Opinion
Case Nos. 01-12264-SSM, 01-12465-SSM, (Jointly Administered).
April 8, 2002
Alexander M. Laughlin, Esquire, Gold, Morrison Laughlin, P.C., McLean, VA, Local counsel for Pathnet, Inc.
H. Bradley Evans, Jr., Esquire, Redmon, Peyton Braswell, L.L.P., Alexandria, VA, Counsel for Gordon P. Peyton, Trustee.
K. Stewart Evans, Jr., Esquire, Pepper Hamilton LLP, Washington, DC, Local Counsel for Cisco Systems Capital Corp.
John G. McJunkin, Esquire, Piper Marbury Rudnick Wolfe LLP, Washington, DC, Counsel for Nortel Networks, Inc.
MEMORANDUM OPINION
An evidentiary hearing was held in open court on February 28, 2002, on the objection of Pathnet, Inc. ("PNI" or "the debtor in possession") to the claims filed by Gordon P. Peyton, the chapter 7 trustee of Pathnet Operating, Inc. ("POI"), and by Nortel Networks, Inc. ("Nortel"), and Cisco Systems Capital Corporation ("Cisco"). PNI, Peyton, the Official Committee of Unsecured Creditors, Nortel, and Cisco were present by counsel. The United States Trustee was not present. For the reasons stated, the claims will be disallowed.
There are actually two Peyton claims. One (Claim No. 387) was filed on February 4, 2002, in the amount of $24,095,399.00. The other, filed as Document No. 377 on September 20, 2001, is entitled "Trustee's Preliminary Assessment of Rejection Damages." It alleges in general terms the ways in which POI has been damaged as a result of the rejection of the Intercompany Services Agreement, but does not assert a specific dollar amount. At the hearing, the trustee's attorney stated he did not intend to press "the $24 million claim" but reserved his right to bring an adversary proceeding, which has since been filed, asserting constructive trust claims. The only claim as to which evidence was offered was a rejection claim in the amount of $545,052.48.
Background
At issue is the rejection of an Intercompany Services Agreement dated August 9, 2000, between PNI and its affiliate, POI. PNI and POI are both subsidiaries of Pathnet Telecommunications, Inc. ("PTI"). POI had been formed in April 2000 as the vehicle for PNI's expansion from microwave into fiber-optic communications routes. POI had no employees of its own and had apparently been set up as a separate corporation at the request of Nortel and Cisco, who were providing financing for the needed acquisition of equipment. Indeed, Nortel was expressly stated to be a third-party beneficiary of the agreement.
Under the Intercompany Services Agreement, PNI agreed to provide, at POI's request, a broad range of services categorized under the headings of "Professional Services," "CLEC Services," and "Other Services." The "Professional Services" category identified 26 examples of services, including (among others) strategic planning, data processing, management of financial assets, administration of accounts payable, purchasing, property management, insurance services, legal counsel, engineering, real estate and construction services, and maintenance of the fiber optic network.
"CLEC" is an abbreviation for "competitive local exchange carrier."
In exchange, POI was required to pay an "Intercompany Services Fee" consisting of "Professional Services Costs," "Wireless Network Transport Costs," "CLEC Services Costs," and "other reasonable, necessary and actual out-of-pocket costs incurred by PNI" in providing intercompany services. The Professional Services Costs were to be determined on a annual basis and would be equal to 112.25% of "the sum of the reasonable and actual salary[,] general and administrative costs and expenses incurred by PNI in providing the Professional Services," multiplied by POI's fractional share of the POI and PNI combined revenues. At the time the chapter 11 petitions were filed, the fractional share of costs borne by POI was 75%. The Intercompany Services Fee was to be invoiced on a quarterly basis, and payment was due within 45 days following receipt of the invoice.
