Arrowsmith v. Mallory (In re Health Diagnostic Lab., Inc.)Arrowsmith v. Mallory (In re Health Diagnostic Lab., Inc.)
PROCEDURAL HISTORY
HDL provided lab testing of biomarkers for the indication of risk for cardiovascular disease, diabetes, and other illnesses. Mallory was a co-founder of HDL and owned 8.9048% of HDL's stock as of June 7, 2015 (the "Petition Date"). She served as CEO of HDL from its formation in 2008 through September 2014 and as chairman of the HDL board of directors ("Board") from 2008 through the end of 2014. HDL was a
In 2013, the United States Department of Justice ("DOJ") and United States Department of Health and Human Services' Office of Inspector General ("HHS OIG") began investigating HDL and their outside sales team, BlueWave Healthcare Consultants, Inc. ("BlueWave"), in connection with HDL's business practices, including its payment of process and handling fees ("P & H Fees") to the referring physicians (the "DOJ Investigation").
In April 2015, HDL signed a settlement agreement with DOJ (the "DOJ Settlement"), as well as a separate corporate integrity agreement with HHS OIG. In the DOJ Settlement, HDL agreed to pay $47,000,000 to settle all the government's claims against it in connection with the P & H Fees. During this time, HDL's relationship with its prepetition secured lender, Branch Banking and Trust Company ("BB & T"), was deteriorating. When HDL defaulted under its loan facilities with BB & T, BB & T discontinued HDL's borrowing ability and cut off HDL's access to its existing accounts. With no ability to access its cash and with no alternative sources of financing immediately available, HDL resorted to Chapter 11 bankruptcy.
On the Petition Date, Health Diagnostic Laboratory, Inc., Central Medical Laboratory, LLC, and Integrated Health Leaders, LLC (collectively the "Debtors") commenced bankruptcy cases (collectively the "Bankruptcy Case") by each filing a voluntary petition for relief under Chapter 11 of Title 11 of the United States Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Eastern District of Virginia (the "Court").
On September 17, 2015, the Court entered a sale order (the "Sale Order"), which authorized the sale of substantially all of the Debtors' assets to True Health Diagnostics, LLC ("True Health") under the terms of an Asset Purchase Agreement.
On September 16, 2016, the Liquidating Trustee commenced this adversary proceeding ("Adversary Proceeding" or "D & O Action") by filing a complaint (the "D & O Complaint") against over 100 different defendants including HDL's former officers and directors, BlueWave, and BlueWave salespersons (referred to collectively with BlueWave as "BlueWave Defendants"). After this Court denied in part, and granted in part, several motions to dismiss the D & O Complaint, the Liquidating Trustee filed an amended complaint ("Amended D & O Complaint") against dozens of defendants including Mallory.
This Court implemented a streamlined judicial mediation process to facilitate the efficient resolution of the D & O Action. On June 12, 2017, U.S. District Court Judge Henry E. Hudson referred the D & O Action to United States Magistrate Judge David J. Novak for mediation and empowered him with full authority to settle the Adversary Proceeding, subject "only to Rule 9019 of the Federal Rules of Bankruptcy Procedure."
On February 2, 2018, the Court entered a separate order (the "Order Directing Judicial Settlement Conference") requiring the Liquidating Trustee, Mallory, and LeClairRyan P.C. ("LeClairRyan") to participate in a renewed settlement conference before Judge Novak in order to revive stalled mediation proceedings involving those parties in the D & O Action.
Among other terms, the Settlement Agreement provides that the Liquidating Trustee will release the claims of the Liquidating Trust against Mallory in exchange for Mallory's cooperation in other litigation. Mallory will become jointly and severally liable to the Liquidating Trustee along with Scott Mallory in the amount of $10,000,000 (the "Settlement Amount"), plus certain additional consideration recited in the Settlement Agreement including a provision allowing for the satisfaction of Mallory's personal liability.
