as a formal requirement for equitable subordination). Based on the foregoing, I conclude that if no fault equitable subordination can still be pursued in this Circuit, the circumstances allowing it would be extremely limited. I decline to adopt no fault equitable subordination in this case.

The Government further argues that the Series B Noteholders waived defenses by failing to intervene, constituting an attempt to reverse the burden of proof in this matter. As the moving party, the Government has the burden of coming forward with evidence to rebut the prima facie validity of the claim and, once the movant comes forward with material evidence of misconduct, the burden shifts to the claimant to demonstrate the fairness of his conduct. Mid-American Waste, 284 B.R. at 69 . Accordingly, I will review whether the Government has come forward with evidence of misconduct of the Series B Holders.

(a) Inequitable Conduct

The Government has not proven that the Series B Holders are “insiders” of Scott Cable. When equitable subordination claims are leveled against noninsider, non-fiduciary claimants, the level of pleading and proof and even higher. ABF Capital Mgmt v. Kidder Peabody & Co. (In re Granite Partners, L.P.), 210 B.R. 508, 515 (Bankr.S.D.N.Y. 1997) . While equitable subordination can apply to an ordinary creditor, the circumstances supporting such a claim are few and far between. Id. Generally, a creditor may improve its position vis-à-vis another creditor provided he does not receive a preference or fraudulent transfer. Granite Partners, 210 B.R. at 515 . Courts have described the type of inequitable conduct needed to equitably subordinate a non-insider creditor as “gross and egregious,” “tantamount to fraud, misrepresentation, overreaching or spoliation,” or “involving moral turpitude.” Id.; Sentinel Mgmt., 728 F.3d at 670 .

The Series B Holders obtained a share of the Junior PIK Notes through direct negotiations between the Creditors Committee and the 1993 Junior Noteholders. The Government claims that seven members were named to the Creditors Committee in the 1996

Bankruptcy Case: four of them were members of the pre-petition Informal Bondholders Committee, and one of the new members was Texas Commerce Bank, as Indenture Trustee for the Public Debenture Holders. The Government further contends that the Creditors Committee had knowledge of the scheme through the pre-petition presentation to the Informal Bondholders Committee by the Debtors’ advisor, DLJ. Further, the Government argues that a memorandum to members of the Creditors Committee from their counsel noted the Committee’s awareness of the plan to “leap-frog” over the capital gains taxes by stating: “the holders of the [1993 Junior Notes] want to preserve any upside potential and are unwilling to eliminate any of their debt because to do so will only transfer value to the taxing authorities.” (Stip. Facts – Gov. ¶ 420.) The Government also argues that negotiating for a portion of the Junior PIK Notes was inequitable because it enabled Public Debenture Holders to receive more than 100% of their allowed claims in the 1996 Bankruptcy Case.

I cannot impute any misconduct of individual Creditors Committee members to all of the Series B Holders. A leading commentator has noted that committees cannot bind their constituents, writing:

Although committees are charged with negotiating the plan on behalf of their constituencies, the committees are not authorized or empowered to bind their constituencies. They are vested with considerable power and authority under the Code, but they are not the agents of and cannot bind the groups they represent. The plan will be submitted to creditors and to equity security holders for voting and those holders may or may not follow the committees’ recommendations.

7 COLLIER ON BANKRUPTCY ¶1103.05[1][d][i] (Alan N. Resnick & Henry J. Sommer, eds., 16th ed. rev.2014). Here, the Creditors Committee represented all unsecured creditors, not just the Public Debenture Holders. Their actions did not bind all unsecured creditors — or even individual Public Debenture Holders. Moreover, the parties concede that after the 1996 Bankruptcy Case, many of the Series B Junior PIK Notes were traded on the open market. The Government has not provided evidence of egregious misconduct by the individual Series B Holders. “[A]lthough it is a court of equity, [the Bankruptcy Court] is not free to adjust the legally valid claim of an innocent party who asserts the claim in good faith merely because the court perceives that the result is inequitable.” Noland, 517 U.S. at 539, 116 S.Ct. at 1526 . The record before me does not reveal whether the holders of the Series B Junior PIK Notes at the time of confirmation of the 1996 Plan are the same as the Series B Holders in the 1998 Bankruptcy Case. I conclude that the Government has not met its burden of proving gross and egregious misconduct by the Series B Holders.

V. CONCLUSION

For the reasons set forth above, I conclude that (i) the Government’s recharacterization claim is denied; and (ii) the Government’s equitable subordination is granted with respect to the Series A Junior PIK Noteholders, and denied with respect to the Series B Junior PIK Noteholders.

[1] This Opinion constitutes the findings of fact and conclusions of law required by Fed.R.Bankr.P. 7052.

[2] As explained in more detail below, the plan confirmed in the 1996 Bankruptcy Case provided for the distribution of secured Junior PIK Notes to certain creditors who had previously held only unsecured public subordinated debentures and unsecured junior subordinated notes in the 1996 Bankruptcy Case. U.S. Bank National Association (“U.S. Bank” or the “Indenture Trustee”) is the successor to State Street Bank & Trust Co. as indenture trustee for the Junior PIK Notes.

[3] The Indenture Trustee and the intervening defendants are referred to herein as the “Defendants.”

[4] If it is later determined that a final order or judgment by this Court in this matter is not consistent with Article III of the United States Constitution, then this Opinion and Order are submitted as proposed findings of fact and conclusions of law for the District Court to consider in accordance with the District Court’s Amended Standing Order of Reference dated February 29, 2012.

[5] The Government’s Negotiated Facts found at D.I. 739 (hereinafter, the “Stip. Facts – Gov.”) includes the facts as negotiated between the Government and the Defendants prior to trial, modified to reflect the Court’s rulings of May 10, 2007, on the Defendants’ objections thereto that had been reserved in Joint Trial Exhibit A.

[6] The media/communications group at T.A. Associates eventually became a separate entity called T.A. Communications. (Tr. D.I. 777 at 9:10 – 9:12 (Churchill Test.)). Churchill was a general partner of T.A. Communications, which was a general partner of Media/Communications Partners, L.P. (Id. at 10:24-11:8). These entities raised funds from investors and then invested and managed those funds for the investors. (Id. at 11:14-11:20). Churchill and others who worked for T.A. Communications or Media/Communications Partners, L.P. invested their own monies in separate investment funds (such as T.A. Investors, Milk Street Partners, Inc., and Chestnut Street Partners, Inc.), which invested alongside Media/Communications Partners, L.P. (Id. at 11:17-13:12; 18:7-18:12). All of the foregoing entities may be collectively referred to herein as “MC Partners.” Media/Communications Partners, L.P and Allstate Insurance Company had prior experience investing in MSOs with Simmons Communications. (Stip. Facts – Gov. ¶¶ 24-25).

[7] The Defendants’ Negotiated and Agreed Facts, docketed at D.I. 713 (hereinafter, the “Stip. Facts – Def.”) were negotiated between the Government and the Defendants and moved into evidence without objection on February 23, 2007.

[8] The senior secured Revolving Credit Agreement dated as of January 19, 1988 (the “Bank Loan” or the “Revolver”) among Scott Cable and Canadian Imperial Bank of Commerce, individually and as agent for a syndicate of three banks (collectively, the “Banks”) provided for total advances not to exceed $65,625,000, but loaned Scott the approximate aggregate principal amount of $56,767,000. (Stip. Facts – Def. ¶6; Stip. Facts – Gov. ¶64.)

[9] This unsecured Zero Coupon Note was payable to Scott Cable’s former owner, Jim Scott (the “Scott Note”).

[10] The Subordinated Debentures due 4/15/01, refers to the 12 ¼ % Public Subordinated Debentures due 4/15/01, and were issued pursuant to an indenture dated March 15, 1986 (the “Public Debentures”). The Public Debentures were not obtained to finance the 1988 LBO, but were assumed by the new, post-merger Scott Cable (Stip. Facts – Gov. ¶64; Stip. Facts – Def. ¶10, ¶13.) The Public Debentures were publicly tradable. (Stip. Facts – Def. ¶11.)

[11] The Series A, B, C, and D Senior Secured Notes (the “Senior Secured Notes”) were issued pursuant to the senior secured Note Agreements dated as of January 20, 1988 between Scott Cable and CIG & Co., MONY Life Insurance Company of America (“MONY”), The Mutual Life Insurance Company of New York (“Mutual of New York”), and New England Mutual Life Insurance Company (collectively, the “Insurance Companies”).

[12] The Senior Subordinated Zero Coupon Notes due 7/31/93 (the “Senior Subordinated Notes”) were issued to MONY and Mutual of New York.

[13] The stock of Scott Cable held by the Holding Companies was pledged as further security to the collateral agent, State Street Bank & Trust Company of Connecticut, National Association, for both the Senior Secured Notes and the Senior Subordinated Notes. (Stip. Facts – Gov. ¶69.)

[14] The “Junior Noteholders” refers to the holders of the 1988 Junior Notes and the 1993 Junior Notes (defined infra.).

[15] In the Deloitte audits, the Junior Notes were always considered debt and included in “Notes and Loans Payable” on the balance sheet. (Stip. Facts – Def. ¶45.)

[16] Simmons and the Junior Noteholders had considered that prospective buyers might want to purchase Systems that were located in close proximity to each other. To provide for future sales of geographically clustered assets in transactions that would constitute stock sales, the Scott Cable LBO was structured using layers of corporations, including holding or “mirror” corporations, that could be used for those future sales. (Stip. Facts – Gov. ¶162-¶165.) Under a mirror corporation transaction, a portion of Scott Cable’s assets could be transferred to a holding or mirror corporation so that the stock of the mirror corporation could be sold to the buyer. (Id. at ¶167.) Later internal discussions by MC Partners’ managers expressed concerns that any transfer of assets made when Scott Cable was insolvent could be subject to tax treatment by the IRS as an asset sale and deferred inter-company taxable gain under Section 332 of the Internal Revenue Code. (Id. at ¶170.) Further, the internal discussions also raised concerns of potential personal liability for Scott Cable’s officers and directors if the company was deemed to be insolvent and the officers and directors allowed payment of creditors instead of federal taxes. (Id. at ¶171).A mirror corporation transaction was never executed by Scott Cable. (Id. at ¶177).

[17] Simmons Management was renamed Scott Cable Management Company, Inc.(“Scott Management”) (Pl. Ex. 77 at 10346.)

[18] Simmons Communications was renamed American Cable Entertainment (ACE). (Stip. Facts – Gov. ¶287.) The Holding Companies were renamed ACE-U.S., Inc.; ACE-Texas, Inc.; ACE-Central, Inc.; ACE-East, Inc.; ACE-West, Inc.; and ACE-South, Inc. (Stip. Facts – Gov. ¶288; Pl. Ex. 114 at 1306.)

[19] Bloch was a director of Scott Cable at this time, but resigned on November 10, 1995, about three months prior to Scott Cable’s initial bankruptcy filing. (Def. Ex. 187 Sched. 7.20.)

[20] After the 1993 Restructuring, the Scott Note is referred to as the Unsecured Zero Coupon Notes.

[21] “Other” unsecured claims included unsecured claims other than Class 5 (the Unsecured Zero Coupon Notes), Class 6 (the Public Debentures) and Class 7 (the 1993 Junior Noteholders).

[22] The 1996 Plan described the terms of the Senior PIK Notes as (i) having an initial aggregate principal amount of $49.5 million; (ii) paying interest semi-annually through the issuance of additional Senior PIK Notes at the rate of 15% per annum on the unpaid principal balance; (iii) maturing five years and three months from the Effective Date, subject to acceleration upon the occurrence of certain events; and (iv) being secured by a lien on the assets of Scott Cable, subordinate to the lien granted to Finova in the Post-Confirmation Credit Facility. (Pl. Ex. 114 at 1377.)

[23] The 1996 Plan described the terms of the Junior PIK Notes as (i) having an initial aggregate principal amount of $38,925,797; (ii) paying interest semi-annually through the issuance of additional Junior PIK Notes at the rate of 16% per annum on the unpaid principal balance; (iii) maturing five years and seven months from the Effective Date, subject to acceleration upon the occurrence of certain events, and (iv) being secured by a lien on the assets of Scott Cable, subordinate to the liens granted to (a) Finova in the Post-Confirmation Credit Facility, and (b) the holders of the Senior PIK Notes. (Pl. Ex. 114 at 1378.)

[24] Although defined in the 1996 Disclosure Statement without reference to a Plan section, the definition of “Transaction Event” was not included in the section for defined terms or the section regarding class treatment, but, instead, was buried in Section 10.6 of the 1996 Plan (describing convertibility of the stock) as “(i) the merger, consolidation, liquidation, reorganization or dissolution of Reorganized Scott; (ii) the sale of all of the cable television systems currently owned by Scott, and (iii) any similar transaction including, without limitation, the reclassification of the capital stock of Reorganized Scott or the dividend or other distribution of any corporate asset to shareholders.” (Pl. Ex. 114 at 1400.)

[a] From Waller appraisal (See Article VIII of the Disclosure Statement)

[b] Fifteen (15%) percent Chapter 7 discount. See Article IX.B. of the Disclosure Statement.

[c] Projected Cash on Confirmation Date.

[d] Estimated by Scott.

[e] Estimated by Scott.

[f] Estimated by Scott.

[g] Represents estimated tax liability based on assumed capital gain of $120,914,000, reduced by estimated net operating loss carryforward available to Scott of approximately $11,000,000.

[25] Although the October 16, 1996 memorandum advises of the deadline for filing objections to the Initial Plan, the deadline was actually for filing objections to the Initial Disclosure Statement. (See Def. Ex. 18.) Moreover, the fax cover sheet attached to the October 16, 1996 memorandum shows that Jefferson sent the memo to Hennessey; however, Jefferson stated that, while she did not have a specific recollection, she also would have faxed the memorandum to Campbell, although it may have been after the objection deadline. (Id.; Tr. D.I. 783 at 43:17-45:10.)

[26] The hearing to approve the First Amended Disclosure Statement was scheduled for Friday, November 1, 1996. (Pl. Ex. 115.)

[27] The objections were filed by holders of Senior Secured Notes that voted to accept the 1996 Plan “conditionally,” but objected to the total claim amount that the Debtors proposed to pay to them on the effective date due to a dispute over whether the noteholders were entitled to payment of interest at the default rate. At the Court’s direction, the Debtors were ordered to place specific amounts into an escrow account to protect the objecting parties pending resolution of the interest rate issue. (Pl. Ex. 119.)

[28] Hereinafter, holders of the Series A Junior PIK Notes are referred to herein as the “Series A Holders,” and holders of the Series B Junior PIK Notes are referred to as the “Series B Holders.”

[29] The Connecticut Bankruptcy Court framed the issue to be decided on remand as requiring “a determination of whether the classification of the [Junior PIK Notes] as holders of secured claims in the confirmed Delaware Plan is binding on the IRS” or “[p]ut another way, . . . assuming that the IRS would have objected if it had been given specific notice, the issue is whether the Delaware Plan would have been confirmed over any objection that the IRS might have raised.” Scott III, 263 B.R. at 8.

[30] Like the res judicata defense, the Government contends that this issue was already decided against the Defendants and the law of the case bars them from re-arguing the §1144 issue. In an opinion denying the Indenture Trustee’s Motion for Summary Judgment, Judge Walsh commented that “[t]he [Government] does not assert that §§ 1127 and 1144 are implicated here. I agree they are not.” United States v. State Street Bank and Tr. Co., 303 B.R. 35, 40 n. 6. (Bankr.D.Del. 2003) . Hence, Judge Walsh’s comment was not a determination of whether the instant adversary proceeding is an attempt to revoke the confirmation order.

[31] The Defendants argue that the Government was a party in interest to the 1996 Bankruptcy Case and, therefore, subject to the 180-day limitation of §1144. The Government argues that it was not a party in interest to the 1996 Bankruptcy Case. However, even assuming (without deciding) that the Government was a “party in interest,” I conclude that §1144 is not applicable here.

[32] The decision Medallion Knitwear, Inv. v. Parkdale Mills, Inc. (In re Crown-Globe, Inc.), 107 B.R. 60 (Bankr.E.D.Pa. 1989) appears to have similarities to the current adversary, but can be distinguished. In Crown-Globe, an unsecured creditor brought an action against a secured creditor alleging that the secured creditor failed to liquidate the debtor’s assets properly and, as a result, the assets remaining for distribution to unsecured creditors was diminished by at least $450,000.00. The Court allowed claims for conversion, breach of a third-party beneficiary contract, intentional misrepresentation and negligent misrepresentation to proceed against the secured creditor, but dismissed the claim for equitable subordination, deciding that the equitable subordination claim was an untimely attempt to revoke confirmation of the debtor’s plan because “it attempts to shift priority of claims as they are to be paid under the debtor’s confirmed plan.” Id. at 62. Unlike this case, both parties in the Crown-Globe action were creditors receiving distributions under the Crown-Globe plan, and the dismissed claim would have directly altered the plan’s distribution of the estate assets. Here, the Government did not receive any distribution under the 1996 Plan. Instead, the Government challenges the competing claims to distribution of the sale proceeds obtained in the later 1998 Bankruptcy Case.

[33] This matter is more closely analogous to the reasoning of a later Continental decision, in which former shareholders challenged the release in the debtor’s plan that barred the shareholders’ claims against former officers and directors. Gillman v. Continental Airlines (In re Continental Airlines), 203 F.3d 203 (3d Cir. 2000) (“Continental II”) . A “Tripartite Settlement” among the debtors, the officers and directors and their insurers was approved by the Court — without objection — prior to confirmation. The shareholders objected to plan confirmation, which incorporated the Tripartite Settlement and an expanded release, but the objection was overruled by the Bankruptcy Court. The District Court affirmed, finding that the shareholders did not object to or appeal the Tripartite Settlement and deciding that the settlement was a key element of the plan. Continental II, 203 F.3d at 208 . When the matter was appealed to the Third Circuit, the Third Circuit determined that the appeal was not equitably moot because the shareholders’ appeal, if successful, would not necessitate the reversal of the entire plan of reorganization. Id., 203 F.3d at 210 . Further, in balancing the policy favoring finality against other equities in the case, including that the shareholders “never had their day in court,” the Third Circuit determined that the equities did not dictate dismissal for equitable mootness. Id., 203 F.3d at 211 .

