Rick D. Lange v. Robert C. Schropp ( 2006 )

United States Bankruptcy Appellate Panel
FOR THE EIGHTH CIRCUIT
___________________________
06-6009/6010/6012/6013NE
___________________________
In re: *
Brook Valley IV, Joint Venture; *
Brook Valley VII, Joint Venture *
*
Debtors *
________________________________ *
*
Rick D. Lange *
*
Plaintiff - Appellee/Cross-Appellant * Appeal from the United
* States Bankruptcy Court
vs. * for the District of Nebraska
*
Robert C. Schropp; Leo E. Dahlke; *
RCS & Sons, Inc.; *
Phoenix Properties, LLC; *
Phoenix Properties of Brook Valley 1, LLC; *
Phoenix Properties of Brook Valley 2, LLC; *
R&L Valley Properties, LLC *
*
Defendants - Appellants/ *
Cross-Appellees *
*
Jerry Slusky *
*
Defendant - Cross-Appellee *
*
John Does, 1 through 20 *
*
Defendants *
____________________
Submitted: July 6, 2006
Filed: August 15, 2006
_____________________
SCHERMER, FEDERMAN, and VENTERS, Bankruptcy Judges
_____________________
FEDERMAN, Bankruptcy Judge
This is an appeal and cross-appeal from a Judgment of the United States
Bankruptcy Court for the District of Nebraska issued on February 3, 2006, in which
the court granted judgment, awarded monetary damages, and imposed a constructive
trust, in favor of the plaintiff, Rick D. Lange, the Chapter 7 Trustee (the “Trustee”)
of debtors Brook Valley IV, Joint Venture, and Brook Valley VII, Joint Venture
(“Brook Valley” or “Debtors”), and against defendants Robert C. Schropp; Leo E.
Dahlke; RCS & Sons, Inc.; Phoenix Properties, L.L.C.; Phoenix Properties of Brook
Valley 1, L.L.C.; Phoenix Properties of Brook Valley 2, L.L.C.; and R&L Valley
Properties, L.L.C. (the “Defendants”). We affirm in part, reverse in part, and remand
for entry of judgment in accordance with this opinion.
FACTUAL BACKGROUND
In this adversary proceeding, the Trustee contends that two insiders of the
Debtors, Robert Schropp and Leo Dahlke, formed a corporation, Phoenix Properties,
L.L.C., to secretly purchase the Brook Valley buildings after they caused the Debtors
to consent to a foreclosure of the buildings, and further that these two individuals
made an express misrepresentation to the court denying they had done so. We will
deal with these issues seriatim.
2
I. The Events Leading up to the Debtors’ Bankruptcy Filing and Foreclosure
Schropp and Dahlke were partners in thirteen commercial real estate
partnerships with Prime Realty, Inc., an entity solely owned and controlled by James
McCart. (Hereafter, McCart and Prime Realty are collectively referred to as “Prime
Realty.”) Brook Valley IV and Brook Valley VII, the Debtors herein, were two of the
single-asset commercial real estate partnerships owned by Schropp, Dahlke, and Prime
Realty. In the fall of 2001, Schropp and Dahlke had a falling out with Prime Realty.
In September 2001, Prime Realty filed suit in Nebraska state court to dissolve the 13
partnerships, including the two Brook Valley partnerships. Throughout 2001 and
2002, several of the properties owned by Schropp, Dahlke, and Prime Realty were
foreclosed by the lenders, with the partners and their lenders losing substantial sums
of money. Prime Realty filed for Chapter 11 protection in March 2002.
The Brook Valley buildings were encumbered by first Deeds of Trust to First
National Bank of Omaha. The Brook Valley properties were also allegedly
encumbered by liens held by Darland Construction Company and Prime Realty,
although the validity of those liens is subject to dispute. Schropp and Dahlke had
personally guaranteed at least the First National Bank debt, and, perhaps, the Darland
Construction debt as well.
By the spring of 2002, construction on the Brook Valley buildings was
substantially completed and the buildings were partially occupied by tenants.
Although the Debtors were servicing their debts on these properties and meeting their
operating expenses, the loans on the two buildings became due on April 1 and June
1, 2002, respectively, and First National Bank would not forbear or convert the
construction loans to long-term loans. Consequently, Schropp and Dahlke authorized
the filing of Chapter 11 Petitions for the two Brook Valley partnerships on April 2,
2002. Because Prime Realty had dissociated itself from the Brook Valley
3
partnerships, Prime Realty was not involved in the filing of the bankruptcy petitions.1
After the petitions were filed, the Debtors acted as debtors-in-possession under the
exclusive control of Schropp and Dahlke until June 2004, when the cases were
converted to Chapter 7 and the Plaintiff was appointed as Trustee.
Seventeen days after filing the Debtors’ bankruptcy cases, Schropp and Dahlke,
on behalf of the Debtors, agreed with First National Bank that the automatic stay
should be lifted to permit First National Bank to commence foreclosure proceedings,
and they filed stipulated motions for relief. The bankruptcy court entered orders
approving the stipulations on May 17, 2002. Although Prime Realty did not originally
protest the stipulated motions, Prime Realty requested the court to reconsider the
orders approving the stipulations, asserting that the buildings had equity and the rents
were sufficient to service the debt. Prime Realty also requested that a trustee be
appointed. Prime Realty’s requests were denied, and Prime Realty did not appeal
those orders. However, Prime Realty requested and received authorization from the
court to incur debt in order to pay off First National Bank and stop the foreclosure
sale, which was set for September 24, 2002. Apparently, however, Prime Realty was
unable to obtain appropriate financing before the sale, so the court allowed the
foreclosure sale to proceed as scheduled. Phoenix Properties, LLC, an entity formed
by Schropp and Dahlke not long after they filed the Debtors’ bankruptcy cases and
just before the foreclosure sale, was the successful bidder at the sale.
