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Sixth Circuit Sorts Out Bankruptcy Slugfest Between Friends

It has often been said that you should never do business with friends or family. A bankruptcy court decision that was recently affirmed by the U.S. Court of Appeals for the Sixth Circuit is further evidence of this proposition. 

The Facts

George Bavelis immigrated to the United States from Greece in 1958 and became a successful real estate investor and entrepreneur. In 1996, he and a group of investors acquired Florida-based Sterling Bank, and its parent Sterling Holding. Through his dealings with the bank, Bavelis met Ted Doukas, another successful businessman, and they became close friends. During the financial crisis in 2009, Bavelis came under considerable financial pressure, and struggled to service more than $18 million in bank debt from various business ventures, all of which he had personally guaranteed. In addition, Sterling Bank needed cash infusions totaling over $12 million.

Bavelis turned to Doukas for help. Doukas and Bavelis entered into a series of financial transactions resulting in: (i) Doukas purchasing $200,000 of Sterling Holding stock, (ii) Doukas depositing $2 million into his Sterling Bank accounts, (iii) Bavelis signing a $14 million promissory note payable to Quick Capital, one of Doukas' businesses, (iv) Bavelis signing a security agreement granting Quick Capital an interest in certain shares of Sterling Holding, and (v) Bavelis and Doukas entering into a loan agreement through which Doukas loaned Bavelis $200,000 (which was quickly repaid by Bavelis).

According to the Sixth Circuit's opinion, based on the findings of the bankruptcy court, the parties had no expectation of following through on the remaining terms of the documents (for example, the repayment by Bavelis of the $14 million promissory note), because Bavelis only signed them because Doukas had convinced him that they were part of "a complicated estate-planning scheme that Doukas would arrange on Bavelis' behalf." Prior to signing, "Bavelis obtained an oral promise from Doukas that Bavelis would not have to make any payments on the notes."

Following these transactions, Doukas agreed to purchase almost $1.5 million of Sterling Holding stock in September 2009. While Doukas never signed a subscription agreement for the stock purchase, he informed an employee of Sterling Bank that he wished to purchase the stock, and the employee sent an email to Doukas confirming the purchase. Doukas responded and authorized the purchase, and issued payment for the stock. Doukas received the stock certificate on February 8, 2010, but then rejected the certificate via a letter dated February 15, 2010, claiming that he "never requested any stock." Rather, he claimed he sent the money as part of the consideration for the $14 million promissory note.

The Bankruptcy

Bavelis filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code in July 2010. He then filed a 15 count adversary proceeding against several defendants, including Doukas and Quick Capital. Count 3 of the complaint sought declaratory judgment that the promissory note (i) fails for lack of consideration, (2) is void, (3) should be rescinded based on fraudulent inducement, and (4) has been fully satisfied.

Quick Capital filed a $1.7 million proof of claim in the bankruptcy for "Money Loaned," an amount equal to Doukas' stock purchases in 2009, and subsequently amended the proof of claim in the amount of $14 million plus interest for the promissory note. Quick Capital alternatively argued that, if the court held that it had purchased the shares, then Doukas had a claim against Bavelis under Florida securities laws.

The bankruptcy court held an evidentiary hearing on Count 3 of the complaint after which it issued an opinion disallowing Quick Capital's claim and amended claim, holding that the claim based on the promissory note failed, among other reasons, for lack of consideration and because of fraudulent inducement. The bankruptcy court also held that Doukas had no claim under Florida securities law because there was no evidence the sale of securities was unlawful.

The Appeal

Quick Capital and Doukas appealed to the Bankruptcy Appellate Panel which affirmed the bankruptcy court's decision in its entirety. The defendants further appealed to the Sixth Circuit.

Core vs. Noncore

Doukas argued on appeal that the bankruptcy court lacked authority to enter judgment on his right of recession of the Sterling Bank stock sale because his claim was "noncore" and, thus, the bankruptcy court did not have constitutional authority to enter a final judgment.