[34] The 11-factor test used by the Sixth Circuit includes: (1) the names given to the instruments, if any evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identity of interest between the creditor and the stockholder; (7) the security, if any, for the advances; (8) the corporation’s ability to obtain financing from outside lending institutions; (9) the extent to which the advances were subordinated to the claims of outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayments. Roth Steel Tube, 800 F.2d at 630 . See also In re Exide Tech., Inc., 299 B.R. 732, 741 (Bankr.D.Del. 2003) .

[35] The Eleventh and Fifth Circuits’ 13-factor test includes: (1) the names given to the certificates evidencing the indebtedness; (2) the presence or absence of a fixed maturity date; (3) the source of payments; (4) the right to enforce payment of principal and interest; (5) participation in management flowing as a result; (6) the status of the contribution in relation to regular corporate creditors; (7) the intent of the parties; (8) “thin” or adequate capitalization; (9) identity of interest between creditor and stockholder; (10) source of interest payments; (11) the ability of the corporation to obtain loans from outside lending institutions; (12) the extent to which the advance was used to acquire capital assets; and (13) the failure of the debtor to repay on the due date or to seek a postponement. Stinnet’s Pontiac, 730 F.2d at 638 .

[36] The seven-factor test considers: (1) the name given to the instrument; (2) the intent of the parties; (3) the presence or absence of a fixed maturity date; (4) the right to enforce payment of principal and interest; (5) the presence or absence of voting rights; (6) the status of the contribution in relation to regular corporate contributors; and (7) certainty of payment in the event of the corporation’s insolvency or liquidation. Cohen v. The KB Mezzanine Fund, II, L.P. (In re SubMicron Sys. Corp.), 291 B.R. 314, 323 (D.Del. 2003) quoting In re Color Tile, Inc., 2000 WL 152129, *4 (D.Del. Feb. 9, 2000).

[37] The Government’s proposed 23-factor test includes: (1) whether new money was supplied for the security; (2) identity between creditors and shareholders; (3) extent of participation in, or influence over, management by the holder of the instrument at issue; (4) voting power of the holder of the instrument; (5) ratio of debt to equity in the capital structure and the “thinness” of the of the equity within the capital structure; (6) whether the advance was contributed by shareholders in proportion to their stock interests; (7) formal indicia of the investment; (8) provision of a fixed rate of interest; (9) presence or absence of a meaningful, fixed maturity date; (10) relative position of the obligees as to other creditors regarding the payment of interest and principal; (11) whether repayment of the advance was subordinated to the repayment of other obligations; (12) presence or absence of security for the obligation, the value of the collateral, and the amount of that value committed as a security to more senior obligations; (13) right to enforce the payment of the obligation in the event of default and whether the right is realistically enforceable; (14) source of payment of interest and principal; (15) whether a sinking fund was maintained to pay the obligation; (16) whether an outside lender would have made the same advance under the same or similar terms; (17) risk involved in the investment; (18) whether the purported loan was held out to others as a contribution of capital or equity; (19) whether the advance was used to acquire the company or to purchase capital assets or to pay operating expenses; (20) contingency on the obligation to repay; (21) whether postponement of the obligation was obtained; (22) whether the alleged debt was repaid per its term or repaid at all; and (23) intent of the parties.

[38] The Government argues that the transfer of the security interest to the Series A Holders was both an actual fraudulent conveyance and a constructive fraudulent conveyance. In a related decision, issued simultaneously with this one, I denied the chapter 7 Trustee’s request to bring fraudulent conveyance claims against the Indenture Trustee based upon the equitable doctrine of laches (the claims were brought more than twelve years after the allegedly fraudulent transfer and nine years after the 1998 Bankruptcy Case) and collateral estoppel (I have already denied requests to assert late fraudulent conveyance claims at least three times in this adversary). The Government also argues that illegality is present in this case because the Defendants’ conduct in connection with the 1996 Bankruptcy Case amounts to bankruptcy fraud under 18 U.S.C. §371. However, the record does not contain any indication that any criminal action was ever brought against the Defendants. See Mid-American Waste, 284 B.R. at 58 (plea agreements admitted into evidence showed that the debtor’s CEO engaged in bribery).

[39] See Sentinel Mgmt., 728 F.3d at 669 (“Underhanded behavior is typically clearest, however, when corporate insiders have attempted to convert their equity interests into secured debt in anticipation of bankruptcy.”) (internal punctuation omitted). Although this case instead involves the conversion of unsecured debt into secured debt, the result is the same.

[40] It is true, however, that the procedures employed by the IRS for the handling of the 1996 Bankruptcy Case do not show the Government at its best.

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New Bankruptcy Opinion: IN RE SAINT VINCENTS CATHOLIC MEDICAL CENTERS OF NEW YORK – Court of Appeals, 2nd Circuit, 2014

IN RE: SAINT VINCENTS CATHOLIC MEDICAL CENTERS OF NEW YORK,

ERICA T. KAGAN, Appellant,

v.

SAINT VINCENTS CATHOLIC MEDICAL CENTERS OF NEW YORK, Debtor-Appellee.

No. 11-2560-bk.

United States Court of Appeals, Second Circuit.

October 15, 2014.

YETTA KURLAND, The Kurland Group, New York, NY., for Appellant.

P. BRADLEY O’NEIL (Benjamin C. Wolf, on the brief), Kramer Levin Naftalis & Frankel, New York, NY. for Debtor-Appellee.

Present: ROBERT A. KATZMANN, Chief Judge, DENNY CHIN, Circuit Judge, LORETTA A. PRESKA, Chief District Judge. [*]

SUMMARY ORDER

RULINGS BY SUMMARY ORDER DO NOT HAVE PRECEDENTIAL EFFECT. CITATION TO A SUMMARY ORDER FILED ON OR AFTER JANUARY 1, 2007, IS PERMITTED AND IS GOVERNED BY FEDERAL RULE OF APPELLATE PROCEDURE 32.1 AND THIS COURT’S LOCAL RULE 32.1.1. WHEN CITING A SUMMARY ORDER IN A DOCUMENT FILED WITH THIS COURT, A PARTY MUST CITE EITHER THE FEDERAL APPENDIX OR AN ELECTRONIC DATABASE (WITH THE NOTATION “SUMMARY ORDER”). A PARTY CITING A SUMMARY ORDER MUST SERVE A COPY OF IT ON ANY PARTY NOT REPRESENTED BY COUNSEL.

ON CONSIDERATION WHEREOF, it is hereby ORDERED, ADJUDGED, and DECREED that the decision of the district court is AFFIRMED.

Appellant Erica T. Kagan appeals from a May 27, 2011 judgment entered by the U.S. District Court for the Southern District of New York (Rakoff, J.), which affirmed the decision of the bankruptcy court (Morris, Chief Bankr. J.) staying Kagan’s state court action against the New York Department of Health (“DOH”) brought under New York’s Freedom of Information Law (“FOIL”), N.Y. Pub. Off. Law § 87. In her state court action, Kagan sought the disclosure of certain public records related to the closure of a Manhattan hospital owned by Debtor-Appellee Saint Vincents Catholic Medical Centers of New York (“Saint Vincents”). The bankruptcy court found that the purpose of Kagan’s action was to investigate claims belonging exclusively to the bankruptcy estate and concluded that the suit was barred by the automatic stay under 11 U.S.C. § 362(a). In the alternative, the bankruptcy court found that Kagan’s state court suit would interfere with the bankruptcy court’s administration of the estate and therefore stayed the suit pursuant to its equitable authority under 11 U.S.C. § 105(a). The district court affirmed. On appeal, Kagan argues that the bankruptcy court’s factual findings were clearly erroneous, that her state court suit does not violate the automatic stay, that the bankruptcy court lacked authority to extend the stay under § 105(a), and that the bankruptcy court’s orders violate her constitutional rights under the First, Fifth, Tenth, and Fourteenth Amendments. We assume the parties’ familiarity with the underlying facts, procedural history of the case, and issues presented for review.

“On appeal from the district court’s review of a bankruptcy decision, we review the bankruptcy court decision independently, accepting its factual findings unless clearly erroneous but reviewing its conclusions of law de novo.” In re Bernard L. Madoff Inv. Sec. LLC, 740 F.3d 81, 87 (2d Cir. 2014) (quoting In re Baker, 604 F.3d 727, 729 (2d Cir. 2010) ). Where the bankruptcy court possesses equitable authority, “we review the exercise of that equitable authority only for abuse of discretion.” Adelphia Bus. Solutions, Inc. v. Abnos, 482 F.3d 602, 607 (2d Cir. 2007) .

On our independent review of the record, we agree with the district court that the bankruptcy court acted within its authority when it stayed Kagan’s state court action pursuant to its equitable powers under § 105(a). A bankruptcy court has equitable authority under § 105(a) “to assure the orderly conduct of the reorganization proceedings.” In re Baldwin-United Corp. Litig., 765 F.2d 343, 348 (2d Cir. 1985) . Here, the bankruptcy court reasonably found that the purpose of the state court action was to investigate causes of action within the bankruptcy court’s exclusive purview. After all, Kagan’s petition initiating the state court action attached an affirmation containing incendiary allegations of fraud, waste, and improper transfers in connection with the operation and closing of the hospital, which were purportedly uncovered as part of an ongoing “investigation into the financial practices of St. Vincent’s Hospital.” App. 62. Such claims of fraud, waste, and improper transfers clearly represent property of the bankruptcy estate. See Chartschlaa v. Nationwide Mut. Ins. Co., 538 F.3d 116, 122 (2d Cir. 2008) (per curiam) (explaining that property of the estate includes “causes of action owned by the debtor or arising from property of the estate”). Indeed, at the time Kagan commenced her state court action, these same kinds of claims were already the subject of an investigation authorized by the official committee of unsecured creditors. In these circumstances, the bankruptcy court reasonably determined that by placing issues within the bankruptcy court’s exclusive jurisdiction before a state court, Kagan had invited judicial confusion and raised “the specter of direct impact on the res of the bankrupt estate.” Picard v. Fairfield Greenwich Ltd., ___ F.3d ___, 2014 WL 3882481, at *9 (2d Cir. Aug. 8, 2014) (quoting In re Quigley Co., 676 F.3d 45, 58 (2d Cir. 2012) ). We see no abuse of discretion in the bankruptcy court’s exercise of its equitable authority under § 105(a).

Because we affirm the bankruptcy court’s extension of the stay under § 105(a), we need not address whether Kagan’s state court action violated the automatic stay under § 362(a). With respect to Kagan’s constitutional claims, which Kagan failed to raise to the bankruptcy court but which the district court rejected on the merits, we reject Kagan’s arguments for substantially the reasons stated by the district court in its well-reasoned opinion and order entered on May 24, 2011.

Kagan also urges us to vacate the bankruptcy court’s order in light of facts that have arisen in the meantime, including the fact that Saint Vincents has now emerged from bankruptcy. Because these facts were not available to the bankruptcy court when it issued its order, we will not consider them on this appeal. However, notwithstanding our rejection of Kagan’s arguments on appeal, nothing in this order prevents Kagan from returning to the bankruptcy court and filing a motion for the court to lift its previously imposed stay based on changed circumstances. The bankruptcy court in its discretion may then consider such a request and the relevance of any changed circumstances in the first instance.

We have considered all of the appellant’s remaining arguments and find them to be without merit. Accordingly, for the foregoing reasons, the judgment of the district court is AFFIRMED.

[*] The Hon. Loretta A. Preska, Chief Judge of the United States District Court for the Southern District of New York, sitting by designation.

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New Bankruptcy Opinion: IN RE NATURAL MOLECULAR TESTING CORPORATION – Dist. Court, WD Washington, 2014

In re: NATURAL MOLECULAR TESTING CORPORATION, Debtor.

NATURAL MOLECULAR TESTING CORPORATION, Plaintiff,

v.

CENTERS FOR MEDICARE & MEDICAID SERVICES, et al., Defendants.

Bankr. Case No. 13-19298-MLB, Adv. Case No. 13-01635-MLB, Case No. C14-1284RSL.

United States District Court, W.D. Washington, Seattle.

October 10, 2014.

ORDER DECLINING TO WITHDRAW REFERENCE

ROBERT S. LASNIK, District Judge.

This matter comes before the Court on defendants’ “Motion for Withdrawal of Reference to the Bankruptcy Court.” Dkt. # 1. [1] This particular procedure is an outgrowth of the district courts’ and bankruptcy courts’ shared jurisdiction over bankruptcy proceedings. Sec. Farms v. Int’l Bhd. of Teamsters, 124 F.3d 999, 1008 (9th Cir. 1997) (noting that Congress granted district courts “original but not exclusive jurisdiction over all bankruptcy proceedings”). A United States district court has power to initially refer all bankruptcy proceedings to a bankruptcy court (28 U.S.C. § 157(a)), and this district has exercised that option through LCR 87(a). A district court also has authority to withdraw the reference in whole or in part for cause shown. 28 U.S.C. § 157(d). Defendants argue that the reference should be withdrawn and this action dismissed because the underlying dispute involves the appropriateness of Medicare payments which must first be determined in an administrative appeals process before it can be reviewed by the courts.

Section 157(d) provides:

The district court may withdraw, in whole or in part, any case or proceeding referred under this section, on its own motion or on timely motion of any party, for cause shown. The district court shall, on timely motion of a party, so withdraw a proceeding if the court determines that resolution of the proceeding requires consideration of both title 11 and other laws of the United States regulating organizations or activities affecting interstate commerce.

Regardless of whether a party is seeking a discretionary withdrawal under the first sentence of § 157(d) or a mandatory withdrawal under the second sentence, the request must be timely made. Although the statute does not define timeliness, courts generally find that a request for withdrawal must be made as soon as the requesting party is aware of the grounds for withdrawal in order to avoid unnecessary expense and delay in the administration of the bankrupt’s estate. See Eide v. Haas, 343 B.R. 208, 213 (N.D. Iowa 2006); U.S. v. Kaplan, 146 B.R. 500, 503 (D. Mass. 1992) ; Central Ill. Savings & Loan Assoc. v. Rittenberg Co., Ltd., 70 B.R. 742, 746 (N.D. Ill. 1987); Boyajian v. DeFusco, 50 B.R. 327, (D.R.I. 1985) (once it becomes apparent that the “other laws” described in § 157(d) are implicated, “a party has a plain duty to act diligently — or else, to forever hold his peace.”). The Local Rules of this district expressly require that “[a]ny motion for withdrawal of reference . . . be filed and served promptly after service of any pleading or document in which the basis for the motion first arises.” Local Bankr. R. 5011-1(b).

In this case, it was apparent from the beginning of the adversary proceeding that the appropriateness of reimbursements under Medicare program rules, regulations, and policies was at issue. Defendants, in fact, asserted that very ground in support of a motion to dismiss filed in the bankruptcy court on January 23, 2014. The motion was denied on its merits. When plaintiff amended its complaint, [2] defendants again attacked the pleading in the bankruptcy court (a motion which remains pending) before finally deciding that they should request a withdrawal of reference on July 22, 2014, seven months after the initial complaint was filed. Nothing prevented defendants from filing their motion to withdraw reference sooner: instead, they waited until their chances for a quick dismissal dwindled in the bankruptcy court before seeking an alternative forum. Defendants have not been diligent, costs and delay have arisen, and the risk of forum shopping is significant. For all of the foregoing reasons, the Court DENIES the motion to withdraw reference as untimely.

[1] This matter can be decided on the papers submitted. The parties’ requests for oral argument are DENIED.

[2] Assuming for purposes of this argument that resolution of plaintiff’s new claims will require consideration of “other laws” under § 157(d), the need for such consideration had already been apparent for six months. No new ground for withdrawing the reference came into existence as a result of the amended pleading. It is therefore inappropriate to evaluate the timeliness of defendants’ motion based solely on the date on which the amended complaint was filed.

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New Bankruptcy Opinion: WBCMT 2007-C33 OFFICE 9720, LLC v. NNN REALTY ADVISORS, INC. – Dist. Court, SD Texas, 2014

WBCMT 2007-C33 OFFICE 9720, LLC, Plaintiff,

v.

NNN REALTY ADVISORS, INC., et al., Defendants.

Civil Action No. H-13-2525.

United States District Court, S.D. Texas, Houston Division.

October 15, 2014.

MEMORANDUM AND ORDER

NANCY F. ATLAS, District Judge.

This case is before the Court on the Motion for Summary Judgment [Doc. # 21] filed by Plaintiff WBCMT 2007-C33 Office 9720, LLC (“WBCMT”) seeking summary judgment against Defendant NNN Realty Advisors, Inc. (“NNN Realty” or “Guarantor”). NNN Realty filed an Opposition [Doc. # 22], and WBCMT filed a Reply [Doc. # 23]. Having reviewed the full record and applicable legal authorities, the Court denies the Motion for Summary Judgment as to NNN Realty’s guaranty obligation and grants the Motion as to the affirmative defenses.

I. BACKGROUND

WBCMT is the current owner and holder of certain loan documents, including an Indemnity and Guaranty Agreement (“Guaranty”) dated June 20, 2007, under which NNN Realty Advisors, Inc. is the Guarantor. The underlying loan in the principal amount of $17,500,000.00 was made by Wachovia Bank, N.A. (“Wachovia”), to seventeen “NNN Cypresswood Drive, LLC” entities. [1] The Loan was secured in part by a Deed of Trust, Security Agreement and Fixture Filing (“Security Agreement”) encumbering certain commercial real property (“Property”) in Harris County, Texas. Pursuant to a Note Modification dated July 11, 2007, “NNN Cypresswood Drive 25, LLC” was added to the list of entities defined as “Borrower.”