II. The Formation of Phoenix Properties, L.L.C.
Originally, a group comprised of Schropp, Dahlke, and some of Darland
Construction’s principals planned to form a new entity and arrange financing to
1
At one point, the question of whether Schropp and Dahlke had the authority to file the
petitions without Prime Realty’s authorization was at issue. While Defendants argue in their
brief that they did have such authority, the Plaintiff does not disagree, so we need not address
that issue.
4
participate in the bidding at the foreclosure sale. In the week before the sale, however,
the Darland principals withdrew from the group. Nevertheless, Schropp and Dahlke
formed Phoenix Properties, L.L.C. The partners in Phoenix Properties were RCS &
Sons, Inc. (an entity controlled by Schropp) and Dahlke. Once formed, Phoenix
Properties obtained financing from Great Western Bank sufficient to cover the bulk
of the First National Bank liens. And, after Darland Construction dropped out of the
formation of the new partnership, Schropp and Dahlke arranged for an additional
$600,000 in financing from an entity referred to as “Phoenix Brook Valley Re-Cap,”
and paid Darland Construction $300,000 for an assignment of Darland’s rights under
its alleged second lien position.
After the foreclosure sale, Phoenix Properties became the owner of the Brook
Valley properties; Great Western held the first liens; and Phoenix Brook Valley Re-
Cap held second liens. Prime Realty’s alleged lien was wiped out. Phoenix
Properties, and the subsidiaries they formed to operate and manage the properties,
(Defendants Phoenix Properties of Brook Valley 1, LLC and Phoenix Properties of
Brook Valley 2, LLC) were at all times controlled by Schropp and Dahlke.
At the time of the foreclosure sale, Schropp and Dahlke had appraisals showing
combined values of $2,480,000 - $3,700,000, meaning that the equity after payment
of First National’s debt would have been between $415,724 and $1,635,724. Great
Western, which financed Phoenix’s purchase, appraised the properties at a total of
$3,310,105, again showing substantial equity.
III. The Foreclosure Sale
Although at least one other bidder submitted a bid at the September 24, 2002
foreclosure sale, Phoenix Properties was the successful bidder, paying $1,467,000 for
the Brook Valley IV property, and $939,430 for Brook Valley VII. After satisfying
the First National Bank liens and paying approximately $135,000 for unpaid special
5
assessments, the sale should have produced a surplus of $146,862.35 on the Brook
Valley IV property, possibly subject to the disputed Darland Construction and Prime
Realty liens. Pursuant to the bankruptcy court’s orders, which Schropp and Dahlke
acknowledged at the time, anyone other than First National Bank making a bid was
to pay the purchase price in cash, and any surplus over First National’s debt was
expressly required to be turned over to the court pending a determination of the
validity and priority of the Darland and Prime Realty liens. In contravention of these
requirements, and contrary to counsel’s post-foreclosure representations made to the
court that the surplus was being held and would be turned over, Phoenix Properties,
which had acquired Darland’s lien position, purportedly “credit bid” that amount
against the Darland lien and did not pay that part of the purchase price in cash. Thus,
the Debtors, through Schropp and Dahlke, never turned over the surplus, despite court
orders to do so and representations that they would.
After the sale, Phoenix Properties and its subsidiaries, all of which are
controlled by Schropp and Dahlke, took over control of the management and
operations of the two Brook Valley properties.
IV. The Post-Foreclosure Events
Sometime in November of 2002, Prime Realty discovered that Schropp and
Dahlke owned Phoenix Properties. On November 21, 2002, Prime Realty filed a
motion requesting, as relevant here, that a trustee be appointed, and that Schropp and
Dahlke be required to account for all post-petition financial activities of the Debtors.
In such motion, Prime Realty contended that Phoenix Properties was owned by
Schropp and Dahlke. The Debtors objected to the motion, saying:
Great Western Bank entered into a transaction with Phoenix Properties,
LLC. Phoenix Properties, LLC also apparently entered into a transaction
with Phoenix Brook Valley Re-Cap, LLC. The purpose of both
transactions was apparently to provide financing to Phoenix Properties
6
to allow it to bid at the trust deed foreclosure sale conducted by the First
National Bank of Omaha. Both of these transactions and the supporting
documents were entered into between parties who are not parties to this
bankruptcy proceeding. Those private transactions which apparently
provided the financial resources for Phoenix Properties, LLC to bid on
and buy the real estate being sold at public auction have nothing to do
with this bankruptcy case. (Emphasis added.)
Based in part on this response, the bankruptcy court denied Prime Realty’s motion for
appointment of a trustee.2
Meanwhile, Schropp and Dahlke, through Phoenix Properties, continued to
operate and manage the Brook Valley properties. They operated at a profit.
On June 10, 2004, with essentially all of their assets having been sold, the
Debtors’ cases were voluntarily converted to Chapter 7, and the Plaintiff was
appointed Trustee.
After the case was converted, the Trustee requested that the Debtors turn over
the $146,862.35 in surplus sale proceeds on the Brook Valley IV property. Debtors’
counsel responded that Darland had held a second lien on Brook Valley IV and that
Phoenix Properties had purchased the Darland lien and credit bid the amount in excess
of the first lien. “There was no doubt that Darland was in second position,” they said.
