Opinion
Case No. 302-08915
December 12, 2003
MEMORANDUM
This matter is before the court on the debtor's motion for an "Order Authorizing Debtors to Reject Warrant Agreement." For the reasons hereinafter cited, the court grants the debtor's motion and finds the damages stemming from rejection are $846,369.85. The debtor shall prepare an Order consistent with this Memorandum within ten (10) days of entry of this Opinion.
Factual Background
The Warrant Agreement provides that the debtor is required to issue two series of warrants which, in aggregate, are exercisable to purchase up to 3,265,315 share of the common stock, $0.01 par value, constituting 19.9% of the company's outstanding shares of common stock. The warrant holders must surrender the warrant certificate to the company with payment, and the debtor must thereafter issue and deliver the appropriate number of shares.
According to the debtor, under Section 8.1 of the confirmed Second Joint Amended Plan of Reorganization (the "Plan"), "[a]ll executory contracts with the Debtors that have not, as of ten (10) days following the Effective Date, been specifically rejected shall be deemed contracts that the Debtors intend to assume, provided the Debtors agree to pay any Allowed Cure Claim." Because the debtor contends that the Warrant Agreement is an executory contract, the debtor moved to reject the Warrant Agreement in exercise of its' business judgment as most beneficial to the estate.
The Lenders, however, contend that rejection of the Warrant Agreement cannot occur for at least three reasons: (1) the express terms of the Plan prevent such ("Record Holders of Interest in AHP Common Stock shall Retain their Interests." Interest is defined in the Plan as "the equity interests in the AHP Common Stock or any options, warrants or rights to purchase or acquire such stock."); (2) the debtor is estopped from rejecting the Warrant Agreement because the debtor failed to list the Warrant Agreement in Schedule G or Amended Schedule G which listed all "Executory Contracts and Unexpired Leases" and; (3) the Warrant Agreement is not an executory contract as a matter of law and therefore cannot be rejected.
If rejected, then both sides have different arguments on how the rejection damages should be calculated. The parties requested until close of business on December 5, 2003 to file post-trial briefs. Now having received all evidence, the court finds that the Warrant Agreement is an executory contract, and that rejection is in the best interest of creditors and the estate. The damages stemming from the rejection are $846,369.85.
Discussion A. Can the Warrant Agreement Be Rejected?
1. Does the Plan Prevent Rejection of the Warrant Agreement?
The Lenders argue that the plan prevents rejection of the Warrant Agreement because the plan states:
Record Holders of Interest in AHP Common Stock shall Retain their Interests.
The Plan then defines record holders as "equity interests in AHP Common Stock or any options, warrants or rights to purchase or acquire such stock."
The Disclosure Statement provides:
Additionally, American HomePatient has in place various stock option plans, pursuant to which options to purchase a significant number of shares of common stock nave been issued to current and former employees and directors of the Company. Many of these options have an exercise price so high that they have little or no value. Under existing, applicable legal principles, the Company believes that these existing options are executory contracts. The Company has not made any decision as to whether it will assume or reject these contracts. If assumed, the existing options and warrants may be exercised after the Effective Date pursuant to their terms. If any of these options or warrants are rejected, then the holder of the rejected contract may have an Unsecured Claim against the Debtor.
The court finds that the Disclosure Statement, when read in conjunction with the Confirmed Plan, does not preclude rejection by the Debtor if the warrants are executory contracts. The Disclosure Statement clearly states that the Debtor considers the warrant agreement to be an executory contract and that the Debtor is considering rejection of same. The plan states that whatever interest the warrant holders had before the plan, they retain such after the plan. In other words, whatever interest the warrant holders had under the Warrant Agreement, they will still have those interests. That interest is as a party to a possible executory contract that might be rejected.
The court therefore overrules the Lender's objection to rejection based on the language of the confirmed plan.
2. Is the Debtor Estopped from Rejecting Warrant Agreement Because the Debtor Failed to List the Warrant Agreement as Executory in its Schedules?
The Debtor did not list the Warrants or Warrant Agreements in Schedule G in the bankruptcy statements and schedules. The debtor's failure to list such, according to the Lenders, is a judicial admission that the warrants are not executory. The Lenders contend that the mere fact that the debtor may be able to amend their Schedule G is not enough because the failure to include such is a judicial admission. The lenders rely upon Larson v. Groos Bank, N.A., 204 B.R. 500 (W.D. Tex. 1996) (failure to list cause of action in schedules operated as a judicial admission to non-existence of damages in subsequent lawsuit). The Lenders argue that the failure to include the Warrant Agreement judicially estopps the Debtor from rejection of the Warrant Agreement if it is executory.