On November 30, 2012, WBCMT sent Borrower and Guarantor notice that an “Event of Default” had occurred because “certain sums due and payable . . . are now past due and remain unpaid.” See Letter dated November 30, 2012, Exh. A17 to Motion. Demand for immediate payment of amounts then currently due was made “upon Borrower,” but there was no acceleration of the Loan at that time.

On December 31, 2012, NNN Cypresswood Drive 25, LLC filed a voluntary Chapter 11 bankruptcy petition and listed its interest in the Property as an asset of the bankruptcy estate.

On May 7, 2013, WBCMT conducted a non-judicial foreclosure sale of the Property, excluding NNN Cypresswood Drive 25, LLC’s interest of approximately 3.3%, and purchased the remaining approximately 97% for $6,925,000.00.

On August 20, 2013, WBCMT gave Notice of default based on the bankruptcy filing by NNN Cypresswood Drive 25, LLC. On October 23, 2013, WBCMT obtained relief from the automatic stay in the bankruptcy proceeding. On December 3, 2013, WBCMT purchased the remaining 3% interest in the Property at a second non-judicial foreclosure sale. At that point, there remained a $14,605,545.06 deficiency owing on the Loan.

WBCMT filed this lawsuit to collect on the Guaranty. [2] WBCMT subsequently filed the pending Motion for Summary Judgment against NNN Realty. WBCMT seeks summary judgment on its breach of guaranty claim, and on NNN Realty’s affirmative defenses. The Motion has been fully briefed and is now ripe for decision.

III. SUMMARY JUDGMENT STANDARD

Summary judgment is proper only if the pleadings, depositions, answers to interrogatories, and admissions on file, together with any affidavits filed in support of the motion, 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. FED. R. CIV. P. 56(a). The moving party bears the burden of demonstrating that there is no evidence to support the nonmoving party’s case. Celotex Corp. v. Catrett, 477 U.S. 317, 325 (1986) ; Nat’l Union Fire Ins. Co. v. Puget Plastics Corp., 532 F.3d 398, 401 (5th Cir. 2008) . If the moving party meets this initial burden, the burden shifts to the nonmovant to set forth specific facts showing the existence of a genuine issue for trial. See Hines v. Henson, 293 F. App’x. 261, 262 (5th Cir. 2008) (citing Pegram v. Honeywell, Inc., 361 F.3d 272, 278 (5th Cir. 2004) ). The Court construes all facts and considers all evidence in the light most favorable to the nonmoving party. Nat’l Union, 532 F.3d at 401 .

III. WBCMT’S BREACH OF GUARANTY CLAIM

In order to obtain summary judgment on its breach of guaranty claim against NNN Realty, WBCMT must demonstrate that there is no genuine issue of material fact regarding: (1) the existence and its ownership of the Guaranty; (2) the performance of the terms of the contract by WBCMT; (3) the occurrence of the condition on which liability is based, and (4) Guarantor’s failure or refusal to perform its promise under the Guaranty. See Stone v. Midland Multifamily Equity REIT, 334 S.W.3d 371, 378 (Tex. App.-Dallas 2011, no pet.) .

In this case, it is undisputed that WBCMT is the owner of the Guaranty and that the underlying loan proceeds were provided by WBCMT’s predecessor, Wachovia. It is also undisputed that NNN Realty has refused to pay under the Guaranty.

The disputed issue in this case involves whether a condition for NNN Realty’s liability under the Guaranty has occurred. The Guaranty provides for liability of the Guarantor for amounts due and owing after “the Property or any part thereof becom[es] an asset in (x) a voluntary bankruptcy or insolvency proceeding of Borrower or [Guarantor].” See Guaranty, Exh. A4, p. 3. Plaintiff WBCMT argues that NNN Cypresswood Drive 25, LLC’s bankruptcy, in which its 3% interest in the Property was listed as an asset of the bankruptcy estate, is an event that gives rise to NNN Realty’s obligation under the Guaranty, which WBCMT claims is the entire outstanding obligation. Defendant NNN Realty argues that its obligation under the Guaranty does not arise based on a bankruptcy filing unless all entities included in the defined term “Borrower” file bankruptcy.

When interpreting a guaranty, the “ultimate goal is to determine the intent of the parties.” Resolution Trust Corp. v. Cramer, 6 F.3d 1102, 1106 (5th Cir. 1993) . The Court’s first task is to determine whether the Guaranty is ambiguous, and this inquiry is a question of law. See id. “If the meaning of a guaranty agreement is uncertain, its terms should be given a construction which is more favorable to the guarantor.” Moayedi v. Interstate 35/Chisam Road, L.P., 438 S.W.3d 1, *7 (Tex. 2014). A “guaranty agreement is strictly construed and may not be extended beyond its precise terms by construction or implication.” Reece v. First State Bank of Denton, 566 S.W.2d 296, 297 (Tex. 1978) .

In this case, Guarantor’s obligation under the Guaranty arises if, inter alia, any part of the Property becomes an asset in a bankruptcy proceeding “of Borrower.” See Guaranty, ¶ 1. “Borrower” is a defined as the identified NNN Cypresswood Drive, LLC entities. See id., p. 1. The first sixteen entities are connected with the final listed entity only by the word “and” — not “and/or.” The parties’ use of the conjunctive indicates that the term “Borrower” refers to the full complement of entities. [3] The Note Modifications each quote the original Guaranty list of entities comprising the “Borrower” and contain a separate Schedule listing additional entities within the definition of “Borrower.” See, e.g., Note Modification dated July 11, 2007, Exh. A5 to Motion.

WBCMT argues that the Guaranty incorporates the definition of “Borrower” from the Security Agreement. Accepting for purposes of the pending Motion that the Security Agreement’s definition of “Borrower” applies to the Guaranty, it provides little assistance. The Security Agreement also lists all the NNN Cypresswood Drive, LLC entities, joined together only with the word “and,” and contains the additional language “individually or collectively as the context may require.” See Security Agreement, Exh. A4, p. 1. It is unclear from the documents whether the bankruptcy provision of the Guaranty “may require” that each entity in the list of entities is to be treated individually or collectively. The Court concludes that, when only the agreement language is considered, there is an ambiguity in the Guaranty provision regarding part of the Property becoming an asset of the bankruptcy estate in a bankruptcy proceeding “of Borrower” being a triggering event for Guarantor liability.

WBCMT also asserts that Borrower defaulted on the underlying Loan by failing to make payments. WBCMT does not cite to any provision in the Guaranty that provides for liability of the Guarantor in the event Borrower fails to make payments, and NNN Realty argues affirmatively that the Guaranty contains no such provision. WBCMT did not address this issue in its Reply. The Court rejects WBCMT’s contention as unsupported by the controlling documents.

Based on the foregoing, WBCMT is not entitled to summary judgment on its breach of guaranty claim.

IV. AFFIRMATIVE DEFENSES

In its Answer [Doc. # 14], NNN Realty asserts nine affirmative defenses. In the Motion for Summary Judgment, WBCMT argues that each of the defenses fails as a matter of law. In its Opposition, Guarantor did not explain the legal and factual basis for its affirmative defenses or otherwise address Plaintiff’s argument. As a result, summary judgment is granted in favor of WBCMT on NNN Realty’s affirmative defenses.

V. CONCLUSION AND ORDER

The Guaranty is ambiguous and, as a result, WBCMT is not entitled to judgment as a matter of law that NNN Realty is obligated under the Guaranty to pay any deficiency. Absent evidence, argument or legal authority in support of NNN Realty’s affirmative defenses, WBCMT is entitled to summary judgment on those defenses. It is, therefore, hereby

ORDERED that Plaintiff’s Motion for Summary Judgment [Doc. # 21] is DENIED as to the breach of guaranty claim and GRANTED as to the affirmative defenses. The case remains scheduled for docket call at 3:00 p.m. on November 17, 2014, and the parties are required to mediate this dispute prior to that date.

[1] Specifically, the Guaranty defines “Borrower” as “NNN Cypresswood Drive, LLC” and 16 other limited liability companies designated as “NNN Cypresswood Drive” followed by a numeral, followed by “LLC” (e.g., NNN Cypresswood Drive 1, LLC). In subsequent Note Modifications dated July 11, 2007, and October 4, 2007, an additional fifteen entities were included in the “Borrower” list of companies.

[2] Daymark Realty Advisors, Inc., the successor to NNN Realty, is listed as a Co-Defendant.

[3] Indeed, WBCMT implicitly acknowledges the disconnect between its argument and the Guaranty’s language because WBCMT repeatedly refers in its Motion to “Borrowers” in the plural, despite the Guaranty’s use of the singular form when including all the “NNN Cypresswood Drive, LLC” entities.

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New Bankruptcy Opinion: RESIDENTIAL FUNDING COMPANY, LLC v. COMMUNITY WEST BANK, NA – Dist. Court, Minnesota, 2014

RESIDENTIAL FUNDING COMPANY, LLC, Plaintiff,

v.

COMMUNITY WEST BANK, N.A., Defendant.

RESIDENTIAL FUNDING COMPANY, LLC and RESCAP LIQUIDATING TRUST, Plaintiffs,

v.

PNC BANK, N.A., as successor in interest to National City Mortgage Co., NCMC Newco, Inc. and North Central Financial Corporation, Defendant.

RESIDENTIAL FUNDING COMPANY, LLC, Plaintiff,

v.

HOMESTEAD FUNDING CORP., Defendant.

RESIDENTIAL FUNDING COMPANY, LLC, Plaintiff,

v.

STANDARD PACIFIC MORTGAGE, INC., Defendant.

Civil Nos. 13-3468 (JRT/JJK), 13-3498 (JRT/JSM), 13-3520 (JRT/JSM), 13-3526 (JRT/JJK)

United States District Court, D. Minnesota.

October 14, 2014.

David Elsberg, QUINN EMANUEL URQUHART & SULLVIAN LLP, New York, NY and Donald G. Heeman, FELHABER LARSON, Minneapolis, MN, for plaintiff.

Jeffrey R. Ansel and Michael A. Rosow, WINTHROP & WEINSTINE, PA, Minneapolis, MN, for defendant Community West Bank, N.A.

Richard E. Gottlieb, BUCKLEYSANDLER LLP, Chicago, IL and David A. Schooler, BRIGGS AND MORGAN, PA, Minneapolis, MN, for defendant PNC Bank, N.A.

Arthur G. Boylan, STINSON LEONARD STREET LLP, Minneapolis, MN, for defendant, Homestead Funding Corp.

Philip R. Stein, BILZIN SUMBERG BAENA PRICE & AXELROD LLP, Miami, FL, and Janine Wetzel Kimble, GREENE ESPEL PLLP, Minneapolis, MN, for defendant Standard Pacific Mortgage, Inc.

MEMORANDUM OPINON AND ORDER ON MOTIONS TO DISMISS

JOHN R. TUNHEIM, District Judge.

Plaintiff Residential Funding Company, LLC (“RFC”) is an entity that purchased mortgage loans from various banks and securitized them in batches to sell to investors. After the subprime mortgage crisis in 2007 and 2008, RFC was sued by investors who had purchased its residential mortgage-backed security (“RMBS”) investments. RFC went into bankruptcy as a result, and has ultimately reached a global settlement for over $10 billion. RFC now brings these actions — four at issue here, but many more in this district and across the country [1] — against the banks from which it originally purchased the mortgages involved in its global settlement. Before the Court are RFC’s lawsuits against four banks: Defendants Community West Bank, N.A. (“Community West”), PNC Bank, N.A. (“PNC”), Homestead Funding Corp. (“Homestead”), and Standard Pacific Mortgage, Inc. (“Standard Pacific”) (collectively, “Defendants”). [2] RFC brings two claims against each Defendant: one count for breach of contract on the basis that Defendants breached various representations and warranties about the quality of the mortgages they sold to RFC when they knew those representations and warranties to be false, and one count for indemnification for the portions of the $10 billion settlement that RFC claims are attributable to each Defendant.

Each Defendant moves to dismiss. Defendants’ arguments for dismissal generally fall into three categories. First, Defendants argue that RFC’s claims are barred by the statute of limitations because most of the mortgage sale agreements were executed more than six years before RFC initiated these suits in December 2013. Second, Defendants argue that RFC lacks standing to assert rights under the mortgage sale agreements because it assigned the relevant rights to third-party investors upon reselling the mortgages. Finally, Defendants argue that RFC fails to state a claim because it has failed to specifically identify which warranties and representations Defendants made falsely, how the loans were defective, and how any of the warranties’ and representations’ alleged falsities caused damage to RFC.

The Court concludes that the statute of limitations was tolled when RFC entered bankruptcy proceedings on May 14, 2012, so RFC’s claims for mortgages it purchased before May 14, 2006 are barred by the statute of limitations, but claims for those purchased after May 14, 2006 are not. With regard to standing, the Court declines to consider the documents forming the basis of Defendants’ arguments at this pleading stage, but concludes in the alternative that they would likely present a fact issue inappropriate for dismissal at this stage in the proceedings. Finally, the Court concludes that RFC has adequately alleged claims for breach of contract and indemnification. The Court will therefore deny each Defendant’s motion to dismiss.

BACKGROUND

I. RFC’S BUSINESS

RFC is a Delaware limited liability company with its principal place of business in Minneapolis, Minnesota. (Community West Docket, Am. Compl. (“Community West Compl.”) ¶ 13, April 7, 2014, Docket No. 33.) [3] Prior to its bankruptcy in May 2012, Plaintiff RFC was in the business of acquiring and securitizing residential mortgage loans. (Id. ¶ 2.) RFC’s business model was built on acquiring loans from correspondent lenders, such as the Defendants, and distributing those loans in two ways: by pooling those loans together with similar mortgage loans to sell into residential mortgage-backed securitization (“RMBS”) trusts, or by selling them to whole loan purchasers. (Id. ¶ 3.)

RFC purchased loans from each of the Defendants here. From Defendant Community West, RFC purchased more than 75 mortgage loans with an original total principal balance of more than $25 million dollars. (Id. ¶ 4.) From Defendant PNC, RFC purchased more than 37,500 mortgage loans, with an original total principal balance of more than $7.6 billion to RFC. (PNC Docket, Am. Compl. (“PNC Compl.”) ¶ 4, Mar. 28, 2014, Docket No. 41.) From Defendant Homestead, RFC purchased more than 500 mortgage loans, with an original total principal balance of more than $66 million. (Homestead Docket, Am. Compl. (“Homestead Compl.”) ¶ 4, Apr. 25, 2014, Docket No. 28.) From Defendant Standard Pacific, RFC purchased more than 1,000 mortgage loans, with an original total principal balance of more than $350 million. (Standard Pacific Docket, Am. Compl. (“Standard Pacific Compl.”) ¶ 4, Apr. 4, 2014, Docket No. 35.)

A. Loan Purchases From Defendants

RFC alleges that it entered into contractual agreements with its correspondent lenders, including each of the Defendants, which required the lender to abide by loanlevel contractual representations and warranties. (Community West Compl. ¶ 5). These representations and warranties are set forth in the RFC Client Guides, (the “Client Guide”), which is a document created by RFC that is part of its contracts with lenders and incorporated by reference into those contracts. (See, e.g., PNC Docket, Am. Compl., Ex. A at 16 (incorporating GMAC-RFC Client Guide into loan sale contract).) RFC alleges that the Client Guide and contract “collectively form the parties’ Agreement, and set the standards to which [Defendants'] loans sold to RFC were expected to adhere.” (Id. ¶ 18.) RFC has attached excerpts of the Client Guide to each amended complaint, alleging that “[t]he complete versions of the Client Guide are known to the parties and too voluminous to attach in their entirety,” but that “the omitted portions of the Client Guides do not affect the obligations set forth in this Amended Complaint.” (Id.) RFC lists examples of the warranties and representations assured to it in the Client Guide, which include, for example, representations that

[n]o Loan is a . . . loan considered a `high-cost,’ covered, `high-risk,’ `predatory’ or any other similar designation under any State or local law in effect at the time of the closing of the loan if the law imposes greater restrictions or additional legal liability for residential mortgage loans with high interest rates, points and/or fees[,]

(id. ¶ 24(h)), and that “[t]he Loan is of investment quality, has been prudently originated and has been underwritten in compliance with all requirements of this Client Guide,” (id. ¶ 24(j)). It appears that there are several versions of the Client Guide and that various versions applied at different points in time, such that different versions apply to different loans sold to RFC by Defendants. RFC alleges that the representations and warranties in the Client Guide were “material terms” in its agreements with the banks, because if they “turned out to be false, RFC could have exposure to . . . third parties (to which it sold loans).” (Id. ¶ 25.)

RFC alleges that, as correspondent lenders, Defendants had the initial responsibility for collecting information from the borrower, verifying its accuracy, and underwriting the loans. RFC alleges that it was understood between the parties that RFC would generally not be re-underwriting the loans. (Id. ¶ 20.) The representations and warranties were important to RFC’s business because RFC took the loans it purchased from Defendants and sold them again, making its own representations and warranties. If any of Defendants’ representations and warranties turned out to be false, this could expose RFC to the third parties. (Id. ¶ 25.) Pursuant to the Client Guide, Defendants’ failure to comply with its representations and warranties or any other requirements, terms, or conditions of the Client Guide constituted an “Event of Default,” as did Defendants’ failure to provide RFC with true, accurate, and complete information in a timely manner. (Id. ¶ 26.)

RFC alleges that under its Agreements with Defendants, the Defendants expressly agreed that RFC was permitted to exercise any remedy allowed by law or in equity in connection with such Events of Default. (Id. ¶ 28.) Furthermore, RFC alleges that the Client Guide specifies the remedies available to RFC in case of an Event of Default. (Id. ¶ 29.) These remedies included, but were not expressly limited to, repurchase of the defective loan, substitution of another loan for the defective one, or indemnification against liabilities resulting from such breaches. (Id.) The repurchase provisions required Defendants to compensate RFC for defective loans according to a formula specified in the Client Guide that is based on the original principal balance of the loans. (Id. ¶ 31.) RFC also alleges that Defendants were obligated to repurchase loans and/or pay RFC the repurchase price even if the loans had already been foreclosed upon. (Id. ¶ 32.)

