Opinion
Case No. 02-43420 (ALG)
March 14, 2003
MEMORANDUM OF DECISION AND ORDER
Nygard International ("Nygard"), a judgment creditor in this Chapter 11 case, has moved under §§ 362, 543, 1104(a)(1), 1112(b)(1) and 105(a) of the Bankruptcy Code for (i) modification of the automatic stay and an order under § 543(d) to revest a prepetition receiver with the authority to sell, in accordance with District Court orders, a certain condominium owned by the debtor; (ii) conversion of the Chapter 11 proceeding to a Chapter 7 proceeding; or (iii) in the alternative, appointment of a Chapter 11 trustee. The United States Attorney, on behalf of the Internal Revenue Service, has also filed a motion to dismiss or convert the case; that motion has been held in abeyance pending determination of Nygard's pleading. The parties who have appeared on Nygard's motion have opposed or supported the motions or part of it, as set forth below. For the reasons stated herein, the motion to convert the Chapter 11 proceeding to Chapter 7 is granted and that part of Nygard's motion that concerns sale of the condominium is held in abeyance pending determination of the position of the Chapter 7 trustee.
The Parties
Nygard obtained its judgment against Marc Gardner ("Gardner" or the "Debtor") as the result of a jury verdict and judgment entered in its favor by the United States District Court for the Southern District of New York on counterclaims it asserted in a copyright infringement suit instituted by Gardner.
The Debtor filed the instant petition on November 14, 2002. He opposes Nygard's motion on several grounds, asserting that his case was filed in good faith and is progressing, that conversion of this case or the appointment of a tmstee is not necessary or to the benefit of his creditors, and that Nygard lacks an allowable claim and is merely intent on vengeance.
Also opposing Nygard's motion is Sara Gardner, the Debtor's first wife. After the verdict was reached in the aforementioned suit, it appears that the Debtor contacted Sara Gardner and advised her to protect her interests. Thereafter, Sara Gardner entered a confession of judgment in the amount of $7.6 million against the Debtor, and she asserts it is a valid lien against the condominium, superior to Nygard's lien. Sara Gardner opposes the immediate sale of the Debtor's apartment but took no position on the issue of conversion of the case or appointment of a trustee.
In support of the motions are Edith and Richard Wolf (collectively the "Wolfs"). The Wolfs hold a mortgage in the amount of $225,000 against the condominium. The validity of the Wolfs' claim is not disputed at this time, nor is it disputed that their mortgage is senior to any lien on the condominium held by Nygard or Sara Gardner. There appears also to be two other senior liens on the property in the amounts of $61,506.03, in favor of Washington Mutual Savings Loan Association, and $178,423.72, in favor of Wells Fargo. Neither of these mortgagees made an appearance.
The United States Attorney, on behalf of the Internal Revenue Service (the "IRS"), is also in support of conversion or dismissal of the case, principally on the ground that prior to the filing the Debtor failed to file tax returns from 1994 to 2001. The Debtor also failed to include any tax liability on his schedules as initially filed. The IRS has filed a proof of claim for unassessed taxes in the amount of $127,084.47, of which $33,590.90 represents a priority claim and $93,493.57 represents a general unsecured claim.
The United States Trustee supports dismissal or conversion of the case on the basis that there is no likelihood that the Debtor will successfully reorganize and that the Debtor's defaults to date during the Chapter 11 case demonstrate the need for a trustee. The United States Trustee takes no position on that portion of Nygard's motion seeking relief from stay and an order under § 543(d) to revest a prepetition receiver with the authority to sell the Debtor's condominium.
The condominium at issue is located on First Avenue in Manhattan and is owned by the Debtor, who values it at approximately $2.2 million. The condominium is currently under contract of sale for $1,250,000. The proposed buyers, Laura and Joshua Blau, appeared in support of that part of Nygard's motion that seeks an immediate consummation of the sale of the property.
