Sabatini Frozen LLC v. Weinberg, Gross, & Pergament LLP: A Cautionary Tale

The recent decision in Sabatini Frozen LLC v. Weinberg, Gross, & Pergament LLP[1] is a tale of a failure of corporate governance of a closely-held corporation, coupled with the failure of debtor’s counsel to adequately address that matter. The decision also illustrates the real limitations on a “wronged” creditor’s recourse against debtor’s counsel for counsel’s conduct during a bankruptcy case.

Acme Cake Co. was a small wholesale manufacturer of baked goods whose stock was held in equal shares by two married couples, Thomas and Patricia Semon and William and Debra Wenzel (William and Patricia were siblings). William was Acme’s president, and his brother-in-law, Thomas, was its secretary. In addition, Thomas and William were Acme’s only two directors.[2] The available record does not indicate that there was any provision for breaking a deadlock, either of the board or between the two voting blocs. There seems to have been discord between the Semons and Wenzels because on June 6, 2005, Wenzel filed a 12-count complaint against Semon in New York state court relating to Semon’s conduct as an officer of Acme.[3]

Sabatini Frozen Foods, LLC was a longstanding distributor of certain Acme frozen baked goods, pursuant to an agreement that the parties entered into in 1999 (the “distribution agreement”). In June 2006, Sabatini sued Acme in the U.S. District Court for the Eastern District of New York for an alleged breach of the distribution agreement, seeking monetary damages and injunctive relief. On March 19, 2008, a jury awarded Sabatini damages of $1,768,840 (the “federal verdict”).

Two weeks later, on April 2, 2008, Acme filed a chapter 11 petition in the U.S. Bankruptcy Court for the Eastern District of New York.[4] Attached to the petition was a corporate resolution signed by Wenzel and purportedly approved by Acme’s board during a “duly called” meeting. The resolution purported to authorize Acme to file the petition and retain Weinberg, Gross & Pergament LLP (WGP) and Marc Pergament as debtor’s counsel.[5] Semon claimed that he informed Pergament at a meeting shortly after the Acme bankruptcy commenced that no such board meeting had occurred, and that he opposed the bankruptcy filing.[6] Acme and its counsel continued the Acme bankruptcy over Semon’s informal objection.[7]

As there was no secured creditor, Sabatini, far and away Acme’s largest creditor, could by itself block confirmation of any chapter 11 plan that it opposed.[8] Over the next two years, Acme proposed a chapter 11 plan and filed a motion to sell substantially all of its assets to an entity controlled by Wenzel. The sale motion disclosed this insider relationship and further disclosed that Acme’s board had not approved the proposed transaction. Sabatini opposed the sale motion and proposed plan, along with various other actions proposed by the debtor. On July 14, 2010, Acme withdrew the sale motion.[9]

On July 19, 2010, Sabatini moved to dismiss the Acme bankruptcy, in part because of its own implacable opposition and in part because the bankruptcy estate had become administratively insolvent.[10] On Oct. 28, 2010, the bankruptcy court dismissed the Acme bankruptcy without prejudice, noting that “[t]here is no evidence in the record that [Acme] abused the bankruptcy process.”[11] Two days later, several creditors (other than Sabatini) filed an involuntary chapter 7 petition against Acme. [12] This case was fully administered, but Sabatini did not receive any proceeds from that estate.[13]

On April 2, 2014, Sabatini filed a complaint in the instant matter naming WGP and Pergament as defendants, and seeking damages pursuant to New York Judiciary Law § 487, which provides, in relevant part, that an attorney who is guilty of any deceit or collusion or consents to any deceit or collusion, with intent to deceive the court or any party … [i]s guilty of a misdemeanor, and … forfeits to the party injured treble damages, to be recovered in a civil action.[14]

Sabatini alleged that the defendants had colluded with Wenzel to knowingly file a false corporate resolution “with the intent to induce” the bankruptcy court clerk to accept the petition, thereby permitting the Acme bankruptcy to commence.[15] Sabatini further alleged that the defendants willfully delayed the administration of the case and improperly appealed the verdict that Sabatini received against Acme on March 19, 2008.[16]

On June 27, 2014, the defendants moved to dismiss the complaint, arguing that the doctrine of collateral estoppel barred Sabatini’s claims because the bankruptcy court had already ruled on them. The defendants further argued that Sabatini had failed to meet the obligations imposed by Fed. R. Civ. P. 12(b)(6) because the conduct ascribed to defendants in the complaint involved “mere advocacy in the context of garden-variety legal and factual issues that are contested in bankruptcy court every day,” and did not rise to the level of conduct required by New York Judiciary Law § 487.[17]

