Court: United States Bankruptcy Court, N.D. Illinois; May 27, 2008; Us Bankruptcy; United States Bankruptcy Court
Debtors J.S. II, L.L.C. and related entities filed an objection to the claim from Thomas A. Snitzer and Snitzer Family L.L.C. (SFLLC), alongside a counterclaim for breach of fiduciary duty, breach of contract, and equitable subordination. In response, Snitzer initiated a third-party complaint against John Kinsella, Sid Diamond, and associated entities, seeking equitable subordination of their interests. Both the Debtors and Kinsella and Diamond moved to dismiss Snitzer's third-party complaint under Federal Rules of Civil Procedure 12(b)(6) and 14(a). The court denied the motions to dismiss under Rule 12(b)(6) but granted the motion under Rule 14(a).
The court confirmed jurisdiction under 28 U.S.C. 1334, categorizing the matter as a core proceeding. Background details reveal that the Debtors, Illinois limited liability companies, were established for the Bridgeport Village residential project, with JS II owning the project and adjacent lands. Snitzer and SFLLC owned a 50% interest in the Debtors, though the Debtors contest SFLLC's membership in JS II. Snitzer was previously the manager until removed in 2005 by a Chancery Court ruling favoring Kinsella and Diamond, who cited management issues jeopardizing project integrity. Kinsella and Diamond were then appointed to manage the project, while Snitzer retained his membership interests. The project faced significant difficulties, with only the first phase, Bridgeport Village, completed before complications arose, leaving substantial undeveloped land.
Debtors filed for Chapter 11 bankruptcy relief on March 5, 2007, attributing the project's failure to Snitzer, their former manager. Snitzer contends that the bankruptcy was caused by the commingling, undercapitalization, and mismanagement by Kinsella and Diamond after his removal. The Debtors accuse Snitzer of gross misconduct and breach of fiduciary duty, specifically citing violations of City of Chicago ordinances regarding building codes, permits, and construction standards affecting approximately ninety homes. Allegations detail that Snitzer inadequately supervised the project, visiting the site infrequently, and failed to register or hire licensed contractors or necessary professionals like architects and engineers.
Additionally, it is claimed that Snitzer altered plans without proper authority, leading to significant code violations including structural issues, exceeding height restrictions, unsafe materials, and unpermitted constructions. The City of Chicago found violations in all ninety homes, with remediation costs exceeding $3 million. Accusations also include Snitzer's concealment of violations and obstruction of enforcement, particularly following complaints from a disgruntled subcontractor since 2003. Despite these issues, Snitzer reportedly misled stakeholders about the project's compliance. Between May 2002 and November 2004, seventy-eight stop work orders were issued due to permit violations, culminating in a comprehensive stop work order on November 5, 2004, after an inspection revealed extensive issues. Stanley Kaderbeck from the City’s Building Department then became directly involved, following Snitzer’s assurances to resolve the violations.
Snitzer's assurances permitted the resumption of construction on a project, but questions arose regarding his failure to address violations and repeated non-compliance with requests to meet with Kaderbeck. In January 2005, the City halted the project again, prompting the lender to call in its loan. The Debtors claim Snitzer exhibited recklessness, negligence, and breaches of fiduciary duty, citing inadequate accounting practices as he maintained project records on a personal computer without employing an independent accountant for an audit. Allegations also include Snitzer's misuse of Debtors’ assets for personal projects, specifically constructing an addition to his brother-in-law's home using Debtors’ funds and a subcontractor. Furthermore, Snitzer's involvement in unrelated litigation regarding Dearborn Park raised concerns, particularly regarding the alleged misappropriation of $24,000 from Debtors for his legal expenses.
