Husted v. Taggart (In re ECS Ref., Inc.)

• Decision Date: 15 December 2020
• Docket Number: Case No. 18-22453-A-7,Adv. No. 20-02093-A
• Parties: IN RE: ECS REFINING, INC., Debtor. Kimberly J. Husted, Plaintiff, v. Kenneth Taggart et al., Defendants.
• Court: United States Bankruptcy Courts. Ninth Circuit. U.S. Bankruptcy Court — Eastern District of California

625 B.R. 425

IN RE: ECS REFINING, INC., Debtor.

Kimberly J. Husted, Plaintiff,

v.Kenneth Taggart et al., Defendants.

Case No. 18-22453-A-7

Adv. No. 20-02093-A

United States Bankruptcy Court, E.D. California.

Signed December 15, 2020

Christopher D. Sullivan, Roxanne Bahadurji and Quentin Roberts, Diamond McCarthy LLP for Kimberly J. Husted, Chapter 7 trustee; Howard M. Privette and Kay S. Kress, Troutman Pepper Hamilton Sanders LLP for Kenneth Taggart, James Taggart and Jack Rockwood; Jamie P. Dreher and Joseph K. Little, Downey Brand LLP for Sinclair Partners LLC, ECS Big Town LLC, and All Metals, Inc.

MEMORANDUM

Fredrick E. Clement, United States Bankruptcy Judge Directors of insolvent corporations owe fiduciary duties to creditors. ECS Refining, Inc., was insolvent. It owed SummitBridge a $26 million secured debt. When SummitBridge refused to restructure its debt, ECS Refining's directors employed bare-knuckled and, in some instances self-interested, tactics designed to "take out" SummitBridge. Caught in the crossfire, unsecured creditors’ interests suffered. After ECS Refining filed bankruptcy, the Chapter 7 trustee brought an action against the directors. Has she stated a cause of action?

I. FACTS

A. The Preamble

ECS Refining, Inc. ("ECS") is a Delaware corporation. It conducted business in California, Oregon, Texas, Ohio, and Arkansas. Founded in 1980, its primary business was the disposal and, in some cases, re-furbishing and re-selling of post-consumer electronic goods. Prior to filing bankruptcy, it employed 325 people and had been quite profitable.

ECS was founded by Kenneth Taggart and James Taggart. Collectively, the Taggarts were ECS's sole shareholders and constituted its board of directors.¹ They also comprised the majority of ECS's officers. James Taggart was its Chief Executive Officer and Kenneth Taggart was its Executive Vice President. A third person, Jack Rockwood (collectively the "Individual Defendants"), served as its president.

The Taggarts are the primary, if not exclusive, owners of--and control--three entities with whom ECS regularly did business: Sinclair Partners, LLC; ECS Big Town, LLC; and All Metals, Inc. (collectively the "Insider Entity Defendants").

The Insider Entity Defendants had long-term real property leases with ESC. Sinclair Partners, LLC, leased 262,000 square feet, known as "the Stockton facility," to ECS under a 20-year lease. Rent was $90,000 per month, subject to a 3.25% cost of living adjustment each year. ECS Big Town, LLC, leased 216,000 square feet, known as "the Mesquite facility," to ECS under a 10-year lease. Rent for that facility was $51,000 per month. All Metals, Inc., also leased space to ECS. Those facilities were larger than reasonably required for ECS's operations conducted at those sites.

Butch and Sundance, LLC, is a limited liability company. It was formed on the eve of ECS's bankruptcy and its only members are the Taggarts. It was formed for the specific purpose of providing post-petition financing to ECS to be secured by receivables, inventory, cash and new equipment.

B. The SummitBridge Loans

In 2012, Bank of America made two loans to ECS: a $15 million revolving loan and a $35 million term loan. Those loans were secured by ECS's equipment, inventory, goods, works in process, proceeds, fixtures, patents and trademarks and a pledge of stock in another company, Regenesys Glass Processing, LLC.²

In 2017, Bank of America sold its interest in the loans, and assigned its collateral securing those loans, to SummitBridge National Investments V LLC ("SummitBridge"), a private equity firm.

About the same time, ECS wanted to restructure its long-term debt, now held by SummitBridge. To that end it retained MCA Financial Group, Ltd. ("MCA") and the law firm of Snell & Wilmer LLP ("Snell & Wilmer") to negotiate restructuring the SummitBridge loan. MCA and Snell & Wilmer did secure a forbearance agreement for ECS from SummitBridge through December 31, 2017.

However, as the forbearance agreement neared expiration, it became clear that the Taggarts and SummitBridge were at an impasse with respect to ECS's ultimate goal of long-term restructuring of SummitBridge's debt. The Taggarts insisted that they have control of ECS and at least 40% ownership each; SummitBridge was agreeable to further concessions but wanted further equity in ECS. Finding SummitBridge's demands unacceptable, the Taggarts, MCA and Snell & Wilmer developed a plan to "take out" Summit Bridge. But they needed time to identify and implement that strategy. So, from January through April 2018, Snell & Wilmer LLP and MCA engaged in "duplicitous negotiations" with SummitBridge without any intention of giving it additional equity in ECS while the Taggarts positioned ECS for bankruptcy.

