ON REMAND FROM THE HONORABLE RICHARD L. WILLIAMS UNITED STATES DISTRICT COURT FOR THE EASTERN DISTRICT OF VIRGINIA RICHMOND. C.A. NO. 3-.95CV197
Opening Statement
This matter returns to this Court on remand from the District Court for a determination as to the number of parties holding claims against Cold Harbor when the involuntary petition was filed.
Findings of Fact
On November 4, 1994, ALI, Inc. (ALI) filed an involuntary Chapter 11 petition against Cold Harbor Associates, L.P. (Cold Harbor) as a sole petitioning creditor in an effort to resolve a dispute between the parties concerning a nonrecourse note on which payments were not being made held by ALI and secured by deed of trust on the Cold Harbor Shopping Center, the principal asset of Cold Harbor, exclusive of the adjacent unimproved parking lot properties, also owned by Cold Harbor. The nonrecourse note with a value of approximately $1,475,000 was due and payable in May, 1992, and has been in default since April, 1992. In response, and in an attempt to thwart the effect of the involuntary Chapter 11, Cold Harbor filed its own voluntary Chapter 7 petition and a motion to dismiss the involuntary Chapter 11 petition. After a hearing in chambers on January 18, 1995 this Court entered an Order for Relief on the involuntary petition and necessarily dismissed Cold Harbor’s Chapter 7 petition as it was required to do in order to prevent the impermissible result of a debtor having two open bankruptcy cases in the same court at the same time. Cold Harbor appealed the entry of the Order for Relief to the District Court which entered a Memorandum Opinion and Order on August 9, 1995 affirming all of this Court’s findings, but remanding the matter back to this Court for a determination of the number of “holders of claims” as of the date of the involuntary petition. Cold Harbor appealed the matter, but the Fourth Circuit Court of Appeals dismissed Cold Harbor’s appeal of the District Court’s order for lack of jurisdiction, and this dispute returned to this Court. On November 14, 1996, this Court held a hearing for the purpose of ascertaining the number of “holders of claims” as of November 4,1994.
The language of the remand order from the District Court to this Court is quite briefi In the Memorandum Opinion, the District Court stated:
Without the benefit of factual findings from the Bankruptcy Court, this Court is unable to rule on whether ALI can qualify as a sole petitioning creditor. Therefore, this matter is remanded to the Bankruptcy Court for a determination as to the number of holders of claims against Cold Harbor at the time the involuntary petition was filed.
Memorandum Opinion at 6 (emphasis added).
By the express language of the Memorandum Opinion, the District Court reserved to itself the ability to determine if ALI can continue as a sole petitioning creditor. It is clear that the only input the District Court
ALI has strenuously argued that Cold Harbor should be precluded from amending the record to show that they had more than twelve creditors as of November 4, 1994. ALI bases its contention upon the theories of waiver and judicial estoppel, claiming since Cold Harbor admitted it had fewer than twelve creditors in its answer to the original involuntary petition they are now barred from presenting evidence of the existence of twelve or more creditors. ALI buttresses this argument by pointing out that when Cold Harbor filed its own voluntary Chapter 7 petition, its pleadings once again reflected fewer than twelve creditors. Cold Harbor responded these issues were presented to the District Court and the Circuit Court, both of which found ALI’s argument to be without merit. This Court believes that Cold Harbor has misstated the record of this case. Whether or not the argument was presented to Judge Williams, his August 9, 1995 Order and Memorandum Opinion is devoid of any mention of the issues of waiver or judicial estoppel. In addition, the Fourth Circuit Court of Appeals expressly declined to resolve the issue in its opinion.
[I]t would not be appropriate for us to decide the waiver issue (and thus perhaps the three-petitioner issue) in the first instance. Athough we have no idea at this stage how this subject will or should be resolve, it at least has the potential to be dispositive of the case.
Slip Op. at 3.