Additionally, the Debtors accused Snitzer of further fiduciary breaches related to a contract with Banyan Distribution and Building Supplies, owned by his associate Michael Kennedy, who lacked the necessary contractor’s license. This contract gave Banyan exclusive rights to supply materials for 414 homes without the consent of the non-managing members, Kinsella and Diamond, who were reportedly unaware of its existence. Snitzer and Kennedy ordered materials prematurely, creating potential obsolescence and warranty issues that left the Debtors responsible for defects. Another allegation involves an unauthorized deferred compensation agreement between River West and Kennedy, which also required non-managing members' consent. Questions arose regarding the liquidation of this account and a $395,000 transfer to Kennedy’s account on the day of Snitzer's removal from the Bridgeport Project, allegedly without proper authorization from Kinsella, Diamond, or the court. The Debtors assert that Snitzer engaged in multiple insider deals detrimental to their interests.
Snitzer allegedly acted without authorization from other members by granting Arthur Hershkowitz an open-ended listing contract for the sale of industrial properties in Bridgeport Village. It is questioned whether Snitzer concealed this contract from Kinsella and Diamond, despite his involvement in selecting another agent for marketing the property. Hershkowitz has filed a $1 million claim against the Debtors based on the agreement with Snitzer.
Snitzer disputes the Debtors’ allegations and attributes the project's failure to Kinsella and Diamond's actions after his removal as manager, claiming that the project was thriving under his management. He cites the significant increase in home prices in Bridgeport Village and a reduction in debt from approximately $16 million to $1 million, allowing him to return $2.5 million to Kinsella and Diamond. Snitzer also highlights awards received during his tenure and favorable acquisitions of real estate by River Village West.
Snitzer asserts that after his removal, Kinsella and Diamond mismanaged the project, leading to bankruptcy. He maintains that he managed the Debtor companies separately and adhered to the Illinois Limited Liability Company Act, denying any improper commingling of funds. Snitzer outlines the distinct roles and purposes of the Debtor entities, asserting that Kinsella and Diamond were aware of the management structure and operations.
Allegations arise that Kinsella and Diamond disregarded formalities by using funds from one LLC to cover liabilities of another without a majority vote. Snitzer also claims that the project's downfall was exacerbated by undercapitalization, as Kinsella and Diamond only contributed $2.5 million each instead of the agreed maximum of $8.5 million, which he later returned during more promising times for the project.
Kinsella and Diamond's contributions to River Village have been classified by Snitzer as loans, despite the operating agreement requiring at least $8.5 million in capital contributions before any additional funds could be classified as loans. Snitzer asserts that he was not consulted about this classification. He argues that proper funding would have prevented the project's bankruptcy and cites several management issues attributed to Kinsella and Diamond. These include:
1. **Inventory Mismanagement**: In 2005, approximately $6 million worth of homes were unsold when the project shut down, which could have been liquidated to avoid financial decline.
2. **Hiring Practices**: Snitzer criticizes Kinsella and Diamond for hiring FCL Construction, which specializes in commercial rather than residential projects, at fees significantly higher than those of previous superintendents.
3. **Excessive Subcontractor Payments**: He claims Kinsella and Diamond made unreasonably high payments to subcontractors.
4. **Repair Expenses**: Snitzer argues they spent too much on warranty and punch-list repairs for completed homes.
5. **Building Code Compliance**: He disputes the installation of structural gates mandated by the City of Chicago, suggesting the Debtors should challenge this requirement or seek reimbursement from the design professionals responsible for the defect.
6. **Sales Decline**: Snitzer attributes the lagging home sales to his removal as manager in June 2005.
In response, Snitzer filed a third-party complaint seeking equitable subordination of Kinsella and Diamond's interests under 11 U.S.C. § 510(c) of the Bankruptcy Code. The Debtors and Kinsella and Diamond filed motions to dismiss, arguing that Snitzer's claims are derivative and he lacks standing, thus violating the automatic stay. They also cite the Barton doctrine and raise a res judicata issue concerning previously raised capitalization allegations. The court had previously overruled objections during a property sale authorization. Kinsella and Diamond further contended that Snitzer's third-party complaint is procedurally improper under Fed. R. Civ. P. 14(a).