Bankruptcy courts have differing authority depending on whether a claim before them is "core" or "noncore." In core proceedings - identified in a non-exhaustive list found in 28 U.S.C. § 157(b)(2) - a bankruptcy judge "may enter appropriate orders and judgments" subject to appellate review. In noncore proceedings, bankruptcy judges "shall submit proposed findings of fact and conclusions of law to the district court, and any final order or judgment shall be entered by the district judge after…reviewing de novo" the objections, if any, of the parties. The parties may waive this limitation to the bankruptcy court's power.

The bankruptcy court held that Count 3 was a core proceeding which fell under at least two examples on the 157(b)(2) list, specifically (i) that the objection involves the "allowance or disallowance of claims against the estate," and (ii) that the resolution of the objection affects the adjustment of the debtor-creditor relationship under 28 U.S.C. §157(b)(2)(O).

The Sixth Circuit affirmed the bankruptcy court's ruling, explaining that Count 3 was in the nature of an affirmative defense to Doukas' proof of claim, not an independent cause of action, and thus was a core proceeding not a state action as the defendants alleged. The Sixth Circuit also held Doukas' noncore argument to be without merit due to the "invited error doctrine," meaning that Doukas invited the alleged error by seeking a ruling regarding Bavelis' legal obligations under Florida law.

Due Process

Doukas argued that his due process rights were violated because he never had "his day in court" on the Florida securities law claim. The Sixth Circuit held that, because Doukas raised the issue for the first time on appeal, he had forfeited his right to bring this due process challenge.

Stock Sale Exempt from Florida Securities Law

Doukas further argued that the bankruptcy court erred by finding that the Sterling Holding stock sale was exempt from Florida's registration requirements. However, the Sixth Circuit affirmed the bankruptcy court's ruling that Doukas had been provided with a full and fair disclosure of all material information related to the stock sale and, accordingly, the sale fell into one of Florida's securities law's exemptions from registration requirements.

Doukas' Right to Recission

Florida's securities law requires a three-day right of recession for securities purchasers. Doukas argued that he was not properly notified of this right. The Sixth Circuit disagreed with Doukas and affirmed the bankruptcy court's ruling that the private placement memorandum at issue in this case satisfied Florida law with respect to notifying stock purchasers of their right to rescind their purchase.

Timely Recision

Doukas' final argument was that, even if the transaction at issue was lawful, the bankruptcy court erred by ruling that his attempted recession of the stock purchase was not timely. Florida law gives purchasers of stock three days to rescind. Doukas received the private placement memorandum on September 7, 2009, and paid for the stock on September 23, 2009. Therefore, Doukas' right of recession lapsed on September 26, 2009, well before his attempted recession in February 2010.

Conclusion

A number of lessons can be drawn from this case beyond "don't do business with friends." An important one is that, if you do choose to do business with friends, it's important to carefully and thoroughly negotiate and document the terms of your deal. If you don't, and things go south, there's a good chance that a court - bankruptcy or otherwise - will be sorting things out for you. In addition, this case is a good example of the need for skilled bankruptcy counsel. Seemingly routine actions, such as filing a proof of claim, can have big implications on substantive rights as well as jurisdictional issues. Every action a creditor takes in a bankruptcy proceeding must be thoughtful and purposeful.

If you have any questions about the issues raised in this case, or bankruptcy issues in general, please contact Laura Genovich at lgenovich@fosterswift.com.

Categories: 6th Circuit Court of Appeals, Chapter 11

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practice focuses on bankruptcy, municipal law, collections, and trial-level and appeals litigation. In the bankruptcy arena, she represents primarily Chapter 7 trustees. Laura has handled a wide range of trial and appellate matters for individual and business clients and has appeared before the U.S. Sixth Circuit Court of Appeals, the Michigan Court of Appeals, and the United States Bankruptcy Court for the Western District of Michigan, as well as Michigan circuit and district courts across the state.

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