As bankruptcy practitioners, we generally see proposed settlements get approved without objection. However, when objections are lodged, court involvement is necessitated. In this case, United States Bankruptcy Judge Elisabetta G. M. Gasparini for the District of South Carolina approved, in a published opinion, a Notice and Application of Settlement and Compromise filed by Michelle L. Vieira, as Chapter 7 Trustee (the “Trustee”) for Jasper Pellets, LLC (“Debtor”) over an objection filed by U.S. Bank Trust Company, N.A., as Indenture Trustee (“USB”). The settlement motion sought Judge Gasparini’s approval to globally resolve the disputed pre-petition and post-petition claims between the Trustee and CM Biomass Partners A/S (“CMB”), the latter of which was represented by Nelson Mullins partners Frank B. B. Knowlton and Scott D. MacLatchie.
The Court held an evidentiary hearing and the Trustee was called as a witness in that proceeding to testify in support of the proposed settlement. The Trustee was subjected to cross-examination by counsel for USB and each side introduced multiple exhibits. Judge Gasparini approved the settlement after careful consideration of the factors and arguments raised below.
Case Background
The Debtor was the owner of a pellet mill in Ridgeland, South Carolina and was in the business of manufacturing biomass wood pellets. After shutting down its operations, it filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. As of the petition date, the Debtor’s estate had assets valued at about $25 million, with about $12.5 million in secured debt, and about $2 million in unsecured debts. At the time of subject settlement, Debtor’s Claim Register reflected over $58 million in claims asserted against the Debtor’s estate. USB was the Debtor’s main secured creditor, holding over $10 million in revenue bonds secured by a mortgage and security agreement with the Debtor. USB asserted that it had a perfected security interest in the pellet mill and all of its improvements, personal property, and proceeds.
CMB was involved in a pre-petition contract with the Debtor for the purchase and sale of wood pellets. Both CMB and the Debtor asserted that the other breached this contract in various ways, including by the Debtor not upgrading production equipment and CMB reducing the price it paid per ton of wood pellets due to the Debtor’s failure to deliver the volume of wood pellets required under the contract.
On August 19, 2022, Debtor filed a motion seeking authorization under 11 U.S.C. § 363 to sell substantially all its assets and approval of bidding procedures to auction them. As the highest bidder, CMB entered into an Asset Purchase Agreement (“APA”) whereby CMB agreed to buy substantially all the Debtor’s assets used in connection with manufacturing wood pellets for consideration of over $24 million. Pursuant to the APA, CMB deposited a $250,000 Good Faith Deposit in escrow with counsel for the Debtor.
On October 24, 2022, CMB’s counsel contacted Debtor’s counsel and advised that, in communicating with the Town of Ridgeland, Debtor’s pellet mill may have been violating the Town of Ridgeland’s noise ordinance. Due to this issue, counsel for CMB informed the Court that the APA was terminated pursuant to its terms on November 4, 2022. On November 16, 2022, the Court entered an Order denying the sale and concluded that the APA was not approved.
The Debtor’s bankruptcy was converted from Chapter 11 to Chapter 7 on February 15, 2023, and the Trustee was appointed on February 21, 2023, to administer the estate. The Trustee was ordered to hold the Good Faith Deposit pending further order of the Court. The Trustee then abandoned the Debtor’s pellet mill and real estate approximately three months later with Court approval. As of December 15, 2023, USB had taken no action to foreclose on it.
Adversary Proceeding Allegations and Counterclaims
On December 1, 2022, CMB filed an adversary proceeding against the Debtor, seeking (a) a judgment against Debtor finding that it breached the APA, committed various forms of fraud, and engaged in unfair and deceptive trade practices; (b) a declaratory judgment that, due to the various acts, omissions, fraud, and concealment allegedly committed by Debtor, the APA is null and void, CMB’s obligations thereunder are extinguished, and the $250,000.00 Good Faith Deposit should be returned to CMB; and (c) an award of compensatory, punitive, and treble damages to be awarded to CMB in an amount determined by the Court. More specifically, the Complaint asserted a total of nine causes of actions against Debtor and essentially alleged that Debtor made representations in the marketing teaser that the facility was “turnkey” ready, when in fact it was not. Through discussions with representatives of the Town of Ridgeland, CMB alleged it was informed of Debtor’s violation of noise ordinances and of possible issues with obtaining the required licenses to continue operating the Debtor’s pellet mill. Accordingly, CMB alleged that the Debtor acted fraudulently in making misrepresentations in its marketing material and failing to include relevant information in the data room, which conduct resulted in the breach of the APA on the part of Debtor, thus excusing CMB’s termination of the APA.