The discussion section emphasizes that a Motion to Dismiss under Fed. R. Civ. P. 12(b)(6) assesses the sufficiency of the complaint rather than its merits, affirming that well-pleaded allegations should be viewed favorably towards the plaintiff, and dismissal is inappropriate if the complaint presents evidence that could lead to a reasonable inference of proof required at trial. The Debtors' primary contention is Snitzer’s lack of standing to assert his claim for equitable subordination.
Snitzer's allegations of commingling, undercapitalization, and mismanagement are considered derivative claims belonging solely to the Debtors, who act as debtors-in-possession, and thus any attempt by Snitzer to assert these claims violates the automatic stay in place since the case was filed. The Debtors are seeking sanctions against Snitzer for this violation. Generally, creditors lack standing to pursue derivative claims such as undercapitalization or breach of fiduciary duty without court approval, as these claims belong to the debtor. This principle is supported by case law, including Chrysler Rail Transp. Corp. and Koch Ref. v. Farmers Union Cent. Exch. Inc. However, the Seventh Circuit allows creditors to have standing for equitable subordination claims under 11 U.S.C. § 510, as established in Matter of Vitreous Steel Products Co. and In re SRJ Enterprises, Inc. In the context of equitable subordination, the individual creditor's interests may differ from the estate's overall interests.
To equitably subordinate a claim, a three-prong test must be applied, evaluating: 1) whether the creditor engaged in inequitable misconduct; 2) whether this misconduct injured other creditors or provided an unfair advantage; and 3) whether subordination aligns with the bankruptcy code. Snitzer's third-party complaint alleges that Kinsella and Diamond engaged in inequitable behavior by failing to adhere to corporate formalities, undercapitalizing the LLCs, and mismanaging the Debtors, which, if accepted as true, fulfills the first prong of the test. Furthermore, Snitzer claims that this misconduct led to the Debtors' bankruptcy, injuring him as a member of the LLCs, thus meeting the second prong. If Snitzer's subordination claim is successful, it would align with the good faith requirements of the Bankruptcy Code, fulfilling the third prong and positioning him ahead of Kinsella and Diamond in potential distributions.
Snitzer has established standing to pursue an equitable subordination claim under 11 U.S.C. § 510, rendering the motion to dismiss for lack of standing under Fed. R. Civ. P. 12(b)(6) denied. Consequently, Snitzer's actions do not violate the automatic stay, and any sanctions against him are inappropriate.
The Debtors argue that Snitzer’s third-party complaint violates the Barton doctrine by targeting Kinsella and Diamond for their post-petition management actions. Specific allegations within his complaint include:
1. Kinsella and Diamond's failure to observe corporate formalities and their intention to commingle funds of separate LLCs since taking over management in June 2005.
2. Misuse of funds from River Village West’s industrial properties to finance unrelated expenditures for River Village.
3. Using equity from River Village West’s assets as collateral for loans benefiting River Village.
4. Unauthorized assumption of River Village’s liabilities by JS II.
5. A proposal for substantive consolidation that would disadvantage River Village by reallocating proceeds from River Village West’s properties.
Further claims detail Kinsella and Diamond's refusal to restore or contribute necessary capital, leading to the Debtors’ bankruptcy and significant financial losses. They have acknowledged River Village's need for capital, suggesting mismanagement that has harmed profitability. Snitzer believes that Kinsella and Diamond committed serious management errors and seeks full discovery to assess their impact and the appropriateness of expenditures made under their management, including potentially excessive costs for warranty repairs.
Kinsella and Diamond are advised to seek reimbursement from the design professionals, contractors, or material suppliers responsible for an alleged structural issue addressed by the City of Chicago, rather than agreeing to the costly installation of "structural gates." They should contest the gates as unreasonable given that the City has not imposed similar requirements on other homes and has acknowledged that the alleged structural problem poses no safety risks. Kinsella and Diamond are also criticized for gross negligence regarding the slow pace of home completion and sales at River Village post-June 2005, which worsened the liquidity issues for the entity. Additionally, their failure to sell undeveloped lots at Bridgeport Village for over two years is noted as gross negligence that hindered revenue generation.
