588 B.R. 154
Bankr. E.D. Va.2018Background
- HDL (Health Diagnostic Laboratory) filed Chapter 11 after losing lender access and settling with DOJ; a Liquidating Trust was formed under a confirmed Plan that assigned to the Trust specified Litigation Claims and empowered the Liquidating Trustee to prosecute and settle them.
- Liquidating Trustee sued dozens of former officers, directors, and third parties (D&O Action). Mallory, former CEO and 8.9% shareholder, was a defendant in those claims and in a related federal False Claims Act (Qui Tam) action.
- The Liquidating Trustee and Mallory executed a mediated Settlement Agreement under which Mallory (and Scott Mallory) become jointly and severally liable for $10,000,000 plus additional consideration (notes, third-party payments, contingent gifts, and proceeds from Mallory’s malpractice claim against LeClairRyan) in exchange for releases and cooperation.
- The United States objected to court approval of the Settlement under Fed. R. Bankr. P. 9019, arguing the Settlement would violate the Federal Priority Statute (31 U.S.C. § 3713) and that the Trustee could not reserve rights to challenge the U.S. distribution priority.
- The South Carolina district court had entered a judgment for the United States against Mallory shortly before the bankruptcy hearing for $111,109,655.30, but the confirmation order and Plan (which the United States did not appeal) govern distribution from Trust recoveries.
- The bankruptcy court held an evidentiary hearing, found the Settlement the product of arms‑length mediation, concluded § 3713 is inapplicable to title 11 cases (and in any event the Settlement assets are not Mallory’s property subject to § 3713), overruled the U.S. objection, and approved the Settlement under Rule 9019.
Issues
| Issue | Plaintiff's Argument (United States) | Defendant's Argument (Liquidating Trustee / Mallory) | Held |
|---|---|---|---|
| Whether the Settlement should be approved under Fed. R. Bankr. P. 9019 | Settlement violates Federal Priority Statute and is unfair to the U.S.; Trustee cannot reserve rights to contest U.S. claim distribution | Settlement is fair, reasonable, benefits creditors, and Trustee may reserve rights; U.S. is bound by confirmed Plan | Settlement approved as fair and equitable under Rule 9019; Trustee acted within business judgment |
| Whether 31 U.S.C. § 3713 (Federal Priority Statute) applies to distributions from the Liquidating Trust | § 3713 gives U.S. priority that prevents the Settlement’s distribution scheme from being implemented | § 3713(a)(2) expressly excludes cases under title 11; Plan governs distribution and binds the U.S. | § 3713 inapplicable to bankruptcy cases; Plan and Confirmation Order control |
| Whether Settlement assets are property of Mallory (thus recoverable by U.S. under § 3713) | Various Settlement proceeds effectively belong to Mallory and should be subject to federal priority | Settlement sources (assigned CREO notes, ITS note, third-party payments, contingent gifts, LeClairRyan waterfall) are not Mallory’s property or are structured to preserve U.S. priority where applicable | Court found Settlement assets are not Mallory’s property subject to § 3713; LeClairRyan waterfall preserves U.S. priority for those proceeds |
| Whether Trustee waived right to contest U.S. claim distribution by reserving rights in Settlement | Trustee’s reservation is ineffective; cannot challenge amount/distribution to U.S. | Trustee merely reserved rights; Plan and court retain jurisdiction to resolve disputes later | Reservation permitted; court will address distribution disputes if they arise; Trustee did not expand rights improperly |
Key Cases Cited
- Protective Comm. for Indep. Stockholders of TMT Trailer Ferry, Inc. v. Anderson, 390 U.S. 414 (1968) (standard for approving compromises in bankruptcy; settlements are a normal part of reorganization)
- United Student Aid Funds, Inc. v. Espinosa, 559 U.S. 260 (2010) (bankruptcy court confirmation order is a final judgment binding on parties)
- United States v. Ron Pair Enterprises, Inc., 489 U.S. 235 (1989) (plain‑meaning statutory interpretation governs)
- United States v. Estate of Romani, 523 U.S. 517 (1998) (Congress amended priority statute to make it inapplicable to title 11; bankruptcy priorities govern)