It is been over a year since the unusual involuntary bankruptcy case of In re Scandia Seafood (New York) Inc. was tried on a motion by the assignee in an assignment for the benefit of creditors (ABC) to dismiss, and for sanctions against the petitioning creditors and their counsel.[1] What made the case unusual was that it consisted of an involuntary bankruptcy against a debtor that had been liquidating in state court under an ABC for 117 days. This is significant, because it meant that if the bankruptcy court had kept the case, there would be no opportunity for preferential transfer litigation, since that period is measured from the filing date of the chapter 7 case and more than 90 days had elapsed since the assignment for the benefit of creditors had been filed and was pending.[2]
This author was originally retained by certain creditors for the purpose of defending a state court preference action in the ABC, then pending in New Jersey Superior Court in Elizabeth, N.J. The retention occurred three days before the expiration of the 120-day deadline under § 303(h)(2).[3] I was not even looking at the possibility of an involuntary bankruptcy case until, as a standard practice, I pulled the file from the state court ABC files in Elizabeth, N.J. It was immediately apparent that there were discrepancies in the papers that seemed to contradict themselves. Most notably, this included a simultaneous combined motion for (1) the sale of assets of the for the grand total of $45,000 to the insiders of Scandia Seafood, and (2) the simultaneous approval of a management agreement between the assignee and the owners of Scandia Seafood, who were purchasing the assets of the debtor, that would pay them a $60,000 management fee. This latter request was allegedly made with the intention of preserving the value of the assets pending the sale. In other words, the assignee appeared to have agreed to pay the insiders a fee that was $15,000 more than the price he had agreed to accept as the purchase price for the assets, for the alleged purpose of preserving the value of assets whose purchase price could not have justified the expense.
In addition, and pending the sale, the insider purchasers were going to be paid an additional management fee equal to all of the profits derived from the operation of the business. These initial facts led me to further inquiry.[4]
Moreover, it appeared from state court records that within the 120 days prior to the filing of the ABC, the debtor had paid vendors approximately $3.2 million for inventory consisting of seafood products that could be quickly turned around for profit. The notion, therefore, that this going-concern business, which had paid out so much money in the 120-day period prior to the ABC, could only be worth $45,000 seemed incredulous. Further inquiry, both by review of the debtor’s Facebook page and other sources, quickly led this author to discover that the debtor failed to disclose the existence of a trademark, owned by the debtor, as well as a going-concern business operated by the debtor called Nautical Foods, which had an active website and was promoted on the QVC Home Shopping Network. It quickly appeared that this was a business that was worth much more than the $45,000 sales price. On the date of the involuntary filing, the debtor’s principal had surreptitiously filed an assignment transferring the trademarks from the debtor to the insiders’ wholly owned entity and designated purchaser.
The court, in its determination after trial to keep the case, was less impressed with what this writer thought was overwhelmingly persuasive math that appeared to demonstrate the impossibility of the creditor body receiving more in the ABC with preference actions than in an involuntary bankruptcy case without any preference actions, than with the overreaching self-dealing apparent from testimony adduced at trial during the course of this case.[5]
During the course of a preliminary motion for the appointment of an interim trustee filed by the petitioning creditors, it was revealed that absolutely no marketing efforts had been undertaken and no valuation had occurred with respect to the value of the assets to be conveyed by the assignee to the insiders. During the course of the trial on the motion to dismiss itself, it developed on cross-examination that the assignee had actually been approached several weeks before the assignment was made by the insiders, with whom he admitted to having corresponded on numerous occasions prior to the assignment, and who allegedly consulted with the assignee on a number of issues, including the pre-negotiated pre-executed management agreement that they had negotiated amongst themselves. By admitting that he had consulted with the principals on numerous occasions about several issues that would have been relevant and material in the administration of the then-yet-to-be filed ABC, the assignee essentially revealed that he had a conflict that should have precluded his subsequent acceptance of an assignment as a fiduciary for the creditors.[6] Once he accepted the assignment, the assignee acknowledged that he had conducted absolutely no due diligence whatsoever with respect to the value of Scandia Food’s Nautical Foods business as a going concern. This gifting of the ongoing business to the insiders, including all of the inventory, which was utilized by the insiders to generate further profits, without any inquiry whatsoever conducted by the assignee, was central to the court’s determination that the equities favored the retention by the bankruptcy court of this chapter 7 case, even if it meant that potential avoidance actions for $3.2 million would not be available to the debtor.
The clear lesson from this case is that an attorney needs to make a choice when confronted with the likelihood of a client looking to file an assignment for the benefit of creditors. He/she can either be the attorney for the owners of the business, or an assignee for the benefit of the creditors, but he/she cannot be both. The more appropriate role for the assignee in this instance would have been to continue his relationship as counsel for the debtor and to have sought the appointment of an independent assignee to fulfill those appropriate fiduciary duties. If he wanted to have a different role, he should have discontinued all conversation with the insiders immediately and recommended alternative counsel to them so that he could fulfill an unblemished role as a fiduciary for the benefit of creditors. The court determined that since he was not an independent fiduciary, the assignee needed to be replaced by a chapter 7 trustee, and that is what occurred.
Additionally, an assignee needs to do more as a fiduciary for creditors if it is to fend off a potential involuntary case. This includes an active and independent investigation into the value of the assets involved, particularly when a sale is proposed to the insiders. A transaction of that sort is subject to a higher level of scrutiny than a sale to a third party after active competitive bidding. In this case, the assignee only investigated the value of the business after the fact and after a motion for an interim trustee was filed in the bankruptcy court. No due diligence was done prior to the initial submission to the state court for approval of the agreement to sell the assets. Moreover, the assignee approved of the agreement before he was even appointed by the court as a fiduciary.
In summary, the assignee needs to respect the role that it plays as fiduciary for the creditors, or a court may determine that the assignee is more inclined to compete with the interests of creditors rather than to safeguard them.[7]
[1] In re Scandia Seafood (New York) Inc., 2017 Bankr. LEXIS 1298 (Bankr. S.D.N.Y. 2017).
[2] The chapter 7 trustee, one year after his appointment, made the unusual motion to obtain permission from the bankruptcy court to continue the state court preference actions, and this was soundly dismissed by the bankruptcy court as being without legal foundation.
[3] 11 U.S.C. § 303(h)(2) provides a basis for the filing of an involuntary case if “within 120 days before the date of the filing of the petition, a custodian … was appointed or took possession” of the assets of the debtor.
[4] During the trial, it was revealed that there were hundreds of thousands of dollars of inventory that the insiders were allowed to keep and sell for profit, cost-free. In re Scandia Seafood (New York) Inc., supra at *10.
[5] This math was made clear to this writer by reason of the fact that the assignee’s counsel had obtained from the state court an order authorizing 40 percent contingency fees without any further judicial approval, plus the 20 percent statutory commissions available to the assignee and ABC in the state of New Jersey. The combination of 60 percent of these funds going to professionals precluded any possibility of the creditors receiving a return on their claims as a whole. The court disagreed with this analysis, but in the end, it was the ethical issues that held the most importance for the court — and rightfully so.
[6] Scandia Seafood (New York) Inc., supra at *8.
[7] Douglas T. Tabachnik is Board Certified by the American Board of Certification in Business Bankruptcy Law. The American Board of Certification is a nonprofit entity jointly sponsored by the American Bankruptcy Institute and the Commercial Law League of America, and duly accredited by the American Bar Association.