Opinion
No. 1-88-01058
July 27, 1990
Trustees — Standing — Choses in Action — Property of the Estate — Automatic Stay — Injunctions — Class Actions — Fraud and RICO Claims. — A bankruptcy trustee only has the right to assert (and to protect by preventive measures) causes of action which belong to the bankruptcy estate. The test is whether the claim is "`brought for the benefit of all creditors and shareholders with an interest in the estate'" and whether the injury alleged is "`general and common'" as opposed to "`peculiar and personal.'" Not only does the trustee's standing and the character of the choses in action as estate property depend on these determinations but so too does the applicability of the automatic stay. Broadly speaking, the availability of Section 105 injunctive relief hinges on these factors as well. Here, a Chapter 11 investment company was charged with running a Ponzi scheme which defrauded investors of their investments and the estate as a whole of its assets. A class of investors initiated a suit in Federal district court against individuals associated with the debtor for violations of the Racketeer Influenced and Corrupt Organizations Act and common law fraud. The estate itself filed a district court lawsuit alleging RICO and pendent state law claims. Thereupon the trustee instituted this present adversary proceeding in bankruptcy court to halt, either through a declaration that the automatic stay applies or through the imposition of a Section 105 injunction, the investors' district court action. The adversary proceeding was dismissed, based on the merits of the allegations, as failing to state a claim upon which relief could be granted. Succinctly stated, there were major differences between the theories posited and the facts alleged by the class of investors compared to the matters put in issue by the trustee. The lawsuits were distinct. "[The trustee's] position would expand the situations in which the automatic stay would apply to any situation where a single tortfeasor simultaneously harms several victims. The logical corollary would then be that any bankrupt tort victim has a preeminent claim over his non-bankrupt fellow victim." The exception to stay coverage for situations in which the defendants are so intertwined with the debtor as to impede reorganization was not applicable.
See Sec. 105 at ¶ 7045, Sec. 323(b) at ¶ 8208, Sec. 362(a) at ¶ 8602, Sec. 541(a)(1) at ¶ 9502, Sec. 1106(a) at ¶ 12,015, Rule 7012 at ¶ 21,310, and Rule 7041 at ¶ 21,229.
On July 25, 1990, the Court heard plaintiff's motion for stay or preliminary injunction and defendants' motion to dismiss the adversarial complaint. James J. Garrett of Morrison Foerster and Steven M. Olson of Geary, Shea, O'Donnell Grattan appeared for plaintiff. William Bernstein of Lieff, Cabraser Heimann appeared for defendants. Steven W. Linthicum appeared for the Creditors' Committee of the bankruptcy estate.
Upon consideration of the submissions of the parties, the argument of counsel, and the applicable law, the Court hereby DISMISSES this adversary proceeding.
I. BACKGROUND
Plaintiff in this adversary proceeding is the successor Chapter 11 Trustee for the estate in bankruptcy of LendVest Mortgage, Inc. ("LendVest"). Defendants are the plaintiff class in Sweet v. Hanson, Action No. C884041-DLJ, currently pending before this Court (hereinafter referred to as "the Class Action"), which arises out of the same events and circumstances leading to LendVest's bankruptcy. The Class plaintiffs contend that those circumstances are a series of investment frauds perpetrated through a "Ponzi" scheme involving LendVest and related business ventures. The Class plaintiffs are individuals who invested funds with LendVest and related ventures and lost their investments.
The Class Action plaintiffs are barred from pursuing claims against the bankruptcy estates by the automatic stay provisions of the Bankruptcy Code, 11 U.S.C. § 362(a), and they have not moved for relief from the stay. Instead, the Class Action focuses on individual defendants and on LendVest's former attorneys and its former accountants, a partnership known as KMG Main Hurdman Co. A settlement has been entered with the attorney defendants, in which the LendVest estate participated. The LendVest estate has pending a separate district court action alleging RICO violations and pendent state law fraud, negligence, malpractice and breach of contract claims, No. C90-1638-JPV, filed June 22, 1990.
Through this adversary proceeding filed in Bankruptcy Court on May 25, 1990, the Trustee has alleged that the Sweet v. Hanson Class Action will interfere with the estate's ability to conduct its separate lawsuit and therefore is subject to the automatic stay provisions just as if the Class Action had been brought against the estate. By Order filed June 6, 1990, the Court withdrew reference of the Adversary Proceeding from the Bankruptcy Court, pursuant to 28 U.S.C. § 157(d).