On April 2, 2001, PTI, PNI, POI, and three POI subsidiaries filed voluntary chapter 11 petitions in the United States Bankruptcy Court for the District of Delaware. An order was entered for the joint administration of all six cases, which were thereafter transferred to this district. POI continued to operate for a short period of time while efforts were made to sell the company as a going concern. When those efforts failed to bear fruit, Nortel and Cisco, who had liens against all of POI's cash, notified POI on June 29, 2001, that use of cash collateral would not be permitted after June 30, 2001. On June 30, 2001, PNI laid off somewhere between 50 and 100 employees. With no available funds to continue in business, POI acceded to Nortel's and Cisco's motion to convert its case to chapter 7, and on July 19, 2001, the POI case was converted to chapter 7. The three POI subsidiaries were also converted to chapter 7; however, PTI and PNI remained in chapter 11 as debtors in possession.
Pathnet Fiber Equipment, LLC, Pathnet Real Estate, LLC, and Pathnet Real Estate of Virginia, Inc.
Nortel and Cisco subsequently consented to POI's limited use of cash collateral, up to a maximum amount of $115,348.00, through August 10, 2001, to pay certain designated employees and to provide security for Nortel's and Cisco's collateral.
Gordon P. Peyton was appointed as the chapter 7 trustee of POI and its three subsidiaries. PTI and PNI promptly filed a motion on August 1, 2001, to approve rejection of the Intercompany Services Agreement as of July 19, 2001. The motion, after reciting the relationship among the parties and the termination of the cash collateral stipulation, stated that PNI sought to reject the Intercompany Services Agreement "because POI has ceased to pay for the services provided by PNI" and because "POI's ability to pay for these services . . . has been limited by liens asserted on POI's cash by [Nortel] and [Cisco]." Mr. Peyton acknowledged that he had no legal basis to oppose rejection of the agreement, although he did seek to have rejection conditioned upon the furnishing of certain accountings. In any event, the motion to reject the Intercompany Services Agreement was granted on August 21, 2001.
Because the POI estate had no unencumbered assets, Nortel and Cisco entered into a cash collateral agreement with Mr. Peyton on or about September 10, 2001, allowing him to use cash collateral for the purpose of liquidating POI's assets for the benefit of the secured creditors, with a "carve out" for unsecured creditors. That agreement was approved by the court on September 20, 2001.
That same day, Mr. Peyton, Nortel, and Cisco each filed pleadings asserting damage claims arising from the rejection of the Intercompany Services Agreement. Each claim was for an unliquidated amount. Mr. Peyton asserted that damages were "likely to be in excess of One Million Dollars," while Nortel's and Cisco's claim did not set forth even a ball-park amount but merely asserted damages "measured by at least the diminution in value" of the collateral securing their respective loans "that may be shown to result from PNI's ceasing to provide the Intercompany Services." At the hearing, the trustee presented a schedule of expenses he had paid totaling $545,052.48 to the following persons or entities:
Redmon, Peyton Braswell $154,052.08 William Smedberg $41,869.35 Sean O'Donnell $101,431.17 Ricky Moore $63,383.67 Anita Elkins $927.00 Diane Harbaugh $3,351.21 Phillip Groce $4,343.00 QC2 $160,695.00 Century Business Services $15,000.00
Redmon, Peyton Braswell is the trustee's law firm, which has been employed (with court approval) to represent him. QC2 is a contractor employed by the trustee to recover and remove Nortel and Cisco equipment from various regional Bell operating company locations.
Century Business Services is the accountant employed by the trustee for the POI bankruptcy estate. Smedberg, O'Donnell, Moore, Elkins, Harbaugh, and Groce are all former PNI employees who were hired by the trustee under the title of "Cash Collateral Contractor." The trustee presented no evidence as to the nature of the services performed by his law firm or as to the specific duties performed by the "Cash Collateral Contractors."
Discussion A.
A trustee or debtor in possession is permitted, with court approval, and in the exercise of sound business judgment, to assume or reject executory contracts, that is, contracts with respect to which performance remains due to some extent on both sides. § 365(a), Bankruptcy Code. Rejection, however, is not cost-free to the bankruptcy estate; rather, rejection constitutes a breach of the contract, § 365(g), Bankruptcy Code, and thereby gives rise to a claim against the estate for any damages resulting from the failure to perform. The advantage to the bankruptcy estate, however, is that the breach is treated as a prepetition claim even though the rejection actually occurs post-petition. § 365(g)(1), Bankruptcy Code. Since prepetition unsecured claims are often paid at mere pennies on the dollar, rejection enables the bankruptcy estate to avoid payment of what might otherwise be a large administrative liability resulting from the post-petition failure to perform its contract.