Background
The Debtor is a designer and marketer of women's clothes. He has apparently operated in the past through several wholly owned companies. In 1999, the Debtor, through his wholly owned company, Queenie, Ltd. ("Queenie"), commenced an action in the District Court for the Southern District of New York against Nygard and others claiming, among other things, copyright infringement. Nygard interposed an answer with counterclaims against the Debtor personally as well as against two other entities, Joseph Heaven ("Heaven") and Heavenly Fabrics, Inc. (collectively, "Heavenly"). In October 2001, the jury returned a verdict against the plaintiff and in favor of Nygard on its counterclaims, awarding punitive damages against Gardner individually for $500,000 and against Queenie for $250,000. In summarizing the verdict in connection with post-trial motions, Judge Buchwald stated that "the jurors had essentially found that the plaintiff and counterclaim defendants had perpetrated a fraud on the Copyright Office and had attempted to similarly deceive the Court and jury." (Memorandum and Order 1/7/02 at 7.) On January 25, 2002, a judgment was entered against Gardner for the awarded punitive damages plus attorneys' fees.
The judgment entered by the District Court in favor of Nygard was appealed by Queenie, Gardner and the Heavenly counterclaim co-defendants. While the Second Circuit found that the automatic stay of Gardner's intervening Chapter 11 case stayed the appeal proceedings with regard to Gardner and his wholly owned corporation, Queenie, the Circuit Court proceeded to consider the merits of the appeal with regard to the Heavenly parties. The Court found that there had been an implicit waiver of the argument that under applicable New York law punitive damages could not be awarded in the absence of any general damages, as the parties had agreed to have the jury first determine the issue of punitive damages. Thus the appellate court did not disturb the District Court's findings and affirmed the judgment as against the Heavenly counterclaim defendants.
The Debtor did not obtain a stay of the judgment of the District Court, and Nygard commenced execution proceedings during the pendency of the appeal. It sought the appointment of a receiver on the ground that, after the jury verdict, Gardner had transferred an interest in three cars to his mother-in-law, had executed a confession of judgment in the amount of $7.6 million in favor of his former wife, Sara Gardner, had refused to comply with post-judgment discovery requests and had made payments in violation of a post-judgment restraining order. The matter was referred to Magistrate Judge Eaton who found, based on Debtor's failure to file returns for tax years 1994 through 2001, his efforts to divest himself of assets and his history of using his corporations as "personal piggy banks," that there was a real risk of Gardner diverting money away from Nygard. (Mag. Judge Eaton, Transcript 7/26/02 at 40). Nygard's counsel, John Triggs, was named as Receiver, and he was authorized to sell Gardner's property and to deposit the proceeds of the sale, after payment of taxes and fees of the sale, into an escrow account for the benefit of Gardner's creditors. Gardner was also directed to turn over to the Receiver all of the checks, checkbooks and other similar documents of all of his corporations and was limited as to the amount he could spend personally.
Based on allegations of continuing violations by Gardner, including making payments without the Receiver's approval, paying personal and family expenses from corporate accounts, and transferring money from accounts via electronic debits, Nygard returned to the District Court to force Gardner's compliance. Three subsequent orders were entered against Gardner directing him to comply with the District Court's prior orders.
On November 5, 2002, the Magistrate Judge held a hearing and thereafter entered an order that, among other things, found that the Receiver had "presented evidence that Mr. Gardner has violated my prior orders — by obtaining large amounts of income and using them to make large payments without the knowledge and approval of the Receiver." The Court continued, "So far, Mr. Gardner has not persuaded me that he has not grabbed far more than the salary." (Mag. Judge Eaton, Order 11/14/02 at 1.) At the November 5th, hearing, the Magistrate Judge was also informed that the sale of the Debtor's condominium was scheduled to close on November 18, 2002, and he gave the Debtor five business days to vacate and evict any tenants or roommates.