However, as mentioned above, the alleged credit bid was in contravention of the
court’s requirement that any bidder except First National pay in cash, with the excess
2
After later learning of the true relationship between Schropp, Dahlke, and Phoenix
Properties, and of their attorneys’ role in all of this, the bankruptcy court ordered counsel who
made such misrepresentations to show cause why they should not be sanctioned for their actions
“which benefitted only Mr. Schropp and Mr. Dahlke, but not the debtors.” (App. at 108).
7
over First National’s debt to be paid into the court pending resolution of the validity
and priority of the liens.3
After investigating Schropp and Dahlke’s handling of the estates of the debtors-
in-possession, the Trustee filed this adversary proceeding against Schropp and Dahlke,
and their various entities, asserting breach of fiduciary duties and conversion, and
requesting reconveyance of the properties and an accounting. Essentially, the Trustee
contends that there was substantial equity in the properties, and that Schropp and
Dahlke had a fiduciary obligation to preserve that equity for the benefit of creditors.
Instead of preserving that equity, the Trustee alleges, Schropp and Dahlke
immediately consented to a foreclosure of the properties, secretly purchased them at
the sale, and then made an express misrepresentation to the Court denying that they
had done so. After the adversary proceeding was filed, the parties agreed that the
properties could be sold by Phoenix Properties, with the net proceeds to be held in the
court registry pending a final determination as to who is entitled to them. The sales
occurred in 2005. After satisfaction of the liens held by Great Western and Brook
Valley Re-Cap LLC, and sale expenses, there remained net sale proceeds of
$488,453.95 for Brook Valley IV, and $377,485 for Brook Valley VII, which are on
deposit with the registry of the court.
On February 3, 2006, the bankruptcy court issued a Judgment and
Memorandum Order finding that the properties were still part of the Debtors’
bankruptcy estates at the time of the foreclosure sale and that Schropp and Dahlke
breached their fiduciary duties in purchasing the properties, and in not properly
reporting the terms of sale. The court therefore imposed a constructive trust on the
sale proceeds, meaning that they would be paid to the trustee. The court also found
that Schropp and Dahlke had converted $146,862.35, representing the proceeds bid
3
Although they initially resisted the Trustee’s request to turn over the surplus, the
Defendants now concede that they were required to turn it over. They do not appeal from the
part of the court’s Judgment requiring them to turn over those funds.
8
for the Darland Construction lien at the foreclosure sale. However, the court held that
they would not be required to repay such amount if they consented to payment of the
sales proceeds to the Trustee, in the total amount of $865,938.95. And, the court also
held that the net cash flow received by the Debtors from the date of the bankruptcy
petition, April 2, 2002, until the date of the foreclosure sale, September 24, 2002,
totaling $86,581.32, was property of the estate. Once again, the court held that it
would not require repayment of such funds by Schropp and Dahlke if they consented
to payment of the sales proceeds to the Trustee. Finally, the Court held that the
evidence was insufficient to establish the net cash flow received by Phoenix Properties
after the foreclosure sale on September 24, 2002, and prior to its sale of the properties
in 2005. Therefore, the Trustee was not allowed to recover any damages for income
received from the properties by Phoenix Properties. By separate order, the court also
ordered the attorneys representing the Debtors, Schropp, and Dahlke to submit
declarations or affidavits explaining their actions in the case, and explaining why they
should not be sanctioned for their conduct. The court’s ruling on that issue remains
pending.
The Defendants appeal from the court’s judgment, and the Trustee cross-
appeals as to the amount of damages awarded.
STANDARD OF REVIEW
A bankruptcy appellate panel shall not set aside findings of fact unless clearly
erroneous, giving due regard to the opportunity of the bankruptcy court to judge the
9
credibility of the witnesses.4 We review the legal conclusions of the bankruptcy court
de novo.5
DISCUSSION
I. The Trustee’s Action is Not a Collateral Attack on Final Orders of the
Bankruptcy Court
The Defendants first contend that the claims asserted by the Trustee in this
action are collateral attacks on final orders of the bankruptcy court, and are therefore
barred by collateral estoppel or res judicata. As stated, on May 17, 2002, the
bankruptcy court entered an order lifting the automatic stay, with the consent of
Schropp and Dahlke in their capacity as principals of the debtors-in-possession.
Thereafter, on May 23, 2002, Prime Realty moved for reconsideration of the order,
contending that there was equity in the properties. Upon the denial of the motion, the
properties were foreclosed, without the involvement of the bankruptcy court. Later,
on November 22, 2002, Prime Realty, having discovered that Schropp and Dahlke had
formed Phoenix and used it as a vehicle to buy the property at the foreclosure sale,
asked that a trustee be appointed and that the debtors-in-possession be required to
account for all postpetition financial activities. After Schropp and Dahlke responded
by specifically denying any involvement in Phoenix, that motion was denied. The
Defendants contend that the rulings on these three motions bar the Trustee’s suit here.
4
Gourley v. Usery (In re Usery), 123 F.3d 1089, 1093 (8th Cir. 1997); O'Neal v.
Southwest Mo. Bank (In re Broadview Lumber Co., Inc.), 118 F.3d 1246, 1250 (8th Cir. 1997)
(citing First Nat'l Bank of Olathe v. Pontow, 111 F.3d 604, 609 (8th Cir.1997)). Fed. R. Bankr.
P. 8013.
5
First Nat’l Bank of Olathe v. Pontow (In re Pontow), 111 F.3d 604, 609 (8th Cir. 1997);
Sholdan v. Dietz (In re Sholdan), 108 F.3d 886, 888 (8th Cir. 1997).