C. Preparing for ECS's Bankruptcy

While occupying SummitBridge with restructuring discussions, the Taggarts employed a tripartite strategy designed to subdue SummitBridge and to maximize Taggarts’ control over ECS during and after the bankruptcy process. First, the Taggarts weakened ECS's overall financial health by minimizing ECS's cash position. Commercial rental payments to the Insider Entity Defendants were increased. For example, during the negotiations with SummitBridge the Taggarts, acting through ECS Big Town, increased rent for the Mesquite facility from $31,679 per month to $51,332 per month. They also increased the rent for the Stockton facility by $3,000 per month to $112,583 per month. ECS also paid unnecessarily high salaries and wages to its employees. Trustee Husted complained that the Taggarts failed to address the "bloated overhead by adequately trimming the workforce" and made the "irrational decision to keep over" 325 full time employees. First Am. Compl. 13:15-17, ECF No. 28. ECS also paid vendors at rates greater than historical norms.

Second, the Taggarts undermined SummitBridge's position as a secured creditor. Trustee Husted described the Taggarts efforts as "a scheme to minimize ESC's assets that were subject to [its] security interest [in the days] leading up to the bankruptcy." Id. 12:18-20. As one of ECS's financial advisors described the strategy,

Well, the strategy...is a great way to put the screws to Summit by squeezing of as much of the [accounts receivable] as possible before filing. Summit is limited to collecting from and receiving proceeds from the [accounts receivable] at the time of filing ONLY . That will include cash on hand at the time of filing. So that means once collected it should immediately be used to pay down critical expenses otherwise the money will need to be held FBO Summit.

Id. at 14:23-27 (emphasis added).

This strategy involved collecting accounts receivable, spending available cash and ceasing production, and segregating incoming inventory. Because a large portion of SummitBridge's collateral for the loan was "inventory goods, works in progress, fixtures, and proceeds of the foregoing," stepping down the aggregate value of these assets increased its unsecured debt relative to its secured debt and marginalized its influence as a creditor.

D. Chapter 11

After positioning itself, ECS filed Chapter 11 bankruptcy. ECS's counsel of choice in the Chapter 11 was Snell & Wilmer, as well as Ringstad & Sanders LLP.

At the time ECS sought bankruptcy protection, SummitBridge was owed $26.690 million.³ The collateral securing that debt had a value of $5 million. Id.

Third, the Taggarts attempted to capitalize on their prebankruptcy strategies with a loan from their new-formed company Butch and Sundance, LLC. Under the control of the Taggarts, ESC filed a first-day motion to authorize it to obtain post-petition financing from Butch and Sundance, LLC, of up to $6 million, granting it liens and superpriority administrative claims, and authorizing the use of cash collateral. Emergency Ex Parte Mot. for Order Authorizing Post-Petition Financing 2:3-4:25, In re ECS Refining, Inc. , No. 2018-22453 (Bankr. E.D. Cal. April 24, 2018), ECF No. 12. That motion represented:

There is no dispute that, without substantial post-petition financing, the Debtor will be forced to immediately cease business operations and engage in a fire sale of its assets without the ability to maximize their value through its planned organization, which it plans to effectuate within the exclusivity period, if not sooner, and will benefit all creditors.

First Am. Compl. 20:6-9.

At the initial hearing of the motion there was "no disclosure that Butch & Sundance LLC was purely self-funded and operated by the Taggarts." Id. 20:10-11.

The motion was supported by the unsigned declaration of ECS president, Jack Rockwood, who declared the terms were "fair, reasonable and adequate." Id. 20:17-19. But that is not true. For example, the proposed order approving the loan stated that the loan was "negotiated in good faith and at arm's length" between ECS and Butch and Sundance, LLC. Ex Parte Motion 32:9-10. Notwithstanding its claim of evenhandedness, Butch and Sundance, LLC, conditioned its willingness to make the loan on terms that were one-sided: (1) waiver of the trustee's surcharge rights, 11 U.S.C. § 506(c) ; freeing post-petition acquired property from any security interests granted to a pre-petition lender, i.e., SummitBridge, 11 U.S.C. § 552 ; (2) automatic stay relief on default; and (3) preclusion of any person from using post-petition loan proceeds to "investigate, assert, join, commence, support or prosecute any action" for "any avoidance action or other actions arising under Chapter 5 or Section 724(a)." Id. 39:18-40:5, 40:27-41:24, 42:4-19.

Under the terms of the proposed post-petition financing, in exchange for a loan of up to $ 6 million, Butch and Sundance LLC would receive a superpriority administrative expenses claim, 11 U.S.C. § 364(c) ; a first priority security interest against "any unencumbered pre-petition assets and all post-petition assets of the debtor"; a security interest "on any and [all] pre-petition assets, subject...