The First Amended Complaint in the Adversary Proceeding seeks (1) a declaration that the LendVest estate owns RICO and other causes of action against KMG Main Hurdman asserted by LendVest creditors who are members of the Class Action plaintiff class; (2) a declaration that the Class Action violates the automatic stay provision of the Bankruptcy Code; and (3) a stay or injunction of the Class Action pending final judgment in LendVest's civil action against KMG Main Hurdman, No. 90-1638-JPV.
The motions before the Court are, in effect, cross-motions: (1) motion to dismiss the Adversary Proceeding, brought by the Class Action plaintiff class under Fed.R.Civ.P. 12(b)(6); and (2) motion for preliminary injunction to stay the Class Action pending resolution of LendVest's separate district court action, No. 90-1638. The Trustee's motion for preliminary relief addresses the substantive issues raised in the Adversary Complaint, as does the Class plaintiffs' motion to dismiss. Therefore, resolution of these motions requires determination of all the substantive issues in the Adversary Proceeding.
For the reasons discussed below, the Court finds that the Trustee has failed to make the necessary showing to obtain preliminary relief and that equity and considerations of judicial economy require dismissal of the Adversary Proceeding.
II. MOTION FOR PRELIMINARY INJUNCTION OR STAY A. Standard for Preliminary Injunction
The standard for determining whether a preliminary injunction should issue is well settled within the Ninth Circuit. See Rodeo Collection, Ltd. v. West Seventh, 812 F.2d 1215 (9th Cir. 1987); San Diego Comm. Against Registration and the Draft v. Governing Board of Grossmont Union High School Dist., 790 F.2d 1471, 1473 n. 3 (9th Cir. 1986); Sardi's Restaurant Corp. v. Sardie, 755 F.2d 719, 723 (9th Cir. 1985). "To qualify for a preliminary injunction the moving party must show either (1) a combination of probable success on the merits and the possibility of irreparable harm, or (2) that serious questions are raised and the balance of hardships tips sharply in the moving party's favor." Rodeo, 812 F.2d at 1217. These are not two distinct tests, but rather the opposite ends of a single "continuum in which the required showing of harm varies inversely with the required showing of meritoriousness." Id. (quoting San Diego Comm., 790 F.2d at 1473 n. 3).
Plaintiff asserts that he will ultimately prevail in the adversary proceeding because the Class Action against the non-bankrupt third party accountants of the estate's predecessor corporation violates the automatic stay provisions of the Bankruptcy Code. This position is premised upon the theory that the Class plaintiffs' RICO and state law misrepresentation causes of action against KMG Main Hurdman are "derivative" of LendVest's own RICO and state law claims, and that therefore, they are properly asserted solely by the corporation "for the common community of interests in the corporation — creditors as well as stockholders." Pepper v. Litton, 308 U.S. 295, 307 (1939). Such choses in action are property of the estate, pursuit of which is foreclosed by the automatic stay effected by filing the petition in bankruptcy. In re S.I. Acquisition, Inc., 817 F.2d 1142, 1149 (5th Cir. 1987).
In the alternative, plaintiff argues that the balance of hardships tips sharply in his favor because the Class Action interferes with his ability to fruitfully prosecute the estate's claim against KMG Main Hurdman. Plaintiff finds authority for this theory in the Supreme Court's ruling in Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416, 92 S.Ct. 1678 (1972), as read by the Bankruptcy Court in In re E.F. Hutton Southwest Properties II, Ltd., 103 B.R. 808 (Bkrtcy.N.D.Tex. 1989).
B. Applicability of Automatic Stay
Filing of a bankruptcy petition operates as an automatic stay of "any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate." 11 U.S.C. § 362(a)(3). "Property of the estate includes choses in action. Whether an action belongs to the estate depends on how the action is characterized under the applicable state (or federal) law. If an action under a particular theory belongs to the corporation . . . then the action is `property of the estate.' [Citations]." In re E.F. Hutton Southwest Properties II, Ltd., 103 B.R. 808, 811 (Bkrtcy.N.D.Tex. 1989) (footnote omitted) (emphasis added). The trustee has the power and duty to prosecute actions belonging to the estate, for the benefit of all creditors and shareholders of the estate. Id. at 812. The Trustee here alleges that, by prosecuting the Class Action, the Class plaintiffs are attempting to obtain the estate's "property," i.e., the estate's claim against KMG Main Hurdman. At the hearing counsel for the Trustee conceded that in order to accept this theory, the Court must consider the fund for potential recovery available from KMG Main Hurdman as estate "property" along with the estate's cause of action.
