Opinion
Case No. 01-12219-RGM
October 17, 2002
MEMORANDUM OPINION
Before the Court is a motion by creditors Newcom Holdings, Pty. Ltd., Newcom Technologies, Pty. Ltd., and Keith Benson (hereinafter "Newcom creditors") requesting the appointment of a Chapter 11 trustee in this case pursuant to 11 U.S.C. § 1104(a) and Bankruptcy Rules 2007.1(a) and 9014. As reasoning for such request, the Newcom creditors allege "gross mismanagement of the Estate", "incompetence", "fraud", "dishonesty", "breaches of fiduciary duty", "conflicts of interest", and "wrongful conduct" on the part of the Debtor's current management. The Newcom creditors suggest the appointment of a Chapter 11 trustee is in the interest of creditors and the Debtor's equity security holders. Furthermore, these creditors provide several arguments which undoubtably are intended as "other interests of the estate" for purposes of granting the requested motion under Section 1104(a)(2) of the Bankruptcy Code.
This Court has jurisdiction over this matter pursuant to 28 U.S.C. § 157 and 1334. This is a core proceeding pursuant to 28 U.S.C. § 157(b)(2).
FACTUAL BACKGROUND
Funge Systems, Inc. (hereinafter "Debtor") is a Delaware corporation incorporated in late 1999 for the purpose of commercializing internet and wireless telecommunications technology which allows financial transactions to be executed and the resulting data to be transported in the virtual world. The Debtor's business purpose was to engage this technology through the use of so-called "smart cards", the Internet, and wireless mobile devices. The technology was invented by Keith Benson (hereinafter "Benson"), but developed by Newcom Technologies Pty. Ltd. and its parent corporation Newcom Holdings, Pty. Ltd. Newcom Technologies and Newcom Holdings are privately held Australian companies controlled by Benson. The Debtor was created to serve as a means of bringing in venture capital, primarily from U.S. capital markets, for the purpose of funding the enterprises. The Debtor raised over $10.8 million in investments by placing 19% of its common stock with private investors in the U.S., the Cayman Islands, and Australia ("Minority investors"). The remaining 81% of the common stock is held by Funge Systems International, Ltd. ("FSIL"), a Cayman Islands company, in a trust for the benefit of the shareholders of Newcom Holdings.
The Debtor purchased Newcom's U.S. patent applications and rights to the "Funge technology" from FSIL and Newcom for $2 million. Almost immediately, the Debtor engaged in a program called "Navy Cash" between March 2000 and January 2001 to replace the use of cash on U.S. Navy vessels with digital smart cards. Much of the technology and consulting for this program was provided by the Newcom entities. The expenses incurred in setting up the Navy Cash program left the Debtor substantially undercapitalized by September 2000.
There were unsuccessful attempts to raise additional funds between September 2000 and January 2001. As the Debtor's working capital became depleted, it stopped paying its employees' salaries and its creditors. During March and April 2001, attempts were made to restructure the company and obtain financing. See, letter agreement dated March 22, 2001, wherein Benson, FSIL, and Newcom agreed to transfer all of the "Global Funge technology" owned by them to the Debtor (Newcom Exhibit 8). Benson signed the agreement on behalf of Newcom Technologies, the Debtor and FSIL. (Newcom Exhibit 8). The proposal at that time would have vested 85% ownership of the new entity in the Newcom group and 15% ownership for the minority shareholders. This increased the Newcom group's interest from 81% and diluted the minority shareholder's interest by the same amount. Some debate exists as to whether the Debtor was to acquire this technology or whether the technology was to be acquired through a special purpose off-shore entity created by the parties. Nevertheless, an attempt was made by Benson to transfer the Global Funge technology to an off-shore entity.
The effect of this letter and whether it, or portions of it, form a binding contract, are hotly contested.
By way of contrast, the Debtor's proposed plan of reorganization would eliminate the Newcom group's ownership interest in the reorganized and merged debtor while the debtor's two directors who are also shareholders would have about a 15% ownership interest in the reorganized and merged debtor.
Sometime between a Board of Directors meeting held on April 11, 2001, at which time the Board voted in favor of the transfer of assets, and April 23, 2001, a struggle for corporate control of the Debtor transpired, leaving two of the minority shareholders at the helm of the Debtor, and ousting Benson as the Debtor's CEO. Several of the minority shareholders formed a company called "Funge Merger Corporation" on May 11, 2001, which was incorporated in Delaware, for the purpose of providing a financial restructuring vehicle for the Debtor. Christopher Girvan and Eric Schreiber, the two remaining officers of the Debtor, filed a voluntary Chapter 11 petition on behalf of the Debtor on May 18, 2001.