Despite the fact this issue appears to have been preserved for future, determination by both the District Court and the Circuit Court, this Court does not believe that resolution of this issue is appropriate in this Court. As previously noted, the District Court’s remand instructions confined the permissible scope of the present inquiry to the purely factual issue of the number of creditors existing as of November 4,1994. If the parties desire a ruling on the issues of waiver and estoppel presented by ALI, they must look elsewhere.
The requirements for commencing an involuntary petition in bankruptcy is found in 11 U.S.C. § 303(b), which states:
§ 303(b) An involuntary ease against a person is commenced by the filing with the bankruptcy court of a petition under chapter 7 or 11 of this title—
(1) by three or more entities, each of which is either a holder of a claim against such person that is not contingent as to liability or the subject of a bona fide dispute, or an indenture trustee representing such a holder, if such claims aggregate at least $10,000 more than the value of any lien on property of the debtor securing such claims held by the holders of such claims;
(2) if there are fewer than 12 such holders, excluding any employee or insider of such person, and any transferee of a transfer that is voidable under section 544, 545, 547, 548, 549 or 724(a) of this title, by one or more of such holders that hold in the aggregate at least $10,-000 of such claims.
At the present time, all disputes as to whether ALI may qualify as a sole petitioning creditor under § 303(b) have been resolved in ALI’s favor save for the issue now before the Court concerning the number of creditors as of the date of the petition. 1
ALI, Inc.
Neither party contended at the fact finding hearing that ALI was not a creditor at the date of filing. As the existence of ALI as a claim holder is apparently not in dispute, this Court will not engage in a lengthy analysis on this issue and will count ALI as the first creditor whose existence has been established for purposes of the Court’s § 303(b) inquiry.
The Trade Creditors
Cold Harbor has attempted to demonstrate that several relatively small debts incurred as a result of the day-to-day operations of Cold Harbor Shopping Center were claims against the Debtor for purposes of § 303(b). ALI contended many of the potential claims in question were more properly characterized as debts of the shopping center’s management company, Drucker & Falk, rather than a debt attributable to Cold Harbor Associates.
For § 303(b) purposes, the question of whether a creditor holds a claim against a management company or the owners of property it manages is subjective. The determination turns on whether the creditor in question believed that it was dealing with the principal or the agent. “[I]n the minds of creditors, the services rendered were to be paid by the management company.”
In re Arriola Energy Corp.,
This Court notes that the debtor has introduced into evidence several cheeks made out to various trade creditors by the Chapter 7 trustee who had been appointed during the debtor’s voluntary petition. 2 Apparently, the debtor provided these items in the belief this would be evidence the creditors paid off by the trustee were claim holders. This Court does not find this to be probative evidence, as these checks were written after the involuntary petition was filed. The actions of the Chapter 7 trustee after the involuntary petition was filed have no value for determining who held a claim against the debtor as of the date of the involuntary petition.
At the fact finding hearing, ALI produced uncontradicted testimony that most, if not all of the day-to-day operations of Cold Harbor Shopping Center were handled by Drucker &
Hanover County Public Utilities is alleged to hold a claim for water and sewer services in the amount of $1,025.83. The Summary of Account Activity provided to the Court, as evidence of this claim, merely bills the service address of 100 “Cold Harbor Ctr”. It does not disclose what party actually contracted for the services rendered or if the identity of the shopping center property owner was ever revealed to the utility. Because there is no evidence linking Cold Harbor Associates, L.P. to this bill, this Court finds that the Hanover County Public Utilities does not qualify as a claim holder.
Tes Lawn Service is alleged to hold a claim against the debtor in the amount of $800 for routine maintenance done on the property of Cold Harbor Shopping Center. The contract by which Tes Lawn Service was employed clearly states that the agreement is between Tes and Cold Harbor Associates. The Court finds that this is sufficient evidence to demonstrate that Tes held a claim against the debtor and not the management company.