Indeed, that is very much the case here. Shortly after the hearing on the rejection claim, PNI's plan of liquidation was confirmed providing for only a small pro-rata distribution, probably not exceeding 3 cents on the dollar, on general unsecured claims.
B.
PNI asserts, however, that the POI estate is not entitled to recover any damages from the breach because POI itself had already breached the contract by repudiation. It is, of course, hornbook law that the party who first materially breaches a contract cannot claim damages against the other party for that party's subsequent failure to perform. Horton v. Horton, 254 Va. 111, 114, 487 S.E.2d 200, 204-05 (1997). The doctrine of anticipatory repudiation is simply an extension of this principle, and merely says that the innocent party need not wait for the time when performance by the other party would be due, if the other party has clearly and unequivocally communicated "a fixed purpose not to perform the contract in any event or at any time." City of Fairfax v. Washington Metropolitan Area Transit Auth., 582 F.2d 1321, 1326 (4th Cir. 1978); Link v. Weizenbaum, 229 Va. 201, 203, 326 S.E.2d 667 (1985) (anticipatory repudiation must be "clear and unequivocal and it must cover the entire performance of the contract").
With respect to the Intercompany Services Agreement, the only obligation of POI was to pay for the services rendered. The issue thus resolves to whether Nortel's and Cisco's withdrawal of permission to use cash collateral — which unquestionably left POI without any funds to pay for the intercompany services — clearly signaled that POI would not or could not perform its obligations under the contract.
A compelling argument can certainly be made that the pulling of the financial plug by the secured creditors should be treated as a repudiation. Since POI's only obligation was to pay for the services rendered, and since POI had no funds, other than those subject to the Nortel and Cisco liens, by which it could make payment, nonpayment was pretty much a foregone conclusion, even though PNI had not yet invoiced POI for any post-conversion services and the time for payment had not yet occurred.
Nortel and Cisco rejoin that they were never unwilling to pay for necessary services but simply no longer wanted existing management in control of the checkbook. They point to the fact that subsequent to conversion, they entered into a cash collateral agreement with POI's chapter 7 trustee as evidence that they were willing to allow payment for at least those expenses necessary to dispose of their collateral.
Nortel, indeed, goes so far as to argue that the POI trustee would not have been required to pay PNI anything, since under the literal terms of the agreement, PNI would have been required to provide any requested Professional Services for free. This result follows, according to Nortel, because the reimbursement formula measures the POI payment at 112.25% of PNI's cost of providing the services, multiplied by the ratio of POI's revenues to the combined revenues of PNI and POI. Since POI's revenues after July 19, 2001 were zero, POI's fractional share of the costs was likewise zero, Nortel argues, thereby leaving PNI to bear all the costs. A fatal flaw with this argument, however, is that PNI likewise had no revenues during that time frame. So the payment formula would require multiplying 112.25% of the costs incurred by PNI by a fraction consisting of zero (POI's revenues) divided by zero (the combined revenues of POI and PNI). Division by zero, however, is mathematically undefined. Thus, the reimbursement formula fails altogether.
In any event, the court agrees with PNI that nothing in the email message withdrawing Nortel's and Cisco's consent to the use of cash collateral even remotely hinted that the withdrawal of consent was intended to be only temporary or that Nortel and Cisco intended, once the case was converted, to enter into an agreement with the POI trustee that would payment to PNI for necessary services. Nor did Nortel or Cisco come forward, once PNI filed its rejection motion specifically citing POI's inability (because of Nortel's and Cisco's liens) to pay for intercompany services, to say they were prepared to allow POI's trustee some limited use of cash collateral for that purpose.
