In re Open Medicine Institute, Inc., 639 B.R. 169 (B.A.P. 9th Cir. 2022)

Dear constituency list members of the Insolvency Law Committee, the following is a case update written by Kathleen A. Cashman-Kramer, of Counsel at Sullivan Hill Rez & Engel (Cashman-Kramer@Sullivanhill.com), analyzing a recent case of interest:

SUMMARY

The Bankruptcy Appellate Panel for the Ninth Circuit (“BAP”) affirmed the bankruptcy court’s approval of a settlement between the chapter 7 trustee (the “Trustee”) of debtor Open Medicine Institute, Inc. (“OMI”) and its founder and former principal, Dr. Andreas Kogelnik, himself a debtor in possession in his individual chapter 11 case, that resolved the Trustee’s claims against Dr. Kogelnik for breach of fiduciary duties and claims held by OMI in pending state court litigation. Certain creditors (the “Targeted Parties”) of OMI and of Dr. Kogelnik appealed.  The Targeted Parties had opposed the settlement on the primary grounds that the settlement should have been evaluated as a sale under Section 363, not just as a settlement under Rule 9019, and on the grounds that they had offered the Trustee more money than Dr. Kogelnik had.  The BAP opinion focused on these two grounds in its decision.  

To review In re Open Medicine Institute, Inc., 639 B.R. 169 (B.A.P. 9th Cir. 2022), click here.

FACTS

The bankruptcy cases arose out of “business divorce” litigation among OMI, its founder and former principal, Dr. Kogelnik, and OMI’s current principals and creditors, Spark Factor Design, Inc. (“Spark Factor”) and Working Dirt R2, LLC (“Working Dirt”) (the Targeted Parties).  (The details of the facts that gave rise to the claims between them is lengthy and the opinion itself should be referred to for details, as well as the discussion regarding evidentiary objections.)  Pertinent to the settlement are the following facts: (1) Dr. Kogelnik started OMI in 2008 and was its sole shareholder; (2) Spark Factor and Valley Community Fund, Inc. (“VCFI”) acquired the majority stake in OMI in 2019; (3) beginning in December 2019, OMI borrowed $2.3 million from Spark Factor and $2.5 million from Working Dirt, and Dr. Kogelnik personally guaranteed the loans; (4) in early 2020, Laura Gingher (Spark Factor’s operations manager) became OMI’s CFO and assumed other roles in the company, and Abraham Farag (Spark Factor’s CEO) became the chairman of OMI’s board and this effectively ousted Dr. Kogelnik (whose ownership interest in OMI was reduced to five percent) from control of OMI; (5) Dr. Kogelnik claimed that Mr. Farag and Ms. Gingher improperly forced him out; conversely, Spark Factor and Working Dirt asserted that the board forced Dr. Kogelnik to resign due to his gross mismanagement of OMI, misappropriation of its assets, and deception of lenders, investors, and others for his personal benefit; (6) the Trustee contended that Spark Factor improperly, pre-petition, extended OMI’s lease and sublet the properties (including to OMI) at a profit, including assigning the $1.9 million deposit to Spark Factor; and (7) OMI filed three state court complaints against Dr. Kogelnik and other entities, including his companies Basis Diagnostics, Inc. (“Basis”) and  Open Medicine Clinic, Inc. (“OMCI”), asserting that Dr. Kogelnik breached his fiduciary duties to OMI and appropriated OMI’s money, resources, services, and intellectual property to benefit his other companies.

After the Chapter 7 petition was filed by OMI in November 2020, Dr. Kogelnik filed a $1.35 million proof of claim based on prepetition loans.  In addition to taking over the existing state court litigation, the Trustee asserted that OMI had various litigation claims against the officers, directors, and insiders of OMI, including Mr. Farag, his wife and brother, Ms. Gingher, Spark Factor, Working Dirt, and VCFI (also referred to as the Targeted Parties), for breaches of their fiduciary duties to OMI by engaging in conduct that benefitted themselves to the detriment of OMI and other claims.  Meanwhile, Dr. Kogelnik filed his own chapter 11 petition. The Trustee filed an unliquidated proof of claim in the chapter 11 case asserting that Dr. Kogelnik may have breached his fiduciary duties to OMI and caused financial injury to OMI. Additionally, Spark Factor and Working Dirt filed complaints against Dr. Kogelnik under Sections 523 and 727.

