UNITED STATES BANKRUPTCY COURT

EASTERN DISTRICT OF KENTUCKY

LEXINGTON DIVISION


IN RE:

WALLACE'S BOOKSTORES, INC.

DEBTOR CASE NO. 01-50545

LYNDON PROPERTY INSURANCE COMPANY PLAINTIFF

VS. ADV. NO. 02-5032

EASTERN KENTUCKY UNIVERSITY,

SOUTHERN ILLINOIS UNIVERSITY,

SOUTHERN UNIVERSITY,

GLENVILLE STATE COLLEGE DEFENDANTS


MEMORANDUM OPINION

1. Overview

This matter which was tried in two parts on October 30, 2002, and May 8, 2003, is now before the court for decision. The October 30, 2002 portion of the trial addressed the issues arising in regard to defendants Glenville State College ("Glenville") and Southern University ("Southern"); the May 8, 2003 portion addressed those arising in regard to defendants Eastern Kentucky University ("EKU") and Southern Illinois University ("SIU"). The plaintiff, Lyndon Property Insurance Company ("Lyndon"), issued surety bonds securing the obligations of Wallace's Bookstores, Inc. ("the debtor") to operate bookstores on the campuses of each of the defendants (collectively "the college defendants") pursuant to contracts entered into by the debtor with each of them ("the bookstore contract(s)"). These defendants have made claims against these bonds. Lyndon maintains that it is not liable on any of the bonds and that it is in fact entitled to damages from each of the defendants. In preparation for the trial, the parties entered into extensive joint stipulations which are of record in this matter. Pertinent provisions of the joint stipulations will be cited specifically below. All references to exhibits are to exhibits attached to the joint stipulations.

2. Jurisdiction

Lyndon asserted this court's jurisdiction of this matter and its core nature in its complaint, amended complaint, and second amended complaint pursuant to 28 U.S.C.  1334 and 28 U.S.C.  157(b)(2)(B), (D),(G), (M), and (O). SIU, in its counterclaim and first amended counterclaim, and Glenville in its counterclaim, agreed that the court has jurisdiction and that this is a core proceeding. They further stated that to the extent that this was determined to be a non-core proceeding, they consented to the entry of a final order or judgment by this court.

EKU also asserted this court's jurisdiction and the core nature of this proceeding in its counterclaim. Southern denied Lyndon's jurisdictional allegations in its answer, stating that the court lacks jurisdiction as to Lyndon's claims pursuant to the Eleventh Amendment to the United States Constitution insofar as those claims might be interpreted to seek a money judgment against Southern, a Louisiana state institution. The Sixth Circuit Court of Appeals has held in Hood v. Tenn. Student Assistance Corp. (In re Hood), 319 F.3d 755 (6th Cir. 2003), that "with the Bankruptcy Clause[] the states granted Congress the power to abrogate state sovereign immunity. ... Congress clearly exercised that power in 11 U.S.C.  106. Accordingly, [the state government entity] is not immune from suit[.] Id. at 767. Unless and until the Hood decision is overturned, it is the law in the Sixth Circuit. In any event, the court later determined that this is non-core, related proceeding in which it could hear and enter final orders and/or a judgment pursuant to 28 U.S.C.  157(c)(1) and (2). All parties to the proceeding, including Southern, consented to the court's hearing the matter and entering final orders (TE 10/30/02, p. 169). The following therefore represents findings of fact and conclusions of law pursuant to Rule 7052 of the Federal Rules of Bankruptcy Procedure which makes Rule 52 of the Federal Rules of Civil Procedure applicable in bankruptcy.

3. Procedural History

Lyndon initiated this matter by the filing of its Adversary Complaint for Sequestration and Turnover of Trust Funds, for Allowance of Administrative Claim and for Declaratory Relief on March 26, 2002. This filing was followed the next day by the filing of an amended complaint for the purpose of correcting an error in the style of the case, according to Lyndon. The complaint and amended complaint named the debtor as a defendant. The complaint and amended complaint made allegations applicable to all the college defendants in Count III. All defendants filed answers and the college defendants filed counterclaims as well.