The Debtor contends that it was oversight not to include the Warrant Agreement. Rule 1009 allows the amendment to a list or schedule as a matter of course at any time before the case is closed. While it is true that courts do not allow amendment to statements and schedules once an intentional deceit is discovered, oversight is the basis for nearly all amendments to statements and schedules. There is no proof to suggest that the Debtor intentionally excluded the Warrant Agreement from Schedule G. In fact, the proof is to the contrary since the Disclosure Statement, that was mailed to ALL creditors included a plain statement that the debtor considered the Warrant Agreement to be an executory contract.
Furthermore, the doctrine of judicial estoppel prevents party from asserting a legal position contrary with one successfully and unequivocally asserted by the same party in a prior proceeding. In re Duke , 172 B.R. 575 (M.D. Tenn. 1994). The Debtor has not made a prior successful and unequivocal showing in a prior proceeding. The court therefore, overrules the Lenders' objection on this basis as well.
3. Executoriness is in the Eye of the Beholder
The definition of "executory contract," proposed by Professor V. Countryman in Executory Contracts in Bankruptcy, Part I, 57 Minn. L.Rev. 439, 460, is:
a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.
This definition was found by the Sixth Circuit to be helpful but not controlling in the resolution of what is an executory contract. In re Jolly , 574 F.2d 349 (6th Cir. 1978). Rather, the Sixth Circuit suggested that in determining whether the contract is executory, the court should work backward from an examination of the purposes to be accomplished by rejection and, if they have already been accomplished, then the contract cannot be said to be executory. In re Magness, 972 F.2d 689, 694 (6th Cir. 1992).
This widely cited language in Jolly articulates what is called the "functional approach." In re Sentle Trucking Corp. , 93 B.R. 551, 557 (Bankr. N.D. Ohio 1988). Under the functional approach, courts must "look first at the results which would obtain if the contract were held to be executory." Id. Generally, a court should find the contract executory if such a determination allows the debtor to reject a burdensome or unfavorable contract. A court may find a contract is executory under the functional approach, even though it might not have found the contract to be executory under the Countryman test. Jolly , 574 F.2d at 351.
The ultimate purpose behind section 365 is "to allow a trustee to pick and choose among the debtor's agreements and assume those which benefit the estate and reject those which do not." Phar-Mor, Inc. v. Strauss Bldg. Associates 204 B.R. 948, 952-953 (N.D. Ohio, 1997) (quoting In re G-N Partners , 48 B.R. 462, 465 (Bankr. D.Minn. 1985)). "Working backwards," then, the court must answer two questions in this case: (1) under the Warrant Agreement does the debtor have material unfulfilled obligations extending into the future? and (2) might the debtor's rejection of the Warrant agreement reasonably benefit the estate?" Phar-Mor, Inc. v. Strouss Bldg. Associates 204 B.R. 948, 952-953 (N.D. Ohio, 1997).
Judge Lundin explained the inquiry as follows:
The Sixth Circuit arrived at its definition of executory contract through analysis of the purposes of rejection. Jolly , 574 F.2d at 351. It determined that a contract is not executory if the objectives of rejection "have already been accomplished, or if they can't be accomplished through rejection." Id. Those purposes include: (1) taking advantage of contracts which will benefit the estate; (2) relieving the estate of burdensome contracts; (3) promoting the debtor's fresh start; (4) permitting the allowance and determination of claims; and (5) preventing parties from remaining "in doubt concerning their status vis-a-vis the estate." See Jolly, 574 F.2d at 351; In re Norquist , 43 B.R. 224, 225, 11 COLLIER BANKR. CAS.2d (MB) 1146 (Bankr. E.D. Wash. 1984); H.R. REP. 595, 95th Cong., 1st Sess. 348 (1977) reprinted in 1978 U.S. CODE CONG. AD. NEWS at 6304.
In re Monument Record Corp. 61 B.R. 866, 868 (Bankr. M.D.Tenn., 1986) (footnotes omitted).