THE SETTLEMENT AND OPPOSITION

The Trustee and Dr. Kogelnik eventually agreed to resolve the disputes between OMI’s estate and Dr. Kogelnik, and motions to approve the settlement were filed in both cases. The settlement by the Trustee provided for: (1) a settlement of the claims that the Trustee held against Dr. Kogelnik, Basis and OMCI; (2) a sale to Basis of the OMI estate’s rights and interests in the claims against the Targeted Parties; and (3) withdrawal of OMI’s proof of claim in Dr. Kogelnik’s bankruptcy case. In exchange, Dr. Kogelnik, Basis and OMCI agreed that: (1) Basis would pay the Trustee $200,000; (2) Basis would pursue, at its own expense, the litigation against the Targeted Parties in an adversary proceeding and deliver to the Trustee fifty-five percent of the net recovery on those claims; and (3) Dr. Kogelnik would subordinate his claim in OMI’s bankruptcy case to all allowed claims of non-insiders.  Id. at 175-76.

The Trustee argued that the proposed compromise comported with the four factors laid out in Martin v. Kane (In re A & C Properties), 784 F.2d 1377, 1381 (9th Cir. 1986), and submitted his business judgment on each of these factors: (1) the probability of success in the litigation, (2) the difficulty, if any, to be encountered in collection, (3) the complexity of the litigation involved and the expense, inconvenience, and delay necessarily attending it, and (4) the paramount interest of creditors and proper deference to their reasonable views.  Most pertinent to this decision, the Trustee argued that the settlement was in the best interests of OMI’s creditors because it would result in the immediate realization of $200,000 for the estate, plus fifty-five percent of any recovery against the Targeted Parties, and the subordination of Dr. Kogelnik’s claim would reduce the pool of allowed unsecured claims by $1.35 million and increase the potential distribution to other creditors.

Finally, the Trustee addressed the sale to the Kogelnik Parties of the Litigation Claims against the Targeted Parties. He stated that he was exercising his business judgment to present the sale as a private sale not subject to overbid. He represented that the Kogelnik Parties were of the opinion that the Litigation Claims were worth between $10 million and $20 million and that the probability of success at trial was between sixty and eighty percent. He stated that he found those estimates reasonable.

Id. at 177.  The Trustee further stated that he would not consider an overbid from any of the Targeted Parties because they lacked incentive to prosecute the claims against themselves, but he set forth what minimum overbid terms he would accept if the court disagreed.  Id. at 177. 

Because Dr. Kogelnik was also in bankruptcy, the compromise required approval in both OMI’s and Dr. Kogelnik’s cases, and Dr. Kogelnik filed his own application to approve the compromise that mirrored the Trustee’s motion. Id. at 177. 

Spark Factor and Working Dirt objected to the Trustee’s and Dr. Kogelnik’s proposed compromise stating: (1) the compromise of claims was a sale that required analysis under Section 363; (2) the Trustee erroneously analyzed the A & C Properties factors; (3) Spark Factor and Working Dirt had offered $300,000 to the Trustee plus 100 percent of recovery against Dr. Kogelnik, Basis and OMCI, which they claimed was superior to the proposed settlement with Dr. Kogelnik; (4) the motion was unfair because the compromise did not allow for overbid, or, alternatively, they would have to pay over $3 million to overbid; and (5) the litigation costs by Dr. Kogelnik, Basis and OMCI would exceed $1 million, which would decrease the amount of money available to Dr. Kogelnik’s creditors.  While they discussed the effect of the transaction on the OMI estate, they did not discuss its effect on Dr. Kogelnik’s estate, filing what was essentially a “carbon copy” of their brief in both cases.