RFC also alleges that the Client Guide includes “broad indemnification provisions,” stating that Defendants shall indemnify RFC

from all losses, damages, penalties, fines, forfeitures, court costs and reasonable attorneys’ fees, judgments, and any other costs, fees and expenses . . . includ[ing], without limitation, liabilities arising from (i) any act or failure to act, (ii) any breach of warranty, obligation, or representation contained in the Client Guide, (iii) any claim, demand, defense or assertion against or involving [RFC] based on or resulting from such breach, (iv) any breach of any representation, warranty or obligation made by [RFC] in reliance upon any warranty, obligation or representation made by [Defendant] contained by the Client Contract. . . .

(Id. ¶ 33.)

B. Sale to Third Parties

RFC explains in the complaints that it sold the loans it acquired from the Defendants, either into RMBS trusts, which issued certificates to outside investors, or in whole loan portfolios to other mortgage companies and banks. (Id. ¶ 36.) When it sold the loans, it “passed on a more limited set of representations and warranties to the Trusts,” and “in making those representations and warranties, RFC relied on information provided to it by” Defendants, and that “that information in many cases violated [Defendants]‘ representations and warranties to RFC.” (Id. ¶¶ 36-37.)

C. Problems with Loans

RFC alleges that Defendants breached their “extensive contractual representations and warranties by delivering loans that were not originated or underwritten in accordance with the requirements of the Agreement,” and “did not meet the representations and warranties made as to those loans.” (Id. ¶ 38.) Specifically, RFC alleges that “[o]ver time, many of the loans sold” to it by Defendants “defaulted or became seriously delinquent” at rates that far exceeded “what would normally be expected in a given population of mortgage loans.” (Id. ¶¶ 39-40.) It alleges that internal reviews it conducted determined that many of the loans sold to it by the banks “violated the Client Guide and/or other representations or warranties made by [Defendants], resulting in an Event of Default under the Agreement.” (Id. ¶ 41 (alleging that “hundreds” of loans sold by Community West violated the Client Guide”); see also PNC Docket, Am. Compl. ¶ 41 (alleging that upon internal reviews of loans sold by PNC, “[m]ore than 50% of the loans reviewed were deemed to have a defect”); Homestead Docket, Am. Compl. ¶¶ 39-40 (“[m]ore than ten percent of the loans [Homestead] sold RFC and RFC securitized eventually sustained losses,” and the “delinquency and default rates far exceed what would normally be expected in a given population of mortgage loans”); Standard Pacific Docket, Am. Compl. ¶ 41 (“Internal reviews conducted by RFC determined that dozens of the loans sold to RFC by Standard Pacific violated the Client Guide . . . .”).) It alleges that “[t]ypes of defects varied, but included income misrepresentation, employment misrepresentation, insufficient credit scores, appraisal misrepresentations or inaccuracies, undisclosed debt, and missing or inaccurate documents.” (Community West Compl. ¶ 42.) It further alleges that “a number of the loans defaulted very shortly after origination (constituting Early Payment Defaults or EPDs), which is widely recognized in the industry as often signaling fraud or other problems in the origination and underwriting of the loans.” (Id.)

In each complaint, RFC then lists examples of loans with “significant and material defects violating the Client Guide representations and warranties.” (See, e.g., id. ¶ 43.) For example, the Community West complaint lists the following example:

Loan ID # 3141050 — The borrower on this loan left both of his jobs prior to the funding date, which was not disclosed at the time of funding. In addition, the borrower took out a loan during the gap period with a monthly payment of $180. Not long after the loan funded, the borrower filed for chapter 13 bankruptcy protection. The failure to disclose the borrower’s lack of employment and the additional debt made it materially riskier than represented by Community West which rendered the loan unacceptable to RFC.

(Id. ¶ 43(a).) The Community West complaint contains nine examples of defective loans. (See id.) An example listed in RFC’s complaint against Standard Pacific states:

Loan ID #10900725 — This loan’s combined loan-to-value ratio, as well as the borrower’s debt-to-income ratio, materially exceeded program guidelines and did not qualify the borrower for the terms of the loan. Review by RFC’s internal quality audit personnel also revealed the borrower had inadequate reserves and adverse credit. The loan therefore contained material breaches of Standard Pacific’s representations and warranties, including a number of those identified in paragraphs 24 and 27 above, rendering the loan unacceptable to RFC.

(Standard Pacific Compl. ¶ 43(a).) The Standard Pacific complaint includes four examples of defective loans. (See id.) The other complaints similarly include specific examples: the PNC complaint includes five examples and the Homestead complaint includes two examples. (See PNC Compl. ¶ 43; Homestead Compl. ¶ 43.) RFC does not intend for such examples “to be an exhaustive list of the loans . . . that contained material breaches of representations and warranties;” instead, “these loans represent a sampling of the material defects found in the loans . . . sold to RFC.” (Id. ¶ 44.) RFC acknowledges that, prior to the commencement of these lawsuits, the Defendants conceded that certain of their loans sold to RFC were materially defective and had already paid sums to RFC to cover those defects. RFC is not seeking to recover again on those sums. (Id. ¶ 34.)

II. BANKRUPTCY AND THIS ACTION

RFC alleges that due to the failure of Defendants and other correspondent lenders to honor their contractual representations and warranties, RFC was sued by numerous counterparties and investors in its RMBS securities, based on allegations that the loans were defective and rife with fraud and compliance problems. (Id. ¶¶ 46-50.) By May 2012, RFC was facing over two dozen lawsuits, all alleging that the loans RFC has securitized were defective, as well as claims by investors in hundreds of its RMBS securities seeking tens of billions of dollars based on loan-level problems. (Id. ¶ 8.) RFC’s complaints detail several of the lawsuits that are specific to the loans sold to RFC by each Defendant. (See, e.g., id. ¶¶ 51-55; PNC Compl. ¶¶ 54-57; Homestead Compl. ¶¶ 58-63; Standard Pacific Compl. ¶¶58-65.) All of the lawsuits alleged that “the loans RFC sold into RMBS securitizations were defective in a variety of ways, including because of borrower fraud, missing or inaccurate documentation, fraudulent or inflated appraisals, misrepresentations concerning owner-occupancy, or failure to comply with applicable state and federal law.” (Community West Compl. ¶ 57.) RFC alleges that, “[a]cross the dozens of securitizations involved in these lawsuits,” each of the Defendants were responsible for a given number of the loans involved: Community West was responsible for over 35 loans, PNC was responsible for over 11,000 loans, Homestead was responsible for over 500 loans, and Standard Pacific was responsible for over 1,000 loans. (Id. ¶ 59; PNC Compl. ¶ 62; Homestead Compl. ¶ 67; Standard Pacific Compl. ¶ 69.)

As a result of the exposure from the lawsuits, RFC filed for Chapter 11 bankruptcy protection in the Southern District of New York on May 14, 2012. (Id. ¶¶ 49, 61.) In each complaint, RFC provides specific examples of proofs of claim filed on the basis of defective loans, alleging that trustees and investors in RFC-sponsored securitizations asserted loan-level defects totaling in the millions of dollars. (Id. ¶ 62; PNC Compl. ¶ 65; Homestead Compl. ¶ 70; Standard Pacific Compl. ¶ 72.) RFC resolved its RMBS-related liabilities through bankruptcy in global settlement for over $10 billion of allowed claims in its bankruptcy case. (Id. ¶¶ 10, 65-66.) Pursuant to the Second Amended Joint Chapter 11 Plan Proposed by Residential Capital, LLC, et. al and the Official Committee of Unsecured Creditors, which took effect on December 17, 2013, ResCap Liquidating Trust succeeded to all of RFC’s rights and interests under RFC’s agreements with each of the defendants, and now controls RFC. (Id. ¶¶ 13, 66.)

RFC initiated these actions against Defendants on December 13, 2013. (Community West Docket, Compl., Dec. 13, 2013, Docket No. 1; PNC Docket, Compl., Dec. 13, 2013, Docket No. 1; Homestead Docket, Compl., Dec. 13, 2013, Docket No. 1; Standard Pacific Docket, Compl., Dec. 13, 2013, Docket No. 1.) It has since amended its complaint in all four actions. The amended complaints include two counts: one for breach of contract and one for indemnification. With its breach of contract claim, RFC alleges that it entered into an Agreement with each Defendant under which RFC acquired mortgage loans, and that pursuant to those Agreements, the banks “made representations and warranties to RFC regarding the quality and characteristics of the mortgage loans sold,” but that Defendants “materially breached [their] representations and warranties to RFC inasmuch as the mortgage loans did not comply with the representations and warranties.” (Community West Compl. ¶¶ 69-71.) RFC alleges that these material breaches constituted Events of Default under the Agreements and that RFC has been injured and suffered financial loss as a result. (Id. ¶¶ 73-74.)

With its indemnification claim, RFC alleges that it has incurred liabilities, losses, and damages on account of the defects in the loans sold to RFC and that Defendants “expressly agreed to indemnify RFC for the liabilities, losses, and damages” which RFC has incurred. (Id. ¶ 78.) It alleges that pursuant to its express contractual obligations, Defendants are obligated to compensate RFC for the portion of the global settlement associated with its breaches of representations and warranties, as well as for the portion of RFC’s other liabilities and losses, including RFC’s attorneys’ fees to defend against, negotiate, and settle claims relating to allegedly defective loans associated with those breaches. (Id. ¶ 67.)

All Defendants now move to dismiss RFC’s claims. [4] The three primary arguments presented by Defendants in favor of dismissal are that (1) RFC’s claims are time-barred because Defendants sold the loans to RFC over six years before this action was initiated in 2013, (2) RFC does not have any rights under any agreements with Defendants to assert because it assigned them all to the third-party purchasers of the loans, and (3) RFC’s allegations are inadequate and fail to state a claim. [5]

ANALYSIS

I. STANDARD OF REVIEW

In reviewing a motion to dismiss brought under Federal Rule of Civil Procedure 12(b)(6), the Court considers all facts alleged in the complaint as true to determine if the complaint states a “`claim to relief that is plausible on its face.'” Gomez v. Wells Fargo Bank, N.A., 676 F.3d 655, 660 (8th Cir. 2012) (quoting Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009) ). To survive a motion to dismiss, a complaint must provide more than “`labels and conclusions’ or `a formulaic recitation of the elements of a cause of action.'” Ashcroft, 556 U.S. at 678 (quoting Bell Atl. Corp. v. Twombly, 550 U.S. 544, 555 (2007) ). “A claim has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.” Id. “Where a complaint pleads facts that are merely consistent with a defendant’s liability, it stops short of the line between possibility and plausibility,” and therefore must be dismissed. Id. (internal quotation marks omitted). Finally, Rule 12(b)(6) “authorizes a court to dismiss a claim on the basis of a dispositive issue of law.” Neitzke v. Williams, 490 U.S. 319, 326 (1989) .

II. STATUTE OF LIMITATIONS

Defendants argue that RFC’s claims are barred by the six-year statute of limitations applicable to breach of contract and indemnification claims.

A. Breach of Contract

Under Minnesota law, breach of contract claims have a statute of limitations of a period of six years, running from the time of breach. See Minn. Stat. § 541.05, subd. 1(1); Pederson v. Am. Lutheran Church, 404 N.W.2d 887, 889 (Minn. Ct. App. 1987) . Defendants generally argue that RFC’s breach of contract claims are untimely because RFC alleges that the Agreements included representations and warranties for the loans that Defendants knew to be false at the time of the sale, such that the statute of limitations began to run when Defendants sold the loans to RFC. They assert that most of the loan sales occurred more than six years before RFC initiated these suits on December 13, 2013. RFC counters that the statute of limitations was tolled for two years when it filed for bankruptcy on May 14, 2012, so, at a minimum, loans sold after May 14, 2006 are within the statute of limitations. It does not concede that loans sold before that date are untimely, but rather argues that they may be timely depending on the facts and circumstances of the case, which is not properly resolved at the pleading stage.

1. Bankruptcy Tolling

Under 11 U.S.C. § 108(a), if a limitations period “has not expired before the date of the filing of the petition, the trustee may commence such action only before the later of” the expiration of the limitations period or two years after the final approval of the reorganization or liquidation plan. 11 U.S.C. § 108(a)(1)-(2). Although RFC is not the trustee here, it argues that it is entitled to this tolling because it is the debtor-in-possession with respect to the bankruptcy proceeding and 11 U.S.C. § 1107(a) affords a debtor-inpossession the same rights as a trustee with respect to § 108(a). See 11 U.S.C. § 1107(a) (“[A] debtor in possession shall have all the rights, other than the right to compensation under section 330(a) of this title . . . of a trustee serving in a case under this chapter.”); see also Johnson v. First Nat. Bank of Montevideo, Minn., 719 F.2d 270, 278 n.11 (8thCir. 1983) (“Although the language of § 108 refers only to the trustee, it is generally agreed that the debtor-in-possession is also entitled to the statute’s privileges.”).

RFC was the debtor-in-possession when it filed for bankruptcy on May 14, 2012 and therefore § 108(a) tolled the statute of limitations on RFC’s claims such that, when it filed these actions on December 13, 2013, any claims arising on or after May 14, 2006 were timely. Defendants make two arguments against this conclusion, neither of which is persuasive. First, Defendants point to the Eighth Circuit’s unpublished opinion in Comcast of Illinois X v. Multi-Vision Elecs., Inc., 369 F. App’x 761, 763 (8th Cir. 2010), in which it held that the district court did not abuse its discretion in concluding that a debtor’s claims were untimely despite § 108(a), because the debtor was not a trustee, and was therefore not entitled to tolling. The court there did not cite 11 U.S.C. § 1107(a), nor did it explain whether or why its conclusion might extend to a chapter 11 bankruptcy, like RFC’s here, rather than a chapter 7 bankruptcy. In light of the statute and Eighth Circuit precedent, see Johnson, 719 F.2d at 278 n.11, Comcast does not deprive RFC of bankruptcy tolling here.

Second, Defendants argue that when the global settlement plan was approved on December 11, 2013, (see Community West Compl. ¶ 10), RFC no longer existed as an entity and was replaced by a liquidating trust, such that RFC could not benefit from tolling when it filed these actions on December 13, 2013. But the plan did not become effective until December 17, 2013, (id. ¶ 66), and the Court treats the plan’s effective date as the relevant date for determining whether RFC remained in existence as the debtor-in-possession. Even if RFC could be considered to have dissolved into the liquidating trust before the filing of this action, some courts have held that liquidating trusts in this situation are entitled to § 108(a) tolling as a representative of the estate. Antioch Litig. Trust v. McDermott Will & Emery LLP, 500 B.R. 755, 763 (S.D. Ohio 2013) (permitting trust, as representative of the estate, to toll claims under § 108(a), observing that “[o]ther courts have concluded that estate representatives, other than a trustee or a debtor-in-possession, can invoke the tolling provisions of Section 108,” and that “[t]he Trust is acting on behalf of a debtor-in-possession, as a representative of its estate, and is pursuing claims that belonged to the debtor for the benefit of the debtor’s creditors”). The Court therefore concludes that the tolling provision in § 108(a) renders timely RFC’s claims for loans sold on or after May 14, 2006.

2. Loans Sold Before May 14, 2006

RFC does not concede that loans sold before May 14, 2006 are time barred, and instead argues that it would be premature to dismiss claims based on those loans because, depending on the facts of each loan, its claims for breaches of the warranties and representations may be timely. In support, it cites to cases that indicate that where contracts involving continuing performance over time or where “future event[s] . . . will determine whether” a contract is breached, “the statute does not begin to run until the happening of such future event.” City of Pipestone v. Wolverine Ins. Co., Civ. No. 4-84-634, 1985 WL 1845, at *4 (D. Minn. June 28, 1985); see also Moore v. Medtronic, Inc., Civ. No. 99-2066, 2001 WL 1636248, at *2 (D. Minn. July 30, 2001) (“Where a contract provides for continuing performance over a period of time, each breach may begin the running of the statute anew such that accrual occurs continuously.” (internal quotations omitted)).

RFC has not demonstrated how any of its allegations suggest that Defendants’ alleged breaches could be the type that occurred over time or after the initial sale of the loan. Nor does it explain how Defendants could be liable in the event that the circumstances for a loan changed after its initial sale to RFC such that the representations and warranties became false at a date later than the initial sale. Cf. Residential Funding Co., LLC v. Mortgage Access Corp., Civ. No. 13-3499, 2014 WL 3577403 (D. Minn. July 21, 2014) (observing that the defects RFC alleges were present in the loans — income misrepresentation, employment misrepresentation, owner occupancy misrepresentations, appraisal misrepresentations or inaccuracies, undisclosed debt, and missing or inaccurate documents — “occur at the time a loan is underwritten, not at some later date,” and dismissing as untimely RFC’s claims for loans sold before May 14, 2006). The Court will therefore grant Defendants’ motion to dismiss with respect to RFC’s claims for loans it purchased from Defendants prior to May 14, 2006. [6]

B. Indemnification

Defendants also argue that RFC’s indemnification claims are barred by the statute of limitations. “Under the common law, the right of indemnity does not accrue until the liability of the party seeking indemnity has become finally fixed and ascertained, or until after the claimant has settled or has paid the judgment or more than a commensurate share of it.” Metro. Prop. & Cas. Ins. Co. v. Metro. Transit Comm’n, 538 N.W.2d 692, 695 (Minn. 1995) (internal quotations omitted). Here, RFC’s losses were presumably fixed or attained during the bankruptcy proceeding, which began in May 2012.