During the Bankruptcy Case, the United States became involved in a False Claims Act ("FCA") case in the United States District Court for the District of South Carolina (the South Carolina District Court"). On August 7, 2015, the United States filed a Complaint in Intervention in a consolidated whistleblower suit against several defendants including HDL, BlueWave, Floyd Calhoun Dent, III, Robert Bradford Johnson, and Mallory (the "Qui Tam Action").
Accordingly, on the day of the Hearing, the United States had a final judgment against Mallory from the Qui Tam Action subject only to appeal, and the Liquidating Trustee had a signed Settlement Agreement with Mallory subject only to Court approval pursuant to Bankruptcy Rule 9019. The United States objected to the Motion and Settlement Agreement in an apparent attempt to forestall the Liquidating Trustee's ability to satisfy the estate's litigation claim against Mallory. The United States objected to the Motion and Settlement
JURISDICTION AND VENUE
The Court has subject matter jurisdiction over this contested matter pursuant to
DISCUSSION
Compromise and settlements are " 'a normal part of the process of reorganization.' " Protective Comm. for Indep. Stockholders of TMT Trailer Ferry, Inc. v. Anderson ,
Pursuant to the terms of the Plan confirmed in the Bankruptcy Case and the Order Directing Judicial Mediation entered in this Adversary Proceeding, the Liquidating Trustee is empowered to settle the Litigation Claims
The crux of the United States' argument is that the Settlement Agreement is not fair and equitable because it would require Mallory to violate the Federal Priority Statute. For any one of three separate reasons, the Court will overrule the Objection advanced by the United States. First, the terms of the Plan confirmed in this Bankruptcy Case are binding upon the United States. Second, the text embodied within the Federal Priority Statute renders it inapplicable to bankruptcy cases. And third, the terms of the Settlement Agreement itself do not serve to disrupt the priority the statute would otherwise mandate, if it did apply.
The United States was an active participant in this Bankruptcy Case. The Plan confirmed by the Court specifically binds "all present and former Holders of Claims and Interests, and their respective successors and assigns, including, but not limited to, the Liquidating Trust and the Liquidating Trustee."
As provided by the confirmed Plan, section 1123 of the Bankruptcy Code, and the trust agreement executed to implement the Plan, the HDL Liquidating Trust is the successor of the Debtors and the Creditors' Committee.
The United States negotiated for language to be inserted into the Plan that permitted the United States to continue its pursuit of its FCA claims in the Qui Tam Action outside of this Bankruptcy Case.
By settling the Litigation Claim against Mallory in this Adversary Proceeding, the Liquidating Trustee is fulfilling one of the fundamental duties imposed on him by the Plan. The United States cannot belatedly invoke the Federal Priority Statute to prohibit the Liquidating Trustee from liquidating the Litigation Claims and otherwise distributing the proceeds as provided by the express terms of the confirmed Plan. Any such objection should have been advanced at the confirmation hearing. In the absence of such an objection and particularly in light of its prior active participation as the holder of an allowed Class Three Claim, the United States, as a claimholder, is bound by the terms of the Plan.
Next, the Objection finds no support in the statutory text. The Federal Priority Statute plainly states that it is inapplicable to the case at bar. See
Subsection (a) of the Federal Priority Statute provides:
(a)(1) A claim of the United States Government shall be paid first when-
(A) a person indebted to the Government is insolvent and-
(i) the debtor without enough property to pay all debts makes a voluntary assignment of property;
(ii) property of the debtor, if absent, is attached; or
(iii) an act of bankruptcy is committed; or
(B) the estate of a deceased debtor, in the custody of the executor or administrator, is not enough to pay all debts of the debtor.
(2) This subsection does not apply to a case under title 11.