Metro Regional Security is alleged to hold a claim against the debtor in the amount of $300 for security services rendered. The materials submitted to this Court, however, show merely that Metro Regional Security submitted a bill to Drueker & Falk for work done at the Cold Harbor Shopping Center. Whether Metro Regional Security was advised that it was performing services for the separate legal entity Cold Harbor Associates L.P. is not apparent. Therefore, this Court finds that Metro Regional Security did not hold a claim against the debtor.
Virginia Power Company is alleged to hold a claim against the debtor in the amount of $545 for electric power usage. Although the bills were sent to Drueker & Falk, they quite clearly state that they are charges to Cold Harbor Associates, L.P. Based upon this evidence, this Court finds that Virginia Power held a claim against the debtor.
Executive Maintenance is alleged to have held a claim against the debtor in the amount of $450 for janitorial services rendered. The contract letter and billing statements from Executive Maintenance are addressed to “Cold Harbor Shopping Center e/o Drueker & Falk”, which is not the correct legal entity. However, the acceptance line signed by Mr. Thomas of Drueker & Falk states that his signature is on behalf of Cold Harbor Associates, L.P. The Court finds that this is specific enough to alert the creditor to the fact that they were actually dealing with the debtor in this case, and accordingly this Court holds that Executive Maintenance held a claim against the debtor.
The debtor alleges that National Security held a claim against it in the amount of $300 for security services. However, there is no indication on the contract or the invoices submitted by National Security that would indicate that the creditor knew the legal entity of Cold Harbor Associates, L.P. was in any way involved. The client is listed as Cold Harbor Shopping Center, and the bills are addressed to the shopping center and not to the partnership. This Court finds that this is insufficient evidence to hold that National Security held a claim against the debt- or.
The debtor has provided a bill from the County of Hanover for real estate taxes on property listed as Cold Harbor Village Center in the amount of $5,624.31. Although the bill in its pre-printed form makes refer
Rosewood Glass Company is alleged to have held a claim against the debtor in the amount of $954.44 for boarding up some windows. However, the contract documents make no mention of Cold Harbor Associates L.P. As has been previously noted, this Court finds that evidence that a creditor dealt with Cold Harbor Shopping Center through Drucker & Falk is insufficient evidence that it knew that it was dealing with the debtor. Therefore, this Court finds that Rosewood Glass did not hold a claim against the debtor.
The debtor claims that it was indebted to Richmond Newspapers, Inc. in the amount of $649.28 as of the date of the initial petition. However, the evidence submitted by the debtor on this issue leads this Court to a different conclusion. Richmond Newspapers sent amalgamated bills for advertising on several properties to Drucker & Falk. It listed Cold Harbor Shopping Center on the bills, along with several other properties which Drucker & Falk managed. There is no indication anywhere on the invoice that Richmond Newspapers was informed that it was dealing with Cold Harbor Associates, L.P. Therefore, this Court finds that Richmond Newspapers cannot be considered to have held a claim against the debtor as of the date the involuntary petition was filed.
The debtor also lists Hill Electrical as a creditor in the amount of $141 for electrical work. The work order presented as evidence of this debt owed by the debtor is utterly devoid of any mention of Cold Harbor Associates, L.P. It is instead directed to Drucker & Falk, with the job location entry having been filled out as “Mechanics-ville Seafood”, a tenant of the debtor. From this evidence the Court finds that Hill Electrical cannot be considered a claim holder.
Although the question has been raised about the propriety of Maloney, Yeatts & Barr acting as counsel in the current case and their position as a pre-petition creditor, until there is an unappealable final order in this case the debtor is not technically bankrupt. Therefore, any questions about the potential conflicts inherent in acting as counsel to a debtor while maintaining the position of a creditor in the same case are premature at this time. As the evidence presented at the factual hearing established that Maloney, Yeatts & Barr was aware that Cold Harbor Associates, L.P. was their client, this Court finds that it held a claim for § 303(b) purposes.
The Tenants
The debtor contends that the tenants of its shopping center should be considered creditors for § 303(b) purposes by virtue of the rental security deposits they provided to the debtor when they initially leased space in Cold Harbor Shopping Center. For the following reasons, this Court finds that the shopping center tenants did not hold claims against the debtor as of the date of the initial petition by virtue of their security deposits.