But Defendants argue that this common law rule does not apply here because RFC’s indemnification claims are too intertwined with its contract claims and are therefore governed by the statute of limitations for its contract claims, which is six years from the initial sale of the loan. They argue that, because RFC has the right to seek repurchase of the loans in the event of a failure of a representation or warranty, the relevant statute of limitations for indemnification should be the same date as it would be for repurchase. Citing two cases from other districts, they argue that such date would be the sale of the loan. See Lehman Bros. Holdings, Inc. v. Evergreen Moneysource Mortg. Co., 793 F. Supp. 2d 1189 (W.D. Wash. 2011) ; Lehman Bros. Holding Inc. v. Standard Pacific Am. Mortg. Co., Civ. No. 13-cv-930, 2014 WL 1715365 (D. Colo. April 30, 2014). But both cases involved a different factual circumstance than is present here: in both, the plaintiff-loan purchasers made demands for payment upon the defendant-loan sellers, which were refused. In Universal American Mortgage, the court found that plaintiff’s breach of contract claim accrued at the time it purchased the mortgage from defendants, not when it repurchased the allegedly defective loan from the third-party purchaser to which it had sold the loan. 2014 WL 1715365, at *3. The court also rejected plaintiff’s alternative argument that the suit was timely because the defendants’ failure to repurchase the loan within thirty days of the plaintiff’s demand was an independent breach, starting its own statute of limitations. Id. at *4.

In Evergreen, the court similarly rejected Plaintiff’s argument that the statute of limitations for breach of contract action did not begin to run until after the defendant refused, by letter, to indemnify plaintiff for losses it suffered on a loan purchased from defendant. 793 F. Supp. 2d at 1194 . The court reasoned that the defendant’s duty to “indemnify for losses incurred as a result of a mortgage loan is only triggered by a breach of any of the representations, warranties, or covenants” and that New York carries a six-year statute of limitations from the date of the first alleged breach of a contract. Id. (internal quotations omitted). The court also rejected what it considered to be plaintiff’s attempt to “improperly circumvent statutes of limitations by simply recasting their claims [for breach of contract] as ones for indemnity.” Id. at 1199 n.2. Significantly, the plaintiff in Evergreen did not allege that it suffered any liability to a third party. Id.

The Court concludes that RFC’s claim for indemnification accrued, at the earliest, when it filed for bankruptcy in May 2012. This is not a case where the plaintiff has made a demand for indemnification upon a defendant pursuant to a contractual provision, which was refused. In that circumstance, if the plaintiff believed the refusal to be contrary to a contractual provision, it would give rise to a breach of contract claim, not necessarily an indemnification claim. But here, where RFC alleges that it has been ordered to make payments to third parties on account of mistakes for which it alleges Defendants are required to indemnify it, it would not make sense for the statute of limitations to have accrued at the original sale. Such a rule would leave open the possibility that a plaintiff was required to file a lawsuit for indemnification before any judgment or order for it to make payment to a third party was final, in order for the plaintiff to preserve a claim’s timeliness. The rulings in Evergreen and Universal American Mortgage do not pose such a challenge because there, the adverse judgment or demand for payment had been made upon the plaintiff such that the amount and details of the indemnification demand against the defendant were known. Without further support from Minnesota case law to ignore its clear rule regarding the application of the statute of limitations for indemnity claims, the Court declines to adopt the restrictive interpretation urged by Defendants. Cf. Discovery Grp. LLC v. Chapel Dev., LLC, 574 F.3d 986, 989 (8th Cir. 2009) (applying Missouri law, and holding that where third-party claims against plaintiff “remained unresolved . . ., the full measure of their losses in defending against [the third-party] claims was not yet sustained or capable of ascertainment, so their cause for indemnity had not yet accrued”). The Court therefore concludes that RFC’s claims for indemnification are timely. [7]

III. STANDING

Defendants argue that RFC lacks standing to bring these claims against them because RFC assigned its rights in the loans to third-party purchasers. They point to RFC’s agreements with its third-party purchasers, arguing that under the terms of those agreements, RFC assigned to the purchasers any contract rights it had against the banks, and that a “breach-of-contract claim cannot be maintained when the rights vested in the contract have been assigned to another party.” Dunn v. National Beverage Corp., 729 N.W.2d 637, 648 (Minn. Ct. App. 2007), aff’d, 745 N.W.2d 549 (Minn. 2008) .

In making this argument, Defendants point to the securitization agreements that RFC had with its purchasers, which are not part of RFC’s pleadings. For example, PNC points to loans listed as examples in RFC’s complaint, which are covered by securitization agreement 2005-KS2 AA, which it includes as an exhibit to its counsel’s declaration. (See Decl. of Richard A. Gottlieb, Ex. 8, Apr. 25, 2014, Docket No. 50.) It points to language in that securitization agreement that states:

Concurrently with the execution and delivery hereof, RFC hereby assigns to the Company, and the Company hereby assumes, all of RFC’s rights and obligations under the Seller Contracts with respect to the Mortgage Loans to be serviced under the Pooling and Servicing Agreement, insofar as such rights and obligations relate to (a) any representations and warranties regarding a Mortgage Loan made by a Seller under any Seller Contract and any remedies available under the Seller Contract for a breach of any such representations and warranties if (i) the substance of such breach also constitutes fraud in the origination of the Mortgage Loan or (ii) the representation and warranty relates to the absence of toxic materials or other environmental hazards that could affect the Mortgaged Property, or (b) the Seller’s obligation to deliver to RFC the documents required to be contained in the Mortgage File and any rights and remedies available to RFC under the Seller Contract in respect of such obligation or in the event of a breach of such obligation; provided that, notwithstanding the assignment and assumption hereunder, RFC shall have the concurrent right to exercise remedies and pursue indemnification upon a breach by a Seller under any Seller Contract of any of its representations and warranties.

(Id. at 10, ¶ 6 (emphasis added).) PNC does not quote the emphasized portion at the end. Defendants do not exhaust all of the applicable securitization agreements, but argue that these are illustrative of the assignment language applicable to RFC’s securitization agreements with purchasers. Defendants point to this contractual language as demonstration that RFC assigned away its rights, including the right to bring suit against Defendants, when it sold loans to the third-party purchasers.

The Court finds that, at this pleading stage, RFC has adequately alleged that it has standing to assert its rights in the loan sale Agreements with Defendants. First, the Court observes that this argument is based upon documents not included in RFC’s pleadings. Although the Court may consider documents “necessarily embraced by the pleadings,” Saterdalen v. Spencer, 725 F.3d 838, 841 (8th Cir. 2013) (internal citation and quotations omitted), the connection between RFC’s pleadings and the securitization agreements upon which Defendants rely is thin. RFC alleges that it “sold the[] loans to RMBS trusts and whole loan purchasers,” and that when it “sold the loans, it passed on a more limited set of representations and warranties to the Trusts, and, as required by SEC regulations, disclosed pertinent information about the loans to investors in the RMBS.” (Community West Compl. ¶¶ 25, 37.) Defendants have not pointed to any other provisions of RFC’s complaints that arguably relate to the securitization agreements. These allegations do not mention any contract between RFC and the third parties, much less any contractual arrangements under which RFC assigned its rights in the loan agreements. The Court concludes that the securitization agreements are not necessarily embraced by the pleadings, and therefore does not consider them at this stage in the proceeding. [8]

However, even if the Court were to consider the third-party agreements, the Court would conclude that they raise factual issues that are not properly resolved at this pleading stage. At a minimum, the language from the portion of the agreement referenced by PNC does not unambiguously support Defendants’ position. Although it states that “RFC hereby assigns . . . all of RFC’s rights and obligations under the Seller Contracts with respect to the Mortgage Loans,” it later includes a disclaimer “that, notwithstanding the assignment and assumption hereunder, RFC shall have the concurrent right to exercise remedies and pursue indemnification upon a breach by a Seller under any Seller Contract of any of its representations and warranties.” (Gottlieb Decl., Ex. 8 at 10, ¶ 6.) The Court cannot conclude that this language, which PNC points to as an example of the assignments, deprives RFC of standing to assert rights under the Agreements. Cf. Maniolos v. United States, 741 F. Supp. 2d 555, 567 (S.D.N.Y. 2010), aff’d, 469 F. App’x 56 (2d Cir. 2012) (“[W]hen the language of a contract is ambiguous, its construction presents a question of fact, which of course precludes summary dismissal on a Rule 12(b)(6) motion.” (internal quotations omitted)). The Court concludes that RFC has plausibly alleged that it has standing to assert its rights in the Agreements against Defendants.

IV. ADEQUACY OF THE PLEADINGS

A. Breach of Contract

Defendants argue that RFC has failed to allege specific facts that adequately state a claim for breach of contract. In essence, they argue that, while RFC’s complaints allege generally that loans it purchased from lending institutions were likely defective and partially responsible for the lawsuits by third-parties for which RFC has now resolved in a $10 billion settlement, RFC’s allegations fail to specifically allege that the individual loans it purchased from Defendants caused any of RFC’s injuries. Defendants’ arguments focus on the level of detail of the allegations with regard to the defects in the loans in many respects. First, they argue that RFC fails to identify the loans in a way that allows Defendants to identify the loans because in the attachments to the complaints RFC uses the identifying loan numbers that RFC has assigned to the loans, not the numbers that the Defendants used. Second, they argue that RFC’s allegations fail to identify the contracts that Defendants allegedly breached, because different versions of the Client Guide were in effect at different times, and RFC does not indicate what language from each Client Guide applies to each allegedly defective loan. Third, they argue that RFC’s allegations fail to identify which representations and warranties were violated with regard to loans, or how Defendants had violated them. Finally, they argue that RFC’s allegations fail to identify how Defendants or any of their alleged conduct caused any of the damages RFC alleges it suffered. Defendants argue that without allegations of these details with regard to each allegedly defective loan, RFC has not provided them with adequate notice of the claims against them and has failed to plausibly allege that Defendants breached any loan sale Agreements in a way that actually caused RFC injury.

RFC argues that its allegations suffice to state claims against Defendants for breach of contract, because it is not necessary to plead with specificity with regard to each individual loan it alleges is defective. Rather, it argues that its pleadings adequately give rise to a plausible inference that Defendants breached their contracts with RFC if it both gives examples of the types of defects in the loans and includes allegations making it plausible that the defects were widespread. It argues that it has adequately pleaded as much because the complaint and exhibits list which loans are at issue (see, e.g., Community West Compl., Ex. C), how the loans are defective and which contract provisions those defects violate, that these defects were widespread, and how they harmed RFC. RFC also argues that case law indicates that loan-level allegations are not required to survive a motion to dismiss. In particular, it points to Ace Securities Corp. Home Equity Loan Trust, Series 2007-HE3 ex rel. HSBC Bank USA, Nat. Association v. DB Structured Products, Inc. (“Ace Securities”), Civ. No. 13-1869, 2014 WL 1116758 (S.D.N.Y. Mar. 20, 2014), an action brought by trusts which had purchased securitizations against the sponsor of those securitizations — so akin to the third-party investors here bringing an action against RFC. There, the plaintiff alleged that the defendant failed to repurchase loans which would have been eligible for repurchase on account of defects that violated representations and warranties the defendant made to plaintiffs. Id. at *1-4. The relevant contract required the plaintiff to send a notice to the defendant whenever it discovered a breach of representations and warranties. Id. at *4. Some of the notices were included in the pleadings, and “provided, for each loan as to which a breach had been identified, the loan number, the specific representations and warranties that had been breached, the specific subsections of the MLPA setting forth those representations and warranties, and a description of the facts establishing the breaches.” Id. The court held that the plaintiff’s allegations sufficed to meet the plausibility standard in Twombly and Iqbal, observing that “a complaint for repurchase need not contain specific allegations regarding each loan at issue,” and that “many courts have accepted statistical `sampling’ as a means of demonstrating liability.” Id. at *13 & n.9.

Defendants argue that Ace Securities does not help RFC here because it is a different kind of case — one by investors against the sponsor of securitizations rather than a case by the sponsor against loan originators — and while sampling may be acceptable in an RMBS securitization case, it is not here, where Defendants sold individual loans rather than securitizations to RFC. Defendants further argue that, even if the court’s holding in Ace Securities that loan-level allegations are not necessary applies here, the allegations there were far more detailed than those here, as the notices with specific information about many of the loans at issue were included in the pleadings. The Court recognizes the distinction between an RMBS case against a securitization sponsor as in Ace Securities and RFC’s claims against the loan originators, and thus does not find that case to be dispositive of whether loan-level allegations are necessary here. [9]

Instead, examining RFC’s allegations in light of the elements of a breach of contract claim under Minnesota law, the Court concludes, drawing on “its judicial experience and common sense,” Iqbal, 556 U.S. at 679, that RFC’s allegations here adequately give rise to a plausible inference that Defendants breached the representations and warranties in its loan sale Agreements with RFC without loan-level allegations. Residential Funding Co., LLC v. Broadview Mortgage Corp., Civ. No. 13-3463, 2014 WL 4104819, at *5 (D. Minn. Aug. 19, 2014) (“RFC will not be required to plead with loan-by-loan specificity in the cases at issue here. Requiring such specificity in cases involving hundreds or thousands of loans contravenes the requirement of pleading a `short and plain statement’ of claims.” (quoting Fed. R. Civ. P. 8(a)).

To adequately plead a cause of action for breach of contract under Minnesota law, a plaintiff must show (1) formation of a contract, (2) performance by the plaintiff of any conditions precedent, (3) breach of the contract by defendants, and (4) damages. General Mills Operations, LLC v. Five Star Custom Foods, Ltd., 703 F.3d 1104, 1107 (8th Cir. 2013) . The parties do not dispute the first two elements. Looking to whether RFC has adequately alleged that Defendants breached their Agreements with RFC, the Court concludes that RFC has adequately alleged which provisions Defendants breached and how it breached them. It is sufficient that RFC alleges that Defendants breached the representations and warranties provisions of the Client Guide and listed specific examples of the representations and warranties it breached. (See, e.g., Community West Compl. ¶ 24.) To the extent that Defendants argue that this is inadequate because RFC does not allege specifically which representations and warranties were false with respect to each individual loan, as the Court explains below, that level of specificity is not necessary to bring these allegations past “the line between possibility and plausibility of `entitlement to relief.'” Iqbal, 556 U.S. at 678 (quoting Twombly, 550 U.S. at 557 ). [10]

RFC has also plausibly alleged how Defendants breached the representations and warranties. It lists examples of defective loans for each Defendant in each complaint, explaining how those example loans breached representations and warranties. (See, e.g., Community West Compl. ¶ 43(a); Homestead Docket, Am. Compl. ¶ 43(a).) Defendants make various arguments as to why these examples are faulty, including, for example, that they have already been repurchased, were sold before May 14, 2006, or are simply too few to support plausible allegations that other loans were similarly defective. But RFC includes extensive other allegations that support a plausible inference that the types of problems identified in the examples are widespread. It alleges that the loans it purchased from Defendants had high delinquency and default rates — higher than what would have been expected in a normal population of loans — and that many of the loans defaulted shortly after origination, which “is widely recognized in the industry as often signaling fraud or other problems in the origination and underwriting of the loans.” (Community West Compl. ¶¶ 39-40, 42.) It also alleges that it undertook its own internal review, which determined that many of the loans sold to RFC by Defendants violated the Client Guide and other representations and warranties. (Id. ¶ 41.) Furthermore, RFC alleges that with the loans at issue, it sought repurchase of loans from Defendants at higher rates than average. For example, RFC alleges that it “ordinarily received a limited number of repurchase demands,” but that in 2007 it began to receive repurchase demands and repurchased over $340,000 worth of loans from a bank affiliated with PNC. (PNC Docket, Am. Compl. ¶¶ 51-52.) Taken as a whole, these allegations support a plausible inference that defects such as those listed in the example loans in each complaint were widespread. Cf. Broadview Mortgage, 2014 WL 4104819, at *6 (“The higher than normal delinquency and default rates of Defendants’ loans plausibly demonstrate a failure in underwriting procedures.”); but see Residential Funding Co., LLC v. Embrace Home Loans, Inc., Civ. No. 13-3457, 2014 WL 2766114, at *5 (D. Minn. June 18, 2014) (“RFC is asking the Court to make a leap: some of Embrace’s loans sustained losses or went into early default, therefore Embrace breached its representations and warranties. This leap is unsupported by the facts pled.”). RFC has adequately alleged that, by selling loans with these types of defects, Defendants breached the representations and warranties in the Client Guide.

Finally, RFC has also adequately alleged that these breaches caused the losses RFC has faced and continues to face on account of its liability to trusts and third-party investors. RFC alleges that its RMBS offerings “included a number of RMBS that became the subject of more than a dozen lawsuits brought by investors and other participants in the securitizations, alleging that an abnormally high percentage of the loans contained in the RMBS offerings were defective in one or more ways.” (PNC Docket, Am. Compl. ¶ 50.) On this point, Defendants similarly argue that RFC has failed to specifically allege how the loans that each of them sold to RFC caused the loss to the securitization trusts, particularly where the loans from each Defendant may have amounted to a very small percentage of the loans in any given securitization. This argument is best left for later stages in the proceeding — whether the effect of defects in a very small number of loans in the context of a securitized batch of loans is enough to cause any loss suffered by the security as a matter of law is a fact-specific inquiry. The Court declines this invitation to convert this causation of damages question to one for summary judgment. Where RFC has plausibly alleged that the loans that Defendants sold contained defects that violated the representations and warranties and that it was sued on account of securitizations, where high percentages of the loans in the securitizations were defective, it has adequately alleged that defects in Defendants’ loans caused the losses RFC now faces. [11]

B. Indemnification

Defendants also argue that RFC has failed to adequately allege a claim for indemnification. In making this argument, Defendants reiterate arguments they made with regard to the damages element in RFC’s breach of contract claim — for example, that RFC fails to plead how defective loans from Defendants caused RFC’s losses, which is required by the indemnification clause in the Client Guide. The Court, as explained above, finds that the sum of RFC’s pleadings suffice to allege that Defendants’ defective loans caused RFC’s losses, even when those loans were combined with many others in securitizations and may have accounted for only a small portion of the security. Defendants also argue that RFC’s allegations fail to account for the possibility of RFC’s wrongdoing and amount to fraud allegations, neither of which would entitle it to indemnification under the Client Guide. But this argument ignores the standard of review on a motion under Rule 12(b)(6) — the Court accepts RFC’s allegations as true. If Defendants believe there are facts indicating that RFC is not, in fact, entitled to the relief it seeks, they should raise those arguments at later stages in this proceeding. The Court concludes that RFC has alleged a plausible claim for relief for indemnification.