On January 17, 2023, Debtor filed an Answer to the Complaint raising twenty defenses and asserting five counterclaims, which was then amended once the Trustee was substituted as a party in interest. Among other arguments and defenses, the Debtor (and subsequently the Trustee) disputed that the marketing materials contained false representations, claimed that CMB had no basis to terminate the APA because Debtor was not in default under its terms, and relied on the “as is” provision in the APA containing CMB’s acknowledgment that it had conducted — or had the opportunity to conduct — an independent investigation and inspection of the condition of Debtor’s assets. CMB filed a Motion for Partial Dismissal of one the Trustee’s counterclaims for defamation pursuant to Fed R. Civ. P. 12(b)(6). On July 6, 2023, the Court granted CMB’s Motion and dismissed that counterclaim with prejudice.
The Settlement between CMB and the Trustee
On September 14, 2023, the Trustee filed the subject settlement motion, seeking the approval of the settlement agreement reached with CMB to globally resolve the disputed pre-petition and post-petition claims between the parties. In the settlement motion, the Trustee acknowledged that continuing to litigate the adversary proceeding and the Trustee’s contemplated claims against CMB would be costly, time consuming, and complex, without any guaranteed recoveries for the benefit of creditors, especially considering that the estate is currently without any funds to support the litigation.
Part of the terms of settlement provided that CMB would pay $655,000 to the Trustee to resolve the pre-petition claims, the Trustee would withdraw its defenses and counterclaims in the adversary proceeding, and that the Trustee would not oppose an entry of default judgment in favor of CMB for the return of the Good Faith Deposit to CMB. USB objected to the settlement motion for various reasons, including that it was not in the best interest of the estate or its creditors and that it was made without USB’s consent, which was necessary due to its asserted lien on the Good Faith Deposit.
Testimony in Support of Settlement
At the evidentiary hearing, the Trustee testified about her investigation of the estate’s claims against CMB and the due diligence she undertook to reach the proposed global resolution. The Trustee further acknowledged that any recovery in the adversary proceeding would have required additional costly litigation with USB as to its alleged interest on those funds, and using any of the Good Faith Deposit being held in escrow to pay any of the pre-petition claim settlement amount would similarly invite additional litigation with USB. While she acknowledged that she was aware of USB’s position as to its asserted interest in the Good Faith Deposit, the Trustee testified it had always been her position that, in order for the Good Faith Deposit to become property of the bankruptcy estate, the adversary proceeding would have to be litigated to its conclusion.
The Trustee also testified that she considered the possible recovery and success of any litigation with respect to the pre-petition claims. Because the bankruptcy estate had no funds and proceeding with the litigation of the APA Adversary Proceeding would be incredibly expensive — with no guarantee of any recovery for creditors — the Trustee stated that she would be willing to “walk away” from the Good Faith Deposit in exchange for CMB waiving its claim against the estate and CMB’s agreement to cooperate with the Trustee in possible future litigation against third parties who may have contributed to the termination of the APA through their dissemination of false information. As she evaluated the outcome of the APA Adversary Proceeding, she also determined that because CMB was asserting claims based on Debtor’s fraud, which were clearly based on disputed factual allegations, the proceeding could not be disposed of through summary judgment but would most likely have to continue to trial.
Fourth Circuit Law on Bankruptcy Settlement Approvals
Federal Rule of Bankruptcy Procedure 9019 provides that “[o]n motion by the trustee and after notice and a hearing, the court may approve a compromise or settlement.” All compromises and settlement must be fair and equitable. The burden to establish the fairness and reasonableness of the settlement falls on the Trustee as the proponent of the settlement. A bankruptcy judge is not required to conduct a full evidentiary hearing or mini trial before approving a settlement. Rather, the court must determine whether the settlement falls below the lowest point in the range of reasonableness and must consider the following factors: (1) the probability of success in litigation; (2) the potential difficulties in collection; (3) the complexity of the litigation and the expense, inconvenience, and delay necessarily involved therein; and (4) the interest of creditors.