10
The cases primarily relied on by the Defendants concern the finality of court-
approved sales of property. In Regions Bank v. J.R. Oil Co., LLC,6 a lender contended
that a bankruptcy court order approving a sale of estate assets had been obtained
improperly due to alleged RICO violations by the debtor and others. The Eighth
Circuit held that once a sale of assets is approved by a final order of the bankruptcy
court, that judgment is shielded from collateral attack:
The bankruptcy court...approved the sale and found the sale to be in
good faith, for fair value, and in the best interest of [the debtor] and its
creditors. A bankruptcy sale under 11 U.S.C. § 363, free and clear of all
liens, is a judgment that is good against the world, not merely as against
parties to the proceeding.7
The Eighth Circuit in Regions Bank relied in part on the decision of the Seventh
Circuit in In re Met-L-Wood Corp.8 There, the trustee attempted to set aside a
judicially-authorized § 363 sale, claiming that the sale was rigged, that a shill bidder
for an officer of the debtor was involved, and that there was inadequate consideration.
The trustee also sought damages for fraud against the parties to the conspiracy. In
ruling against the trustee, the Court held that the case amounted to an impermissible
collateral attack on the order authorizing the sale. If a creditor or trustee discovered
that a sale order had been obtained fraudulently, the Court held, a motion to set aside
the sale must comply with the requirements of Rule 60(b), as made applicable in
bankruptcy cases by Bankruptcy Rule 9024. Ordinarily, such a motion would be
required to be filed within one year after entry of the order approving the sale.9
However, as the Seventh Circuit noted, there is an express exception to the time
6
387 F.3d 721 (8th Cir. 2004).
7
Id. at 732.
8
Gekas v. Pipin (In re Met-L-Wood Corp.), 861 F.2d 1012 (7th Cir. 1988).
9
Id. at 1018.
11
limitation for “fraud upon the court.”10 Here, Prime Realty did, within one year after
the order lifting the stay, discover that Schropp and Dahlke were the owners of
Phoenix, and that such ownership interest had not been disclosed. Therefore, they
filed the November 22, 2002 motion. That motion was denied, but only after Schropp
and Dahlke falsely represented to the Court that they had no ownership interest in
Phoenix. That response constitutes a fraud upon the court.
This is an action for breach of fiduciary duties. Since the sale of the property
to Phoenix was never subject to approval by the bankruptcy court, this is not a suit to
set aside such sale. Instead, it is a suit to recover funds which would have been
available to creditors had Schropp and Dahlke acted in the best interests of creditors,
rather than their own. In bankruptcy cases in this Circuit, “the principle of res
judicata should be invoked only after careful inquiry because it blocks ‘unexplored
paths that may lead to truth.’”11 Here, it was the actions of Schropp and Dahlke, in
misrepresenting their ownership of Phoenix Properties, which prevented the court
from learning the truth at the time it ruled on the prior motions. Therefore, the orders
allowing the bank to foreclose, and refusing to appoint a trustee, do not serve to bar
the relief sought by the Trustee.
II. The Brook Valley Buildings Were Property of the Debtors’ Bankruptcy Estates
The Defendants assert that the Brook Valley properties were no longer property
of the Debtors’ bankruptcy estates when the Defendants purchased them at the
foreclosure sale. The bankruptcy court found that they were, and we agree.
When a bankruptcy court lifts, or modifies, the automatic stay, it merely
removes or modifies the injunction prohibiting collection actions against
10
Id.
11
In re Ladd, 450 F.3d 751, 755 (8th Cir. 2006) (citations omitted).
12
the debtor or the debtor’s property. Although the property may pass
from the control of the estate, that does not mean that the estate’s interest
in the property is extinguished. . . . Relief from an automatic stay
entitles the creditor to realize its security interest. . . in the property, but
all proceeds in excess of the creditor’s interest must be returned to the
trustee. . . . Thus, an order lifting the automatic stay by itself does not
release the estate’s interest in the property and the act of lifting the
automatic stay is not analogous to an abandonment of the property.12
To hold otherwise would repudiate the express language of § 554.13 Accordingly,
because the bankruptcy court only granted relief from the stay to permit First National
Bank to conduct a foreclosure sale, but did not order an abandonment of the Brook
Valley properties, the Debtors retained their rights in those properties after the stay
was lifted and up until the buildings were sold. Under bankruptcy law, the buildings
were property of the Debtors’ estates when the foreclosure sale was conducted.
The Defendants assert, nevertheless, that under Nebraska law, where a notice
of default is given and the thirty-day cure period passes, a borrower has no further
right to cure and loses all interest in the property.14 Further, they point out, Nebraska
law does not provide a right of redemption.15 Thus, the Defendants assert, by the time
of the foreclosure sale, the bankruptcy notwithstanding, the Debtors had lost all
interest in the Brook Valley properties under Nebraska law.
We agree that, under Nebraska law, notice of default and failure to cure causes
the borrower to lose the right to bring the note current and reinstate the deed of trust
12
Catalano v. Comm’r of Internal Revenue, 279 F.3d 682, 686-87 (9th Cir. 2002)
(citations and internal quote marks omitted). But see In re Griggs, 82 B.R. 532 (W.D. Mo.
1988).
13
Id. at 686.
14
Neb. Rev. Stat. § 76-1012.
15
Neb. Rev. Stat. § 76-1010(2).
13
as if no default had occurred. Nevertheless, as the bankruptcy court held, until the
property is actually sold at foreclosure, the borrower still owns the property and may
pay the note in full, thereby causing a release of the deed of trust lien and the
borrower’s retaining all ownership rights.16
The Defendants argue that the Debtors had no interest in the property at the
time of the foreclosure sale because they were unable to pay the note in full.