REASONING

The bankruptcy court found that the Trustee had properly examined the proposed settlement under the bankruptcy rule governing compromise and the factors set forth in A & C Properties, and it was not required to evaluate the proposed compromise as a sale of estate assets under Section 363, even though the compromise entailed the transfer of certain litigation claims.  It further found that the bankruptcy court did not abuse its discretion in granting the Trustee’s and Dr. Kogelnik’s motions. 

On appeal, the BAP affirmed each of these findings in turn.  In doing so, while it noted that the Trustee’s statements in support of the compromise would have been more helpful had they been more detailed, the panel agreed overall that the bankruptcy court had properly analyzed and decided the issues under the A & C Properties case, and that there was no abuse of discretion or error in that decision. 

On the issue raised by appellants — that the bankruptcy court erred in failing to also analyze the settlement as a sale under Section 363 — there was a lively and lengthy discussion wherein the BAP concluded that the bankruptcy court properly analyzed the compromise as a whole under Rule 9019 and did not need to evaluate the transfer of the claims against the Targeted Parties separately under Section 363, even though it did so when it applied a “heightened scrutiny”.  Id. at 179.  In doing so, it concluded that the BAP’s reasoning in Goodwin v. Mickey Thompson Ent. Grp. (In re Mickey Thompson Ent. Grp.), 292 B.R. 415, 420 (9th Cir. BAP 2003), supported a finding that “it is not always necessary for a bankruptcy court to treat a compromise of claims as a sale under § 363” and that the bankruptcy court has the discretion to apply Section 363 procedures to a sale of claims pursuant to a settlement approved under Rule 9019 but was not required to do so.  Id. at 181 (citing In Adeli v. Barclay (In re Berkeley Delaware Court, LLC), 834 F.3d 1036 (9th Cir. 2016)).

The opinion also specifically noted that, unlike in Mickey Thompson, the Trustee and the Kogelnik Parties had claims against each other, and the transfer of the Litigation Claims was only one element of an integrated transaction settling all of those claims and was not a “one-way sale” requiring scrutiny under Section 363.  Id. at 181-82. 

CONCURRING OPINION

Judge Gary Spraker filed a concurring opinion in which he agreed with the BAP’s result but stated wholeheartedly that he believed that the bankruptcy court was in fact required to consider the transfer of OMI’s claims against the Targeted Parties as a sale under Section 363.  In his view, and contrary to what the majority found, the Mickey Thompson decision requires that a transaction such as the one in question here – where the Trustee “sells” claims as part of a settlement – be analyzed under Section 363, regardless of competing claims.  In his opinion the majority focused too much on the existence of mutual claims between OMI and Dr. Kogelnik and his entities.  At the end of the day, he agreed that there was no error by the bankruptcy court, since it had essentially evaluated the agreement under Section 363 (despite the court finding that it was not required to do so).  

AUTHOR’S COMMENTS

This decision could be read in conjunction with the January 27, 2022 decision by the Ninth Circuit BAP in In re Portland Injury Institute, LLC, No. 21-1138, 2022 WL 263490 (B.A.P. 9th Cir. 2022), where the BAP affirmed the bankruptcy court’s decision that, in the case of a sale of estate claims against the debtor’s principal to a creditor, the court was not required to analyze such a sale under the settlement standard (Bankruptcy Rule 9019) as well as the sale (Section 363) standard. To review a case summery analyzing Portland Injury Institute, 2022 WL 263490: click here. 

It bears repeating: In deciding whether to structure an agreement as a compromise or sale, trustees often consider several factors including whether a sale could generate overbids, whether closing an opposed sale could moot an appeal, or whether there are mutual claims that must be resolved via a compromise. Before documenting your next settlement and drafting the required motion to approve compromise, practitioners would be well-advised to review these two cases, educate the client so he or she may make an informed decision, and provide a sufficient record to satisfy both standards.

These materials were authored by Kathleen A. Cashman-Kramer, Of Counsel at Sullivan Hill Rez & Engel (Cashman-Kramer@Sullivanhill.com), with editorial contributions from ILC advisor Thomas Rupp of Keller Benvenutti Kim LLP (trupp@kbkllp.com).