The document references the Barton doctrine, which states that a trustee of a bankruptcy estate cannot be sued without court permission, emphasizing that this principle protects the integrity of bankruptcy proceedings. The doctrine applies to both the appointing court and external forums, and a debtor-in-possession enjoys similar protections as a trustee. Snitzer presents three counterarguments against claims of Barton doctrine violations, asserting that the precedent in marchFIRST was wrongly decided and only applies to external suits, differentiating his case from Linton since it seeks equitable subordination rather than damages, and claiming the doctrine does not apply as he is addressing pre-petition acts. He argues that allowing his claims would not threaten the integrity of bankruptcy jurisdiction, as the matter would be adjudicated by the appointing court.
Snitzer contends that the ruling in marchFIRST is non-binding dicta because it was ultimately decided on a statute of limitations issue. However, the policy concerns identified in both Linton and marchFIRST regarding the necessity of prior court approval for lawsuits against trustees are applicable here. Allowing suits against trustees could burden them and impact the efficient administration of bankruptcy estates. Consequently, this Court will not disregard the marchFIRST ruling. Snitzer's argument regarding the distinction between remedies is acknowledged, but the burdens of defending against claims remain for trustees, regardless of whether the claim targets the trustee or other creditors. The Debtors are not named as defendants in the third-party complaint, and no relief is sought against them.
Snitzer argues that the Barton doctrine, which restricts claims against trustees without court approval, does not apply to events that occurred prior to the bankruptcy petition. However, Snitzer would be prohibited from pursuing claims against Kinsella and Diamond for actions after March 5, 2007, without prior court approval. The potential for sanctions under the Barton doctrine is considered premature, but it does not undermine Snitzer’s claim for equitable subordination.
Regarding res judicata, the Debtors assert that Snitzer's undercapitalization claims are barred because a final judgment on the merits precludes relitigating issues. For res judicata to apply, there must be: (1) a final judgment from an earlier action, (2) an identity of the cause of action, and (3) an identity of parties. A bankruptcy sale order is deemed a final judgment. The Seventh Circuit employs a "same transaction" test to determine cause of action identity, which revolves around a single core of operative facts.
The Debtors argue that Snitzer’s claims were resolved when the Court approved the sale of the "Iron Street" property on December 10, 2007. This sale was necessitated by a $5 million payment obligation to a secured lender due in early 2008. Snitzer had objected to the sale, arguing that Kinsella and Diamond's lack of capital contributions led to a lower sale price, which he termed a "fire sale." He believed that had the contributions been made, the estate would not have needed to sell at a loss. Snitzer's objections were ultimately overruled in the sale order issued on December 10, 2007.
Snitzer contends that res judicata should not apply in this case for several reasons. He cites Precision Industries, arguing it precludes res judicata in situations where the issue is before the same court that issued the sale order in a bankruptcy proceeding. Snitzer emphasizes that his claim for equitable subordination, based on a failure to contribute capital, does not challenge the sale order itself, differentiating it from the cases cited by the Debtors, which involved direct attacks on sale orders.
Snitzer's interpretation of Precision Industries is flawed. In that case, the plaintiff, who leased a warehouse, did not object to a sale order during the bankruptcy of the lessor. After the sale, the lessor denied the lessee access, leading to a lawsuit for wrongful eviction and breach of contract. The lessor claimed that the sale extinguished the lessee’s rights under 11 U.S.C. § 363(f), while the lessee argued for protections under § 365(h). The bankruptcy court ultimately ruled that the sale order eliminated the lessee's possessory interest and that the lessee was barred from further action due to res judicata for not raising objections earlier.
The Seventh Circuit, however, found that res judicata did not apply because both parties sought clarification from the bankruptcy court, which issued a decision on the merits. This case primarily involved property interests stemming from the sale order rather than an attack on the order itself. Consequently, Snitzer's broad assertion that res judicata is inapplicable when the same judge presides over the original matter is unconvincing. Additionally, Snitzer argues that the claims in his third-party complaint and the objection to the sale of the "Iron Street" property differ significantly, despite both being linked to the failure to contribute capital by Kinsella and Diamond under the River Village operating agreement, noting additional facts that render res judicata inapplicable.