On the same day the foregoing order was entered, November 14, 2002, the Debtor filed the instant petition under Chapter 11 of the Bankruptcy Code. Upon learning of the filing, as required under 11 U.S.C. § 543(a) and (b), the Receiver turned over to the Debtor all of the checkbooks and accounts that he had in his possession pursuant to the District Court's Receiver Order and ceased all steps to consummate the sale of the condominium. As appeared during argument of the instant motions, the prospective purchasers remain interested in closing the purchase of the condominium that was scheduled to take place last November at the time of the filing. They stated through counsel, however, that their family has grown as the result of the birth of triplets and that they cannot wait any longer, and they requested that this Court order the return of their downpayment in the event the Court did not approve that branch of Nygard's motion that sought immediate consummation of the sale.
Discussion
At the argument of its motion, Nygard asserted that the most pressing relief was the effectuation of the sale of the condominium and the appointment of a trustee to supervise and/or control the Debtor's finances. For the reasons set forth below, the Court agrees that the appointment of a trustee is plainly necessary and that the facts justify conversion of the case to a case under Chapter 7. Accordingly, the Court will first take up that branch of the motion that seeks to convert the case to Chapter 7 under 11 U.S.C. § 1112(b).
Section 1112(b) provides that a court may convert a case to Chapter 7 or may dismiss the case, "whichever is in the best interest of creditors and the estate, for cause," and it then sets forth 10 non-exclusive examples of cause. Nygard in particular relies on the first subsection, "continuing loss to or diminution of the estate and absence of a reasonable likelihood of rehabilitation." In determining motions to convert or to dismiss under § 1112(b), and in particular subsection (1), courts have examined the conduct of debtors both before and after the bankruptcy filing as well as whether there is any reasonable likelihood that the debtor will be able to propose a timely, workable plan of reorganization. See, e.g., In re Johnston, 149 B.R. 158 (B.A.P. 9th Cir. 1992); In re Chu, 253 B.R. 92 (S.D. Cal. 2000); In re James, 1992 Bankr. LEXIS 91 (Bankr. M.D. Fla. 1992); In re Bryan, 104 B.R. 554 (Bankr. D. Mass. 1989) (all of which are individual Chapter 11 cases).
As is evident from the factual history recounted above, prior to the filing of the petition the Debtor had a long history of misconduct and repeated disregard for court orders. In the words of the District Court, he attempted to perpetrate a fraud on the Copyright Office, the Court and the jury. He failed to file tax returns for many years. He evaded execution proceedings requiring the appointment of a receiver and increasingly severe strictures on his financial independence. At the hearing on this motion and in his papers in opposition, the Debtor did not take serious issue with the litany of his prepetition misdeeds, although he continues to assert that "this Court should be wary of Nygard" and that "Nygard obtained its judgment against me after it twice violated copyrights held by my business." (Gardner Decl. 3/3/03 ¶¶ 35, 36.)
This finding was not affirmed as against the Debtor by the Second Circuit, as the Court found that the case against the Debtor and against Queenie, his wholly owned company, was stayed by this bankruptcy filing. However, the District Court judgment is valid, enforceable and entitled to full recognition by this Court. Heiser v. Woodruff, 327 U.S. 726 (1946). In his papers in opposition to the instant motion, the Debtor gave notice that he intended to use this bankruptcy case to attack Nygard's judgment against him on the same grounds as asserted by the Heavenly parties on the appeal. The Debtor cannot ask this Court to review the District Court judgment, and if he believes the District Court judgment is in error, he may seek leave to modify the automatic stay and complete the appeal. In re Briarpatch Film Coip., 281 B.R. 820, 834 (Bankr. S.D.N.Y. 2002); In re Sletteland, 260 B.R. 657 (Bankr. S.D.N.Y. 2001). There is nothing in the Second Circuit opinion, moreover, to provide any indication that the Court would not have affirmed the District Court's findings against the Debtor as well as against his counterclaim co-defendants.