Therefore, the Court must determine in the first instance whether or not LendVest may be said to "own" the RICO and fraud claims asserted by its investors in the Class Action. A bankruptcy trustee has standing only to assert causes of action which are the property of the estate and is barred from collecting money not owed to the estate. Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416, 428, 92 S.Ct. 1678 (1972). That is to say, the trustee may not bring personal actions which do not belong to the estate. Williams v. California 1st Bank, 859 F.2d 664 (1988). Therefore such personal actions cannot be considered estate property.
The proper analysis for determining whether a bankruptcy estate owns a cause rests on these considerations: (1) the characterization of the claim as one "which is brought for the benefit of all creditors and shareholders with an interest in the corporation," American Nat'l Bank v. MortgageAmerica Corp., 714 F.2d 1266, 1277 (5th Cir. 1983); and (2) whether the injury alleged is "peculiar and personal" to the creditor or "general and common" to the corporation and its creditors, Koch Refining v. Farmers Union Central Exchange, Inc., 831 F.2d 1339, 1349 (7th Cir. 1987). See also S.I. Acquisition, supra, 817 F.2d at 1149 n. 7 (causes of action in dispute were "created for the benefit of the corporation, i.e., to vindicate injury to the corporation caused by improper actions by control persons.").
A trustee of a bankrupt corporation may assert RICO and state law misrepresentation claims against its own controlling principals. Schacht v. Brown, 711 F.2d 1343, 1346-47 (7th Cir. 1983), cited with approval in Kempe v. Monitor Intermediaries, Inc., 785 F.2d 1443, 1444 (9th Cir. 1986). Such claims allege injury to the corporation through depletion of its assets. See, e.g., First Amended Complaint, Sims v. KPMG Peat Marwick, C90-1638-JPV ¶ 45. These claims are properly brought by the corporation to redress a general and common injury to the corporation, its creditors and its shareholders.
However, the RICO statutes and the common law of fraud and misrepresentation cannot be considered actions created for the benefit of the corporation in the same sense as those discussed in the cases cited by the Trustee. Rather, any person injured in business or property by a RICO enterprise is permitted to seek treble damages under 18 U.S.C. § 1962(c). A creditor may bring a cause of action against corporate insiders and fiduciaries where the creditor's cause of action is based on (1) direct injury by the conduct of the defendant; (2) predicate acts of racketeering distinct from those forming the basis of the estate's claim; and (3) injury distinguishable from that suffered by the bankrupt corporation. Ashland Oil Co. v. Arnett, 875 F.2d 1271, 1280(7th Cir. 1989).
The Class Action claims meet all three of these criteria as to the RICO and state law claims. First, they are based on a theory distinct from LendVest's, namely that the corporation was a sham and was established as a vehicle for the alleged "Ponzi" scheme. By contrast, the Trustee's Complaint alleges that KMG Main Hurdman assisted in perpetrating a "Ponzi" scheme run out of its otherwise legitimate operation. The Class plaintiffs allege direct injury in that they are fraudulently induced to invest in the corporation; by contrast, the Trustee alleges injury in that its assets were depleted by perpetration of the fraud.
Furthermore the predicate acts of racketeering alleged in the two complaints are not wholly the same. The Trustee alleges predicate acts in KMG Main Hurdman's forwarding false financial reports to banks and federal agencies with the power to qualify LendVest for continued mortgage brokering activities. C90-1368 Complaint ¶¶ 65-68. By contrast, the Class Action alleges predicate acts under a "fraud on the market" theory, that KMG Main Hurdman aided and abetted dissemination of "false and misleading periodic reports and solicitations in regards to investment offerings, . . . stock offerings, prospectuses, projections, [and] financial statements." Sweet v. Hanson, No. C88-4041-DLJ, Second Amended Class Action Complaint ¶ 69. Thus the scope of the RICO enterprise alleged in the Class Action is far broader than that alleged by the estate.