While it is unnecessary to delve into the legislative history behind the Federal Priority Statute because the plain meaning of the statute prevails, the history nevertheless reveals that Congress included the bankruptcy exception in the 1978 amendments to the Federal Priority Statute in order to create a "coherent bankruptcy policy, eliminate[ ] special priorities found in other laws and bring[ ] all priorities into the bankruptcy code itself." See H.R. Rep. No. 95-595, at 252 (1977), as reprinted in 1978 U.S.C.C.A.N. 5963, 6242. The U.S. Supreme Court succinctly addressed the interplay between bankruptcy law and the Federal Priority Statute in United States v. Estate of Romani ,
The bankruptcy law provides an additional context in which another federal statute was given effect despite the priority statute's literal, unconditional text. The early federal bankruptcy statutes had accorded to " 'all debts due to the United States, and all taxes and assessments under the laws thereof' " a preference that was "coextensive" with that established by the priority statute. As such, the priority Act and the bankruptcy laws "were to be regarded as in pari materia , and both were unqualified; ... as neither contained any qualification, none could be interpolated." The Bankruptcy Act of 1898, however, subordinated the priority of the Federal Government's claims (except for taxes due) to certain other kinds of debts. This Court resolved the tension between the new bankruptcy provisions and the priority statute by applying the former and thus treating the Government like any other general creditor.
Even if the Federal Priority Statute applied to this Bankruptcy Case, it would not prohibit the Court from approving of the Settlement Agreement, as the Settlement Agreement does not violate the statute. None of the assets that fund the Settlement Agreement ("Settlement Agreement Assets") originate from property of Mallory or from property that is otherwise under Mallory's custody or control. The entry of the contemplated consent judgment in the Settlement Agreement does not constitute the transfer of property by Mallory or an "act of bankruptcy" within the meaning of the Federal Priority Statute. The consent judgment only establishes the liability of Mallory to the Liquidating Trustee on certain constructive fraudulent conveyance and breach of fiduciary duty claims asserted in the D & O Action.
The Settlement Agreement identifies five (5) sources of payment to the Liquidating Trustee. First is the assignment of certain demand promissory notes made by CREO Wellness, LLC ("CREO Wellness") payable to the order of Mallory in the aggregate principal amount of $352,853.98 (the "CREO Notes"). Mallory previously pledged the CREO Notes as collateral for amounts she owed to her counsel. Second is a note to be made by ITS Manufacturing Inc. ("ITS") payable to the Liquidating Trustee in the amount of $500,000 inclusive of interest (the "ITS Note").
Mallory does not have possession or control over the CREO Notes.
Similarly, the evidence established that the ITS Note represents an agreed payment by ITS to the Liquidating Trustee in exchange for a release of the subsequent transferee claims that were asserted against ITS by the Liquidating Trustee under section 550(a) of the Bankruptcy Code. ITS is a separate legal entity with its own assets and its own lender.
The evidence was uncontroverted that Mallory is personally unable to make the Cash Payments set forth in the Settlement Agreement.
The obligation to turnover Gift Proceeds does not constitute a transfer of property by Mallory, as there is no existing or anticipated gift, bequeath, or inheritance. The Gift Proceeds are bare unliquidated windfalls contingent on uncertain future events. Counsel for Mallory explained that the hypothetical recovery of Gift Proceeds were included in the Settlement Agreement to account for the rare possibility that Mallory is gifted or bequeathed an amount over $50,000.
Lastly, the United States already enjoys priority status as to the LeClairRyan Waterfall Proceeds. Under the Settlement Agreement, the Liquidating Trustee is entitled to monies recovered from the pursuit of the LeClairRyan Litigation only after the waterfall of payouts have been made to Mallory's attorneys and to the United States.