With specific reference to option type contracts, there is a divergence of opinions as to their executoriness. The first line of cases, finds option agreements are executory contracts. See A. J. Lane Co. , 107 B.R. 435 (Bankr. D.Mass. 1989); In the Matter of Jackson Brewing Company , 567 F.2d 618 (5th Cir. 1978); In re Riodizio, Inc. , 204 B.R. 417 (Bankr. S.D.N.Y. 1997); In re G-N Partners , 48 B.R. 462 (Bankr. D.Minn. 1985); In re Hardie , 100 B.R. 284 (Bankr. E.D.N.C. 1989); In re Waldron , 36 B.R. 633 (Bankr. S.D. Fla. 1984), rev'd on other grounds , 785 F.2d 936 (11th Cir.), cert. dism'd, 478 U.S. 1028, 106 S.Ct. 3343, 92 L.Ed.2d 763 (1986). The other line of cases, holds that an option contract is typically an executed unilateral contract, not an executory contract. In re Robert L. Helms Constr. Dev. Co., Inc. , 139 F.3d 702, 705-06 (9th Cir. 1998); In re Giesing , 96 B.R. 229, 232 (Bankr. W.D. Mo. 1998); In re America West Airlines, Inc. , 179 B.R. 893, 896 (Bankr. W.D. Ariz. 1995); In re Continental Properties Inc. , 15 B.R. 732, 736 (Bankr. Haw. 1981); In re National Financial Realty Trust 226 B.R. 586, 589-590 (Bankr. W.D. Ky., 1998) (recognizing distinction and adopting minority position that option contracts are not executory).
The court agrees with the Debtor that under the Sixth Circuit's more liberal functional analysis, that the Warrant Agreement is an executory contract. The Warrant Agreement undeniably involves obligations that continue into the future because it obligates the company to sell almost 20% of its stock, if the Warrant Holders exercise their option for the sum of approximately $32,000. Even though the obligation arises based on a contingency, the contingent nature of the obligation does not prevent the contract from being executory. In re Phar-Mor, 204 B.R. 948 (Bankr. N.D. Ohio, 1997) (citing Lubrizol Ents. Inc. v. Richmond Metal Finishers, Inc. , 756 F.2d 1043, 1046 (4th Cir. 1985) ("contingency of an obligation does not prevent it from being executory.")).
A case, almost precisely on point, In re Riodizio , 204 B.R. 417 (Bankr. S.D.N.Y. 1997) provides:
Some have found the Countryman "material breach" test too constraining and static. In Chattanooga Memorial Park v. Still (In re Jolly) , 574 F.2d 349 (6th Cir.), cert. denied, 439 U.S. 929, 99 S.Ct. 316, 58 L.Ed.2d 322 (1978) . . .
In this same vein, some advocate a functional analysis which eliminates the requirement of executoriness. See Westbrook , supra, 74 Minn. L.Rev. 227; see also Michael T. Andrew, Executory Contracts in Bankruptcy; Understanding Rejection , 59 U.Colo. L.Rev. 845 (1988) ("Andrew I") — Michael T. Andrew, Executory Contracts Revisited: A Reply to Professor Westbrook , 62 U.Colo. L.Rev. 1 (1991) ("Andrew II"). Under the functional approach, "the question of whether a contract is executory is determined by the benefits that assumption or rejection would produce for the estate." Sipes v. Atlantic Gulf Communities Corp. (In re General Dev. Corp.) , 84 F.3d 1364, 1375 (11th Cir. 1996) (affirming on the basis of the district court's opinion, 177 B.R. 1000 (S.D.Fla. 1995)). . . .
The functional approach does not repudiate the Countryman rule — it merely recognizes its limitations. In re G-N Partners , 48 B.R, 462, 466 (Bankr. D.Minn. 1985). It also conserves the time and effort that the parties and the court otherwise spend resolving the question of executoriness. But it has its critics. To be subject to assumption or rejection, the statute, 11 U.S.C. § 365, expressly requires that the contract be executory. Ignoring executoriness rewrites the statute in a fundamental way. See In re Child World, Inc. 147 B.R. at 851 ("Manifestly, th[e functional] approach ignores the statutory requirement that the contract to be assumed or rejected must be `executory.'").
Options agreements, such as the Warrant, demonstrate the shortcomings of the Countryman definition. "[A]n option contract is essentially an enforceable promise not to revoke an offer." In re III Enterprises, Inc. V , 163 B.R. 453 460-61 (Bankr. E.D. Pa.), aff'd, 169 B.R. 551 (E.D.Pa. 1994). It is a unilateral contract until exercised; upon exercise, it becomes a bilateral contract. W. Jaeger, Williston on Contracts § 61B (3d ed. 1963); John Calamari Joseph M. Perillo, The Law of Contracts § 2-25, at 123 (3d ed. 1987) (an option contract is a hybrid; initially, it is an irrevocable offer, upon exercise, it becomes a bilateral contract); see also Leslie Fay Cos. v. Corporate Property Assocs. 3 (In re Leslie Fay Cos.), 166 B.R. 802, 810 (Bankr. S.D.N.Y. 1994); In re A.J. Lane Co. , 107 B.R. 435, 437 (Bankr. D.Mass. 1989).