Although the lease documents between the debtor and the tenants allow the debtor to place the security deposits into its general accounts, this does not change the ownership of the monies in question or limit the scope of this Court’s inquiry. The nature of the relationship between the debtor and the tenants and whether the tenants may qualify as creditors is a question governed by the law of Virginia. “Congress has generally left the determination of property rights in the assets of a bankrupt’s estate to state law.”
Butner v. United States,
Other bankruptcy courts confronted with similar circumstances have concluded that a tenant is not a creditor solely due to the existence of his security deposit.
In the Matter of Wayco, Inc.,
Because the law of Virginia as announced by the highest court of the Commonwealth holds that security deposits remain entirely the property of a tenant until such time as it violates a covenant in the lease agreement, the monies in question are not debts owed by Cold Harbor. Instead they are the money of another temporarily held by the debtor, and as such do not give rise to a creditor-debtor relationship. Based upon these findings, this Court holds that none of the shopping center tenants can be considered to have held claims against the debtor as of November 4, 1994.
The Promissory Notes
Cold Harbor introduced evidence which it argued demonstrated the existence of several claims against itself in the form of promissory notes held by its own limited partners. At the outset, the Court notes that none of the parties holding these purported promissory notes would be considered insiders under 11 U.S.C. § 101(31)(C), so whether this proffered obligation actually does represent a claim against the debtor will depend upon whether the noted created a debt or equity relationship. This Court is, however, disturbed by the extreme lateness with which these claims have been advanced. Although there is no doubt that the management of Cold Harbor either knew or should have known of a loan arrangement it had made with its own limited partners, the existence of this alleged debt was not raised until one and a half years after the commencement of this case. However, despite these troubling circumstances, the language of the remand order compels this Court to deal with this issue on the merits.
FOR VALUE RECEIVED the undersigned promises to pay to the order of Matilda J. Smithers [the note holder], ON DEMAND, the sum of Three Thousand Five Hundred Eighty & 08/100 Dollars ($8,580.08) plus interest at the rate of Six Percent (6%) per annum, beginning August 1,1992, said interest to compound annually if not paid.
If any default be made in the performance of any provision of this contract between the parties, the entire unpaid principal sum and accrued interest shall at once become due and payable without notice at the option of the holder thereof. Failure to exercise this option upon any default shall not constitute or be construed as a waiver of the right to exercise the said option in the event of any subsequent default.
This note is given without offset, for value received, and the maker or makers, endorser or endorsers, hereby waive protest, presentation, demand and notice of extension as to this obligation, and in the event of default the maker further agrees to pay all expenses incurred in collection and/or reducing to judgement the above obligation, including a reasonable attorney’s fee.
The notes are dated August 12th, 1992, but were not actually drawn up and delivered to the note holders until March 30th, 1993 or later. Cold Harbor borrowed a total of approximately $63,000 from its partners, who each contributed an amount directly in proportion to his ownership interest in the partnership. The money collected was used to pay off an outstanding mortgage held by Crestar Bank which was secured by the unimproved properties of Cold Harbor.
ALI argues that this Court should rechar-acterize this group of transactions, evidenced by the promissory notes and hold the purported loans to have been contributions to equity. ALI claims that the nature of these notes and the circumstances surrounding their issuance more properly display the earmarks of an equity exchange between a partner and partnership rather than a debt exchange between a creditor and debtor. This Court agrees with ALI and as explained hereafter holds that none of the alleged debts purportedly evidenced by the promissory notes qualify as holders of claims for the purposes of § 303(b).
In connection with this issue, ALI has raised the doctrine of equitable subordination to buttress its claim that the alleged loans evidenced by the promissory notes are in fact equity. Under 11 U.S.C. § 510(c)(1) the Bankruptcy Court may “subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest....” As part of this argument, ALI has pointed to cases in which this doctrine has been used to treat debts as equity and subordinate the claims to those of other creditors.
