This month we consider whether a lender may use its claim against a borrower as setoff against an award to the borrower for the lender’s bad faith in filing an involuntary petition against the borrower, whether a bank is liable for the defalcations of an attorney it designated as a settlement agent, and what the requirements are for successor liability.
Petitioning Bank Creditor Filed Involuntary Petition Against Borrower in Bad Faith, Loses Setoff Rights
In U.S. Bank v. Rosenberg, No. 18-1249, 2018 WL 3640987 (3d Cir. July 31, 2018), the bank was slapped with an expensive penalty for what the court considered a misuse of the Bankruptcy Code, 11 U.S.C. §101, et seq. However, the decision was denominated as not precedential. Nevertheless, it is instructive.
Rosenberg created National Medical Imaging (NMI). NMI entered into equipment leases with U.S. Bank’s predecessor. The leases went into default, U.S. Bank sued NMI, the parties reached an agreement modifying the leases, and Rosenberg agreed to be liable for $7.6 million less the amount paid on each modified monthly lease.
About two years later, NMI defaulted on the modified leases. That resulted in Rosenberg having $5 million in personal liability. Entities tied to U.S. Bank filed an involuntary bankruptcy petition against Rosenberg in the U.S. Bankruptcy Court for the Eastern District of Pennsylvania. It was transferred to the U.S. Bankruptcy Court for the Southern District of Florida where Rosenberg lived. The involuntary petition was dismissed.
Rosenberg then filed an adversary case against U.S. Bank in Florida, claiming a violation of 11 U.S.C. §303(i). That provision of the Bankruptcy Code allows one to recover damages, costs, and fees for a bad-faith filing of an involuntary petition. A jury trial in the district court in Florida resulted in an award of $1 million in compensatory damages and $5 million in punitive damages. The final judgment in favor of Rosenberg was $6.12 million.
Not to be outdone by Rosenberg, while the Florida litigation was pending, U.S. Bank sued Rosenberg in the U.S. District Court for the Eastern District of Pennsylvania based on his personal liability for the defaulted leases. Judgment was entered in favor of U.S. Bank for $6.5 million.
U.S. Bank moved the Pennsylvania court to set off the Florida $6.12 million judgment against the $6.5 million Pennsylvania judgment. The result would be that Rosenberg would owe only $380,000. The Pennsylvania court denied the request, and the United States Court of Appeals for the Third Circuit affirmed the ruling.
The appellate court pointed out that setoff was “an equitable right to be permitted solely within the sound discretion of the court.” 2018 WL 3640987 at *2. It also said the lower court had not abused its discretion because the jury determined that U.S. Bank had acted in bad faith. It observed that other courts had concluded that “303(i)’s equitable purpose would be frustrated if bad faith filers were allowed to offset a §303(i) judgment.” Id. The result: the bank must pay the judgment entered against it but is not likely to have any success in collecting on the judgment entered in its favor.
What’s the point? It is clear that federal courts are intent on allowing parties who suffer the entry of unfounded involuntary petitions for relief to enjoy the fruits of any award they may receive under §303(i) of the Bankruptcy Code.
Bank Is Not Liable for Defalcations of Settlement Agent It Used
In Pineda v. Chase Bank USA, N.A., 186 A.3d 1054 (R.I. 2018), the Rhode Island Supreme Court, a jurisdiction not often heard from, weighed in on a bank’s alleged liability for the misconduct of a settlement agent it had used for an aborted mortgage financing.
In 2008, Pineda wanted to refinance mortgages on two properties he owned in Providence. In the process, Pasquale Scavitti, an attorney, acted as settlement agent. But Scavitti absconded with moneys disbursed to him that were intended to satisfy the indebtednesses secured by the two mortgages.
Pineda sued Chase because Chase had engaged Scavitti to act as closer and to use the proceeds of the two $195,000 loans to satisfy the existing mortgages, but he had converted the money to his own use. (In a footnote, the court noted that Scavitti has been disbarred.) Chase argued that it was not liable because Scavitti was not acting as its agent.
The first issue before the court was whether Scavitti was Chase’s agent. The trial court record showed that Pineda had selected Scavitti as settlement agent. As settlement agent, Scavitti received a package from Chase with instructions as to the closing, signed the settlement statement, prepared a title binder and sent it to Chase, sent wire transfer instructions to Chase with additional documents, was authorized by Chase to close the transaction, and had the funds from Chase wire transferred to his office account. But it was Pineda who paid Scavitti for his work.
Based on the foregoing, the appellate court stated there was a genuine issue of material fact as to whether Scavitti was the agent of Chase or Pineda. That would have been enough to upset the trial court’s grant of summary judgment in favor of Chase.
But the appellate court found an alternative basis on which to rule in favor of Chase. In order to establish that Scavitti was acting as Chase’s agent, it had to be demonstrated that Scavitti was acting within the scope of his employment. That called for some evidence that what Scavitti was doing was for Chase’s benefit. And, in that respect, the court said, “Scavitti’s uncontroverted testimony [was] that his defalcation of the loan funds was in no way motivated by a purpose to serve Chase.” 186 A.3d at 1059. That became the basis for the sustaining summary judgment in favor of Chase.