At the same time, even though Nortel and Cisco's withdrawal of consent to the use of their cash collateral cast grave doubt on POI's ability to perform its payment obligations, the evidence does not show that POI clearly and unequivocally signaled "a fixed purpose not to perform the contract in any event or at any time." The trustee was not necessarily without the ability to pay for services even if Nortel and Cisco refused to allow use of their cash collateral. The trustee could have brought a motion under § 363(c)(2)(B), Bankruptcy Code, for authority to use cash collateral notwithstanding the lack of consent, and he could also have brought a motion under § 506(c) to surcharge Nortel and Cisco's collateral. There is obviously no guarantee that such motions would have been granted over Nortel's and Cisco's objection, but that is hardly a foregone conclusion. Anticipatory breach requires more than simply a likelihood that the other party will not perform; as noted, there must be a clear and unequivocal declaration to that effect. In the present case, the chapter 7 trustee never declared to PNI that he would not pay for intercompany services in any event or at any time, as required to sustain a defense of anticipatory repudiation. Accordingly, the court concludes that the defense of repudiation has not been sustained.
C.
That leaves for consideration the question of whether the specific damages alleged by the trustee, Cisco, and Nortel have been proven. Cisco and Nortel put on no evidence to establish any diminution in the value of their collateral resulting from the failure to provide intercompany services. At best, they seem to argue that because any money the trustee spent on services formerly provided by PNI ultimately comes out of their pocket, the value of their collateral is diminished to the extent the cost of procuring those services exceeds what POI would have paid under the Intercompany Services Agreement. Any claim they have is therefore coextensive with the claim of the trustee.
The trustee, as noted, offered in evidence nothing more than a list of amounts he has paid to various persons or entities. He presented no evidence as to the actual services performed in exchange for such payments. Indeed, this court's knowledge that the payments to the six named individuals (all former PNI employees) were for services as "Cash Collateral Contractor" is not derived from any evidence presented by the trustee, Cisco, or Nortel, but from PNI's own exhibits. Even then, the court has no clue as to what a "cash collateral contractor" does. The court is thus left to speculate whether the services paid for by the trustee were covered by the Intercompany Services Agreement. In particular, the court has serious doubts that any services performed by the trustee's law firm would fall within the scope of the agreement. Put another way, even if the Intercompany Services Agreement had not been rejected, the trustee could hardly have employed PNI's attorneys, whether in-house or retained, to represent him generally in the performance of his duties as trustee. Whether PNI's in-house or retained attorneys could (with court approval) have been hired as special counsel — say, for specified transactional or regulatory work — under § 327(e), Bankruptcy Code, is an interesting question, but one the court need not reach, since there has been no showing that the work for which the trustee's law firm was paid could fairly be characterized as a being for a "special purpose, other than to represent the trustee in conducting the case." The court also has difficulty seeing how the sums paid to QC2 to recover and remove Nortel's and Cisco's equipment would properly be covered by the Intercompany Services Agreement, since such removal and recovery would clearly not be part of POI's normal business operations.
More significantly, even assuming the services, or some of them, paid for by the trustee do fall within the scope of the agreement, the court is left to speculate whether those amounts paid exceeded, and if so by how much, the costs the trustee would have been required to pay under the Intercompany Services Agreement. The trustee did not even provide evidence of the dollar amount POI was paying (or was billed) immediately prior to the conversion, which might have served as a reasonable approximation. As discussed above, the court is unable to accept the argument that, because POI had no operating revenue, the trustee would not have been required to pay anything. Rather, because the cost-sharing formula in the contract results in an arithmetic expression (zero divided by zero) that is mathematically undefined, the payment due from POI to PNI would have to be determined on a quantum meruit basis. However, no evidence was presented that would allow the court to determine what that amount might be. The court cannot be expected to simply pull a number out of thin air, which is essentially what the trustee, Cisco, and Nortel are asking the court to do.
D.
Because there is a complete failure of proof as to the trustee's, Nortel's, or Cisco's actual damages resulting from the breach of the Intercompany Services Agreement, the court has no basis upon which to allow their rejection claims. Accordingly, a separate order will be entered sustaining PNI's objection to those claims.