For each of these three different reasons, the Court finds that the Settlement Agreement does not violate the Federal Priority Statute. The Court reviews the Liquidating Trustee's decision to settle the Litigation Claim against Mallory "utilizing a business judgment standard." SunTrust Bank v. Matson (In re CHN Constr., LLC ),
While the Liquidating Trustee believed he would ultimately prevail on his Litigation Claim against Mallory, he nevertheless concluded that pursuing the complex litigation would be expensive, protracted, and require the outlay of significant resources. Given that the Settlement Agreement avoids the inherent risk and uncertainty attendant to litigation, produces an immediate and material benefit to the Litigation Trust by increasing the funds available for distribution to creditors, and eliminates the uncertainty of recovery from the limited financial resources that Mallory
CONCLUSION
The settlement of time-consuming, burdensome, and uncertain litigation-especially in the bankruptcy context-is encouraged. See, e.g. , In re Penn Cent. Transp. Co. ,
As the Settlement Agreement is fair and equitable and is in the best interests of all creditors, including the United States, the Court will approve the Settlement Agreement under Bankruptcy Rule 9019. Going forward, the United States is encouraged to participate in the judicial mediation process that the Court has implemented to resolve the Litigation Claims that remain.
Notes
The Settlement also includes claims by and against Scott Mallory, the resolution of which are not at issue.
Bankruptcy Rule 9019(a) provides that "[o]n motion by the trustee and after notice and a hearing, the court may approve a compromise or settlement. Notice shall be given to creditors, the United States trustee, the debtor, and indenture trustees as provided in [Bankruptcy] Rule 2002 and to any other entity as the court may direct." Fed. R. Bankr. P. 9019(a).
Two other parties-in-interest, G. Russell Warnick and National Union Fire Insurance Company of Pittsburgh, also filed responses to the Motion and Settlement Agreement but did not object to the Settlement Agreement. See G. Russell Warnick's Reservation of Rts. , ECF No. 606; Nat'l Union Fire Ins. Co. of Pitt., Pa.'s Resp. to Mot. to Approve Settlement Agreement , ECF No. 607.
This is a contested matter under Bankruptcy Rules 9013 and 9014. Certain rules under part VII of the Bankruptcy Rules are applicable to contested matters, including Bankruptcy Rule 7052. See Fed. R. Bankr. P. 9014(c). Findings of fact shall be construed as conclusions of law and conclusions of law shall be construed as findings of fact when appropriate. See Fed. R. Bankr. P. 7052.
The Court entered an order on June 9, 2015, authorizing the joint administration of the Debtors' bankruptcy cases. The Debtors were permitted to operate the business of HDL as debtors in possession pursuant to sections 1107 and 1108 of the Bankruptcy Code. No trustee was ever appointed under section 1104 of the Bankruptcy Code. On June 16, 2015, the United States Trustee for the Eastern District of Virginia appointed an Official Committee of Unsecured Creditors (the "Creditors' Committee") in accordance with section 1102 of the Bankruptcy Code.
See Order (I) Approving Asset Purchase Agreement & Authorizing the Sale of Assets of the Debtors Outside the Ordinary Course of Bus., (II) Authorizing the Sale of Assets Free & Clear of All Liens, Claims, Encumbrances & Interests, (III) Authorizing the Assumption & Sale & Assignment of Certain Executory Cont. & Unexpired Leases & (IV) Granting Related Relief, In re Health Diagnostic Lab., Inc. , No. 15-32919 (Bankr. E.D. Va. Sept. 17, 2015), ECF No. 512.
See Order Confirming Debtors' Plan of Liquidation Under Chapter 11 of Bankruptcy Code, In re Health Diagnostic Lab., Inc. ,
See Modified Second Am. Plan of Liquidation Proposed by the Debtors, In re Health Diagnostic Lab., Inc. , No. 15-32919 (Bankr. E.D. Va. Mar. 25, 2016), ECF No. 995.
The Plan became effective on May 12, 2016 (the "Effective Date"). See Notice of Confirmation of Chapter 11 Plan at 1, In re Health Diagnostic Lab., Inc. , No. 15-32919 (Bankr. E.D. Va. May 14, 2016), ECF No. 1106.
See First Am. Compl., ECF No. 375.
See
See Order, ECF No. 315 ("Order Directing Judicial Mediation").
See Order Directing Judicial Settlement Conference, ECF No. 522.