ORDER

Based on the foregoing, and the records, files, and proceedings herein, IT IS HEREBY ORDERED that Defendants’ Motions to Dismiss [Civ. No. 13-3468, Docket No. 38; Civ. No. 13-3498, Docket No. 47; Civ. No. 13-3520, Docket No. 30; Civ. No. 13-3526, Docket No. 49] are DENIED in part and GRANTED in part as follows:.

1. The motions are DENIED with respect to Count II and with respect to Count I for loans sold on or after May 14, 2006.

2. The motions are GRANTED with respect to Count I for loans sold before May 14, 2006. Count I with respect to the loans sold before May 14, 2006, is DISMISSED with prejudice.

[1] See, e.g., Residential Funding Co., LLC v. Broadview Mortgage Corp., Civ. No. 13-3463, 2014 WL 4104819 (D. Minn. Aug. 19, 2014); Residential Funding Co., LLC v. Stearns Lending, Inc., Civ. No. 13-3516, 2014 WL 4186486 (D. Minn. Aug. 22, 2014); Residential Funding Co., LLC v. Americash, Civ. No. 13-3460, 2014 WL 3577312 (D. Minn. July 21, 2014); Residential Funding Co., LLC v. Mortgage Access Corp., Civ. No. 13-3499, 2014 WL 3577403 (D. Minn. July 21, 2014); Residential Funding Co., LLC v. Embrace Home Loans, Inc., Civ. No. 13-3457, 2014 WL 2766114 (D. Minn. June 18, 2014).

[2] The Court addresses Defendants’ motions to dismiss in their respective cases in this consolidated memorandum opinion and order because the motions raise similar legal issues. The order will distinguish between the cases by noting docket items in RFC v. Community West Bank, N.A., Civ. No. 13-3468, as “Community West Docket;” docket items in RFC v. PNC Bank, N.A., Civ. No. 13-3498, as “PNC Docket;” docket items in RFC v. Homestead Funding Corp., Civ. No. 13-3520, as “Homestead Docket;” and docket items in RFC v. Standard Pacific Mortgage, Inc., Civ. No. 13-3526, as “Standard Pacific Docket.”

[3] The amended complaints in each case are substantially similar, with the exception of examples specific to each defendant, which do not affect the numbering of the paragraphs across each complaint. For general background not specific to each Defendant, this Order will cite to the operative complaint against Defendant Community West for the sake of simplicity.

[4] RFC initially filed motions to transfer these actions to bankruptcy court in S.D.N.Y. but has since withdrawn those motions. (Community West Docket, Letter, June 4, 2014, Docket No. 47; PNC Docket, Letter, June 4, 2014, Docket No. 60; Homestead Docket, Letter, June 4, 2014, Docket No. 35; Standard Pacific Docket, Letter, June 4, 2014, Docket No. 63.)

[5] Although Defendants each raise slightly different variations on each of these main arguments, the Court addresses all of Defendants’ arguments collectively and does not distinguish between which Defendants made which version of an argument.

[6] RFC also argues that its claims for loans purchased before May 14, 2006 may proceed because statute of limitations is an affirmative defense, and not appropriate for resolution on a motion under Rule 12(b)(6). See, e.g., Walker v. Barrett, 650 F.3d 1198, 1203 (8th Cir. 2011) (“[A]s a general rule, the possible existence of a statute of limitations defense is not ordinarily a ground for Rule 12(b)(6) dismissal.” (internal quotations omitted)). But the general rule that statute of limitations is not a ground for dismissal under Rule 12(b)(6) is excepted when the “complaint itself establishes the defense.” Jessie v. Potter, 516 F.3d 709, 713 (8th Cir. 2008) . As explained above, RFC’s complaints do not include any allegations giving rise to a plausible inference that its claims are for continuing breaches of representations and warranties or that Defendants breached the contracts after the initial sale. To the extent that RFC argues that the Client Guide provides for remedies for the full life of the loans, that does not establish that RFC may seek remedies for breaches on the basis of representations and warranties becoming false after the initial sale, but rather that it is not precluded from seeking remedies for breaches of representations and warranties after the initial sale of the loans.

[7] The Court has received and reviewed Defendant Standard Pacific’s supplemental filing notifying the Court of the recent disposition in Lehman Brothers Holdings, Inc. v. Universal American Mortgage Co., LLC, Civ. No. 13-92 (D. Colo. Aug. 28, 2014). (See Letter to District Judge, Sept. 2, 2014, Docket No. 75.) The reasoning and ruling in that case does not alter the Court’s conclusion regarding the statute of limitations here.

[8] Defendants also argue that these agreements are properly considered at the pleading stage because they are public records filed with the SEC. The Court nevertheless declines to consider the documents at this stage, because Defendants rely on them to prove the truth of their contents in order to prevail on a fact dispute with RFC over whether RFC has assigned the rights it asserts here to third-party investors. See Lovelace v. Software Spectrum Inc., 78 F.3d 1015, 1018 (5th Cir. 1996) (adopting rule that public SEC documents may be considered “only for the purpose of determining what statements the documents contain, not to prove the truth of the documents’ contents”); see also Hennessy v. Penril Datacomm Networks, Inc., 69 F.3d 1344, 1354 (7th Cir. 1995) (“Given that there was considerable argument over the significance of the 10-K form, the judge properly found that its contents were subject to dispute.”). To the extent that Defendants argue that these documents are not intended to prove that RFC does not have standing, but rather to illustrate that RFC has failed to adequately allege that it has standing, that is a distinction without a difference.

[9] Plaintiffs also point to Oklahoma Police Pension & Retirement System v. U.S. Bank National Ass’n, 291 F.R.D. 47 (S.D.N.Y. 2013), another RMBS case in which investors sued the trustee for fourteen RMBS trusts. Id. at 51-52. As in Ace Securities, the court denied the defendant’s motion to dismiss, observing that plaintiffs “allege[d] that there have been significant losses in the Covered Trusts, that the mortgage files were riddled with document deficiencies, that federal and state investigators have uncovered widespread abuses in such files, and that there were numerous document deficiencies found in the public records of the foreclosures on two of the Covered Trusts,” and further finding sufficient plaintiff’s allegations that the trusts “performed extremely poorly, that there is documented evidence of irregularities in other, similar trusts, and that the seller repurchased less than 1% of the mortgage loans in the Covered Trusts.” Id. at 66-67, 69. Like Ace Securities, the claims at issue in Oklahoma Police Pension & Retirement System are distinct enough from those at issue that the Court does not find the reasoning there to be dispositive with regard to the adequacy of RFC’s allegations here.

[10] Defendants also argue that RFC’s breach of contract allegations are inadequate because RFC does not distinguish between the various versions of the Client Guide nor indicate which version of the Client Guide applies to which loan. RFC attached excerpts of the Client Guide to its complaints (see, e.g., Community West Compl., Ex. B) and alleges that “[t]he complete versions of the Client Guide are known to the parties and too voluminous to attach in their entirety,” but that “the omitted portions of the Client Guides do not affect the obligations set forth in this Amended Complaint.” (Id. ¶ 18.) RFC has adequately alleged that the Client Guide provides the relevant representation and warranties terms, and Defendants do not challenge their facial validity. Rather, counsel for Standard Pacific indicated at oral argument that RFC’s excerpting of the Client Guide was problematic for Standard Pacific because it no longer had in its possession the Client Guides it agreed to for the loan sales to RFC. This is a problem and dispute for discovery and later stages in this proceeding, not the pleading stage, the purposes for which RFC’s allegations suffice.

PNC also argues that RFC’s allegations about the applicability of the Client Guide is faulty because Commitment Letters, which were also part of the loan sale Agreements and which controlled over the Client Guide in the event of a conflict, state that the loans were governed by the seller’s underwriting guidelines, not RFC’s. (See PNC Docket, Mem. in Supp. of Mot. to Dismiss at 15, Apr. 25, 2014, Docket No. 49.) The Court accepts as true RFC’s allegation that the Client Guide governed the loan sales at this pleading stage. PNC’s challenge to the accuracy of that allegation must wait for later stages in this proceeding.

[11] At oral argument, counsel for Defendants informed the Court that they had received voluminous documents the week before the hearing, allegedly listing additional loans. Defendants argued that these filings undermine the adequacy of RFC’s pleadings because the loans in the new documents do not match the lists of loans attached in exhibits to the complaint. RFC explained that it submitted the documents to Defendants as part of voluntary discovery and therefore was not improper, nor does it alter the pleadings in the complaint. The Court does not consider the apparent submission of these documents, which were not provided to it and which it has not reviewed, as either improper or altering its analysis of the adequacy of RFC’s pleadings.

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New Bankruptcy Opinion: IN RE WATERFORD FUNDING, LLC – Bankr. Court, D. Utah, 2014

In re: Waterford Funding, LLC et al., Chapter 11, Debtors.

Gil A. Miller, Chapter 11 Trustee for Waterford Funding, LLC et al., Plaintiff,

v.

Mark Lambourne, Defendants.

Bankruptcy No. 09-22584, Adversary Proceeding No. 11-2012.

United States Bankruptcy Court, D. Utah.

September 30, 2014.

MEMORANDUM DECISION ON MOTION TO COMPEL ABANDONMENT

R. KIMBALL MOSIER, Bankruptcy Judge.

This matter came before the court on the 3rd Day of July, 2014 on the motion of Mark Lambourne (Defendant) filed under 11 U.S.C. § 554(b) seeking an order of the Court compelling abandonment of adversary proceeding case no. 11-2012, Miller v. Lambourne. Lon A. Jenkins and Sara Goldberg of Dorsey & Whitney LLP appeared on behalf of Gil A. Miller the chapter 11 trustee (Trustee), and Alan L. Smith appeared on behalf of Defendant. After considering the pleadings and argument of counsel, the Court issues this memorandum.

I. BACKGROUND

Waterford Funding, LLC and Waterford Loan Fund, LLC filed voluntary petitions under Chapter 11 of the Bankruptcy Code on March 20, 2009 (Petition Date). On January 6, 2010, the Trustee was appointed to serve as the Chapter 11 Trustee. Having entered orders substantively consolidating each of the Debtor entities as of the Petition Date, the Trustee presently serves as the Chapter 11 Trustee for Waterford Funding, LLC, Waterford Services, LLC, Waterford Loan Fund, LLC, Waterford Perdido, LLC, Waterford Candwich, LLC and Investment Recovery, LLC (collectively “Waterford”).

On January 3, 2011, the Trustee commenced this adversary proceeding which is brought under 11 U.S.C. §§ 544, 548, 550, 551, 502(d) [1] and various state law claims seeking recovery of $355,477.86 from Defendant.

Defendant seeks an order compelling abandonment of AP 11-2012 arguing that because Defendant has no assets, has a negative net worth and may file bankruptcy, the adversary proceeding is burdensome to the estate or that it is of inconsequential value and benefit to the estate.

The Trustee opposes the motion arguing that the Trustee has no intention of abandoning the adversary proceeding, and that the Trustee is not persuaded that a judgment against Defendant would be uncollectible.

II. ANALYSIS

Defendant’s motion is brought under § 554. Section 554(b) of the United States Bankruptcy Code provides as follows:

(b) On request of a party in interest and after notice and a hearing, the court may order the trustee to abandon any property of the estate that is burdensome to the estate or that is of inconsequential value and benefit to the estate.

Fundamental to any motion brought under § 544(b) is that the motion must seek abandonment of “property of the estate”. Section 541 defines property of the estate. The scope of § 541(a)(1) is broad, [2] and all interests of the debtor become property of the bankruptcy estate, including causes of action. [3] However, the adversary proceeding at issue, as opposed to property that may be recovered as a result of the adversary proceeding, is not property of the estate. Section 541(a)(3) states that property of the estate includes “any interest in property that the trustee recovers under section 329(b), 363(n), 543, 550, 553, or 723 of this title.” Adversary proceedings brought by a trustee pursuant to his avoiding powers are not included in the §541 definition of property of the estate. Until a trustee actually recovers property pursuant to his avoiding powers, it is not property of the estate. [4]

A trustee’s avoidance powers are granted to the trustee by the bankruptcy code and are clearly of value to the estate. But if the trustee’s avoidance powers are deemed to be property of the estate, creditors and even defendants, as in this case, would be able to create mischief in the trustee’s administration of the bankruptcy estate by challenging the Trustee’s business judgment. Creditors, and particularly defendants in avoidance actions, should not be permitted to interfere with the trustee’s judgment regarding his exercise of his avoidance powers. Because avoidance actions, as opposed to property recovered as a result of avoidance actions, are not property of the estate, § 554(b) has no application to the Trustee’s avoidance action against Mr. Lambourne. For the above reasons, Defendant’s motion to compel abandonment under § 554 must be denied.

[1] Statutory references herein are to Title 11 of the United States Code, unless stated otherwise.

[2] See United States v. Whiting Pools, Inc., 462 U.S. 198 (1983) .

[3] Mauerhan v. Wagner Corp., 649 F.3d 1180 n.3 (10th Cir. 2011) .

[4] Rajala v. Gardner, 709 F.3d 1031, 1038 (10th Cir. 2013) .

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New Bankruptcy Opinion: IN RE TWIN PEAKS FINANCIAL SERVICES, INC. – Bankr. Court, D. Utah, 2014

In re: Twin Peaks Financial Services, Inc., aka Kenneth C. Tebbs, aka MNK Investments, Inc., and MNK Investments, Chapter 7, Debtor.

Duane H. Gillman, as Chapter 7 Trustee, Plaintiff,

v.

Christopher Russell aka Chris Russell, an individual, Defendant.

Bankruptcy Case Nos. 07-25399, 07-25401, Adversary No. 09-02687, Substantively Consolidated as 07-25399.

United States Bankruptcy Court, D. Utah.

September 30, 2014.

MEMORANDUM DECISION ON TRUSTEE’S MOTION FOR SUMMARY JUDGMENT ON COUNT 2 OF COMPLAINT (AVOIDANCE OF FRAUDULENT TRANSFERS UNDER § 548 AND LIABILITY OF TRANSFEREE UNDER § 550)

R. KIMBALL MOSIER, Bankruptcy Judge.

The Trustee’s motion for summary judgment came before the Court on January 15, 2014. Kenneth L. Cannon II and Ian S. Davis of Durham Jones & Pinegar, P.C. appeared on behalf of Duane H. Gillman, the Chapter 7 Trustee (Trustee). Jerome Romero of Jones, Waldo, Holbrook & McDonough, P.C. appeared on behalf of Christopher Russell, the defendant (Defendant) in this adversary proceeding. On February 20, 2014, the Court entered an Order granting the Trustee’s motion for summary judgment with respect to Count 1 of the complaint, which was brought under 11 U.S.C. §§ 547 and 550. After considering the pleadings and argument of counsel, the Court makes the following findings and conclusions with respect to Count 2 of the complaint.

I. JURISDICTION

The Court’s jurisdiction over this adversary proceeding is properly invoked under 28 U.S.C. § 1334(b) and § 157(a) and (b). The Trustee’s motion seeks an order of this Court avoiding an alleged fraudulent transfer pursuant to 11 U.S.C. § 548, [1] making this a core proceeding under 28 U.S.C. § 157(b)(2)(H). The Court may enter a final order. Venue is proper under the provisions of 28 U.S.C. § 1409.

II. PROCEDURAL BACKGROUND

The bankruptcy cases of Twin Peaks Financial Services, Inc. and MNK Investments (collectively “Debtor”) were commenced by separate petitions for orders for involuntary relief under chapter 11 of the United States Bankruptcy Code. Orders for relief under chapter 11 were entered, and the cases were substantively consolidated under case no. 07-25399. The consolidated cases were converted to chapter 7, and Duane H. Gillman was appointed trustee. A related case, In re Kenneth C. Tebbs, case no. 08-20546, was commenced on February 1, 2008. The related case, In re Kenneth C. Tebbs, has not been consolidated into case no. 07-25399.

This Court has already determined in the “Ponzi Proceeding” [2] that the Debtor operated a Ponzi scheme. Although the Debtor’s purported business was real estate investment, the Debtor primarily funded operations by cash receipts derived from investment-type loans from third party individuals and business entities. For a time those who invested early were able to recoup their initial investment plus their promised return. Payments to these investors were not made from the profits of legitimate business operations, but were paid using the money of subsequent investors. Like all Ponzi schemes must, the Debtor’s scheme collapsed, leaving its Johnny-come-latelies owed millions of dollars. This Court has also determined in the “Insolvency Proceeding” [3] that the Debtor was at all times insolvent and engaged in business for which it had an unreasonably small capital.

On November 25, 2009, the Trustee commenced an adversary proceeding against the Defendant, alleging claims of preference under § 547 (Count 1), fraudulent transfer under § 548 (Count 2), and state law fraudulent transfer under § 544(b) (Count 3). The Trustee’s complaint seeks to recover a total judgment against the Defendant in the amount of $441,008.97, which represents the amount the Defendant received in excess of his investment with the Debtor (Transfers).

On May 15, 2013, the Trustee filed a motion for summary judgment with respect to Counts 1 and 2. [4] Although the Defendant filed a memorandum in opposition to the Trustee’s motion for summary judgment under Count 1, he did not contest the entry of summary judgment under Count 1 either in the pleadings or in the hearings on the motion for summary judgment. After the Trustee offered evidence in support of his motion under Count 1, the Defendant either did not dispute the Trustee’s evidence with contradictory evidence or admitted the evidence, and on February 20, 2014, the Court granted the Trustee’s motion for summary judgment under Count 1 of the complaint in the principal amount of $234,590.00.