Chapter 11 is designed to give a debtor a second chance, and some courts have been reluctant to convert Chapter 11 cases based solely on prepetition misdeeds. See, e.g., In re In re GG Transport, Inc., 1998 Bankr. LEXIS 1634 (Bankr. E.D. Pa. 1998). It is important, therefore, that the Debtor's misconduct has continued post-petition. Gardner filed incomplete schedules that have remained so to this date. The Debtor had not filed any monthly reports until the United States Trustee filed a motion to dismiss, and although he has now apparently filed some and perhaps all required reports, at the hearing held on March 5, 2003, the parties did not have them and were unable to comment as to whether there was even facial compliance with the rules. The Debtor has remitted only a portion of the quarterly fees due to the Office of the United States Trustee. While Gardner testified at the hearing that he has started filing tax returns, and by March 5 he had assertedly filed returns for the years 1993 through 1998, he apparently did not begin filing his returns until after the IRS sent him demand letters inquiring about his returns and requiring that any delinquent returns be filed.
The Debtor asserted in response to the instant motion: "I had a wake up call. I needed to reorganize myself and my business. That is what I am pursuing in this case." (Gardner Decl. 3/3/03 at ¶¶ 9-11.) Assuming he had this call, it did not take place when the petition was filed. Every step in the right direction that has been taken by the Debtor since his filing has been prompted by the push of interested parties. When a debtor seeks the protection of Chapter 11, it is obligated to observe the letter and spirit of the Code, and this obligation should be carried out on its own volition as opposed to the behest of the court or its creditors. In re Tornheim, 181 B.R. 161, 164 (Bankr. S.D.N.Y. 1995). While the Court recognizes the divergent roles individual debtors face in Chapter 11 cases, In re Devine, 131 B.R. 952, 956 (Bankr. S.D. Tex. 1991), this is no reason to overlook the obligations placed upon the Debtor or to treat them lightly. In re Tornheim, 181 B.R. at 164-65; In re Sal Caruso Cheese, Inc., 107 B.R. 808, 818 (Bankr. N.D.N.Y. 1989).
Beyond the question of the Debtor's need for supervision, Gardner has no concept of what reorganization entails and no "reasonable likelihood of reorganization" through Chapter 11. The Debtor testified at the March 5th hearing about his reorganization "plans." He now works exclusively through one of his wholly owned companies, Cinq. By his own admission, Cinq (his only extant company) has no value whatsoever, and he cited no other business property that could be sold to satisfy the claims of his creditors. Cinq has one or two other employees, but it is wholly dependent on the Debtor's personal services, and no long term contracts were said to be in place. In the past few years the Debtor has been able to earn from similar personal services about $150-180,000 per year. However, he testified that, after personal expenses, including child support to three young children from a second divorced wife, he could commit to a reorganization plan only a net of about $15,000 per year. His attorney attempted to establish on examination that in some past years Gardner's annual income has been as much as $220,000, but Gardner did not endorse any optimistic predictions as to the future, only hopes. He said that he has committed himself to spending less money on entertainment — he is now "eating out less frequently" — and he said he is actively seeking new ways to stimulate more business to produce more income. But it is painfully obvious that he has absolutely no plan to effectuate a reorganization of millions of dollars of debt and that a personal contribution of $15,000 per year will not be sufficient to fund a serious plan.
In terms of his ability to devote property to the repayment of his debt, the only valuable asset that the Debtor owns is his condominium. As noted above, although there are several mortgages against the property, there would be substantial equity for other creditors but for two judgment liens asserted against the condominium — those held by the Debtor's first wife, Sara Gardner, in the amount of $7.6 million, and by Nygard, in the amount of approximately $500,000. The Debtor does not, however, propose to examine the validity of the lien held by his first wife, which would, if valid, wipe out any equity for most other creditors. Gardner stated that he hopes to enter into an agreement with Sara Gardner to be able to stay in the apartment permanently, and he intends to allow one of their adult sons to move in with him to help pay the maintenance and the prior mortgages. (He apparently has another roommate who is helping to defer expenses.) But his position in his papers in opposition to Nygard's motion and at the hearing is that Sara Gardner has a valid, perfected and enforceable judgment lien against the property in the amount of approximately $7,000,000 (if not the full $7.6 million).