However, there was no specific testimony or substantiated evidence that the
Defendants attempted in good faith to obtain financing from other lenders on behalf
of the Debtors.17 Indeed, the Trustee alleges that, instead of attempting to obtain such
financing to pay off the bank, Schropp and Dahlke sought financing to allow them to
purchase the property for themselves, not to preserve its value for the estate and its
creditors. More importantly, however, this point is irrelevant: the likelihood of the
Debtors’ being able to exercise their right to pay the notes in full does not eliminate
their actual right to do so. The Debtors, therefore, still had ownership rights in the
building up to the foreclosure sale under Nebraska law.
16
See Butts v. Hale, 59 N.W.2d 583, 586-87 (Neb. 1953) (holding that every interest and
right held by a mortgagor, whenever acquired, pass with the mortgage at a foreclosure sale). The
case relied on by the Defendants, In re Jones, 214 B.R. 492 (Bankr. D. Neb. 1997), actually
supports the bankruptcy court’s decision on this point. In that case, the trustee’s sale had
occurred before the debtors filed their bankruptcy petition and the debtors sought to have it set
aside. The court in that case held that, “after the sale was conducted, all of debtors’ ownership
rights were extinguished under Nebraska law.” Id. at 493 (emphasis added).
17
Schropp testified in deposition that they had made no attempts to obtain financing on
behalf of the Debtors. At trial, when confronted with that deposition testimony, Schropp and
Dahlke testified, generally, that they had made attempts on behalf of the Debtor, but gave no
specifics, nor did they mention any specific lenders from whom they sought financing on the
Debtors’ behalf. Similarly, the real estate consultant from whom they sought advice when the
partnerships were failing (who was also an investor in Phoenix Brook Valley Re-Cap) testified
generally about attempts to obtain new financing for the Debtors and named some lenders, but he
also testified he was working for the individuals, rather than the Debtors. All of the witnesses
testified they made no efforts to market or sell the properties.
14
III. Breach of Fiduciary Duties
The Trustee asserts that the Defendants, while acting as debtors-in-possession,
breached their fiduciary duty to the estate and its creditors. Debtors-in-possession, and
those persons in control of them, have a fiduciary duty to the bankruptcy estate and
the debtor’s unsecured creditors: “The United States Supreme Court has made clear
that a debtor in possession, like a chapter 11 trustee, owes the estate and its creditors
a general duty of loyalty.”18 “[I]n practice these fiduciary responsibilities fall not
upon the inanimate corporation, but upon the officers and managing employees who
must conduct the Debtor’s affairs under the surveillance of the court.”19 The same is
true in the case of debtor partnerships.20 Chapter 11 cases are filed on behalf of such
businesses in order to preserve and protect their assets through reorganization, or in
order to effect an orderly liquidation of such assets. In either case, the goal of Chapter
11 is to maximize the value of money and property available for distribution to
creditors. A person in charge of a business in Chapter 11, whether acting as a trustee
or as a debtor-in-possession, is obligated to use best efforts to so maximize the value
18
In re Hampton Hotel Investors, L.P., 270 B.R. 346, 361 (Bankr. S.D. N.Y. 2001)
(citing Wolf v. Weinstein, 372 U.S. 633, 83 S. Ct. 969, 10 L. Ed. 2d 33 (1963)). See also Fulton
State Bank v. Schipper (In re Schipper),109 B.R. 832, 835 (Bankr. N.D. Ill. 1989) (“[a] debtor-
in-possession holds its powers in trust for the benefit of the creditors and has the duty to protect
and conserve property in his possession for their benefit”), aff’d 933 F.2d 513 (7th Cir. 1991); In
re Intermagnetics America, Inc., 926 F.2d 912, 917 (9th Cir. 1991) (“[o]fficers of a debtor-in-
possession are officers of the court because of their responsibility to act in the best interests of
the estate as a whole and the accompanying fiduciary duties.”); Ramette v. Bame (In re Bame),
251 B.R. 367, 373 (Bankr. D. Minn. 2000) (“it is clear that a DIP has a duty to creditors of the
estate not to waste the estate’s assets”); In re Q.P.S., Inc., 99 B.R. 843, 845 (Bankr. W.D. Tenn.
1989) (holding that a Chapter 11 debtor-in-possession is a fiduciary); In re Modern Office
Supply, 28 B.R. 943, 944 (Bankr. W.D. Okla. 1983) (holding that creditors have the right to
require the debtor-in-possession to exercise their fiduciary powers for their benefit).
19
In re Hampton Hotel Investors, 270 B.R. at 361 n. 35 (quoting Wolf v. Weinstein, 372
U.S. at 649, 550, 83 S. Ct. 969)).
20
Id. at 361.
15
of the debtor’s estate.21 That does not mean that such person is responsible solely
because the debtor-in-possession fails or because, in hindsight, such person could
have made better decisions. As is true outside of bankruptcy, courts do not ordinarily
second-guess decisions made by the person in charge of a business if they are
attributable to a rational business purpose. However, where bad faith, self-interest,
or gross negligence are shown, such person is liable for the resulting damages.22
We agree with the bankruptcy court that Schropp and Dahlke breached their
fiduciary duties to the Debtors’ estates continuously throughout this case, beginning
when they stipulated to the relief from stay to protect their personal interests. The
breach of fiduciary duty continued when they secretly bought the buildings at the
foreclosure sale, when they expressly misrepresented to the court their having done
so, when they failed to account for or turn over the foreclosure surplus amount, and
when they failed to turn over the operating profits received from the Debtors’
properties.
