Howard Grobstein of L. Scott Apparel, Inc. v. Lowell Sharron, an Individual, & Beyond Basics, LLC (In re L. Scott Apparel, Inc.)
| Decision Date | 13 April 2020 |
| Docket Number | Bankruptcy Case: 2:13-bk-26021,Lead Case No. 2:19-cv-01471-ODW [,C/w Case No. 2:19-cv01051-ODW] |
| Citation | 615 B.R. 881 |
| Parties | IN RE: L. SCOTT APPAREL, INC., Debtor. Howard Grobstein as Liquidating Trustee of L. Scott Apparel, Inc., Plaintiff, Appellee and Cross-Appellant, v. Lowell Sharron, an individual, and Beyond Basics, LLC, a California limited liability company, Defendants, Appellants and Cross-Appellees. |
| Court | U.S. District Court — Central District of California |
Brian Leslie Davidoff, Keith Patrick Banner, Lori L. Werderitch, Greenberg Glusker Fields Claman and Machtinger LLP, Los Angeles, CA, for Appellant.
Lloyd S. Mann, Mann and Zarpas LLP, Sherman Oaks, CA, for Appellee.
ORDER AFFIRMING THE BANKRUPTCY COURT
Appellants and Cross-Appellees Lowell S. Sharron ("Sharron") and Beyond Basics, LLC ("Beyond Basic") (collectively, "Appellants") appeal the Bankruptcy Court's recharacterization of debt as equity. Appellee and Cross-Appellant Howard Grobstein as Liquidating Trustee of L. Scott Apparel, Inc. ("Trustee" or "Appellee") appeal the finding that Sharron and Beyond Basics are not alter egos of one another.
The Court has jurisdiction under 28 U.S.C. § 158(a) and Federal Rule of Bankruptcy Procedure 8001(b). For the reasons discussed below, the Court AFFIRMS the Bankruptcy Court and DISMISSES all grounds for appeal and cross-appeal.
On June 19, 2013, one of L. Scott Apparel Inc.'s ("Debtor") vendors and two creditors filed an involuntary petition for relief pursuant to Chapter 7 of Title 11 of the United States Code against Debtor. (Appellee's Supplemental Excerpts of Record ("SER") 1042, ECF Nos. 27-1–27-11.) The Bankruptcy Court later confirmed an amended reorganization plan which provided for the creation of a liquidating trust for which Howard Grobstein was appointed liquidating trustee. (SER 1042–43.) On September 23, 2013, Sharron filed his proof of claim ("Sharron Proof of Claim"), which claims $766,783.74 for "Money loaned to Debtor, and unpaid compensation." (Appellants' Excerpts of Record ("ER") 185, ECF No. 23-1–23-5.) Sharron claimed $350,000 as a secured debt perfected by his alleged right to set off. (ER 185.)
Trustee objected to the Sharron Proof of Claim on March 3, 2015 and subsequently commenced the adversary proceeding underlying this appeal ("Adversary Proceeding"). Trustee sought to recoup book balances due from Appellants and to recharacterize a $350,000 loan from Sharron to Debtor as equity not debt. (SER 736.) Trustee and Sharron then jointly consolidated the objection with the Adversary Proceeding.
The parties filed their joint stipulation as to facts, trial occurred, and the Bankruptcy Court issued its Trial Findings and Judgment on January 29, 2019. (ER 896, 1031–35.) The judgment against Sharron and Beyond Basics totaled $567,194.13 and $502,008.46, respectively, plus pre-judgment interest of 10% per annum on both, but the Bankruptcy Court found against Trustee on the alter ego claim. (ER 1031–35.) The judgment further recharacterized the debt as equity, disallowing its use by Sharron as an offset. (ER 1031–35.)
Debtor was incorporated as a California corporation on May 15, 2001 with Sharron as the primary shareholder. (ER 80.) Debtor manufactured garments, sold garments to major retailers in the junior segment, and was in business for approximately twelve years. (ER 116.) As of May 13, 2013, Sharron was Debtor's President, Secretary, Chief Financial Officer, and only Director, and Debtor's principal executive office was Sharron's residence. (ER 81.) As of June 19, 2013—when the involuntary bankruptcy petition was filed—Sharron owned 97.5% of Debtor individually and through his family trust. (ER 128.) Debtor did not hold board or shareholder meetings on an annual basis. (ER 81.)
Debtor financed operations through a factoring agreement with CIT Group/Commercial Services, Inc. ("CIT"), and through advances by Sharron. (ER 116.) Under the factoring agreement, Debtor sold accounts arising from its inventory sales and services, and CIT would advance up to 85% of the amount of sold accounts plus up to $200,000 in the aggregate. (ER 116.) Sharron personally guaranteed the factoring agreement and was therefore at personal risk for repayment of CIT's advances made under the factoring agreement. (ER 166.) Under the factoring agreement, CIT could audit debtor, access Debtor's financial records and regular reports, and terminate the factoring agreement if Debtor breached or Debtor's financial condition was compromised. (ER 116.)