What’s the point? In those jurisdictions where attorneys are designated as settlement agents and misappropriate funds sent to them, the appropriate inquiries in determining liability are who designated the settlement agent, who paid the settlement agent for his or her services, and is there any evidence that the services rendered bestowed a benefit on the lending institution.
Court Rules on Requirements for Successor Liability
The Supreme Court of South Carolina was asked to rule on the requirements for successor liability in Nationwide Mutual Insurance Co. v. Eagle Window & Door, Inc., 424 S.C. 256, 818 S.E.2d 447 (2018).
The question before the court was whether Eagle Window & Door, Inc., was subject to successor liability for defective windows manufactured by a company known as Eagle & Taylor that sold its assets to Eagle in a bankruptcy court sale. This issue is of importance to lenders who may be asked to provide financing for companies such as Eagle. Are there undisclosed liabilities that have not been taken into account in making a credit evaluation?
In 1999, Renaul and Karey Abel entered into a contract with Gilliam Construction Company, Inc., for the construction of a home. Gilliam used windows manufactured by Eagle & Taylor Company that did business under the trade name Eagle Window & Door, Inc. Later, when construction had been completed, the Abels discovered damage due to water intrusion around the windows. They sued Gilliam and its insurer, Nationwide, and settled for $210,000. Nationwide then sued Eagle Window & Door, Inc., claiming it was liable for the obligations of Eagle & Taylor.
When the windows were manufactured, Eagle & Taylor was a wholly-owned subsidiary of American Architectural Products Company. Eagle & Taylor did business under two fictitious names: Eagle Window & Door, Inc., and Taylor Building Products, Inc.
American filed for bankruptcy reorganization in 2000. With bankruptcy approval, American sold all the assets of the fictitious entity Eagle Window & Door, Inc., to Linsalata Capital Partners Fund IV, L.P. Linsalata created a new wholly-owned subsidiary, EWD Acquisition Co., which later changed its name to Eagle Window & Door, Inc. (New Eagle). That was the entity Nationwide sued for contribution.
After the assets were transferred to New Eagle, New Eagle engaged in the same business of making and selling windows and doors, using the same facilities Eagle & Taylor had used. Five Eagle & Taylor officers joined New Eagle, including one who had served as president of Eagle & Taylor for many years.
Prior to the transfer of assets to New Eagle, American was the sole shareholder of Eagle & Taylor. After the transfer, Linsalata owned 88 percent of the shares of New Eagle.
At the time of the asset transfer, Stephen Perry, Linsalata’s Senior Vice President, was the sole Director of New Eagle. Afterwards, Frank Linsalata and Ronald Neill were added, as was David Beeken. New Eagle had eight officers. Five were former Eagle & Taylor officers, and three were designees of Linsalata.
Nationwide claimed New Eagle should be held accountable for the manufacture and sale of the defective windows because it was the “mere continuation” of Eagle & Taylor. It used a similar name, produced the same products in the same facility, and benefitted from the brand’s goodwill. Nationwide’s position was that in order to satisfy the “mere continuation” test, it was only necessary to show a commonality of officers, directors, or shareholders between New Eagle and its predecessor.
The decision in South Carolina’s intermediate appellate court was to sustain the trial court’s ruling that “[a] successor corporation is a mere continuation of its predecessor when the predecessor and successor corporations have substantially the same officers, directors, or shareholders.” [Emphasis added by Nationwide court.] 818 S.E.2d at 450. Judgment was for Nationwide. The Supreme Court of South Carolina disagreed, stating that “the court of appeals erred by finding that carryover of corporate officers resulted in a mere continuation when the record demonstrates there was no commonality of shareholders and directors between [New] Eagle and its predecessor.” 818 S.E.2d at 451.
The Supreme Court said the mere-continuation test requires more than a showing of common officers, directors, or shareholders. It requires a showing of a commonality of all three — officers, directors, and shareholders.
Among the cases cited in support of its ruling, the South Carolina Supreme Court referred to Vernon v. Schuster, 179 Ill.2d 338, 688 N.E.2d 1172, 1176, 228 Ill.Dec. 195 (1997), in which the Illinois Supreme Court opined, “In determining whether one corporation is a continuation of another, the test used in a majority of jurisdictions is whether there is a continuation of the corporate entity of the seller — not whether there is a continuation of the seller’s business operation.” [Emphasis in original.] 818 S.E.2d at 453.
Based on the absence of shareholder and director continuity between New Eagle and Eagle & Taylor, the court ruled in favor of New Eagle.
However, the court said the mere-continuation test is not inflexible, saying that “control is an essential consideration as well” and that “there may be instances where directors or officers — lacking ownership — exert such control and influence over a corporation acquisition that their continued presence after a corporate acquisition is sufficient to establish successor liability.” 818 S.E.2d at 454.
What’s the point? One may be tempted to ask why the bankruptcy sale with its typical language of a sale “free and clear of all liens, claims, encumbrances, and interests” was not determinative. That defense was rejected in Nationwide Mutual Insurance Co. v. Eagle Windows & Doors, Inc., 394 S.C. 54, 714 S.E.2d 322 (2011).
For more information on Financial Services, see Commercial and Industrial Loan Documentation — 2018 Edition. Online Library subscribers can view it for free by clicking here. If you don’t currently subscribe to the Online Library, visit www.iicle.com/subscriptions.