As mentioned above, the Debtors, through Schropp and Dahlke, stipulated to
the relief from stay only seventeen days after filing the bankruptcy petitions, thereby
at least implicitly representing to the court that they believed foreclosure to be in the
best interests of the Debtors’ estates. By making this representation to the court,
Schropp and Dahlke were, in effect, stating to the court that the properties had no
equity and would not otherwise be profitable or produce funds for the estates. Indeed,
in denying the motion of Prime Realty to reconsider the stay lift order, the bankruptcy
court stated that “the majority owners of the debtor believe it is appropriate to permit
the bank to foreclose.”23
21
See In re Apex Oil Co., 92 B.R. 847 (Bankr. E.D. Mo. 1988).
22
See, e.g., In re Integrated Resources, Inc., 147 B.R. 650, 656 (S.D. N.Y. 1992).
(citations omitted).
23
Ohio App. at 175-76.
16
However, that was not the case. The Debtors listed these properties in their
schedules as having substantial equity, showing only the First National Bank liens as
being undisputed. All other liens, including the Darland and Prime Realty liens, were
identified in the schedules as being unliquidated and disputed. In addition, as it turns
out, the properties did produce a consistent stream of net income after the bankruptcy
case was filed, both pre-foreclosure and post-foreclosure. And, the Defendants had
appraisals dated April 19, 2002, which was the same date the stipulated motions for
relief from stay were filed, showing substantial equity.
But, these appraisals were not given to the court until later and, more
importantly, what the bankruptcy court was completely unaware of during all of this,
including the later proceedings instigated by Prime Realty, was that, contrary to their
actual and implied representations to the court, Schropp and Dahlke were not looking
after the best interests of the Debtors’ estates – they have admitted, and the bankruptcy
court subsequently found, that their primary goal from the beginning was to protect
themselves from personal liability on their guaranties. As events have unfolded, it
became evident they had another goal that was hidden from the bankruptcy court at
the time: to obtain financing on their own behalf and buy the properties at the
foreclosure sale in the hopes of making a profit. As insiders of the debtors-in-
possession, instead of searching for financing to support their own purchase of the
buildings, Schropp and Dahlke should have been making efforts to obtain financing
on behalf of the Debtors to salvage the properties. There was no specific or
substantiated evidence submitted as to any efforts made to obtain financing on behalf
of the Debtors; rather, the evidence suggests that they merely tried to convince First
National Bank to forbear or refinance and, when First National refused, they worked
out an agreement to have the stay lifted. At that point, Schropp and Dahlke started
looking for financing on their own behalf, without advising the court. The
Defendants’ assertions, even now, that they believed the buildings had no equity and
were not profitable, are belied by the fact that they rallied to find financing to help
17
them purchase the properties for their own benefit at the foreclosure sale. As it turns
out, the buildings were profitable and did have equity.
We do not suggest that a debtor-in-possession’s mere consent to relief from
stay, even where the property has some equity or ongoing value, is a breach of
fiduciary duties. There may well be a valid business reason not to fight such a motion.
It is the consent to relief, combined with their secret efforts to buy the properties out
from under the estates they were responsible to preserve, which creates the fiduciary
violation here. As the Seventh Circuit noted in Met-L-Wood Corp., “[i]t is
commonplace, and involves no impropriety, for the debtor himself to bid at a
foreclosure sale. . . . Of course, it would be improper for Pipin [the owner],
controlling Met-L-Wood as he did, to use his control to walk off with its principal
assets for a song, shucking off the unsecured creditors in the process. That would
violate the fiduciary obligation that Pipin, controlling the debtor-in-possession, owed
Met-L-Wood’s creditors.”24 When asked at oral argument who was there to protect
the interests of the estate in this case, counsel for the Defendants responded that Prime
Realty was, through its motions to reconsider the order lifting the stay and to set aside
the sale. But, it was not Prime Realty’s duty to assume that role: it was Schropp’s
and Dahlke’s. And they not only failed in that duty, they actively concealed facts,
leaving the court unaware that they were, in fact, not looking out for the best interests
of the estate and its creditors.
Relying primarily on the case of In re Rahe,25 the bankruptcy court held that
trustees and debtors-in-possession are per se prohibited from purchasing property of
the bankruptcy estate. The In re Rahe court noted that the Federal Criminal Code
provides for a fine and forfeiture of office for a person who, being a custodian, trustee,
marshal, or other officer of the court, “knowingly purchases, directly or indirectly, any
24
861 F.2d at 1019.
25
178 B.R. 801 (Bankr. D. Neb. 1995).
18
property of the estate of which the person is such an officer in a [bankruptcy] case,”
and cited cases applying the prohibition against purchasing estate assets in the
bankruptcy case itself.26 The court here held that this prohibition applies no matter
what chapter and no matter what the facts concerning the transaction are.
Thus, the court held that Schropp and Dahlke, as persons who controlled the
debtors-in possession, were absolutely prohibited from purchasing the Brook Valley
properties, either directly or indirectly through Phoenix Properties.
Although we recognize the potential problems inherent in such situations, we
are reluctant to adopt a per se rule prohibiting debtors-in-possession or their insiders
from purchasing property of a debtor’s bankruptcy estate. The existence of a fiduciary
duty is without much debate, but the issue of whether a purchase of estate assets by
such person violates that duty is the subject of some debate.27
As did the bankruptcy court in this case, some courts have held that the
purchase of assets of the estate by a person in charge of such estate is, necessarily, a
breach of fiduciary duty and absolutely prohibited.28 However, with due deference to
26
Id. at 802 (citing 18 U.S.C. § 154; In re Frazin & Oppenheim, 181 F. 307, 309 (2d Cir.