Herzog v. Leighton Holdings, Ltd. (In re Kids Creek Partners, L.P.),
This Court is not required to accept the label of “debt” or “equity” placed by the debtor upon a particular transaction, but must inquire into the actual nature of a transaction to determine how best to characterize it.
Celotex Corporation v. Hillsborough Holdings Corporation (In re Hillsborough Holdings Corporation),
The primary factor this Court is to consider when evaluating whether funds advanced by a shareholder are the result of an equity contribution or a loan is whether the transaction bears the earmarks of an arm’s length negotiation.
Pepper v. Litton,
(1) the names given to the certificates evidencing the indebtedness;
(2) the presence or absence of a fixed maturity date;
(3) the source of payments;
(4) the right to enforce payment of principal and interest;
(5) participation in management flowing as a result;
(6) the status of the contribution in relation to regular corporate creditors;
(7) the intent of the parties;
(8) ‘thin’ or inadequate capitalization;
(9) identity of interest between creditor and stockholder;
(10) source of interest payments;
(11) the ability of the corporation to obtain loans from outside lending institutions;
(12) the extent to which the advance was used to acquire capital assets; and
(13) the failure of the debtor to repay on the due date or to seek postponement.
Celotex Corporation v. Hillsborough Holdings Corporation (In re Hillsborough Holdings Corporation),
Applying these factors to Cold Harbor’s shareholders/promissory note holders, this Court finds that the notes in question most properly reflect an equity contribution rather than a loan. One of these factors is clearly inapplicable to the present case: the failure of the debtor to repay on the due date or seek postponement. Simply put, because the notes are demand notes with no defined due date, and no demand appears to have been made, there is simply no evidence one way or another that would aid this Court in determining the nature of the transactions. The Court will now identify and analyze those factors which led to this determination, beginning with those factors which weigh in favor of finding the transaction in question to have been a loan.
1.
The names given to the certificates evidencing the indebtedness, and the intent of the parties.
These analysis for these two factors is generally similar, and the Court will deal with them together. First, the notes given by Cold Harbor to their shareholders are quite clearly marked as “Promissory Notes”. Labeling the documents in this way is some evidence that the transaction was in fact a loan. Labeling the documents in this manner also sheds light on the intent of the parties, demonstrating that they believed that they were lending money to the partnership. The debtor also introduced deposition evidence that the note holders thought they had made a loan. These pieces of evidence cannot be regarded as conclusive, or even particularly strong evidence, as placing significant weight on the label given to the transaction by the parties would have the effect of rendering moot much of the inquiry into the nature of the transaction. This Court is also very concerned with the approximately seven month delay between the transfers and the drawing and delivery of the notes, which raises doubts in this Court’s mind as to whether the parties determined what they wanted to call the transaction until well after the actual exchange. The lack of a promissory note, in conjunction with a lack of other formalities, may indicate that advances are equities.
Estate of Mixon v. United States,
2. The right to enforce payment of principal or interest. Unlike equity holders, debt holders have the right to enforce repayment under the terms of their note. The notes in question are styled as demand notes, payable to the holder upon his request. In addition, the note holders are entitled to attorney’s fees in the event of a default on Cold Harbor’s part. The note holders’ right to enforce payment, and extract a penalty from Cold Harbor in the event of a failure on its part constitutes evidence weighing in favor of considering the advances to be loans rather than equity.
3. Participation in management flowing as a result. One characteristic of equity is the right to participate in ownership decision making. If the shareholder obtains additional rights to control the actions of the corporation as a result of lending it money, then the transaction will be viewed as having the characteristics of equity. In this ease, however, there has been no evidence that the shareholders gained additional ownership rights based upon the loan, or that their degree of control was dependent upon their advancing these funds. On the other hand, this state of affairs stems primarily from the fact that the loan was made pursuant to a pro rata contribution arrangement based upon the lenders’ original equity ownership. Given that all of the original equity holders contributed in amounts relatively equal to their original capital investment, it is not surprising that the nature of the parties’ ownership interests did not change. For this reason, this Court attaches little weight to this factor.