The Debtor filed a motion for approval of post-petition financing from Funge Merger Corporation on May 25, 2001, and that same day filed an adversary proceeding against the Newcom creditors for turnover of the Global Funge intellectual property pursuant to the letter agreement of March 22, 2001. A second adversary proceeding was filed by the Debtor on June 8, 2001, against Benson, Mr. Hogarth and Newcom for mismanagement, fraud, waste, and other causes of action. This Court granted the motion for post-petition financing on June 12, 2001. The Debtor filed a Joint Plan of Reorganization on September 17, 2001, and amended it on November 30, 2001, which details the proposed merger of Funge Systems, Inc. and Funge Merger Corporation as part of Debtor's Plan of Reorganization.
ARGUMENTS
The Newcom creditors are not satisfied with the current management remaining as debtor-in-possession, and request that this Court appoint a Chapter 11 trustee to oversee the operations and reorganization of the Debtor, and to protect the assets and value of the Debtor's estate. These creditors present four primary arguments that they believe mandate the appointment of a trustee. The first argument is that the Merger Agreement and Plan of Reorganization, if approved, would permit the minority shareholders to purchase all the claims, assets and business opportunities of the Debtor for a severely undervalued price, thereby undermining the Debtor's true value which by other means would be available for creditors and the 81% majority shareholders. As a corollary to this argument, the Newcom creditors suggest that the Debtor has purposefully concealed assets from this Court. (Newcom Corrected Memorandum p. 29). The second argument centers on the actions and motivations involved in the change in Debtor's management. The Newcom creditors believe that the actions of the 19% minority shareholders, particularly Girvan, Schreiber and John Worton, a director and Chief Financial Officer of the Debtor, fraudulently gave Girvan the power to vote the 81% majority shares held by FSIL thereby causing a change in the power structure of the Debtor.
There are presently no significant operations other than the court reorganization and other litigation.
The Newcom creditors suggest that the Debtor's merger agreement and Plan of Reorganization would allow the minority shareholders to ". . . acquire (1) all of the Debtor's claims and assets, which were acquired and developed with the investment of approximately $14.5 million since early 2000, and (2) all of the intellectual property assets of the Debtor's parent company and founder, which have been valued by Debtor's technology expert at $10 million to $60 million." (Newcom Corrected Memorandum p. 2-3). Newcom's complaint is that "in exchange, FMC would pay $500,000 that would go to FSI's creditors, plus the legal fees to pay the minority shareholders' counsel. FSI's 81% majority shareholders would receive nothing." (Newcom Corrected Memorandum p. 2-3).
The creditors believe the motivation behind these actions was simple greed. By taking control of the Debtor's management, the minority shareholders would be able to gain a majority of the equity ownership in the Debtor. The third argument supporting the Newcom creditors' call for a Chapter 11 trustee is that the Debtor (through Girvan and Schreiber) entered into agreements with Funge Merger Corporation without the independent judgment of a disinterested Board of Directors. As directors of the Debtor and sizeable shareholders of Funge Merger Corporation, they argue that Girvan and Schreiber must demonstrate the fairness on both sides of the transaction. The Newcom creditors see a conflict-of-interest which involves self-dealing and personal financial gain on the part of Debtor's current management to the exclusion of all other stockholders. Finally, the creditors argue that this bankruptcy petition was unnecessary, and is a waste of estate assets. This claim is based on Newcom's assertions that a restructuring deal was in the works on April 11, 2001, which was approved by a unanimous Board of Directors at a time when no impending creditor action was imminent. The Newcom creditors believe that in addition to current management's bad faith takeover of the Debtor, their actions, including filing the Chapter 11 petition, have caused needless expense and have forced the estate to incur substantial liabilities.