III. UNDISPUTED FACTS

1. On August 13, 2012, the Court entered findings and conclusions and a judgment in the Insolvency Proceeding, case no. 11-8005. In doing so, the Court found that the Debtor was insolvent within the meaning of the Bankruptcy Code since the commencement of its operations and was engaged in a business for which it had unreasonably small capital.

2. On August 13, 2012, the Court entered findings and conclusions in the Ponzi Proceeding, case no. 11-8006. The Court found that all four characteristics of a Ponzi scheme are present in the Debtor’s case: 1) the returns to investors were not financed through the success of the underlying business venture; 2) the returns to investors were taken from newly attracted investments; 3) investors were promised large returns; and 4) initial investors received promised returns, which attracted additional investors. Accordingly, the Court found that the Debtor operated as a Ponzi scheme.

3. Between June 28, 2006 and October 13, 2006, the Debtor received transfers from the Defendant totaling $520,000.00.

4. In return for the $520,000.00 total investment, the Defendant was paid a total of $961,008.97 by the Debtor, thus allowing the Defendant to receive $441,008.97 more than he had invested with the Debtor.

5. On December 2, 2005, the Defendant transferred funds totaling $465,000.00 to Canyon View Title at the direction of Kenneth Tebbs.

6. On December 7, 2005, the Defendant transferred funds totaling $100,000.00 to Canyon View Title at the direction of Kenneth Tebbs.

7. On January 26, 2006, the Defendant transferred funds totaling $148,035.48 to Canyon View Title at the direction of Kenneth Tebbs. The $148,035.48 was loaned to an individual or entity other than the Debtor.

8. On January 27, 2006, the Defendant transferred funds totaling $151,900.00 to Canyon View Title at the direction of Kenneth Tebbs.

9. On February 2, 2006, the Defendant transferred funds totaling $145,000.00 to Canyon View Title at the direction of Kenneth Tebbs.

10. There is no evidence that the transfers of December 2, 2005, December 7, 2005, January 26, 2006, January 27, 2006, or February 2, 2006, benefitted the Debtor.

11. Kenneth Tebbs is a separate individual and is not the Debtor, nor has the bankruptcy case captioned In re Kenneth Tebbs, case no. 08-20546, been substantively consolidated into the Debtor’s bankruptcy case.

IV. ANALYSIS

Summary judgment is appropriate when there is no genuine dispute as to any material fact and the moving party is entitled to judgment as a matter of law. [5] “A fact is `material’ if, under the governing law, it could have an effect on the outcome of the lawsuit.” [6] “Only disputes over facts that might affect the outcome of the suit under the governing law will properly preclude the entry of summary judgment.” [7] There is no genuine dispute that the Defendant paid $520,000.00 directly to the Debtor and received $961,008.97 directly from the Debtor. If the Court looks exclusively at the Defendant’s dealings with the Debtor, the Defendant received $441,008.97 in excess of his investments with the Debtor. The Defendant asserts that the Court should consider all of his transactions with Kenneth Tebbs because the actions were all part of a single fraudulent scheme. The Defendant maintains that he paid a total of $1,725,635.48 to Tebbs’s entities and received only $1,216,164.00 and he is therefore a net loser in Tebbs’s scheme. The Defendant disputes that the Transfers were made with the subjective intent to hinder, delay, and defraud creditors. The Defendant also asserts that the Debtor was part of Tebbs’s fraudulent scheme and that he has a fraud claim against the Debtor that provides a valid defense to the Trustee’s fraudulent transfer claim.

A. The Defendant’s Transactions With the Debtor and Kenneth Tebbs Must Be Viewed Separately.

The Defendant complains that the Trustee and his expert have isolated and compared only the funds that went into the Twin Peaks bank account while ignoring that Tebbs’s Ponzi scheme was much broader in scope. The Defendant argues that his investment of $1,725,635.48 with Tebbs should be viewed as his investment or “undertaking” for purposes of § 548. The Trustee has not disputed that Tebbs’s fraudulent scheme may have extended beyond the Debtor’s business operations, and the Court will accept the Defendant’s assertion as an undisputed fact. However, the fact that Tebbs’s fraudulent scheme may have extended beyond the Debtor’s business operations does not automatically permit this Court to ignore Tebbs’s and the Debtor’s separateness.

“[S]ubstantive consolidation merges the assets and liabilities of the debtor entities into a unitary debtor estate.” [8] A question central to the appropriateness of substantive consolidation is whether the economic prejudice of continued debtor separateness outweighs the economic prejudice of consolidation. [9] Tebbs’s bankruptcy and the Debtor’s bankruptcy have been pending for more than six years. The cases have not been substantively consolidated, and it would be inappropriate for this Court to ignore the separateness of these two debtors. The situation is akin to two individuals perpetuating a fraudulent scheme. Unless the cases of the two debtors are substantively consolidated, payments made to one debtor cannot also be deemed to be payments made to the other debtor. After a careful weighing of the prejudice and benefits to all creditors, the Court must observe the separateness of the Debtor and Tebbs.

B. Fraudulent Transfer Law and the Ponzi Presumption.

The Defendant did not contest the Ponzi Proceeding and he concedes that the Trustee has established that the Debtor was operating a Ponzi scheme. Once the Court has determined that the Debtor was operating a Ponzi scheme, the “Ponzi presumption” arises. Once the Ponzi presumption is established, the requisite intent to defraud is presumed, and the burden of establishing a statutory defense shifts to the transferee. [10] The Ponzi presumption provides that “`[t]he mere existence of a Ponzi scheme is sufficient to establish actual intent to defraud.'” [11] “One can infer an intent to defraud future undertakers from the mere fact that a debtor was running a Ponzi scheme. Indeed, no other reasonable inference is possible.” [12]

C. The Defendant’s Alleged Fraud Claim Does Not Constitute “Value” for Purposes of § 548.

The Defendant asserts that he has a fraud claim, which gives him a legally enforceable claim. For purposes of evaluating the Defendant’s assertion with respect to his claim for fraud, the Court will assume that the Defendant has a claim for fraud against the Debtor in the amount of $1,725,635.48, the full amount the Defendant alleges. The Court is making this assumption for purposes of this motion only, accepting the proposition that a party may have a claim against all parties participating in a fraud for all of the party’s damages, even though a participant in the fraud may not have received property as a result of the fraud. Although the Defendant’s briefs do not go into great detail, the Court concludes that the Defendant contends that his alleged fraud claim constitutes “value” for purposes of § 548 that was given in exchange for the Transfers.

A trustee may avoid a transfer under § 548(a)(1)(B) if the debtor received less than a reasonably equivalent value in exchange for the transfer. Additionally, under § 548(c), a transferee may retain any interest transferred to the extent the transferee gave value to the debtor in exchange for the interest transferred. In order to defend against the Trustee’s § 548(a)(1)(B) claim, or avail himself of the protection of § 548(c), the Defendant must have given value in exchange for the Transfers he received. The parties do not dispute that the Defendant gave value in the amount of his investment or “undertaking” with the Debtor. The legal dispute is whether the Defendant gave value for the $441,008.97 that he received in excess of his investment.

Section 548(d)(2)(A) defines “value,” for purposes of § 548, as “property, or satisfaction. . . of a present or antecedent debt of the debtor. . . .” The “property” the Defendant gave—his investment—has already been taken into account, and the Defendant gave the Debtor no other “property” in exchange for the Transfers. Therefore, the only value the Defendant can assert that he gave in exchange for the Transfers is the satisfaction of a present or antecedent debt—presumably his alleged fraud claim. The Court must therefore determine whether the Defendant’s alleged fraud claim constitutes value for purposes of § 548 and whether it was given in exchange for the Transfers.

Given the undisputed facts of the case, the Transfers were not given in exchange for satisfaction of the Defendant’s alleged fraud claim. On the date of the Transfers, the Defendant had not asserted a fraud claim. The Transfers were made pursuant to certain investment contracts promoted by the Debtor (Investment Contracts). There was no other reason for the Transfers, and the Defendant cannot now argue that the Transfers were made in exchange for satisfaction of his alleged fraud claim.

D. The Transfers May Be Avoided Under § 548.

The Trustee may avoid the Transfers under § 548(a)(1)(A) or (B).

1. The Trustee Has Established the Elements of § 548(a)(1)(A).

To avoid a fraudulent transfer under 11 U.S.C. § 548(a)(1)(A), the Trustee must demonstrate: (1) that the Debtor transferred to the Defendant an interest of the Debtor in property within the two years prior to the petition date, and (2) that the Debtor made such transfer with actual intent to hinder, delay, or defraud other creditors of the Debtor. The first element has been established by the undisputed facts. The second element is established as a matter of law by the Ponzi Proceeding and the Ponzi presumption arising from the order in that proceeding.

2. The Trustee Has Established the Elements of § 548(a)(1)(B).

The Defendant did not directly address the Trustee’s § 548(a)(1)(B) claim, but the Court assumes that the Defendant does not concede that the Trustee has established the elements of this claim. The Trustee may establish his claim under § 548(a)(1)(B) if he proves: (1) that the Debtor transferred to the Defendant an interest of the Debtor in property within two years of the petition date, and (2) the Debtor received less than a reasonably equivalent value in exchange for such transfer, and either (a) the Debtor was insolvent on the date that the transfer was made, or (b) the Debtor was engaged in business for which any property remaining with the Debtor was an unreasonably small capital. It is undisputed that the Transfers were property of the Debtor, made within two years of the petition date, and that the Debtor was insolvent when the Transfers were made. As discussed above, the Defendant’s potential fraud claim did not constitute value given in exchange for the Transfers, and the Defendant gave no other value in excess of his undertaking. The Trustee has therefore established his § 548(a)(1)(B) claim.

3. The Defendant Cannot Retain the Transfers Under § 548(c).

Section 548(c) provides:

Except to the extent that a transfer or obligation voidable under this section is voidable under section 544, 545, or 547 of this title, a transferee or obligee of such a transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.

Pursuant to this statutory provision, if the payments to the Defendant were fraudulent conveyances, the Defendant is protected to the extent he took for “value” and in “good faith.” The Independent Clearing House court made clear that in Ponzi scheme cases, only the amount of a defendant’s undertaking constitutes “value,” and credit cannot also be given for amounts in excess of that undertaking. [13] “To allow an undertaker to enforce his contract to recover promised returns in excess of his undertaking would be to further the debtors’ fraudulent scheme at the expense of other undertakers.” [14] For that reason, the court in Independent Clearing House looked beyond the terms of the contract to the underlying facts to determine whether the contract was unenforceable on public policy grounds. [15] Looking at the underlying facts, the court found that “any money that a defendant might recover in excess of his undertaking in an action on the contract could not come from the debtors but would have to come from money that rightfully belonged to other, defrauded undertakers.” [16]

As previously discussed, Defendant’s alleged fraud claim was not value within the meaning of § 548, and the Transfers were not made in exchange for the Defendant’s potential fraud claim but were made pursuant to the Investment Contracts. As with the contract claims in Hedged-Investments and Independent Clearing House, to allow the Defendant to retain his avoidable fictitious Ponzi scheme profits by asserting they were in payment of his fraud claim would frustrate the purpose of the fraudulent transfer statute, and would allow the Defendant to profit “at the expense of those who entered the scheme late and received little or nothing.” [17]

E. The Transfers May Be Recovered Under § 550.

The Trustee seeks to recover the Transfers or their value pursuant to § 550(a). The Trustee bears the burden of proving that the Transfers were transferred to the Defendant as the initial transferee. The Trustee has met this burden by showing there is no genuine dispute that the Transfers were transferred to the Defendant as the initial transferee. Therefore, the Defendant is liable to the Trustee for the value of the Transfers under § 550.

V. CONCLUSION

The Trustee has established his claims under § 548(a)(1)(A) and (B). The Defendant’s attempted distinction between the contract claims and the Defendant’s potential fraud claim is not meaningful. The Defendant’s potential fraud claim does not constitute “value” as defined under § 548(d)(2)(A), and the Transfers were not given in satisfaction of the Defendant’s potential fraud claim. Therefore, the Court will grant the Trustee’s motion for summary judgment with respect to Count 2 of the Trustee’s complaint.

[1] All subsequent statutory references are to Title 11 of the United States Code unless otherwise indicated.

[2] Misc. Adv. Proc. No. 11-8006, Docket No. 56.

[3] Misc. Adv. Proc. No. 11-8005, Docket No. 56.

[4] Because the Trustee’s motion did not seek summary judgment on Count 3, the Court will not address the Trustee’s § 544(b) fraudulent transfer claim in this decision.

[5] Fed. R. Civ. P. 56(a), made applicable in adversary proceedings by Fed. R. Bankr. P. 7056.

[6] Adamson v. Multi Cmty. Diversified Servs., Inc., 514 F.3d 1136, 1145 (10th Cir. 2008) .

[7] Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248, 106 S. Ct. 2505 (1986) .

[8] Woburn Associates v. Kahn (In re Hemingway Transp., Inc.), 954 F.2d 1, 11-12 (1st Cir. 1992) .

[9] See Reider v. FDIC (In re Reider), 31 F.3d 1102, 1106-1107 (11th Cir. 1994) .

[10] SEC v. Mgmt. Solutions, Inc., No. 2:11-CV-1165-BSJ, 2013 WL 4501088, at *6 (D. Utah Aug. 22, 2013).

[11] Id. (quoting Donell v. Kowell, 533 F.3d 762, 770 (9th Cir. 2008) .

[12] Merrill v. Abbott (In re Indep. Clearing House Co.), 77 B.R. 843, 860 (D. Utah 1987) .

[13] In re Indep. Clearing House Co., 77 B.R. at 861 ; see also Sender v. Buchanan (In re Hedged-Investments Assocs., Inc.), 84 F.3d 1286, 1290 (10th Cir. 1996) .

[14] In re Indep. Clearing House Co., 77 B.R. at 858 .

[15] Id. (citation omitted).

[16] Id.

[17] Id. at 870.

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New Bankruptcy Opinion: IN RE SIMBAKI, LTD – Bankr. Court, SD Texas, 2014

IN RE: SIMBAKI, LTD; dba BERRYHILL BAJA GRILL; dba BERRYHILL BAJA GRILL & CANTINA, Chapter 11, Debtor(s).

Case No. 13-36878.

United States Bankruptcy Court, S.D. Texas, Houston Division.

October 14, 2014.

MEMORANDUM OPINION

MARVIN ISGUR, Bankruptcy Judge.

The deadline for the assumption of a nonresidential real property lease is satisfied upon the trustee filing a motion to assume the lease. Simbaki, Ltd. filed a motion to assume its lease with Passage Realty, Inc. prior to the statutory deadline. Accordingly, Simbaki’s lease was not terminated by operation of law.

Background

The material facts are not in dispute. Simbaki owns two restaurants in the Houston area that operate out of leased facilities. Simbaki leases space from Passage Realty, Inc. (“Passage”) for use by one of the restaurants. On November 24, 2013, Simbaki filed a voluntary petition for chapter 11 relief. (ECF No. 1). In its amended bankruptcy schedules, Simbaki indicated that it had an unexpired lease with “PM Realty Group” which was to be assumed. (ECF No. 20 at 21). The Court granted a 90-day extension of the statutory deadline to assume or reject the lease on February 26, 2014. (ECF No. 112). June 2, 2014 became the new deadline for assuming or rejecting the lease. Id.

On May 28, 2014, five days prior to the deadline, Simbaki filed a motion to assume the Passage lease. (ECF No. 146). On June 18, 2014 Passage filed an objection to the motion to assume. (ECF No. 154). Passage argued, among other objections, that because Simbaki failed to obtain an order assuming the lease by the June 2 deadline, the lease was rejected as a matter of law. After the deadline passed, Passage began returning rent checks to Simbaki with a letter indicating that the lease has been rejected. (ECF No. 202 at 4). On September 12, 2014, the Court held a hearing to consider Simbaki’s motion to assume the lease. At the hearing, the Court requested briefing on the single issue of whether Passage’s lease is deemed rejected as a matter of law and set the matter for an additional hearing on September 18, 2014. The Court issued an oral ruling at the September 18 hearing that the lease was not deemed rejected.

Discussion

Assumption of a Lease Under 11 U.S.C. § 365(d)(4)

The single issue under consideration is whether the filing of a motion to assume a nonresidential lease is sufficient to satisfy the deadline imposed by 11 U.S.C. § 365(d)(4). Section 365(d)(4) provides that:

(A) Subject to subparagraph (B), an unexpired lease of nonresidential real property under which the debtor is the lessee shall be deemed rejected, and the trustee shall immediately surrender that nonresidential real property to the lessor, if the trustee does not assume or reject the unexpired lease by the earlier of —

(i) the date that is 120 days after the date of the order for relief

(ii) the date of the entry of an order confirming a plan

(B)(i) The court may extend the period determined under subparagraph (A), prior to the expiration of the 120-day period, for 90 days on the motion of the trustee or lessor for cause.

(ii) If the court grants an extension under clause (i), the court may grant a subsequent extension only upon prior written consent of the lessor in each instance.

11 U.S.C. § 365(d)(4) (emphasis added). Passage argues that in order for the trustee to assume the lease within the statutory deadline, the court must issue an order granting the trustee’s motion. Simbaki argues that once the trustee files a motion to assume the lease, the statutory requirements are met, regardless of when the court issues an order.

The meaning of the term “assume” in the context of § 365(d)(4)(A) can only be determined in two ways. “If the statute is unambiguous, the court is to interpret the statute in accordance with its plain meaning and without regards to any extraneous materials.” See Leocal v. Ashcroft, 543 U.S. 1, 9 (2004) . If a statute is ambiguous, however, the court should analyze the statute in light of the intent of Congress. See United States v. Orellana, 405 F.3d 360, 365 (5th Cir. 2005) .