4.
“Thin” or inadequate capitalization.
There was no evidence presented that would relate to this factor. Generally this factor is relevant when a corporation is started by the shareholders with a minimal amount of capital who then make a large loan of money to the newly formed corporation, and thus the relevant time for determining whether capitalization was adequate is generally at the corporation’s creation.
See e.g. Hillsborough
These four factors tend to show that the advances from the limited partners to Cold Harbor exhibited some of the formalities associated with a loan. The purpose of the inquiry into the nature of the transaction is to determine if it is one which could have been made at arm’s length. This Court finds that the following factors establish that the advances made by Cold Harbor’s shareholders should be considered equity contributions, and not loans. For these reasons, the promissory notes in question do not count for § 303(b) purposes.
1.
The presence or absence of a fixed maturity date, a schedule of interest payments, a sinking fund.
Although Court’s have treated these as separate factors in their analysis, they are significantly related. The basic question asked when addressing these factors is: how definite were the plans for repayment. If the terms are vague and nonspecific, then the advance takes on the appearance of equity as it is assumed that a non-shareholder bargaining at arm’s length would demand specifics and formalities to protect their investment. First, the absence of a fixed maturity date, indicates that advances are capital contributions and not loans.
Roth Steel Tube,
2.The extent to which the advance was used to acquire capital assets.
Use of advances to meet the daily needs of an organization is indicative of a loan and not an equity contribution.
Roth Steel Tube,
3.
Presence or absence of security.
Although security was available in the form of the unimproved parking lot properties, the notes purport to be a wholly unsecured loan from the limited partners. Lack of security for a transaction is considered to be a significant indicator that an advance is not a loan.
Roth Steel Tube,
4.
Inability to obtain outside financing.
The question to be asked here is whether a reasonable outside creditor would have made a loan to the debtor on similar terms.
Roth Steel Tube,
5.
Identity of interest between creditor and stockholder.
The final factor to be considered is the relationship between those owning equity and making the advance. This Court considers this to be the most critical factor in its determination due to the exact identity between the two groups. The purported loan was made on a
pro rata
basis, with each partner contributing a percentage
Weighing the various factors, this Court finds that the evidence is predominantly in favor of treating the advances as equity. Although the transactions did have some of the characteristics of a debt transaction, the factors that would favor that conclusion are generally weak. On the other hand, the factors that point to the conclusion that the notes represent an equity investment by the limited partners are quite strong. In fight of these determinations, this Court holds that the promissory notes held by the limited partners do not represent a claim against Cold Harbor for the purposes of § 303(b).
Conclusion
This Court holds that Cold Harbor had six creditors for § 303(b) purposes as of November 4, 1994. Specifically those creditors were: ALI, Tes Lawn Service, Virginia Power Company, Executive Maintenance, the County of Hanover, and Maloney, Yeatts & Barr. None of the other alleged trade creditors were sufficiently well documented for the Court to find that they were creditors of Cold Harbor. In addition, for the reasons stated above, this Court holds that the shopping center tenants, and the limited partner note holders did not hold claims under § 303(b) at the time the involuntary petition was initially filed.
Notes
. It might be added that these issues were not raised with this Court prior to the entry of the order for relief because the petition asserted there were less than twelve creditors and the answer filed by Cold Harbor did not challenge that allegation. There was no reason for this
. Even though the involuntary Chapter 11 petition had been filed, an order for relief under that Chapter had not yet been entered. Consequently, when Cold Harbor filed the voluntary Chapter 7 petition, the United States Trustee, pursuant to 11 U.S.C. § 701, appointed an interim Trustee to operate the debtor’s business, including the collection of rents and payment of any charges incurred on behalf of Cold Harbor, until the decision was reached on the Chapter 11 involuntary relief request. The trustee was subsequently discharged of his trust after the order for relief was entered in the Chapter 11 proceeding.