An option contemplates performance by both parties but requires it from only one. The optionor must keep the offer open. The optionee may but need not exercise the option; if he does, each party must perform its obligations under the resulting bilateral contract. The optionee's failure to exercise the option constitutes a failure of condition rather than a breach of duty. The failure to perform a condition which is not also a legal duty cannot give rise to a material breach. In re Columbia Gas Sys. Inc. , 50 F.3d at 241, see Merritt Hill Vineyards Inc. v. Windy Heights Vineyard, Inc. , 61 N.Y.2d 106, 112-13, 460 N.E.2d 1077, 1081-82, 472 N.Y.S.2d 592, 596-97 (1984), and hence, an option contract is not executory under the Countryman definition. Andrew H, supra , 62 U.Colo. L.Rev. at 32; see, e.g., In re America West Airlines, Inc. , 179 B.R. 893, 896 (Bankr. D.Ariz. 1995) (stock option not executory because optionee has no continuing obligations); Brown v. Snellen (In re Giesing) , 96 B.R. 229, 232 (Bankr. W.D. Mo. 1989) (by paying for the option, debtors-optionees fully performed their obligations under the option, and option could no longer be rejected); Travelodge Int'l, Inc. v. Continental Properties, Inc. (In re Continental Properties, Inc.) , 15 B.R. 732, 736 (Bankr. D. Haw. 1981) (an option is an executed contract and not an executory contract).
Most courts, however, consider an option contract to be executory although they reach their conclusions through different routes. In In re Waldron , 36 B.R. 633 (Bankr. S.D. Fla. 1984). aff'd without op. , (S.D. Fla.), rev'd on other grounds , 785 F.2d 936 (11th Cir.), cert. dismissed , 478 U.S. 1028, 106 S.Ct. 3343, 92 L.Ed.2d 763 (1986), the debtors granted a real estate option to the Shell Oil Company. The debtors subsequently filed a joint chapter 13 petition in order to reject the contract since the value of the property exceeded the option price.
The Waldron court held that the option was executory, but relied on the "some performance due" standard cited in the legislative history rather than the more rigorous Countryman test. Initially, the court noted that "performance continues to remain due on the part of the Debtors" because they had to keep their offer open. In re Waldron , 36 B.R. at 637. In addition, some performance also remained due from Shell. The court assumed, in light of the value of the real estate, that Shell would exercise the option, Id. To do so, Shell had to tender its acceptance in accordance with the terms of the option contract, and this "is the performance that foreseeably remains due by Shell or its assignees." Id. Further, once Shell exercised the option, "the option contract will immediately transform into an executory contract for the sale of real property." Id.
The court reached the same conclusion by an alternative route. Quoting a lengthy passage from In re Booth , 19 B.R. 53 (Bankr. D. Utah 1982), the court tacitly acknowledged the limitations of the Countryman test and presaged the functional analysis discussed above. It observed that executory contracts are not measured by the mutuality of commitments but the nature of the parties and the goals of reorganization. Thus, the benefit to the estate rather than the form of the contract controls. In re Waldron , 36 B.R. at 637.
The option cases that came after Waldron , but adopted the Countryman definition, faced a dilemma. The optionor's obligation — to keep the option open — was substantial, but the optionee did not owe any substantial obligation that could result in a material breach. Andrew If, supra , 62 U.Colo. L.Rev. at 32. To fit the option contract within the "material breach" test, they conflated the option contract with the contingent bilateral contract, finding the optionee's duty of substantial performance in the contingent obligation to perform under the bilateral contract created by the exercise of the option. See, e.g., In re Coordinated Fin. Planning Corp., 65 B.R. 711, 713 (Bankr. 9th Cir. 1986); In re Sundial Asphalt Co. , 147 B.R. 72, 80 (E.D.N.Y. 1992); In re III Enters., Inc. V , 163 B.R. at 468-69; In re Parkwood Realty Corp. , 157 B.R. 687, 690 (Bankr. W.D. Wash. 1993); In re A.J. Lane Co., 107 B.R. at 437: In re Hardie , 100 B.R. 284, 286-87 (Bankr. E.D.N.C. 1989); In re G-N Partners , 48 B.R. at 465.