The Court's Analysis of the Settlement Factors
When analyzing the first factor, the probability of success on the merits, the Court determined that if the settlement was not approved, the Trustee would have to continue litigating factually complex issues with uncertainty as to any recovery for the estate and with no funds whatsoever at this point to do so. The Court relied on the Trustee’s conclusion that the adversary proceeding could not be resolved without a complete adjudication of the alleged fraud claims and a determination of, among other things, the effect of the “as is” clause in the APA versus the “turnkey” representation in the marketing material disseminated by the Debtor. The Court also credited the Trustee’s opinion that, based on her analysis and judgment, there were genuine issues whether ambiguities in the marketing materials might have entitled CMB to seek rescission. Simply stated, as the Trustee argued in her pleadings and testified at the hearing, the adversary proceeding was not a straightforward contract action, and the probability of success was uncertain. Moreover, even if the Trustee was successful on any recovery through the adversary proceeding, the litigation would then have turn to determining whether USB had a lien on any portion of the funds.
Notably, pursuant to the terms of the APA, for the Good Faith Deposit to become non-refundable so that CMB would have to forfeit its rights to it, CMB would have to be at fault for the breach of its obligations under the APA. The Court went a step further and determined that if CMB was at fault, an argument could then be made that the reduction of CMB’s pre-petition claims outlined in the APA would become null and void so that the entire amount of CMB’s pre-petition claims would come back into play in the amount of $43,963,258.00 — as opposed to the agreed-upon amount of $6,000,000.00 in the APA. If that were the case, CMB’s pre-petition claims would dwarf any other claim asserted against the estate (including any deficiency claim asserted by USB), and additional litigation would be required to seek its reduction or disallowance. Accordingly, any recovery against CMB in addition to the Good Faith Deposit, above administrative or priority claims, would in essence be recovered — in large part — by CMB itself as the largest unsecured creditor. For all these reasons, the Court found that the probability of success in litigation weighed in favor of approving the proposed global settlement.
The Court found that the second factor, the potential difficulties in collection, was neutral and did not weigh in the analysis.
As to the third factor, the complexity and cost of the litigation involved, the Court reiterated that the allegations did not involve a simple breach of contract issue. The expense of the litigation would be substantial given the number of witnesses, numerous allegations, and questions of fact involved. The Trustee and CMB collectively identified twenty-three fact witnesses in their initial disclosures pursuant to Federal Rule of Civil Procedure 26(a)(1) in the adversary proceeding (excluding duplicates). As to the pre-petition claims, the enforceability and breach of the wood pellet sale contract would similarly require extensive discovery and possibly expert testimony to establish damages. The expense to conduct the extensive discovery required to pursue the actions through trial would exhaust or even exceed the value of the Good Faith Deposit that USB was fighting over. Simply stated, continued litigation would be a prolonged, expensive, and complex process for an estate which is currently administratively insolvent. Thus, the Court found that proceeding with the settlement would minimize continuing expense, inconvenience, and delay associated with continuing to litigate the issues, weighing in favor of approving the settlement.
As to the fourth and final factor, the paramount interest of the creditors, the court found that the paramount interest of the creditors weighed in favor of approving the global resolution with CMB embedded in the settlement agreement. The settlement would enable a substantial recovery on the pre-petition claims with no continuing legal fees being incurred, while removing the risk that the Trustee might pursue the claims and lose on the merits. With limited exceptions, a chapter 7 trustee’s principal duty is to maximize distributions to unsecured creditors, given that interests of secured creditors are usually protected by collateral. Had the Trustee insisted on the forfeiture of the Good Faith Deposit as part of the settlement, it could have potentially impacted the disallowance of the entire CMB Claim, thus returning CMB’s pre-petition claim to the original asserted amount of over $43 million. Any future recovery by the estate through actions brought against third parties would be distributed to any remaining administrative or priority claim and the rest would be distributed to unsecured creditors, which would be dwarfed by the CMB claim. Said differently, the Trustee would be litigating to pursue the recovery of funds to be used in large part to repay CMB itself!