The Bankruptcy Code does not explicitly define the term “assume.” Section 365(d)(4)(A) states that a lease is deemed rejected “if the trustee does not assume or reject the unexpired lease by the earlier of” 120 days after an order for relief or the order confirming a plan. This language implies that the trustee can unilaterally assume or reject the lease. A reasonable interpretation of § 365(d)(4)(A) is that once the trustee files a motion to assume, the statutory deadline is met. However, § 365(a) provides that any decision to assume or reject the lease must be approved by the court. [1] If § 365(d)(4)(A) is read in conjunction with §365(a), an assumption of a lease can be interpreted to occur only once the court grants the motion. Both interpretations are reasonable given the plain language of the statute. [2] A fundamental provision of statutory interpretation is that “a statute is ambiguous if it is susceptible to more than one reasonable interpretation or more than one accepted meaning.” United States v. Hoang, 636 F.3d 677, 682 (5th Cir. 2011) . Because § 365(d)(4)(A) is susceptible to two reasonable interpretations, the statute is ambiguous as to when a lease is assumed for the purposes of meeting the statutory deadline. [3]

Turning to the intent of Congress to assist in interpreting the ambiguous provision, it is apparent that filing a motion to assume satisfies the statutory deadline. Prior to BAPCPA, § 365(d)(4) allowed the trustee only 60 days to assume or reject the lease, but allowed unlimited extensions of the deadline for cause. [4] BAPCPA eliminated the potentially indefinite assumption period and set forth “a maximum possible period of 210 days from the time of entry of the order of relief.” H.R.Rep. No. 109-34 at 86. Congress’s stated purpose in amending the statute is to “establish a firm, bright line deadline by which an unexpired lease of nonresidential real property must be assumed or rejected.” Id.

Requiring the trustee to obtain a court order approving the motion to assume the lease would destroy the purpose of a bright-line rule. See Cousins Prop., Inc. v. Treasure Isles HC, Inc. (In re Treasure Isles HC, Inc.), 462 B.R. 645, 650 (B.A.P. 6th Cir. 2011) . Instead of having 210 days to file a motion, the trustee would have 210 days less the time it takes the judge to rule on the motion. As the Treasure Island court noted, a trustee could file a motion to assume a lease on the day the debtor files its petition and, through no fault of the trustee, still fail to obtain court approval before the deadline. Id. Additionally, if Passage’s interpretation of the statute were adopted, the business-decision-making period (that is, the period for the trustee to reach a decision) could vary significantly from court to court, depending on the individual courts’ caseloads and procedures.

Additionally, by stating that a lease is deemed rejected unless the trustee assumes or rejects the lease, Congress has indicated that the deadline is satisfied when the trustee takes action, not the court. By contrast, § 365(a) states that “the trustee, subject to the court’s approval may assume or reject any . . . lease of the debtor.” 11 U.S.C. § 365(a) (emphasis added).

When Congress wishes to condition a deadline on Court action, it knows how to craft appropriate language. For example, Congress makes explicit reference to court action in § 362(e)(1), which provides that:

Thirty days after a request under subsection (d) of this section for relief from the stay of any act against property of the estate under subsection (a) of this section, such stay is terminated with respect to the party in interest making such request, unless the court, after notice and a hearing, orders such stay continued . . .

11 U.S.C. § 362(e)(1); see also In re Filene’s Basement, LLC, Case No. 11-13511, 2014 WL 1713416 at *9 (Bankr. D. Del. Apr. 29, 2014). The absence of any reference to court action in § 365(d)(4)(A) is conspicuous when compared to §§ 362(e)(1) and 365(a). Congress could have required the trustee to obtain a court order approving his motion to satisfy the deadline, but chose to omit that explicit requirement.

A review of both pre- and post-BAPCPA cases shows that an overwhelming majority of courts hold that a trustee need only file a motion to assume before the deadline. See, e.g., Turgeon v. Victoria Station Inc. (In re Victoria Station Inc.), 840 F.2d 682 (9th Cir. 1994) ; Filene’s Basement, 2014 WL 1713416 at * 9; In re Citrus Tower Boulevard Imaging Ctr., LLC, Case No. 11-70284, 2012 WL 1820814 (Bankr. N.D. Ga. Apr. 2, 2012); Cousins Prop., Inc. v. Treasure Isles HC, Inc. (In re Treasure Isles HC, Inc.), 462 B.R. 645, 651 (B.A.P. 6th Cir. 2011) ; In re Akron Thermal Ltd. P’ship, 414 B.R. 193 (N.D. Ohio 2009) ; In re Kroh Bros. Development Co., 100 B.R. 480 (Bankr. W.D. Mo. 1989) ; In re Delta Paper Co., 74 B.R. 58 (Bankr. E.D. Ten., 1987) . Passage argues that courts have split with regards to assumption under § 365(d)(4), but notably does not cite to a single case where a court has taken the opposite position. Passage’s interpretation of the case law is incorrect. Collier notes that courts have “generally permitted a post-deadline order if the trustee filed a motion to assume before the deadline.” Collier on Bankruptcy ¶ 365.05[3][b] (Alan N. Resnick & Henry J. Sommer eds., 16th ed. 2013). Furthermore, in In re Treasure Isles, the court stated that “almost every pre-BAPCPA case addressing this issue holds that a trustee need only file its motion to assume the lease prior to the deadline . . . [and] post-BAPCPA cases continue to hold [the same].” Treasure Isles, 462 B.R. at 649 .

Passage’s Brief

Passage makes three additional primary arguments in support of its position. First, Passage acknowledges that no Fifth Circuit case has spoken directly to the point at issue, but instead relies on In re American Healthcare Management, Inc. for support. A pre-BAPCPA case, AHM held that the previous version of § 365(d)(4) authorized a bankruptcy judge to grant multiple extensions of the assumption period, so long as the motion to extend was brought prior to the expiration of the original assumption period. In re American Healthcare Management, Inc., 900 F.2d 827, 830 (5th Cir. 1990) . The Fifth Circuit noted that once the 60-day assumption period has passed, the lease is automatically deemed rejected, and a trustee can no longer bring a motion to extend the assumption period. Id.

Passage interprets AHM to stand for the proposition that once the assumption period expired at 12:01 a.m. on June 3, the lease was automatically rejected and the court may no longer rule on the motion to assume. This reading of AHM goes too far. In fact, AHM held that a bankruptcy court can rule on a motion to extend the assumption period “so long as a motion to extend is brought prior to the expiration of the period as previously extended.” Id. (emphasis added). Although AHM does not precisely address when a motion to assume must be filed, the court expressly held that filing of the motion is all that is required to meet the deadline for extending the lease. Presumably, the court would apply the same logic to a motion to assume the lease and allow the bankruptcy court to rule on the motion even after the deadline had passed. Passage’s reliance on AHM is misplaced.

Second, Passage argues that because under the Bankruptcy Code a lease is not assumed until the bankruptcy court approves a motion to assume a lease, the mere filing of the motion cannot satisfy the statutory deadline. See 11 U.S.C. § 365(a). In effect, Passage is arguing that the plain language of the statute requires court approval before the deadline expires. By pointing to the inconsistency contained within §365, however, Passage implicitly acknowledges that the statute is ambiguous. Section 365(d)(4) requires the trustee to assume the lease within the 210-day deadline, but § 365(a) makes clear that the trustee cannot actually do that on his own.

Third, Passage contends that allowing a court to rule on a motion to assume after the deadline has passed nullifies the restrictive extension provisions of § 365(d)(4)(B). A court can only grant a 90-day extension within 120 days following the order for relief upon motion of the trustee or lessor, for cause. 11 U.S.C. § 365(d)(4)(B). Passage argues that if filing the motion is all that is required to meet the deadline, bankruptcy judges will have discretion to extend the deadline past the 210-day mark. Accordingly, lessors could be left in limbo with regards to the status of the lease after 210 days. The stated purpose of the deadline, however, is to balance the interests of the debtor in having enough time to make informed decisions against the interests of the lessors in “not being left in doubt concerning their status vis-à-vis the estate.” H.R.Rep. No. 95-595, at 348 (1977). If a court rules on a motion to assume a lease after the 210-day mark has passed, the lessor is not in doubt as to the trustee’s intentions. Once the trustee files the motion within the 210 days, the lessor will know whether the trustee intends to assume or reject, and can plan accordingly.

Conclusion

Debtor’s lease with Passage was not automatically terminated on June 2, 2014.

[1] 11 U.S.C. § 365(a) states that “the trustee, subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.”

[2] Passage cites In re Austin to support its position that the Fifth Circuit considers § 365(d)(4) to be “straightforward.” Eastover Bank for Sav. v. Sowashee Venture (In re Austin Dev. Co.), 19 F.3d 1077, 1081 (5th. Cir. 1994) . As Passage acknowledges, however, that case regarded the treatment of a security interest in a lease after it was deemed rejected, and the court never addressed the issue of when a lease must be assumed or rejected.

[3] Although the Court is unaware of a prior case finding § 365(d)(4)(A) ambiguous, numerous cases discussing the deadline for lease assumption turn to the legislative history for guidance. See, e.g., In re Treasure Isles HC, Inc., 462 B.R. 645, 650 (B.A.P. 6th Cir. 2011) ; In re Filene’s Basement Case No. 11-13511, 2014 WL 1713416 at *9 (Bankr. D. Del. Apr. 29, 2014). Because a finding of ambiguity is required to consult legislative history with regards to a statutory provision, these courts have made a sub silentio finding of ambiguity.

[4] Pre-2005, §365(d)(4) read as follows:

Nothwithstanding paragraphs (1) and (2), in a case under any chapter of this title, if the trustee does not assume or reject an unexpired lease of nonresidential real property under which the debtor is the lessee within 60 days after the date of the order for relief, or within such additional time as the court, for cause, within such 60-day period, fixes, then such lease is deemed rejected, and the trustee shall immediately surrender such nonresidential real property to the lessor.

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New Bankruptcy Opinion: IN RE FRATERFOOD SERVICE INC. – Bankr. Court, D. Puerto Rico, 2014

IN RE: FRATERFOOD SERVICE INC., Chapter 11, Debtor.

Case No. 14-00002 BKT.

United States Bankruptcy Court, D. Puerto Rico.

October 15, 2014.

OPINION AND ORDER

BRIAN K. TESTER, Bankruptcy Judge.

Before this court is an Application for Payment of Administrative Expense (“Motion”) filed by Creditor, DDR Del Sol, LLC, S.E. (“Creditor” or “DDR Del Sol”) [Dkt. No. 100], Reply to Motion for Payment of Administrative Expenses and Motion for Entry of Amended Order Nunc Pro Tunc filed by Debtor, Fraterfood Service, Inc. (“Debtor” or “Fraterfood”) [Dkt. No. 113], Joint Motion to Inform filed by Creditor and Debtor [Dkt. No. 119], and Amended Reply to Motion for Payment of Administrative Expenses and Motion for Entry of Amended Order Nunc Pro Tunc filed by Debtor [Dkt. No. 120]. For the reasons set forth below, Creditor’s Motion is GRANTED, and Debtor’s Motion for Entry of Amended Order Nunc Pro Tunc is DENIED.

On July 10, 2002, Debtor and DDR Del Sol executed a lease agreement (the “Lease Agreement”) for the lease of certain nonresidential property (the “Leased Premises”). On October 12, 2009, Debtor executed a sublease agreement (the “Sublease Agreement”) over the Leased Premises with third-party, Sunny Food Corp (“Sunny Food”). DDR Del Sol consented to the Sublease Agreement with Sunny Food on October 15, 2009, as required by Section 12.7 of the Lease Agreement. Including other charges due under the Lease Agreement, Debtor’s rent obligation to DDR Del Sol for the month of January 2014 was $25,580.68. This amount included base rent, real estate taxes, marketing fund fee, insurance, common area maintenance, “patente” tax, and gross income tax. Subsequently, Debtor filed its voluntary petition for Chapter 11 reorganization relief on January 2, 2014.

On January 28, 2014, DDR Del Sol received a check from the Debtor in the amount of $25,580.68 dated January 1, 2014, representing that month’s rent obligations. This check was deposited by DDR Del Sol and the funds cleared its bank on February 3, 2014.

On March 25, 2014, Debtor filed an Urgent Motion for Rejection of Non-Residential Lease Contract whereby it requested this Court’s approval to reject the Lease Agreement. That same day, this Honorable Court granted ten (10) days for DDR Del Sol to reply to Debtor’s rejection of the Lease Agreement.

On April 1, 2014, DDR Del Sol filed a motion, inter alia, acquiescing to Debtor’s rejection of the Lease Agreement. As a result, on April 7, 2014, this Court entered an order granting Debtor’s rejection of the Lease Agreement.

On April 10, 2014, DDR Del Sol filed a Motion for Allowance of Administrative Payment. DDR Del Sol attached an exhibit to said motion detailing $78,537.23 as rent and other charges due and owing for the month of April. On April 24, 2014, the Debtor filed a motion requesting a nunc pro tunc order making the effective date of this Court’s granting of the Debtor’s rejection of the Lease Agreement the same date that the Debtor filed said motion, i.e. March 25, 2014. That amendment in turn would allow the Debtor to avoid the incurrence in the rent and other charges for the month of April as administrative expenses. Several more motions were filed by the parties addressing this issue, and a hearing was held by the court to consider oral arguments.

Debtor’s intention is to have this Court impart retroactive effect to the rejection order, when no such request was originally sought in its rejection motion. It is well settled in the First Circuit that “rejection under section 365(a) does not take effect until judicial approval is secured, but [that] the approving court has the equitable power, in suitable cases, to order a rejection to operate retroactively.” In re Thinking Machines Corp., 67 F. 3d 1021, 1029 (1st Cir. 1995) . However, in the case at bar, Debtor initially did not request, nor did this Court consider, that the rejection of the Lease Agreement would be afforded retroactive effect. Debtor must affirmatively request such retroactive effect. In re Leather Factory Inc., 475 B.R. 710, 713 (Bankr. C.D. Cal. 2012) (stating the “the statute is clear and the control of the date of rejection is in the hands of the trustee, not of the landlord”).

Furthermore, Debtor has not clearly established that this case’s circumstances make it suitable for this Court to grant retroactive relief. Debtor states in its nunc pro tunc motion that it rejected the Lease Agreement in order to stop April’s rent from accruing. However, if that was Debtor’s intention, it should have requested from the onset that any eventual approval of the Lease Agreement’s rejection be afforded retroactive effect to the filing date of the rejection motion.

DDR Del Sol’s application for payment of its post-petition, pre-rejection rent claim was filed on April 10, 2014 for an amount of $78,537.23. As per P.R. LBR 9013-1(c), the application for payment included a notice with “14-day objection language.” Said term was set to expire on April 24, 2014. On April 24, 2014, Debtor filed its nunc pro tunc motion to have this Court impart retroactive effect to the lease rejection order. However, Debtor did not bring forward in that motion any argument directed against DDR Del Sol’s calculation of or entitlement to its $78,537.23 claim. In other words, Debtor did not present this Court with any proper argument whatsoever against DDR Del Sol’s claim within the 14-day objection period established by P.R. LBR 9013-1(c). Debtor’s only act directed against DDR Del Sol’s claim was limited to stating that “it would be unequitable [sic] and unfair for DDR [Del Sol] to try to collect rent in full for April 2014, when the rejection order was entered in [sic] the seventh day of April.” [Dkt. No. 120, ¶ 10].

It would be a stretch of the imagination to classify Debtor’s statements as an objection to DDR Del Sol’s claim. Debtor did not attempt to state with particularity the pertinent facts or reasons why DDR Del Sol’s claim over April 2014’s rent would be inequitable or unfair, nor did it seek the disallowance of April 2014’s rent as relief. Fed. R. Bankr. 9013 clearly states that a “motion shall state with particularity the grounds therefore, and shall set forth the relief or order sought.” Fed. R. Bankr. 9013. Furthermore, P.R. LBR 9013-2(a) states that:

“any motion or response thereto must be accompanied by a supporting memorandum that contains the points and authorities in support of the party’s position, together with any affidavits or documents in support thereof. The memorandum must also include specific reference to the applicable provisions of the Bankruptcy Code, the Federal Rules of Bankruptcy Procedure, these LBRs, and/or other controlling authorities.”

P.R. LBR 9013-2(a). It was not until May 20, 2014, by way of a sur-reply, that Debtor presented for the first time a short and plain statement of its objection to DDR Del Sol’s claim, and demanded that said claim be limited to $25,851.73. Debtor’s objection to DDR Del Sol’s application for administrative expense came forty (40) days after the claim was filed. This was significantly beyond the 14-day objection period provided by P.R. LBR 9013-1(c). As such, it is not only untimely, but it failed to properly create a contested matter.

In light of the above mentioned, it would seem reasonable for this Court to conclude that DDR Del Sol’s application for post-petition, pre-rejection rent be granted because it was untimely opposed. However, Debtor raises an additional issue as to the total administrative expense claim by DDR Del Sol that gives the court pause. Said issue is whether it was legal and/or appropriate for DDR Del Sol to apply the check dated January 1, 2014 to the pre-petition January rent obligations on February 3, 2014 (32 days post-petition) without prior court authorization.

In addressing this issue in a light most favorable to the Debtor, the court answers said inquiry in the negative. However, that would result in twenty-nine (29) days of post-petition rent obligations for the month of January being due and owing as administrative expenses. Calculating twenty-nine (29) days of rent obligations on a per diem basis from a total monthly amount due for January of $25,580.68, gives a prorated amount due of $23,930.31. Therefore, the total administrative expense amount of $78,537.23 being requested by DDR Del Sol should be reduced by $1,650.37. This reduction represents the two (2) days of January that were pre-petition, for a new total of $76,886.86.

WHEREFORE, IT IS ORDERED that Debtor’s request for nunc pro tunc order is DENIED and DDR Del Sol’s Application for Payment of Administrative Expense [Dkt. No. 100] is GRANTED in the total amount of $76,886.86.

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