The case law confirms that executoriness lies in the eyes of the beholder. Despite the contrary case law discussed above, the Warrant, an option contract, is not an executory contract under Countryman's "material breach" test. The debtor granted the option to LLC as additional consideration for the loan. LLC fully performed any legal obligation in connection with the Warrant when it funded the ban. while the exercise of the Warrant is a condition to the debtor's obligation to deliver the shares to LLC, LLC is not legally obligated to exercise the Warrant or do anything (or refrain from doing anything).[4]
[4] Although LLC also argues that the Warrant is not executory, its reasoning is wrong. LLC erroneously contends that the debtor's only duty under the Warrant is the "ministerial" task of delivering the shares to LLC if it exercises the option to purchase. The debtor must, however, keep the offer open, and under New York law, the failure to do so constitutes a material breach of the option agreement as well as the contingent bilateral contract. Cf. Scholle v. Cuban-Venezuelan Oil Voting Trust, 285 F.2d 318, 320 (2d Cir. 1960) (stock optionor's anticipatory breach of its duty to deliver shares excused optionee's tender and entitled it to recover damages); Special Situations Fund III, L.P. v. Versus Tech., Inc. , ___ A.D. ___, 642 N.Y.S.2d 894, 895 (1st Dep't) (same), leave to appeal denied, 88 N.Y.2d 815, 673 N.E.2d 1243, 651 N.Y.S. 2d 16 (1996).
If the "some performance due" test in the legislative history is overly inclusive, the Countryman test excludes too much. It imposes a "material breach" requirement, raising the threshold of executoriness above what Congress seemed to intend. In the case of options, it excludes contracts under which the debtor has benefits and burdens, each party must still perform as a condition to the other party's performance, and assumption or rejection may confer a net benefit on the estate. Under the circumstances, we should question the test rather than condemn the contract to a "legal limbo" in which it can be neither assumed nor rejected. See Westbrook, supra, 74 Minn. L.Rev. at 239.
A test less exclusive than Countryman's that takes into account the mutual performance requirement embodied in the legislative history should be substituted. Under this test, a contract is executory if each side must render performance, on account of an existing legal duty or to fulfill a condition, to obtain the benefit of the other party's performance. Weighing the relative benefits and burdens to the debtor is the essence 61 the decision to assume or reject; if each party must still give something to get something, the contract is executory, and the debtor must demonstrate whether assumption or rejection confers a net benefit on the estate. If the debtor has done everything it needs to do to obtain the benefit of its bargain, assumption serves no purpose, and the debtor may simply sue to enforce its rights. Similarly, if the other party has done everything necessary to require the debtor to perform, the debtor's performance adds nothing to the estate, the debtor will not assume the contract, and the other party can file a prepetition claim. Here, the Warrant is executory: each party must perform under the Warrant in order to obtain the benefits under the contingent bilateral contract of sale. To sell the shares and receive payment, the debtor must keep the offer open. To make payment and acquire the shares. LLC must first exercise the option granted under the Warrant.
In re Riodizio, Inc. 204 B.R. 417, 421-424 Bankr. S.D.N.Y., 1997) (footnotes excluded) (emphasis added). The similarities in the Riodizio opinion and this case are inescapable, and the court finds that under the Sixth Circuit Jolly standard that the Warrant Agreement is an executory contract. The benefits to the estate in rejecting this contract are blatantly obvious.
In their post-trial brief, the Lenders suggest that the Warrant Agreement is not executory because the purported rejection does not prevent the Lenders from obtaining specific performance under applicable state law principles. The court finds this argument unpersuasive. See generally Leasing Service Corp. v. First Tennessee Bank Nat. Ass'n , 826 F.2d 434 (6th Cir. 1987) ("[r]ejection denies the right of the contracting creditor to require the bankrupt estate to specifically perform the then executory portions of the contract"); Silk Plants, Etc. Franchise Systems, Inc. v. Register, 100 B.R. 360 (M.D. Tenn. 1980) (covenant not to compete is not enforceable by injunction against the debtor after rejection of franchise agreement containing the covenant not to compete, but becomes a basis for money damages claim).
Mr. Joseph Furlong's unrebutted and credible testimony clearly established the benefits to the estate from rejection of this executory agreement. Based upon his credible testimony and the legal standards in the Sixth Circuit, the court finds that the Warrant Agreement is an executory contract. Also based on Mr. Furlong's credible testimony, the court finds that rejection demonstrates the debtor's best business judgment. That judgment will not be disturbed unless it is shown there is no reasonable business justification for the decision. Mr. Furlong's testimony provided ample support for the debtor's business decision to reject the Warrant Agreement as an executory contract.