Furthermore, it is axiomatic that the injury an individual fraud victim suffers is distinct from the injury suffered by a corporation fraudulently maintained in business. It is true that one of the corporation's injuries is its obligation to its investors arising from depletion of the assets, but this characterization makes clear the distinction between the personal and general injuries alleged in this action.
Thus a proper analysis of the causes of action alleged against LendVest's accountants by the investors, on one hand, and the corporation, on the other, demonstrates that the LendVest estate has no property right in the investors' causes of action against KMG Main Hurdman. Further, the Court declines to adopt plaintiff's theory that because the estate has a claim against KMG Main Hurdman it has an existing property right in any unitary fund for recovery of its unproven claim and those of the investors. The courts have recognized such a theory only where the property sought to be recovered originated from the bankrupt debtor. E.g., American Nat'l Bank v. MortgageAmerica Corp., 714 F.2d 1266 (5th Cir. 1983) (claim of fraudulent transfer); In re Bialac, 712 F.2d 426, 431-32 (9th Cir. 1983) (debtor's one-sixth interest and redemption right in surplus cash note).
Plaintiff's position would expand the situations in which the automatic stay would apply to any situation where a single tortfeasor simultaneously harms several victims. The logical corollary would then be that any bankrupt tort victim has a preeminent claim over his non-bankrupt fellow victim. Such a rule would promote a rush to bankruptcy rather than avert a rush to judgment, and would impermissible expand the Bankruptcy Code's true function: "securing and preserving the debtor's property and ensuring equal distribution of the debtor's assets to similarly-situated creditors." S.I. Acquisition, 817 F.2d at 1150.
Finally, the Trustee argues that the automatic stay applies to actions against third parties unrelated to the debtor, if such actions severally interfere with the estate's orderly reorganization. This argument relies on the "unusual situation" exception, recognized in A.H. Robins v. Piccinin, 788 F.2d 994 (4th Cir. 1986), to the general rule that the automatic stay is available only to the debtor and not to a third party defendant. The exception applies to third parties who have such identity with the debtor that the debtor may be said to be the real party defendant; it does not apply to third parties who are independently liable to the creditor. Id. at 999.
This exception has never been explicitly recognized in the Ninth Circuit, Matter of Lockard, 884 F.2d 1171, 1179 (9th Cir. 1989), and in any event does not apply to the present situation, which clearly involves KMG Main Hurdman's independent liability to the LendVest investors. But see dicta in S.I. Acquisition, 817 F.2d at 1147 ("a nonbankrupt codefendant may be protected by the automatic stay of section 362(a)(1) if extension of the stay contributes to the debtor's efforts of rehabilitation. . ."); E.F. Hutton, supra, 103 B.R. at 812 (discerning from the court's reading of Caplin that actions by individual parties that interfere with potential estate actions are stayed).
Therefore, there is no basis on which to find that the Class action is subject to the automatic stay provision of the Bankruptcy Code, 11 U.S.C. § 362.
C. Trustee's Standing to Bring Claims
The Trustee argues that, even if the Class Action is not automatically stayed, the Court should exercise its discretionary power under 11 U.S.C. § 105 to stay proceedings against non-bankrupt entities in order to efficiently manage administration of the bankruptcy estate. "The party requesting the exercise of this inherent power to stay must justify the stay by clear and convincing circumstances outweighing the potential harm to the party against whom it is to be operative." S.I. Acquisition, 817 F.2d at 1146 n. 3.
The potential harm to the Class plaintiffs of staying the Class Action is the indefinite delay, if not the loss, of their cause of action against a party who possibly has substantial liability for their injuries, as well as substantial resources for recovery. The Trustee argues that this harm is mitigated by his ability to bring the Class plaintiffs' actions in their behalf. This position is contrary to Ninth Circuit law.
A bankruptcy trustee lacks standing to assert the claims of persons other than the estate, even if those claims are assigned to the Trustee. Williams v. California 1st Bank, 859 F.2d 664 (1988). This lack of standing is the basis for a defendant's motion to dismiss. Id. Therefore, the LendVest Trustee cannot proceed as a representative of the Class plaintiffs, and a stay of their action pending resolution of the Trustee's action would do nothing to advance their causes. Furthermore, a judgment in an action brought by the bankruptcy estate does not bind creditors who have individual personal claims, and thus a stay or injunction would serve no purpose of avoiding a proliferation or litigation. See Caplin v. Marine Midland Grace Trust Co. of New York, 92 S.Ct. 1678, 1687 (1972).
