Spark Factor Design, Inc. v. Hjelmeset (In re Open Medicine Institute, Inc.) (9th Cir. BAP)
The following is a case update written by Reno Fernandez, a bankruptcy appellate specialist with California Appellate Law Group, LLP, analyzing a recent decision of interest:
The U.S. Bankruptcy Appellate Panel for the Ninth Circuit (the “BAP”) recently published an opinion “to clarify that bankruptcy courts do not always need to examine a compromise as a sale under [Bankruptcy Code] § 363.” Spark Factor Design, Inc. v. Hjelmeset (In re Open Medicine Institute, Inc.), 639 B.R. 169 (9th Cir. BAP 2022).
To view the opinion, click here.
The BAP’s opinion opens by describing the underlying circumstances as a “business divorce,” although no formal dissolution was involved. Specifically, there was contentious litigation between the founder and principal of Open Medicine Institute, Inc. (“OMI”), namely Dr. Andreas Kogelnik, and the parties that came to replace him, namely Spark Factor Design, Inc. and Working Dirt R2, LLC. The litigation involved cross allegations of misappropriation of corporate assets, misconduct, breach of fiduciary duty, gross mismanagement, alter ego liability, successor liability, setoff, recoupment, and “deception of lenders,” as well as various loans, leases and subleases. The parties and potential litigants included Dr. Kogelnik, OMI, Spark Factor, Working Dirt, Basis Diagnostics, Inc. (“Basis”), several of their officers and directors, and third parties.
OMI filed a petition for relief under chapter 7 of the Bankruptcy Code in November 2020. Fred S. Hjelmeset was appointed Chapter 7 Trustee. Meanwhile, Dr. Kogelnik commenced a chapter 11 case.
Dr. Kogelnik filed a proof of claim for $1.35 million in OMI’s case, and the Trustee in OMI’s case filed an unliquidated proof of claim in Dr. Kogelnik’s case. Spark Factor and Working Dirt filed complaints for exception from, and denial of, discharge pursuant to Bankruptcy Code §§ 523 and 727 in Dr. Kogelnik’s case.
The Trustee and Dr. Kogelnik agreed to resolve disputes between their estates, and the Trustee brought a motion under Rule 9019 of the Federal Rules of Bankruptcy Procedure to approve a settlement agreement in September 2021. To summarize, the agreement provided for (1) settlement of the Trustee’s claims against Dr. Kogelnik and related parties, (2) a sale of certain causes of action against Spark Factor, Working Dirt and other “Targeted Parties” to Basis, and (3) withdrawal of the Trustee’s proof of claim. In exchange, (1) Basis would pay $200,000 to the trustee, (2) Basis would sue the Targeted Parties, at its own expense, and share 55% of any net recovery with the Trustee, and (3) Dr. Kogelnik’s claim would be subordinated to the allowed claims of non-insiders. The Trustee proposed that the settlement be approved without overbid or, if overbidding is required, that the minimum overbid be $3,170,000, which represented the Trustee’s estimate of the minimum amount that would likely be recovered under the settlement. A similar motion was brought in Dr. Kogelnik’s case.
Spark Factor and Working Dirt objected to both motions, although the objection filed in Mr. Kogelnik’s case was a “carbon copy” of the one filed in OMI’s case and also omitted several exhibits, which were eventually filed late. Spark Factor and Working Dirt offered an overbid of $300,000 plus 100% of any litigation recoveries. The bankruptcy court granted both motions. Thereafter, Spark Factor and Working Dirt timely appealed.
The BAP considered whether the bankruptcy court erred in approving the settlement in general under the familiar factors of Martin v. Kane (In re A&C Properties), 784 F.2d 1377 (9th Cir. 1986) (the “A&C Factors”), which are: (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. The BAP found that the Trustee had satisfied all of the A&C Factors. The BAP cautioned that the Trustee’s analysis of the difficulty of collection should have been more thorough but ultimately found that the Trustee at least “minimally” carried his burden.
The most interesting aspect of the BAP’s opinion is its conclusion that the bankruptcy court need not have scrutinized the settlement as a sale under Bankruptcy Code § 363. Specifically, the BAP carefully reviewed its decision in Goodwin v. Mickey Thompson Ent. Grp. (In re Mickey Thompson Ent. Grp.), 292 B.R. 415 (9th Cir. BAP 2003) and concluded that it requires analysis under Section 363 only if the claims to be settled “ran in only one direction….” In other words, when claims belonging to a bankruptcy estate are simply extinguished in exchange for cash from a defendant, the transaction is more like a sale that is “disguised as a compromise….” The BAP distinguished OMI’s circumstances because the proposed settlement involved compromises on both sides. In addition, the BAP commented that a sale to Spark Factor and Working Dirt would likely be of little value as they lack any incentive to sue themselves and the other Targeted Parties.
Judge Spraker concurred. Although he agreed with the result, he wrote separately to say he believed that the bankruptcy court was required to consider the settlement as a sale under Section 363. Among other reasons, Judge Spraker pointed out that the settlement agreement expressly provided for a sale of claims to Basis. However, Judge Spraker agreed with the majority because he found that the bankruptcy court did, in fact, apply Section 363 and considered the settlement agreement as a sale.
To summarize, the BAP’s opinion concludes that Section 363 need not be considered in every compromise involving a transfer of estate claims. But the opinion is helpful in another way: it clarifies the movant’s burden under the A&C Factors. In particular, the opinion identifies the bare minimum of evidence needed to show difficulty in collection. The Trustee’s evidence consisted of his expectation that “it was doubtful that Dr. Kogelnik had meaningful assets to pay any judgment.” However, the Trustee conceded that he “has not expressly investigated the estate’s ability to collect a judgment….” Nevertheless, the BAP found that the Trustee had shown that there was “serious doubt” about collectability. This was aided by the related factor of expense, specifically that the OMI estate had insufficient resources to pursue litigation. The BAP commented that “the Trustee’s analysis should have been more thorough,” but that “we cannot say that he failed to minimally carry his burden.” It is interesting to note that the BAP did not discuss the impact of the schedules of assets and liabilities that would have been filed in Dr. Kogelnik’s case, which would have been substantial evidence of his ability to satisfy a judgment. The opinion discusses the other A&C and several other issues, including evidentiary objections, but the two big takeaways are that (1) not every settlement must be analyzed as a sale under Section 363, especially where there are substantive compromises on both sides, and (2) in the absence of an explicit investigation, a trustee must at least articulate reasons for serious doubt about collectability.
This review was written by Reno Fernandez, a bankruptcy appellate specialist with California Appellate Law Group, LLP, a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.