Every bankruptcy trustee should read the December 27 opinion by Delaware Bankruptcy Judge Christopher S. Sontchi. It tells a cautionary tale about the dangers that arise when a trustee accepts litigation financing from a creditor and turns over settlement authority to the creditor.
Taking his findings at face value, Judge Sontchi’s 72-page opinion retells a disturbing story of fraud.
Dramatically simplified, an individual owned a highly lucrative business. He came to terms with a buyer to sell the business for $35 million, with most of the purchase price to be paid over time.
A critical term of the sale called for the seller to receive an employment contract on attractive terms. The employment agreement provided, in substance, that ownership would revert to the seller if the buyer were to default on the installment payments.
The buyer could not obtain financing given the agreed-upon terms of the sale. However, the buyer located another lender who would finance the purchase, but not on the terms demanded by the seller. Among other things, the lender would not make the loan if ownership reverted to the seller on default in the payment of installments.
Before closing, the buyer obtained the seller’s signature on a signature page to be held in escrow pending closing. Later, the seller saw the terms of the employment agreement where the lender had deleted the provisions calling for reversion to the seller on default.
The seller unequivocally voiced his objection and refusal to close without reversion of ownership. In substance, the principal of the buyer assured the seller that the lender consented to reversion. The sale closed.
There was a default about one year after closing. Around the same time, the seller investigated and learned that the sale had closed with an employment agreement that lacked reversion on default. The seller told the buyer’s principals that the transaction documents were fraudulent.
The corporate buyer filed a chapter 7 petition.
Although not mentioned in Judge Sontchi’s opinion, the trustee made an agreement three months after filing for the lender to finance prosecution of claims belonging to the estate. As approved, the agreement gave the trustee an advance of $75,000 for the estate, plus between 6% and 10% of recoveries, including recoveries on claims by the estate against the seller.
In the agreement, the lender specified the attorneys to represent the estate in the prosecution of claims. The lender would pay special counsel, who were not required to file fee applications nor to disclose what they were paid, not even to the U.S. Trustee.
The agreement gave the lender an allowed claim for $25 million, secured by all of its collateral, including claims prosecuted by special counsel. The agreement also released any claims of the estate against the lender.
The agreement required the trustee to “confer” with the lender about the lawsuits but said that special counsel “shall take their direction” from the trustee. However, the agreement effectively precluded the trustee from settling claims without the lender’s consent.
A few months after the financing agreement, the trustee sued the seller. The complaint sought a declaration that the bankrupt estate was the owner of the business free of any claims of the seller. In other words, the trustee sought a ruling that the sale was made without reversionary rights.
Claiming the sale was the “product of fraud in the execution,” the owner answered and counterclaimed for everything and the kitchen sink. Judge Sontchi held a trial over seven days. He issued his findings of fact and conclusions of law 10 days after both sides filed proposed findings and conclusions.
The outcome was never in doubt. Judge Sontchi ruled against the trustee and in favor of the seller.
Judge Sontchi found “multiple material misrepresentations” in connection with the purchase. “The evidence adduced at trial demonstrates the Debtors’ liability on the [seller’s] counterclaim for fraud in the execution,” he said.
Without the seller’s knowledge or consent, Judge Sontchi found that the buyer’s principal “or another agent of [the buyer] . . . surreptitiously affixed the [seller’s] signature pages” to a version of the employment agreement that the seller had refused to sign. The evidence, he said, “shows that the Employment Agreements are the product of fraud in the execution.”
Judge Sontchi ruled that the seller was “entitled to seek compensatory damages” and “punitive damages . . . with respect to the [buyer’s] fraud in the execution” of the employment agreement and the debtor’s fraudulent misrepresentations.
The sale agreement was “voidable at the [seller’s] opinion,” Judge Sontchi said, given the buyer’s fraudulent inducements. In view of the lack of mutual consent, he said that the sale contract was “legally unenforceable.”
In ruling against the trustee, Judge Sontchi said that the trustee was not entitled to enforce the sale agreement.
Judge Sontchi closed his opinion by directing the parties to hold a trial at the court’s “earliest convenience” to determine the compensatory and punitive damages to be awarded against the debtor and in favor of the seller.
The upcoming trial, Judge Sontchi said, would also decide whether the lender’s allowed $25 million claim should be subordinated to the seller’s claims.
Observations
What lessons are to be learned?
Perhaps a trustee should not sign a litigation finance agreement until investigating the facts enough to know what claims hold water and what don’t.
And, if it turns out that a lawsuit was filed improvidently, what then? In this instance, the trustee could not compel the lender to withdraw the suit, but perhaps the trustee could have resigned.
When approving a financing agreement where the lender has control of litigation, perhaps a court should insist on inclusion of an escape clause allowing a trustee to stop a lawsuit where prosecution would violate the trustee’s fiduciary duties or the outcome would not be in the best interests of the estate.
Would this be a case to revisit special counsel’s fee arrangement under Section 328(a)? The section allows the court to determine whether the terms of employment were “improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions.”
Every bankruptcy trustee should read the December 27 opinion by Delaware Bankruptcy Judge Christopher S. Sontchi. It tells a cautionary tale about the dangers that arise when a trustee accepts litigation financing from a creditor and turns over settlement authority to the creditor.
Taking his findings at face value, Judge Sontchi’s 72-page opinion retells a disturbing story of fraud.
Dramatically simplified, an individual owned a highly lucrative business. He came to terms with a buyer to sell the business for $35 million, with most of the purchase price to be paid over time.
A critical term of the sale called for the seller to receive an employment contract on attractive terms. The employment agreement provided, in substance, that ownership would revert to the seller if the buyer were to default on the installment payments.
The buyer could not obtain financing given the agreed-upon terms of the sale. However, the buyer located another lender who would finance the purchase, but not on the terms demanded by the seller. Among other things, the lender would not make the loan if ownership reverted to the seller on default in the payment of installments.
Before closing, the buyer obtained the seller’s signature on a signature page to be held in escrow pending closing. Later, the seller saw the terms of the employment agreement where the lender had deleted the provisions calling for reversion to the seller on default.