The Debtor owns timeshare interests in two resort properties, in Barbados and in Arizona. He does not claim that these properties have any substantial value and testified that his second divorced wife may have a lien on them.
The Debtor's position with regard to his wife's lien is alone sufficient to justify the conversion of this case and the appointment of a trustee. See, e.g., In re Altman, 230 B.R. 6 (Bankr. S.D. Conn. 1999); In re Canion, 129 B.R. 465, 470 (Bankr. Tex. 1989); In re Natrl Plants and Lands Management Co., Ltd., 68 B.R. 394, 396 (Bankr. S.D.N.Y. 1986). The Court does not at this time make any determination as to the bona fides of Sara Gardner's lien or judgment. However, there is more than enough evidence that a question exists as to the validity of the lien and that, in light of the Debtor's position, the lien needs to be examined by an independent trustee. At the hearing on the instant motion, the Debtor admitted that he called his former wife after receiving news of the adverse jury verdict for Nygard and suggested that she "protect" herself. The Magistrate Judge expressed "grave doubts about the good faith of the . . . seven million dollar confession of judgment." (Mag. Judge Eaton, transcript 7/26/02 at 45). Determination of the existence and amount of Sara Gardner's lien, as well as the amount of her claim, will be essential steps in this bankruptcy case. Since the Debtor has rejected any possibility of challenging Sara Gardner's lien, and since even a belated expression by him of an intent to conduct an examination would be subject to suspicion, there is a need for a trustee in this case. In In re Natrl Plants, 68 B.R. at 396, the Court found that the need for a trustee to challenge a lien held by a creditor was itself grounds to grant a motion to convert. See also In re Altman, 230 B.R. at 16.
The Debtor objects to conversion and argues that reorganization is akin to his attempt to retain his home, citing Chapter 13 cases in support. Some Chapter 13 cases have found that the retention of a residence is an important part of a Chapter 13 debtor's efforts at "rehabilitation." See In re Donahue, 231 B.R. 865 (Bankr. D. Vt. 1998); Grundy National Bank v. Stiltner, 58 B.R. 593 (W.D. Va. 1986); In re Garner, 18 B.R. 369 (S.D.N.Y. 1982). These cases are inapposite here. The Code does not allow debtors to use Chapter 11 for the sole purpose of keeping their multi-million dollar homes and leading lavish lifestyles. In re Kornhauser, 184 B.R. 425 (Bankr. S.D.N.Y. 1995); see also In re Lonian, 226 B.R. 248 (Bankr. W.D. Ok. 1998); In re Weber, 209 B.R. 793 (Bankr. D. Mass. 1997); In re Walker, 165 B.R. 994 (E.D. Va. 1994). Moreover, the Debtor's position at the hearing was that he can only keep the property if his former wife consents, and he was forthright in his testimony that he cannot afford his condominium and has had to take in roommates or tenants in order to pay the maintenance.
In light of all of the foregoing, it is clear that the interest of creditors demands the appointment of a trustee. Although the interests of the debtor need only be considered on the question of conversion as opposed to dismissal, the Debtor would also likely benefit from a conversion. First, if the Debtor were sincere in his desire to rehabilitate himself and to put his life in order, the Debtor would be the principal beneficiary of an order setting aside his first wife's lien. If there were equity in the property for priority and general creditors, many of his debts could be satisfied, including possibly any non-dischargeable tax obligations, and the Debtor would emerge from bankruptcy with a real fresh start, rather than a fresh start combined with a tax burden.
Second, as the Debtor argues in opposition to Nygard's motion, in a Chapter 7 case, the portion of Nygard's judgment representing punitive damages might be subordinated. 11 U.S.C. § 726(a)(4). Although Chapter 11 plans that have subordinated punitive damage claims have been confirmed, it is not clear whether the priorities in § 726 should generally be applied in Chapter 11 case, and the Debtor and the Debtor's other creditors might presumably benefit from a conversion to Chapter 7, to the extent that a large part of Nygard's judgment might be subordinated.