Snitzer argues that the capital contribution requirement in the operating agreement was activated when the loan payment was due, presenting a preferable financial option over selling the “Iron Street” property as zoned in 2007. In his third-party complaint, he claims undercapitalization caused financial issues due to Kinsella and Diamond's failure to contribute necessary capital after becoming managers in 2005. He differentiates between two claims: the objection to the property sale, which pertains to financial issues in late 2007, and the third-party complaint, which relates to the project's financial status in 2005 and 2006.
The elements of res judicata are assessed, with Snitzer acknowledging that the December 10, 2007, sale order was a final ruling. The parties involved in both the sale objection and the third-party action are the same. The crux of the matter is whether the allegations of undercapitalization in the third-party complaint arise from the same factual basis as the sale objection. Snitzer asserts that the undercapitalization issues are distinct, emphasizing that Kinsella and Diamond should have fulfilled their obligation to contribute capital instead of proceeding with a sale. Under the River Village I LLC Operating Agreement, they were required to contribute up to $8.5 million when the LLC needed it.
Snitzer suggests that the objection indicates a viable alternative to the sale, as it implies that Kinsella and Diamond could have provided the necessary funds for financing or increased payments. While the objection to the sale addresses a different timeframe than the undercapitalization issues from 2005 and 2006, Snitzer aims for equitable subordination rather than challenging the sale order itself. Consequently, since the third-party complaint does not share the same core facts as the sale objection, there is no identity of causes of action. Snitzer's failure to enforce the capital obligation during the sale hearing means his current claims are new, not an attempt to relitigate.
Snitzer was not required to seek equitable subordination in December, as such a process must occur through an adversary proceeding, which is impractical to delay for a sale due to the extended timeline involving discovery and motion practice. The motion to dismiss Snitzer’s third-party complaint regarding undercapitalization under res judicata is denied, as the claims do not cover the same period, and the capitalization issue was not actually litigated in the previous action. The elements for collateral estoppel are not satisfied, as the capitalization issue was neither fully represented nor essential to the prior judgment. The Court's order allowed the sale based on sufficient business justification without determining capitalization requirements, leaving future undercapitalization concerns open for consideration. Consequently, the motion to dismiss Snitzer’s undercapitalization claims on collateral estoppel grounds is also denied. Furthermore, Kinsella and Diamond's argument that Snitzer's third-party complaint is procedurally improper is rejected; they assert that a claim for equitable subordination cannot be a third-party claim, and that Snitzer fails to allege their liability for the claim against them, which undermines his use of Fed. R.Civ. P. 14 for combining related controversies.
Kinsella and Diamond are not alleged to be liable to Snitzer or SFLLC for any claims, resulting in the failure of Snitzer's third-party complaint. Under Fed. R. Bankr. P. 7001(8), claims for equitable subordination must be pursued through an adversary proceeding, which Snitzer acknowledges was improperly filed under Rule 7014. Despite this technicality, the improper filing mandates dismissal, but does not prevent Snitzer from initiating a proper adversary proceeding within thirty days. Consequently, Kinsella and Diamond's motion to dismiss the third-party complaint is granted without prejudice. Additionally, the Debtors’ motions to dismiss are denied. Kinsella and Diamond, represented by Tabet, DiVito, Rothstein, LLC (TDR), were authorized to pursue claims against Snitzer in state court. Section 510(c) allows the court to subordinate claims after notice and hearing, and there is a potential issue regarding whether Kinsella and Diamond were parties in a sale order hearing connected to Snitzer's objections, though they are in privity with the Debtors as current managers. The Debtors' counterclaim related to the objection should also have been filed as an adversary proceeding per Fed. R. Bankr. P. 3007(b).