The court therefore overrules all of the Lenders' objections and finds that the Warrant Agreement is an executory contract, and that the Warrant Agreement is hereby rejected. Unfortunately, rejection does not end the parties' dispute. The debtor and the Lenders are at odds as to how the rejection damages are to be calculated.
B. Rejection Damages
Section 365(g)(1) provides:
Except as provided in subsections (h)(2) and (i) (2) of this section, the rejection of an executory contract or unexpired lease of the debtor constitutes a breach of such contract or lease —
(1) if such contract or lease has not been assume under this section or under a plan confirmed under chapter 9, 11, 12, or 13 of this title, immediately before the date of the filing of the petition;
11 U.S.C. § 365(g)(1). Pursuant to § 365(g)(1), the rejection is treated as a breach that took place immediately prior to the filing of the bankruptcy petition. In re Miller , 282 F.3d 874, 877 (6th Cir. 2002). Thus, a claim is allowable for those damages resulting from the breach, and the Court will determine the amount and validity of the claim as of the date of the breach. 11 U.S.C. § 365(g) and 502(g). See e.g., In re Cochise College Park, Inc. 703 F.2d 1339, 1353 nn. 13-14 (9th Cir. 1983) (rejection claim is allowed in the amount which would be recoverable by the non-breaching party as of the petition); Workman v. Harrison, 282 F.2d 693, 696, 699 (10th Cir. 1960) (rejection of executory investment contract gives rise to claim for damages in amount of value of the contract at date petition was filed); Addison v. Langston (In re Brints Cotton Mktg., Inc.) , 737 F.2d 1338 (5th Cir. 1984) (chapter 7 trustee holding cotton "call contracts" could reject as executory and bankruptcy court did not abuse its discretion in valuing claims for purposes of estimation of claims under section 502(c) as of the petition date); In re O.P.M. Leasing Services, Inc. , 79 B.R. 161 (S.D.N.Y. 1987) (when an executory contract is rejected, the claim for damages is fixed as of the petition date so that once the amount of the damages owing to rejection is determined, it must be discounted to its present value as of the petition date); In re Kent , 91 B.R. 1 (Bankr. E.D.N.Y. 1988) (damages are "precisely those he could claim if his contract had been breached the day before the petition was filed."); In re Al Besade , 76 B.R. 845 (Bankr. M.D. Fla. 1987) (damages should be fixed on the day before bankruptcy filing).
Under the statutory framework of the Bankruptcy Code, section 365(g) makes rejection a breach immediately before the date of filing. Section 502(g) then provides that:
A claim arising from the rejection, under section 365 of this title or under a plan under chapter 9, 11, 12 or 13 of this title, of an executory contract or unexpired lease of the debtor that has not been assumed shall be determined, and shall be allowed under subsection (a), (b), or (c) of this section, or disallowed under subsection (d) or (e) of this section, the same as if such claim had arisen before the date of the filing of the petition.
11 U.S.C. § 502(g). When read together, those sections are consistent with the judicial case law finding that damages stemming from rejection should be determined "as if such claim had arisen before the date of filing the petition." Thus, the court finds that the Code provides for the allowance of the claim arising from rejection in the amount that the Lenders would have recovered as of the time the petition was filed.
A claim arising from rejection is deemed allowed unless objected to under section 502(a). The parties have, as part of this rejection process, asked the court to determine the amount of the claim. Thus, the court treats the damages issue as claims litigation. A proof of claim relating to the rejection damages has been filed. The court treats the proof of claim, the expert reports, and other evidence as proof of the claim and objections thereto.
Both parties relied upon their witness' expert testimony to give the court guidance on how the rejection damages should be calculated. Testifying for the debtor was Michael Collins, who concluded the value at $879,023.00, and testifying for the Lenders was Richard Braun who concluded the value was in the range of $6,528,000 to $6,764,000. As this court noted in its earlier Opinion discussing confirmation, valuation is an imprecise discipline:
Michael Collins is the CEO and Managing Member of 2 Generation Capital. LLC, a merchant banking an venture capital business headquartered in Nashville. 2nd Generation participates in private offerings as an investment principal and as a placement agent. Mr. Collins is a member of Kraft Bros. Esstman Patton Harell, CPAs, based in Nashville. Mr. Collins is a C.P.A. and holder of the speciality designation Accredited in Business Valuation ("ABV"). He has been recognized professionally on numerous occasions. Exhibit 24 sets out Mr. Collins' complete vitae and qualifications. In addition, Mr. Collins testified that he has extensive experience valuing stocks, warrants and options and has participated in numerous valuations of this type just in the last three months.