Therefore, the Trustee has shown little likelihood of success in the adversary proceeding, and the Trustee's showing of hardship would have to be extraordinary indeed to justify the preliminary relief sought, which is nothing less than the likely deprivation to the LendVest investors of their own cause of action against KMG Main Hurdman. The Trustee's showing of hardship falls far short of that required in this case, and therefore the motion for stay or for preliminary injunction is DENIED.
III. MOTION TO DISMISS
The question presented by a motion to dismiss is not whether plaintiff will prevail in the action, but whether plaintiff is entitled to offer evidence in support of his claim. "[T]he accepted rule [is] that a complaint should not be dismissed for failure to state a claim unless it appears beyond doubt the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Conley v. Gibson, 78 S.Ct. 99, 102 (1957). Therefore, the Court will dismiss the complaint or any claim in it without leave to amend only if "it is `absolutely clear that the deficiencies of the complaint could not be cured by amendment.'" Noll v. Carison, 809 F.2d 1446, 1448 (9th Cir. 1987) (quoting Broughton v. Cutter Laboratories, 622 F.2d 458, 460 (9th Cir. 1980) (per curiam).
As discussed above, the theories under which this action is brought find little if any support in the law of this Circuit and elsewhere. While the Court retains equitable powers to grant the relief sought in the Adversary Complaint under 11 U.S.C. § 105, considerations of equity and efficiency favor dismissal of the action.
The Trustee has conceded that the Class plaintiffs, i.e., the LendVest investors, have additional individual federal claims for securities fraud over which the estate has no colorable claim or control. Therefore, a grant of the relief sought in the Adversary Complaint would result only in the severance of certain of the Class Action claims while permitting the rest to go forward. The inescapable conclusion is that observed by the Supreme Court in Caplin: "Thus, there is no showing whatever that by giving the petitioner standing to sue on behalf of the [investors] we would reduce litigation. On the contrary, there is every indication that litigation would be increased, or at least complicated." 406 U.S. at 434. Severance of some of the class claims, as to only some of the class members, would most assuredly complicate this already complex litigation.
Furthermore, as noted above, the policies of the Bankruptcy Code are directed to the orderly administration of the bankrupt estate by providing a breathing space for reorganization and, if necessary, for fair and equitable distribution of the estate assets among the creditors. The Class plaintiffs who are also LendVest creditors have already acceded to estate's orderly administration by forebearing to move for relief from the automatic stay. No bankruptcy policies are served by denying the victims all opportunities to vindicate personal injuries which they claim to have suffered as a result of the massive fraud scheme that led to these lawsuits.
For these reasons, the motion to dismiss is GRANTED, and this adversary proceeding is hereby DISMISSED.
IV. SANCTIONS
In opposing the Trustee's motion for stay or preliminary injunction, the Class plaintiffs urge the Court to consider imposing Rule 11 sanctions on the Trustee for bringing a meritless proceeding.
The Court agrees that this issue deserves close scrutiny. While the adversary proceeding itself arguably was advanced by a good faith argument for the extension of existing law, the Trustee's papers showed a marked lack of candor regarding the current state of the law in this Circuit and elsewhere. Most notably, the Trustee's opening Memorandum failed to cite the highly relevant Ninth Circuit cases Williams v. California 1st Bank, 859 F.2d 664 (1988) and Matter of Lockard, 884 F.2d 1171 (1989), while mischaracterizing far less relevant law, in particular Caplin v. Marine Midland Grace Trust Co. of New York, 92 S.Ct. 1678 (1972) and In re S.I. Acquisition, Inc., 817 F.2d 1142, 1149 (5th Cir. 1987).
The Court is troubled by this failure to directly confront opposing authority in the briefing submitted; however, the Court finds, on objective standards, that it is not in violation of Rule 11. Therefore, no sanctions will be ordered.
V. CONCLUSION
For the reasons stated above, the Trustee's motion for stay or preliminary relief is DENIED, and Adversary Proceeding No. 1-90-0048 is hereby DISMISSED.