It should also be noted that to the extent the Debtor is really honest in seking a fresh start after his "wake up call," a Chapter 7 might allow him to devote his future earnings to his rehabilitation, rather than use them in repayment of old debt. As the Debtor recognizes in his papers, his income from future personal services is not property of the estate. 11 U.S.C. § 541(a)(6). Although the Court need no make any determinations at this time, prima facie, in a Chapter 7 case, the Debtor would not have to fund a plan and could presumably devote his post-petition personal services income to his own rehabilitation as well as child support for his young children and any other nondischargeable debts. The Court recognizes that if the Debtor were able to devote substantial future income to repayment of his prepetition debt, the creditors would benefit, and this would be a reason to keep the case in Chapter 11. However, the Debtor's commitment to fund a plan was vague and the facts were dismal. Most tellingly, the creditors (including his first wife) were unimpressed by his offer and either support conversion or do not oppose it.
Additional Relief
Since the case must be converted, the Court believes that it would be appropriate to hold the motion for relief from the stay under § 362(d) in abeyance pending an immediate investigation of the facts and circumstances by a Chapter 7 trustee. Nygard argued in support of is motion for relief from the stay under § 362(d)(2) that the property was not needed for an effective reorganization (as there was no prospect of any reorganization), and it accepted at face value the Debtor's representation that there was no equity in the property (the Debtor's position is that any equity belongs to his first wife, Sara Gardner). The Debtor contended that relief from the stay should not be granted in that he had a prospect for an effective reorganization. Since the motion to convert has been granted, it is established that the property is not needed for an effective reorganization, but as shown above, there is a very real question whether there is equity in the property for other creditors. The trustee should be able to examine this issue before determining whether to sell the property.
The trustee should also have an opportunity to consider whether to endorse an immediate sale of the condominium by the Receiver. In this regard the trustee can consider the evidence submitted on the motion by Nygard with respect to the proposed sale price and the uncertain state of the real estate market in New York City, as well as any other relevant facts, including the tax consequences of a sale. The trustee will also have the ability to consider any objections raised by Sara Gardner, as well as the fact that the sale was authorized and approved by the Magistrate Judge on behalf of the District Court over the objection of Sara Gardner. In short, the trustee should be able to take a position on any of the following alternatives or propose his own: whether to abandon the property to the Receiver for purposes of completing the sale, with the Receiver to hold the proceeds (net of closing and related costs) for the benefit of the Trustee and the estate; whether to have an immediate sale of the condominium in the Bankruptcy Court, subject to higher and better offers; or whether to await developments (and a determination as to Sara Gardner's alleged lien) prior to effecting any sale.
Since the proposed purchasers have presented strong evidence as to why it would be unjust to subject them to any substantial further delay, the Trustee is hereby given 10 days from the date of his appointment to investigate the foregoing matters, to file any necessary motions (on shortened notice) or, at a minimum, to file a report and serve it on all parties who appeared in connection with the instant motions and any other appropriate parties. Any interested party or the trustee may request a hearing, for cause shown, to be held on short notice after the filing of the report, to consider any necessary next steps. If the trustee does not decide to abandon the condominium to the Receiver or to effect an immediate sale to the current purchasers, he should submit an order that provides for a return of the downpayment to the prospective purchasers of the condominium. No party at the hearing objected to the grant of this relief if there is not a prompt consummation of the sale.
Conclusion
Based on the foregoing, the motion to convert this case to a case under Chapter 7 of the Bankruptcy Code is granted. The Debtor shall file (i) a schedule of unpaid debts incurred after the commencement of the Chapter 11 case within 15 days of the date of this order, and (ii) a final report within 30 days of the date of this order pursuant to Bankruptcy Rule 1019(5). The remainder of Nygard's motion is held in abeyance pending further action by the Chapter 7 trustee, as set forth above.
IT IS SO ORDERED.