Richard Braun is a Managing Director in the Washington, D.C. office of FTI Consulting, Inc. His responsibilities include the issuance of business valuation opinions, the design and valuation of equity securities, including stock, partnerships, options, warrants and other business interests, the analysis of liabilities including debt, lease obligations, and contingent liabilities, the quantification of economic damages, the determination of premiums and discounts, valuations for tax-related matters such as estate and gift taxes; litigation support and expert witness testimony. Mr. Braun has extensive professional experience and has published works on many of his areas of speciality. His qualifications as a valuation expert are set out fully in his Expert Report found at Exhibit A.
"The valuation of property is an inexact science and whatever method is used will only be an approximation and variance of opinion by two individuals does not establish a mistake in either." Boyle v. Wells (In re Gustav Schaefer Co.) , 103 F.2d 237, 242 (6th Cir. 1939): see also Rushton v. Commissioner, 498 F.2d 88, 95 (5th Cir. 1974) ("Valuation outside the actual market place is inherently inexact."); In re Montgomery Court Apartments of Ingham County, Ltd. , 141 B.R. 324, 337 (Bankr. S.D. Ohio 1992) ("Valuations of real property, like projections of income and expenses, are inherently imprecise. Opinions realistically may differ, depending upon the method of valuation used and the nature of assumptions adopted."); In re Jones , 5 B.R. 736, 738 (Bankr. E.D. Va. 1980) ("True value is an elusive Pimpernel.").
Because the valuation process often involves the analysis of conflicting appraisal testimony, a court must necessarily assign weight to the opinion testimony received based on its view of the qualifications and credibility of the parties' expert witnesses. See In re Coates, 180 B.R. 110, 112 (Bankr. D.S.C. 1995) ("The valuation process is not an exact science, and the court must allocate varying degrees of weight depending upon the court's opinion of the credibility of . . . [the appraisal] evidence."). As noted by the Bankruptcy Court for the Southern District of Ohio in In re Smith 267 B.R. 568, 572-573 (Bankr. S.D. Ohio 2001), when "weighing conflicting appraisal testimony, courts generally evaluate a number of factors, including: . . . the appraiser's education, training, experience, familiarity with the subject of the appraisal, manner of conducting the appraisal, testimony on direct examination, testimony on cross-examination, and overall ability to substantiate the basis for the valuation presented." Id. (internal citations omitted). A bankruptcy court is not bound to accept the values contained in the parties' appraisals; rather, it may form its own opinion considering the appraisals and expert testimony. Id. at 573; see, e.g., In re Abruzzo , 249 B.R. 78, 86 (Bankr. E.D. Pa. 2000) ("I am left to some extent with the proverbial battle of the appraisers. Finding merit to both their positions, the only conclusion I can reach is to find some value in between.")
In re American HomePatient, Inc. , 298 B.R. 152, 173 (Bankr. M.D. Tenn. 2003). In this case, the debtor argues an estimation of the maximum possible total rejection damages flowing from rejection of the Warrant Agreement is at most $846,369.85 because the value of the 3,265,315 warrants on July 30, 2002 was $0.2692 per warrant.
To reach this figure, Mr. Collins utilized the Black-Scholes method, a method common in the industry. The Black-Scholes method has the following inputs: (1) time to expiration, (2) annual expected volatility, (3) risk-free interest rate, (4) stock price at the time of pricing, and (5) strike price. The model assumes constant volatility and risk-free rate during the option life and no dividends during that time. Mr. Collins noted that all financial pricing models require assumptions, and the three most critical are volatility, price and term. In this case, the price and term were fixed, and volatility assumptions of 100% to 200% produced little changes in his results. Mr. Collins looked back approximately four years and included over the counter trading, and trades on the exchange. He checked his figures against the company figures which also uses the Black-Scholes model. He therefore assumed 150% as a reasonable assumption of future volatility, which fit nicely with the 142% figure used by the debtor in its own Black-Scholes calculations.
Mr. Collins concluded that based upon the wide fluctuation in closing prices for the preceding thirty days and the high volatility of the securities over time, and the low trading volume, that the fair market value of the securities was $0.27 based on a thirty day average, but in any event not greater than $0.32 (the closing price on July 30, 2002).