In addition to the D & O Action, an interpleader action ("Interpleader Action" or Adversary Proceeding No. 17-03029), a tax action ("Tax Action" or Adversary Proceeding No. 17-04300), and claims objection litigation were pending in this Court. Mallory recently filed a lawsuit against LeClairRyan in state court for alleged malpractice relating to advices she claimed had been given to her by LeClairRyan while she was CEO of HDL (the "LeClairRyan Litigation"). Had the Liquidating Trustee ultimately prevailed in the D & O Action against Mallory, the Liquidating Trustee may have been able to recover any judgment against an award, if any, obtained by Mallory in the LeClairRyan Litigation; however, Mallory's claim in the LeClairRyan Litigation is not an avoidance action under the Bankruptcy Code.
See Mot. Ex. 1.
See Compl. in Intervention, United States v. BlueWave Healthcare Consultants, Inc. (Qui Tam Action ), No. 14-00230 (D.S.C. Aug. 7, 2015), ECF No. 75.
The Carve-Out set forth in section 7.4(b) of the Plan states:
provided, however , that except as provided in Section 7.5 of the Plan nothing contained herein shall enjoin or release any non-Debtors, including any D & O, from any liability to the United States, including but not limited to, any liabilities arising under the Internal Revenue Code, any environmental laws, subchapter III of chapter 37 of title 31 of the United States Code, or any criminal laws, nor shall anything in this Plan or the Confirmation Order enjoin the United States from pursuing or bringing any such claim, suit, action or other proceeding against the non-Debtors, or enjoin any non-Debtors from defending or resolving such claim, suit, action or other proceeding; provided, further , that nothing herein shall constitute a waiver of any rights or defenses of such Persons with respect to such actions.
Plan, supra note 8, ¶ 7.4(b) (emphasis in original). The Carve-Out did not grant the United States leave to interfere with the implementation of the Plan.
See Verdict Form, Qui Tam Action (Jan. 31, 2018), ECF No. 870.
See Final Judgment, Qui Tam Action (May 23, 2018), ECF No. 910.
By order entered May 9, 2017, the Court approved an agreement between the Liquidating Trustee and the United States to allow proof of claim 1335 filed by the United States in this Bankruptcy Case as a general unsecured claim in the amount of $40,644,852.50.
The Court will dispose of the second argument advanced by the Objection, as the Liquidating Trustee is merely reserving whatever rights he may possess. The Settlement Agreement does not expand the rights of the Liquidating Trustee. The Court will address the merits of any dispute concerning payment of the United States' Allowed Claim if and when it actually arises.
Additionally, the confirmed Plan in this Bankruptcy Case provides that this Court retains jurisdiction "[t]o protect property of the Estates, including Litigation Claims, from claims against, or interference with, such property ...." Plan, supra note 8, ¶ 11.1(c). For the reasons stated infra , the Settlement Agreement Assets (defined hereinafter) are property of the Estates. The Plan also provides for the retention of jurisdiction
[t]o issue injunctions or take such other actions or make such other orders as may be necessary or appropriate to restrain interference with this Plan or its execution or implementation by any Entity, to construe and to take any other action to enforce and execute this Plan, the Confirmation Order, or any other order of the Court, to issue such orders as may be necessary for the implementation, execution, performance and consummation of this Plan and all matters referred to herein, and to determine all matters that may be pending before the Court in the Case on or before the Effective Date with respect to any Entity.
Id. ¶ 11.1(c). The terms of the confirmed Plan in the Bankruptcy Case and the Order Directing Judicial Mediation in the Adversary Proceeding require Court approval of the Settlement Agreement under Bankruptcy Rule 9019. The disposition of the Motion will directly affect distribution under, and therefore implementation and execution of, the confirmed Plan.