Newcom suggests that Schreiber owns 8.3% of FMC, while Girvan owns approximately 5.3% of FMC. (Newcom Corrected Memorandum p. 26)
Funge Merger Corporation ("FMC") denies the allegations set forth by the Newcom creditors, and seeks denial of the motion to appoint a Chapter 11 trustee. FMC's has two primary arguments. The first argument is that the actions of the minority shareholders were not wrongful. FMC argues that the Debtor was in serious financial straights, and was being mismanaged by Benson. Schreiber and several other shareholders became concerned that Benson was preparing to convey the Debtor's intellectual property rights outside the reach of creditors, as suggested by the March 22, 2001, letter agreement. As a result, FMC states that Schreiber sought the advice of counsel, who advised the course of action whereby Benson was removed as CEO of the Debtor. As the Debtor was severely undercapitalized in relation to its high debt load, Schreiber and Girvan, as the two remaining directors of the Debtor, chose to file for Chapter 11 protection. FMC argues that the decision to file the Chapter 11 petition was made in good faith, and that the Debtor and its counsel have sought to provide the best information available with regard to the Debtor's schedules and disclosures.
The second argument FMC makes for denial of a trustee appointment is that such appointment constitutes an event of default under the post-petition financing facility provided by FMC, and entitles FMC to "drop dead" relief to enforce its rights will respect to its collateral. Even if the relief from stay is denied by this Court, FMC argues it still has a very large secured claim that would have to be paid before the substantial claims of priority, administrative and general unsecured creditors. FMC says the merger proposal offers a significant payment to creditors, and eliminates FMC's secured claim. In order to achieve this same result, FMC contends a trustee would have to enjoy extraordinary success. Consequently, the appointment of a trustee is a risky gamble, and does not meet the best interest of creditors as required by § 1104(a)(2).
DISCUSSION
The appointment of a Chapter 11 trustee is governed by 11 U.S.C. § 1104(a). This section states:
(a) At any time after the commencement of the case but before confirmation of a plan, on request of a party in interest or the United States trustee and after notice and a hearing, the court shall order the appointment of a trustee —
(1) for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case, or similar case, but not including the number of holders of securities of the debtor or the amount of assets or liabilities of the debtor; or
(2) if such appointment is in the interest of creditors, any equity security holders, and other interests of the estate, without regard to the number of holders of securities of the debtor or the amount of assets or liabilities of the debtor.
The appointment of a Chapter 11 trustee in a bankruptcy proceeding is an extraordinary remedy, and should be considered as the exception to the general rule that a Chapter 11 debtor remain in possession of its own affairs. In re Marvel Entertainment Group, Inc., 140 F.3d 463, 471 (3rd Cir. 1998) ("It is settled that appointment of a trustee should be the exception, rather than the rule." (citing In re Sharon Steel Corp., 871 F.2d 1217, 1225)); Schuster v. Dragone, 226 B.R. 268, 271 (D.Conn. 2001) ("[W]e start with the belief that the appointment of a trustee under Chapter 11 is the exception rather than the rule and that this is an extraordinary remedy available to creditors."). It is well settled that the current management of a debtor is typically better equipped, in that they have intimate knowledge of the debtor's operations, than a trustee to handle the day-to-day requirements of operating the debtor's business. The resulting efficiency from their knowledge and experience thereby maximizes the value of the estate for the benefit of creditors. See In re Petit, 182 B.R. 64, 69 (D.Maine 1995) (citing In re V. Savino Oil Heating Co., 99 B.R. 518, 524 (Bankr.E.D.N.Y. 1989)). Therefore, there is a strong, yet rebuttable presumption that current management will remain in control of the reorganizing debtor. Marvel Entertainment at 471; In re Eichorn, 5 B.R. 755, 757 (Bankr.D.Mass. 1980); Collier on Bankruptcy ¶ 1104.02[3][b][i] (15th ed. 2001). However, the Bankruptcy Code does permit parties in interest to request the appointment of a Chapter 11 trustee for two general evidentiary-based reasons.