1910; In re Q.P.S., Inc., 88 B.R. at 845)).
27
See In re Bame, 251 B.R. at 373 (“[w]hile the exact scope of a DIP’s fiduciary duties
is subject to some debate, it is clear that a DIP has a duty to creditors of the estate not to waste
the estate’s assets”); In re Schipper,109 B.R. at 835 (the scope of the duty is somewhat
undefined).
28
See e.g., In re Rahe, 178 B.R. 801 (Bankr. D. Neb. 1995); In re Q.P.S., Inc., 99 B.R.
843 (Bankr. W.D. Tenn. 1989) (“[r]egardless of whether the trustee or the trustee’s agent and/or
employee in fact profits from the transaction at the expense of the estate, neither a bankruptcy
trustee nor his agents and/or employees may purchase properties of the estate, even for a fair
price” (emphasis in original.)); In re Lowry Graphics, Inc., 86 B.R. 74 (Bankr. S.D. Tex. 1988)
(“[r]egardless of whether [the trustee and the trustee’s agent] in fact profited from this
transaction at the expense of the estate, neither a bankruptcy trustee nor his agents may purchase
or self deal in assets of the estate, even for a ‘fair’ price”); In re Donovan & Schuenke, 226 F.2d
804 (9th Cir. 1955) (“Even if there were full disclosure, adequacy of consideration, absence of
19
those courts, and recognizing the inherent dangers of self-dealing in a fiduciary
relationship, we agree with those courts holding that engaging in these transactions
does not constitute a per se violation of fiduciary obligations: “Rather, the fiduciary
need only prove that the transaction was inherently fair. The essence of the fairness
test is whether or not under the circumstances the transaction carries the earmarks of
an arm’s length bargain.”29
“[B]ankruptcy law does not necessarily prohibit a debtor from purchasing
property from its own bankruptcy estate either directly, or through an alter ego.
Rather, a sale of a bankruptcy estate’s property outside the ordinary course of business
hinges solely upon whether the sale would be in the estate’s best interests.”30 The
important factor in such situations is that the sale be fully disclosed and that vigorous,
arms-length, good faith negotiations take place.31
Here, however, there was neither full disclosure nor independent oversight of
the transaction. Indeed, the Defendants in this case actively concealed the identity of
Phoenix Properties and the facts surrounding the insider deal, both before and after
the sale took place. In sum, while we decline to adopt a per se rule, we agree with the
bankruptcy court that Schropp and Dahlke breached their fiduciary duties by first
consenting to relief from the stay and then purchasing the properties at the foreclosure
sale without disclosure to the court.
secret profit, an open judicial sale will not avail separately or in combination as a defense for
such a fiduciary. The prohibition is absolute in the public interest. It is established to protect the
courts themselves from suspicion of chicanery.”).
29
In re Schipper, 109 B.R. at 835-36 (citations omitted)
30
Grass Lake All Seasons Resort, Inc., 2005 WL 2095890 at *7 (E.D. Mich. 2005)
(citations omitted).
31
In re Apex Oil, 92 B.R. at 847,869, 870 (holding that an insider may buy assets of a
debtor if there are arms-length, good faith negotiations with full disclosure); see also In re Wilde
Horse Enters., Inc., 136 B.R. 830, 842 (Bankr. C.D. Cal. 1991).
20
IV. The Remedy
The bankruptcy court entered judgment against the defendants as follows: First,
it found that Schropp and Dahlke had converted the $146,862.35 in surplus proceeds
from the foreclosure sale that were never turned over. And, it found that the
$86,581.32 pre-foreclosure net cash flow from the two Brook Valley properties was
property of the bankruptcy estate. The defendants concede that both these amounts are
due the Trustee. The court also entered judgment for the net proceeds from the sale
of the two properties, totaling $865,938.95 which is being held in the court’s registry,
and imposed a constructive trust on those funds. We agree with the bankruptcy court
that judgment should be entered against defendants Schropp, Dahlke, and Phoenix
Properties for the $146,862.35 surplus funds which should have been paid by Phoenix
Properties at the foreclosure sale. We also agree that judgment should be entered
against defendants Schropp and Dahlke for the $86,581.32 net cash flow received by
the debtors-in-possession prior to the foreclosure sale. However, contrary to the
bankruptcy court, we conclude that those funds are owed regardless of whether the
defendants satisfy the rest of the judgment.
As to the net sales proceeds received by Phoenix Properties, and held in the
court registry, the court imposed a constructive trust. “The imposition of a
constructive trust is an equitable remedy which the court has the discretion to grant
or deny . . . and may be appropriate if it would be sufficient under applicable state
law.”32 Under Nebraska law, a constructive trust is a relationship, with respect to
property, subjecting the person who holds title to the property to an equitable duty to
convey it to another on the ground that his or her acquisition or retention of the
32
In re MJK Clearing, Inc., 286 B.R. 862, 879-880 (Bankr. D. Minn. 2002); see also N.S.
Garrott & Sons v. Union Planters Nat’l Bank, 772 F.2d 462, 466 (8th Cir. 1985) (stating that
imposition of a constructive trust is appropriate only where it would be applicable under state
law).