The Litigation Claims were clearly identified in Exhibit A to the confirmed Plan and included, among other things, the causes of action alleged in the Amended D & O Complaint against the former officers and directors of HDL and BlueWave Defendants under Chapter 5 of the Code as well as claims against subsequent transferees of avoidable fraudulent transfers under section 550 of the Code (the "Litigation Claims"). See Confirmation Order, supra note 7, Ex A.
Plan, supra note 8, ¶ 7.1.
See id. ¶ 3.3.
Section 6.5(c)(12) of the Plan grants the Liquidating Trustee the power and charges the Liquidating Trustee with the duty of pursuing claims of the Debtors, the estates, and the Creditors' Committee defined in section 1.76 of the Plan. See Confirmation Order, supra note 7, at 81-82.
Plan, supra note 8, ¶ 6.5(c)(12).
See
Section 551 of the Bankruptcy Code provides that "[a]ny transfer avoided under section 522, 544, 545, 547, 548, 549, or 724(a) of the Bankruptcy Code, or any lien void under section 506(d) of the Bankruptcy Code, is preserved for the benefit of the estate ...."
See supra note 17 and accompanying text.
The Plan provided for the transfer of the assets of the bankruptcy estates to the HDL Liquidating Trust. An essential element of the Plan was the preservation and transfer of the "Litigation Claims," which belonged to the bankruptcy estate, to the Liquidating Trust. See Plan, supra note 8, ¶ 6.11. The primary tenet of the Plan was that the Liquidating Trustee would pursue the Litigation Claims on behalf of all creditors and that the proceeds realized therefrom would be distributed in accordance with the priority scheme set forth in the Plan. The Confirmation Order enjoined all creditors holding allowed claims, including the United States, from interfering with that process. The Carve-Out negotiated by the United States in the Plan pertaining to its right to pursue the Qui Tam Action did not limit the Liquidating Trustee's rights or duties under the Plan.
See Plan, supra note 8, ¶ 7.8. The United States was never granted stay relief under section 362(a) of the Bankruptcy Code permitting it to assert custody or control over property of the bankruptcy estate. See Confirmation Order, supra note 7, ¶ 63. Any interference with the Liquidating Trustee's ability to collect property of the estate (including the Litigation Claims) and distribute the proceeds thereof as provided in the confirmed Plan would constitute a violation of the injunction set forth in section 362 of the Bankruptcy Code.
See Confirmation Order, supra note 7.
The case at bar illustrates why Congress created the broad bankruptcy exception to the Federal Priority Statute and did not limit the application of that exception to debtors only, as the Government advocates. The United States maintains that its priority status applies to Government claims of all types regardless of whether the claims have been liquidated or reduced to judgment. All that is necessary is for the claim to have been determined by "an appropriate official of the Federal Government to be owed to the United States by a person, organization, or entity other than another Federal agency."
The ITS Note will have a $250,000 buyout amount that may be exercised by ITS within three years following execution.
Mallory is entitled to retain the first $50,000.
The United States appears to have conflated the CREO Notes with Mallory's interest in CREO Holdings, LLC. While Mallory owns an interest in CREO Holdings, LLC, she does not have any interest in CREO Wellness, which is the maker of the CREO Notes. See Hr'g Tr. 82:15-21, May 24, 2018, ECF No. 613.
Counsel for Mallory is not a representative of Mallory as contemplated by
Claims that are wholly contingent upon happenings after the act of bankruptcy do not constitute claims under the priority statute. Guillermety v. Sec'y of Educ. ,
Hr'g Tr. 16:5-8. On August 9, 2017, Mallory executed and delivered to her counsel a Stock Pledge Agreement granting her counsel a security interest in the 510 shares of common stock she owned in ITS. The Pledge Agreement was perfected long before Judgment was granted in the Qui Tam Action.
Hr'g Tr. 86:5-12.
See
Mot. Ex. 1.
On August 9, 2017, Mallory executed and delivered a Security Agreement, which was duly perfected, providing a security interest to her counsel in the proceeds of the LeClairRyan Litigation to secure outstanding and future legal fees.