The first qualifying reason is for "cause", which would non-exclusively include "fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management". 11 U.S.C. § 1104(a)(1); see also Marvel Entertainment at 472 ("[T]he language of § 1104(a)(1) does not promulgate an exclusive list of causes for which a trustee must be appointed"). Once such "cause" has been found under subsection (1), a court must appoint a trustee. A cost-benefit analysis cannot override the circumscribed direction § 1104(a)(1) sets forth should "cause" be found. Collier on Bankruptcy ¶ 1104.02[3][b][iii] (15th ed. 2001); see also Wilmington Trust Co. v. Aardvark, Inc. (In re Aardvark, Inc.), 1997 WL 129346 (D.Del. 1997); In re General Oil Distributors, Inc. 42 B.R. 402 (Bankr.E.D.N.Y. 1984). Despite this mandatory requirement, the trier-of-fact has considerable discretion in determining whether such "cause" exists. Committee of Dalkon Sheild Claimants v. A.H. Robins Company, Inc., 828 F.2d 239 (4th Cir. 1987). In Dalkon Shield, the Claimants Committee moved for the appointment of a Chapter 11 trustee after the Debtor paid pre-petition debts to certain creditors without court approval, and in violation of a previously entered court order. The District Court denied the Motion for appointment of a trustee, but did appoint an examiner pursuant to Section 1104(b) of the Code. The Committee appealed the denial of a trustee appointment to the Fourth Circuit, which affirmed the lower court, stating:
A determination of cause . . . is within the discretion of the court and due consideration must be given to the various interests involved in the bankruptcy proceeding. "[T]he concepts of incompetence, dishonesty, gross mismanagement and even fraud all cover a wide range of conduct. . . . Implicit in a finding of incompetence, dishonesty, etc., for purposes of section 1104(a)(1), is whether the conduct shown rises to a level sufficient to warrant the appointment of a trustee." General Oil, 42 B.R. at 409. Obviously, to require the appointment of a trustee, regardless of the consequences, in the event of an act of dishonesty by the debtor, however slight or immaterial, could frustrate the purpose of the Bankruptcy Act. Section 1104(a)(1), therefore, must be construed, if possible, to make it harmonious with the Act in its entirety. Such construction requires that the courts be given discretionary authority to determine whether conduct rises to the level of "cause". Dalkon Shield at 242.
The burden of proving that "cause" exists to appoint a Chapter 11 trustee lies with the party seeking the appointment, and most courts require the burden be demonstrated by "clear and convincing" evidence. Marvel Entertainment at 471; Petit, 182 B.R. at 69; General Oil at 402; In the Matter of Parker Grande Development, Inc., 64 B.R. 557, 561 (Bankr.S.D.Indiana 1986).
The Newcom creditors discuss several factors that seemingly fit under a "for cause" analysis, including allegations of fraud and dishonesty on the part of current management. The facts raise troubling questions, particularly where minority shareholders end up with control of the reorganized debtor to the exclusion of the majority shareholders. But, the record does not sufficiently demonstrate that the two members of the Debtor's current management were involved in fraudulent acts, or conspired with others who may have breached fiduciary duties or committed fraudulent acts upon the Newcom creditors. There may have been a misunderstanding of the rights of the parties to control the voting. It may, in fact, be the case that the minority shareholders were correct that Benson was unable to continue to properly manage the business and that the only way the business could be saved was to remove him, which they did. Even if the burden of proof were a preponderance of the evidence standard, the Newcom creditors have not met their burden with respect to a "for cause" appointment under Section 1104(a)(1), as it relates to fraud or dishonesty.
The analysis of § 1104(a)(1) is not limited to the enumerated conditions found in that provision. The factors set forth by Congress in a "for cause" appointment under § 1104(a)(1) are not exhaustive. Marvel Entertainment at 472; In the Matter of Intercat, Inc. 247 B.R. 911, 920-21 (Bankr.S.D.Ga., 2000) ("[A]ppointment is not limited to the enumerated list . . . but extends to "similar cause"). Courts have found that conflicts of interest on the part of a debtor's management justify the appointment of a trustee under § 1104(a)(1). See Intercat at 291; In re Cajun Electric Power Cooperative, Inc., 191 B.R. 659, 661 (M.D.La. 1995) ("Cause can consist of other factors, including an actual conflict of interest."). It has also been held that a conflict of interest alone is sufficient justification under § 1104(a)(1) for the appointment of trustee. Marvel Entertainment at 472. Where an entity or persons operating as a debtor-in-possession act in their own interest rather than that of the debtor, the appointment of a trustee under § 1104(a)(1) is appropriate. In the Matter of Tahkenitch Tree Farm Partnership, 156 B.R. 525 (Bankr.E.D.La. 1993).