On Sept. 25, 2015, the district court granted the dismissal motion in part and denied it in part. The court dismissed all of Sabatini’s claims against defendants save one, making it clear that New York Judiciary Law § 487 did not permit Sabatini “to challenge [in a subsequent proceeding such as the instant matter] every aspect of the entire record of [the] Defendants’ representation of Acme during” the bankruptcy case “as an alternative avenue to recover amounts that it could not recover from Acme through the bankruptcy process.”[18] Thus, the aggrieved creditor could not attempt to collect from debtor’s counsel for their conduct as to the filing of the chapter 11 plan, the abortive § 363 sale to insiders, and the allegedly improper appeal. The court held that regardless of how ill-advised and ultimately ineffective they may have been, these actions simply did not “rise to the level of extreme misconduct contemplated by [New York Judiciary Law] § 487.”[19]

The court did, however, permit one claim to survive, “for which [Sabatini] theoretically has a right to recover in its individual capacity” under New York Judiciary Law § 487.[20] The court held that the bankruptcy case permitted Acme to attempt to use the automatic stay to avoid posting bond for an appeal from the federal verdict—an injury unique to Sabatini. The court further held that the act of attaching the corporate resolution to Acme’s bankruptcy petition raised the factual question of whether the corporate resolution was deceptive, thereby raising the further factual question of whether defendants filed the bankruptcy case under false pretenses in order to thwart Sabatini’s recovery on the federal verdict.

On Oct. 7, 2015, the defendants filed a motion to reconsider, in which they argued that Semon’s failure to file a motion to dismiss the Acme bankruptcy constituted a ratification of the petition, presumably rendering irrelevant the question of whether the defendants knew (or should have known) that the corporate resolution was false.[21] As of the publication of this article, this motion remains pending.

Now that this tale has been told, what lessons can practitioners draw from it? Not surprisingly, there are quite a few.

The Original Sin

The shareholder dispute between Wentzel and Semon seems ultimately to have destroyed Acme, likely because there were no corporate governance documents addressing the issue of deadlock among the directors and shareholders. One suspects that had there been such a mechanism, the bankruptcy case either would have been filed without the corporate resolution issue ever arising, or the case would not have been filed at all.

Best Practice for Debtor’s Counsel

The record is silent about whether Pergament or any other WGP lawyers attended the “duly called meeting” of Acme’s board of directors at which the corporate resolution was purportedly approved. If they had, then the issue of the corporate resolution should never have arisen (because counsel would have known whether the resolution had really been approved). The lesson here is clear: A prospective debtor’s counsel must be intimately involved in every step of the corporate decision-making process in the lead-up to bankruptcy, and should not rely exclusively upon the representations of just one officer or director, particularly when there is strife among the stakeholders. In other words, counsel should (among many other things) attend board meetings, particularly the meeting at which the bankruptcy is authorized. In this particular matter, debtor’s counsel should have been well aware of the strife between Wenzel and Semon, and been far more proactive than they seemed to have been. At the very least, they should have affirmatively discussed the filing with both Wenzel and Semon, and not filed the case if Semon’s consent had not been affirmatively obtained.

The Insider Sale

The district court opinion does not mention the failed § 363 sale, presumably because it was so adamant that New York Judiciary Law § 487 was not a vehicle by which Sabatini could force a review of WGP’s and Pergament’s conduct of the Acme bankruptcy. Yet the failed § 363 sale points out that had it been properly structured, a § 363 sale might have worked as a way out of the Acme bankruptcy. Much would have to have been done that was not (e.g., the insiders ceded control of the debtor by appointing a chief restructuring officer), and such planning should have begun prior to the commencement of the bankruptcy case.

The Limited Options Available to a Vengeful Creditor in a Failed Bankruptcy Case

The bankruptcy judge  apparently characterized the Acme bankruptcy as “terribly, terribly unsuccessful … with no benefit whatsoever for any pre-petition creditors and with tremendous amounts of administrative debt being incurred.”[22] Yet the district court firmly held that a “wronged” creditor could not attempt to hold debtor’s counsel liable for their missteps unless there was evidence of actual wrongdoing — a result that, if it indeed holds, should be of comfort to lawyers who represents debtors in bankruptcy.