Mr. Collins testified carefully and credibly about the extensive "counter-checks" or sensitivity checks he performed to insure the validity of his numbers. Mr. Collins utilized an ex-post approach to determine the value of the warrants immediately prior to the petition, but did use information that became available after the petition date to check the sensitivity of his figures. Mr. Collins credibly explained why the warrant price of $0.2692 per share was a correct valuation in this case.
Mr. Braun did not employ the Black-Scholes method. In his opinion, the Black-Scholes method was an inappropriate valuation tool in this case because the options were "in the money." Mr. Braun concluded that because the warrants were "deep in the money" (stock price greater than the exercise price), that a "Formula Value" approach would produce a more reliable value. Mr. Braun reached his $6,528,000.00 to $6,764,000.00 value range by taking the terminal value of the company in 2009, based on the debtor's financial consultants' projections, and discounting the amount back to July 30, 2002. In other words, Mr. Braun used Houlihan Lokey Howard Zukin's financial projections prepared in association with plan confirmation, to determine an underlying equity value for the company, to compute a warrant value. Mr. Braun's approach used an ex-ante procedure whereby he considered knowledge and information after July 30, 2002 to achieve an accurate estimate of the value of the warrants as of day prior to the petition.
Although the court found Mr. Braun to be a credible and knowledgeable witness, his expert report was less helpful to assist the court in the damages calculation based on the court's duty to set damages that the Lenders would have recovered as of the time the petition was filed. In other words, the most accurate predictor of what the Lender's would have recovered as of the fictitious breach immediately before the petition is the "snap-shot" analysis Mr. Collins provided. Furthermore, the court found Mr. Collins' testimony to be thorough and credible. When "weighing conflicting appraisal testimony, courts generally evaluate a number of factors, including: . . . the appraiser's education, training, experience, familiarity with the subject of the appraisal, manner of conducting the appraisal, testimony on direct examination, testimony on cross-examination, and overall ability to substantiate the basis for the valuation presented." In re American HomePatient, Inc. , 298 B.R. 152, 173 (Bankr. M.D. Tenn. 2003) (quoting In re Smith 267 B.R. 568, 572-573 (Bankr. S.D. Ohio 2001)). After considering all of these factors, and the experts' reports as a whole, the court finds Mr. Collins' testimony to be more persuasive, and helpful in the court's analysis. Accordingly, the court credits Mr. Collins' testimony on the valuation of the warrants as of July 30, 2002.
Mr. Braun's valuation relies upon projections produced by the debtor's own financial advisors. However, those figures were utilized to demonstrate the feasability of the debtor's proposed plan of reorganization. On July 30, 2002, only a crystal ball could have said for sure that the court would accept those projections as feasible and that the plan would be confirmed as proposed. It is almost counter-intuitive that the Lenders continue to contest confirmation on appeal based, at least in part, on the issue of feasability, yet rely on those same numbers to arrive at a valuation suitable to inflate their damages upon rejection of the warrants.
The court, therefore, finds that the proper valuation of the warrants on the date immediately prior to the petition was $.02692 per warrant. When the per warrant value is reduced by the exercise price of $0.01 per warrant, ($0.2592) and multiplied by the total number of warrants ($3,265,315), the resulting damages stemming from the rejection of the executory Warrant Agreement is $846,369.85. The court finds that this provides the Lenders with exactly the amount they would have been entitled to immediately prior to filing, and is consistent with the mandates of 11 U.S.C. § 365(g) and 502(g).
The Lenders contend that treating the Warrant Agreement as executory leads to an "illogical result" because after rejection on July 11, 2003, the debtor could refuse to deliver a share of stock to a warrant holder; pay the warrant holder $0.2692; sell the same share for $2.15 (the share price on July 11, 2003) "and pocket the profit of $1.88 thereby profiting from an intentional breach." To the contrary, this shows the inherent propriety in rejection of the Warrant Agreement. See e.g. In re Riodizio, Inc. 204 B.R. 417, 425 (Bkrtcy.S.D.N.Y. 1997) ("If LLC suffered any damage, this goes far to proving me wisdom of rejection; the debtor can sell the shares (to LLC or a third party) for more than the per share price of $1.00, and pay LLC's claim in tiny bankruptcy dollars).
Conclusion
The court overrules all the Lender's objection to the Motion to Reject the Warrant Agreement. The court finds that the Warrant Agreement is an executory contract and that the resulting damages stemming from the rejection of the executory Warrant Agreement are $846,369,85. The debtors shall prepare an order not inconsistent with this Opinion within ten (10) days of entry of this Memorandum.
It is therefore so ORDERED.