The inquiry courts generally focus on is whether a conflict of interest on the part of the Debtor's management interferes with its ability to fulfill its fiduciary duties to the debtor and the debtor's estate. Intercat at 921. Additionally, courts look to see if there is evenhandedness in management's dealings with insiders in relation to other creditors, and whether there is self-dealing on management's part. Id. A determination that there has been uneven insider transactions or self-dealing clearly may be deemed a breach of fiduciary duty. As one court has found:
The notion of fiduciary obligations proscribe self-dealing and negligent behavior . . . The duty of loyalty and good faith forbids directors and other business operators from using their position for trust and control over the rights of other parties to further their own private interest, either by usurping opportunities, holding undisclosed conflicts, or otherwise exploiting their position. . . . [A]ny attempt by the individual board members to structure deals that would benefit them privately to the detriment of other creditors would contravene the fiduciary relationship. In re Microwave Products of America, 102 B.R. 666, 672 (Bankr.W.D.Tenn. 1989).
This case has always had conflicts of interest lurking in it. The essential element of the case is the struggle for corporate control. This must necessarily be so because the two sides simply no longer share the same underlying assumptions as to the business, the financing of the business, the future of the business and the ability of the other party to properly manage the business. Their views diverge significantly and appear to be irreconcilable. This is, in and of itself, no reason to appoint a trustee. Many of these issues can be addressed in the context of confirmation of a proposed plan of reorganization. However, in this case, the very terms of the proposed plan of reorganization raise numerous questions as to whether Debtor's management has gone beyond the accepted role of management to prepare, present and advocate the best possible restructure for the Debtor. The two remaining officers and directors of the Debtor are also minority shareholders of the Debtor. The corporation the Debtor proposes to merge into upon confirmation of its plan of reorganization is Funge Merger Corporation ("FMC"). FMC was established by several minority shareholders of the Debtor and their affiliates, including Girvan and Schreiber, the Debtor's current directors. The capital contribution sustaining the Debtor through its reorganization efforts has been provided by FMC. The merger agreement between the Debtor and FMC was executed by these same directors on behalf of the Debtor. Girvan and Schreiber collectively own 13.6% of FMC. Benson's interest as that of all shareholders, would be eliminated while Girvan and Schreiber potentially stand to derive significant personal benefit from their present ownership interest in the proposed reorganized merged debtor. The Debtor's majority shareholders have been excluded from obtaining ownership interests in FMC.
See Newcom creditor's Exhibit MT 0068-69, a letter from counsel of FMC to counsel for the Newcom creditors disclosing shareholder interests in FMC. See also, Debtor's First Amended Disclosure Statement, Exhibit B.
It is unclear whether Girvan or Schreiber, who are fiduciaries for the Debtor, ever sought an alternative plan or reorganization, sought alternative financing, or pursued marketing efforts for an independent third-party buy-out of the Debtor.
The potential treatment offends several bankruptcy precepts. All similarly situated creditors or shareholders should be treated the same. Here, the minority shareholders receive a valuable benefit — an ownership interest in the newly merged entity while the majority shareholders receive nothing. The absolute priority rule provides that shareholders should receive nothing on account of their stock interests unless all senior classes have been paid in full. The interest in the merged entity may be an interest on account of the minority shareholder's interest in the Debtor, albeit, an indirect one.
Typically, a debtor's management will be afforded the `business judgment rule" in its reorganization decisions and transactions. Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1046-48 (4th Cir. 1985). However, where as here, the directors stand on both sides of the merger and derive a personal benefit from the transaction to the exclusion of the Debtor's other equity shareholders, their judgment is suspect. Intercat at 923, n. 5 (citing Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)).
While the minority shareholders, the current management of the Debtor, could resolve these issues without raising conflicts of interest, it does not appear that they have done so. The proposed plan clearly shows the difference in treatment of the shareholders, the freezing out of the majority shareholders and the potential for vast gain on the part of the minority shareholders. In these circumstances, an actual conflict of interests has developed and a fair, impartial third party must be placed in control of the Debtor. This conflict constitutes "cause" under § 1104(a)(1).
Section 1104(a) is written in the disjunctive and a best-interests analysis that would be made under § 1104(a)(2) is unnecessary here. The Court is aware of the terms of the debtor-in-possession financing and considered those factors in determining whether the conflict of interest found by the court is so significant that the appointment of a trustee is required. However, a separate analysis of the best interests of the creditors, shareholders and other parties in interest is not required when the relief granted is under § 1104(a)(1).
CONCLUSION
The motion to appoint a Chapter 11 trustee will be granted pursuant to § 1104(a)(1) of the Bankruptcy Code.