In 2002, Sharron advanced to Debtor $200,000 (the "Subordinated Debt") which was recorded on Debtor's compiled financial statements as "subordinated debt-stockholder." (ER 117.) Debtor issued multiple promissory notes that modified the principal and maturity dates on the Subordinated Debt. The Subordinated Debt initially had a January 1, 2005 maturity date and accrued interest at 6% per annum. (SER 70.) Debtor issued a new $350,000 promissory note dated April 30, 2003 with a July 1, 2005 maturity date, still at 6% interest (the "Sharron Subordinated Note"). (SER 72.) The maturity date was extended to January 1, 2010, then January 1, 2012, and finally to January 1, 2015. (SER 85, 87, 89.) The promissory notes collectively show that Debtor and Sharron extended the term from two to twelve years, and the final January 1, 2015 maturity date came due after the order for relief was entered in the bankruptcy case. At trial, Sharron and his accountant, Kabani, testified regarding the decision-making process for extending the Subordinated Debt's maturity date. Sharron testified that he delegated the decision to extend or offset to Kabani, but Kabani testified that a decision was made after mutual discussion. (ER 378, 387–89.)
Interest on the Subordinated Debt was credited by Debtor to the account designated in Debtor's QuickBooks as "1210 – Due from Officer" (the "Due from Officer Account"). (SER 1036; ER 84–85.) From 2002 until the filing of the involuntary petition, Debtor advanced funds to and incurred expenses for Sharron and his family for personal use as reflected in the Due from Officer Account. (ER 84–85.) Expenses included prepayment of $15,259 for family vehicles just before the bankruptcy filing—Sharron testified that these payments, which benefitted Sharron personally, were purposefully made when he was winding down the company. (SER 1039.)
No fixed repayment schedule existed for the Due from Officer Account. (SER 1037.) Sharron never intended to pay off the Due from Officer Account even though he had funds to do so. (ER 120–21.) As of June 28, 2013, the amount Sharron owed Debtor, (i) exclusive of interest, (ii) without regard to any setoff, and (iii) inclusive of all cash and non-cash credits pursuant to the Due from Officer Account, equaled $462,194.53. (SER 1037.)
No principal payments were made on the Subordinated Debt and Debtor's books or records do not indicate that there was a reserve for payment of the Subordinated Debt. (ER 83.) Debtor's books and records also have no record of a payment demand and reflect that no cash payments of interest were paid to Sharron by Debtor. (ER 83.) Debtor's accountant testified that Debtor used the funds from the Subordinated Debt as working capital. (SER 1599–1601.) Sharron never attempted to offset the Subordinated Debt against the Due from Officer Account, except on Debtor's 2013 tax return where Debtor claimed to offset the Sharron Subordinated Note from the Due from Officer Account. (ER 118–19.) Sharron testified that the Subordinated Debt did not have a fixed due date and that he would allow the Subordinated Debt to remain outstanding for as long as there were amounts due from him under the Due from Officer Account. (ER 383–84.)
Sharron stated he opened Beyond Basics because "[w]e were in the middle of some very difficult and changing times in the apparel industry" and it was his "desire to capitalize on a new line of business for children." (ER 128.) "The products would all be made in America which was a trend that many of the largest retailers were contemplating at that time." (ER 128.) Emails between Sharron and Maren Ghalayini show that Sharron: (1) wanted to retain financial control of Beyond Basics (ER 420–21); (2) did not want Debtor and Beyond Basics to compete directly and thus required Ghalayini to sign a non-compete agreement (SER 314, 339); and (3) recognized that there was a "huge risk" in funding Beyond Basics. (SER 335.)
On August 8, 2011, the principals of Beyond Basics—Sharron, Maren Ghalayini, and Riad Ghalayini—executed the Beyond Basics Operating Agreement. (SER 1039.) Debtor and Beyond Basics are separate legal entities in different business segments and Debtor did not own interest in Beyond Basics. (SER 1034, 1040.) The members of Beyond Basics were: Lowell S. Sharron Revocable Trust (61.25%), Maren Ghalayini (33.75%) and Riad Ghalayini (5%.) (SER 1039.) The initial capitalization of Beyond Basics was Lowell S. Sharron Revocable Trust (inventory and materials valued at $72,500), and Maren Ghalayini (assets of separate dissolved entity valued at $6,000.) (SER 1039.) Sharron did not own inventory and testified that any such inventory would have come from Debtor. (SER 1039; ER 432.)
Debtor's contributions were charged to Beyond Basics and reflected on the account designated in Debtor's QuickBooks as account "1222 – Due from Beyond Basics" (the "Due from Beyond Basics Account"). (ER 91–92.) Sharron's initial capital contribution of $50,000 was advanced by Debtor and reflected on the Due from Officer Account. (SER 280, 468.) In December 2011, Debtor contributed an additional $22,500 to Beyond Basics on Sharron's behalf. (ER 92.) Additionally, the value of Debtor's employees' labor for Beyond Basics and expenses paid on behalf of Beyond Basics was included in the Due ...
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Devine v. United States
...fees and taxes that had to be paid at closing. 3. In bankruptcy, equity can be recharacterized as debt. In re L. Scott Apparel, Inc., 615 B.R. 881, 888 (C.D. Cal.), appeal dismissed, 2020 WL 6492082 (9th Cir. 2020); In re Daewoo Motor America, Inc., 471 B.R. 726, 729 (C.D. Cal. 2012), aff'd......
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Devine v. United States
...fees and taxes that had to be paid at closing. 3. In bankruptcy, equity can be recharacterized as debt. In re L. Scott Apparel, Inc., 615 B.R. 881, 888 (C.D. Cal.), appeal dismissed, 2020 WL 6492082 (9th Cir. 2020); In re Daewoo Motor America, Inc., 471 B.R. 726, 729 (C.D. Cal. 2012), aff'd......