21
property would constitute unjust enrichment.33 To establish a constructive trust, the
court must find by clear and convincing evidence that legal title was obtained by
fraud, misrepresentation, or an abuse of an influential or confidential relationship, and
that, under the circumstances, the party holding legal title is not equitably entitled to
hold and enjoy the property.34
The Defendants assert that imposition of a constructive trust is not appropriate
because they incurred debt to acquire the properties. They operated the buildings for
three years, made tenant improvements, worked to increase tenant occupancy, paid
special assessments, and paid down debt on the buildings. They argue that the
commercial real estate market improved over the three years that Phoenix Properties
held title, and that the Debtors and their creditors should not benefit from that. The
measure of damages, they argue, should be the difference between the fair value of the
property at the time of the foreclosure sale, and the amount they paid. And, citing In
re BFP Resolution Trust Corp.,35 they argue that reasonably equivalent value, for
foreclosed property, is the price received at the foreclosure sale, so long as the
requirements of the state’s foreclosure law were complied with. Therefore, they argue,
even if they acted improperly in acquiring the properties, they should be permitted to
retain the profits they realized from owning them.
The problem with the Defendants’ argument is that it ignores the nature of the
Trustee’s action against them. The foreclosure sale was not inevitable; indeed, Chapter
11 is there to allow companies whose assets have equity to attempt to preserve such
equity for the benefit of their creditors. Upon filing the case, and choosing to act as
debtors-in-possession, Schropp and Dahlke were obligated to attempt to do just that.
33
Anderson v. Bellino, 658 N.W.2d 645, 658 (Neb. 2003).
34
Balfany v. Balfany, 476 N.W.2d 681, 684 (Neb. 1991); In re Rine & Rine Auctioneers,
Inc., 74 F.3d 848, 853-54 (8th Cir. 1996).
35
511 U.S. 531, 114 S. Ct. 1757, 128 L. Ed. 2d 556 (1994).
22
Had they acted to obtain financing for the debtors-in-possession, instead of for
themselves, the estate and its creditors could have received the benefit of any rising
market.
The cases which have addressed the problem of sale or misuse of estate
property by a fiduciary or his delegate have either voided the transaction,
. . . assessed the trustee with the measure of profit enjoyed by his
delegate, regardless of whether the trustee shared in that profit
personally, or assessed the trustee with the amount of diminution of the
estate.36
As to the argument that the Defendants spent money for debt service, special
assessments, tenant improvements and the like, the evidence shows that the properties
were self-sustaining. There is no evidence that Schropp and Dahlke needed to
subsidize the properties in order to pay those expenses. As to the argument that they
took a risk in buying the properties, and should be rewarded for doing so, they took
no such risk. At the time of the bankruptcy filing, Schropp and Dahlke were
personally liable for the bank debt due on the properties. They themselves admitted
at trial that the actions they took in the bankruptcy case were intended to protect them
from personal liability on such obligations. In personally guaranteeing the new debt
to Great Western they took no risk; all they did was to substitute one guarantee for
another. The Trustee proved, by clear and convincing evidence, that Schropp and
Dahlke were in a position to purchase the property at the foreclosure sale only because
they both breached their fiduciary duties to the debtors-in-possession, and fraudulently
misrepresented such purchase to the court. Therefore, the bankruptcy court
appropriately imposed a constructive trust on the net proceeds received from the later
sale of such property.
36
In re Lowry Graphics, Inc., 86 B.R. at 81 (citing Mosser v. Darrow, 341 U.S. 267,
273, 71 S. Ct. 680, 683, 95 L. Ed. 927 (1951); additional citations omitted).
23
Similarly, the net cash flow received by Phoenix Properties, after the
foreclosure sale, should also have been earned for the benefit of creditors, not for
Schropp and Dahlke. That amount is $375,605.05. The bankruptcy court declined to
award such damages, finding that the Trustee failed to prove either that such profits
were paid to Schropp and Dahlke, or that they were not used to make tenant
improvements. We find that conclusion to be clearly erroneous. The evidence shows
the amount of net cash flow left after payment of operating expenses. If Schropp and
Dahlke had evidence of other expenses, or other uses of the resulting funds, the
burden was on them to offer such evidence, and to account for the use of such funds.
This they failed to do.
CONCLUSION
The judgment of the bankruptcy court is affirmed in part, and reversed in part.
The case is remanded to the bankruptcy court for entry of judgment as follows:
1. In favor of the Trustee, and against Defendants Phoenix Properties, LLC,
Robert C. Schropp, and Leo E. Dahlke, in the amount of $146,862.35,
representing the excess sale proceeds realized at the foreclosure sale held
on or about September 24, 2002. Upon payment of such funds, the
bankruptcy court should determine whether there are any valid liens
against such funds, and if so, the treatment to be accorded such liens
under applicable law; and
2. In favor of the Trustee, and against Defendants Robert C. Schropp, and
Leo E. Dahlke, in the amount of $86,581.32, representing the net profits
generated by the Debtors while operating as debtors-in-possession; and
3. In favor of the Trustee and against Defendants Robert C. Schropp, Leo
E. Dahlke, Phoenix Properties, LLC, Phoenix Properties of Brook Valley
1, LLC, and Phoenix Properties of Brook Valley 2, LLC, imposing a
constructive trust on funds held in the court registry in the amount of
24
$865,938.95, plus interest which has accrued on such funds while in the
court registry, less any expenses payable to the court registry; and
4. In favor of the Trustee and against Defendants Robert C. Schropp, Leo
E. Dahlke, Phoenix Properties, LLC, Phoenix Properties of Brook Valley
1, LLC, and Phoenix Properties of Brook Valley 2, LLC, in the amount
of $375,605.05, representing the net profits generated by the properties
from September 24, 2002, until the sale of the properties by Phoenix
Properties in 2005; and
5. In all other respects, in favor of the Defendants.
______________________
25