The Settlement Agreement Did Not Require USB's Consent and the "Binding Case Law" Purporting to be in its Favor was Distinguishable
The Court rejected USB’s claim that its consent was necessary to approve the proposed settlement agreement. USB relied on an opinion from the United States Court of Appeals for the Fourth Circuit, Old Stone Bank v. Tycon I Bldg. Ltd. Partnership, in which the Court concluded that an earnest money that was forfeited upon the purchasers’ failure to consummate a sale was received upon disposition of the property and thus constituted “proceeds” subject to the creditor’s lien. 946 F.2d 271 (4th Cir. 1991). In Old Stone Bank, the bank loaned the debtor funds to purchase real estate and, in exchange, acquired a security interest in the property. The potential purchaser of the property ultimately failed to close on the deal and forfeited the $100,000.00 earnest money deposit. The Fourth Circuit concluded that a forfeited earnest money deposit is received upon the disposition of property and should be classified as proceeds.
Judge Gasparini determined that the facts of Old Stone Bank and other decisions following its holding were distinguishable from the facts currently before it. Unlike in Old Stone Bank, while the APA was executed by CMB and Debtor, the Court never approved it — which was a condition precedent to the parties’ obligation to consummate the sale. More importantly, in Old Stone Bank and other cases following its holding, Judge Gasparini determined that the deposit at issue was irrefutably “forfeited” by the potential purchaser, without it being the subject of continuing litigation as to the party entitled to the funds. USB did not cite — and acknowledged at the hearing that it was not aware of — any caselaw directly on point where the good faith deposit on which a secured lender was asserting a security interest had not been forfeited but was rather part of litigation in which the bankruptcy estate was involved and which the Trustee was pursuing. The Court was also unaware of any case that addressed the issue under the facts currently before it.
Here, CMB never “forfeited” the funds. While CMB deposited the Good Faith Deposit into escrow, consistent with the provisions of the APA, the deposit would become non-refundable as to CMB unless CMB’s failure to close was no fault of CMB. Said differently, the Good Faith Deposit was refundable if the failure to close on the transaction was concluded to be a result of Debtor’s fault. The determination of the party at fault for the termination of the APA was the underlying issue of the adversary proceeding — the very same issue that the Trustee was attempting to resolve as part of the global resolution sought in the settlement motion. Therefore, while the sale did not close in this case, the key fact distinguishing this matter from the situation in Old Stone Bank is that here the deposits were not “forfeited” and thus did not become part of the “proceeds” to which USB is entitled.
Moreover, not only was the sale not approved, but, unlike in Old Stone Bank, the Good Faith Deposit remained in escrow subject to CMB’s claims that it was refundable to it and thus never vested to the bankruptcy estate. Any valuable right that USB may have in the Good Faith Deposit was — and always has been — conditioned on the Trustee prevailing on her counterclaims and defenses to the adversary proceeding.
In granting the settlement motion and approving the settlement agreement, Judge Gasparini concluded by holding that
[b]ased on the facts of this case, the lack of any binding precedent which specifically addresses the extent to which a security interest attaches to escrowed deposits that are not forfeited and remain the subject of litigation in the context of a sale that was never approved by the Court, the substance of the transaction at issue, and the extent to which “proceeds” attach under the South Carolina Commercial Code, the Court concludes that USB’s security interest does not extend to the escrowed Good Faith Deposit. For the reasons set forth above, the Court is not persuaded by USB’s argument that the agreement is unfair and that the Trustee wrongfully terminated USB’s interest in the Good Faith Deposit.
In re Jasper Pellets, LLC, 656 B.R. 166, 185–86 (Bankr. D.S.C. 2023).
Post-Order Actions by the Parties
Pursuant to the court-approved settlement agreement, CMB paid the Trustee the agreed-upon settlement funds to resolve the pre-petition claims. In turn, the Trustee abandoned her Answer, defenses, and Counterclaims in the adversary proceeding. CMB then moved for an entry of default and a default judgment against the Trustee, which was granted by Judge Gasparini on February 13, 2024. With the time to appeal Judge Gasparini’s Orders approving the global settlement and default judgment having lapsed, CMB’s Good Faith Deposit is now being returned to CMB.
Conclusion
Global settlements involving resolution of pre-petition and post-petition claims can be complex and tricky to litigate, especially when objections are asserted by the estate’s largest creditor. However, knowing how to overcome such objections and distinguish cases presented to the court as “binding” are key to ensuring a settlement is approved and in the best interests of the creditors.