EKU alleged in its counterclaim that Lyndon owed it $500,000 pursuant to the bond posted in its favor by Lyndon. SIU alleged that Lyndon issued an indemnity bond in its favor in the amount of $310,000. SIU further alleged that it had suffered $240,294.08 in damages on account of the debtor's breach of its contract to operate SIU's bookstore and that Lyndon was indebted to SIU for that amount, as well as damages after December 20, 2001 plus attorney fees and interest. SIU also asked that Lyndon's complaint against it be dismissed. Glenville alleged that it had suffered $434,456.28 in damages on account of the debtor's breach and sought judgment in the amount of its indemnity bond, $75,000. Glenville also asked that Lyndon's complaint be dismissed.

Southern's counterclaim addressed the two bonds which Lyndon posted in its favor. Performance bond number CSB0165837 ("Bond 1") was issued on July 1, 1999 in the amount of $60,000; bond number CSB 3400595 ("Bond 2") was issued on May 2, 2000 in the amount of $150,000. Southern claimed sums due under Bond 1 in the amount of $53,313.33 and under Bond 2 in the amount of $145,352.65. Southern also claimed a penalty of 10% of the total principal amount due under a provision of Louisiana state law. Southern asked for the dismissal of Lyndon's claims against it with prejudice.

Lyndon filed answers to each of the counterclaims and then filed its second amended complaint on June 18, 2002. This complaint brought specific counts against the college defendants. Count IV of the second amended complaint alleged that EKU and Southern failed to provide Lyndon with notice of default by the debtor, that such failure caused Lyndon harm, and that per the terms of their respective bonds they bound themselves to compensate Lyndon for any loss.

Count V alleged that per the terms of the bond issued to Glenville, Lyndon had the option of curing any defaults or completing the bookstore contract upon declaration of a default, and that Glenville did not declare a default or notify Lyndon until after the contract had been assigned to another entity. Count V further alleged that by failing to allow Lyndon to exercise its rights under the bond, Glenville caused harm for which Lyndon is entitled to recover. Count VI made the same or similar allegations in regard to SIU. Southern filed an answer to the second amended complaint; the other college defendants did not.

Bernard Katz, Liquidating Supervisor for the debtor ("Katz"), was substituted as a party defendant in the debtor's place by an agreed order entered July 3, 2002. He filed a motion for summary judgment on July 23, 2002, and an order granting his motion on Counts I and II of the complaint and amended complaint was entered on September 4, 2002. Katz has since been dismissed as a party defendant. On September 17, 2002, SIU filed its first amended counterclaim. There it adopted the allegations of its original counterclaim as Count I. In Count II it alleged that pursuant to its bookstore contract with the debtor, the debtor had agreed to provide SIU with a $650,000 capital investment. Count II further alleged that as a result of the debtor's breach of the bookstore contract, SIU was required to enter into an agreement with a replacement contractor. The replacement contractor agreed to provide a capital investment of $590,000 representing a $60,000 capital investment loss to SIU, and it sought that amount in capital investment damages.

Count III alleged that pursuant to the terms of the bookstore contract the debtor was to pay SIU an annual commission of 11% of gross sales up to $5,000,000. The replacement contractor agreed to pay an annual commission of 9% of gross sales up to $3,500,000 and 10% of gross sales between $3,500,000 and $5,000,000. SIU alleged that it has thereby suffered damages in the form of lost commissions (both those already lost and those projected to be lost in the future) in an amount to be proven at trial. SIU sought a judgment on Counts I, II and III in the maximum amount of the indemnity bond, $310,000.

Beginning in early September 2002, Lyndon filed various motions for summary judgment against each of the college defendants, and each of them filed a motion for summary judgment against Lyndon. All of these motions were heard by the court on October 11, 2002, and all were overruled. The matter then proceeded to trial on October 30, 2002, continuing to May 8, 2003, as set out above. At the conclusion of the trial the court ordered the parties to prepare post-trial briefs which would provide the court with a "road map" of their respective claims.

4. Facts in evidence

The debtor originally filed its Chapter 11 case in the United States Bankruptcy Court for the District of Delaware on February 28, 2001; it was transferred to this court on March 2, 2001. Before its filing, the debtor had been a major operator of college bookstores around the country, including those of the college defendants here. On June 30, 1999, the debtor entered into a General Agreement of Indemnity ("GAI") with Cumberland Surety Insurance Company, Inc. ("Cumberland"). The GAI, pursuant to  17.1, inures to the benefit of any surety from whom Cumberland procured a bond on the debtor's behalf. It also provides for several events of default on the part of both the principal and the obligee, including failure to perform a contract covered by a bond. The bonds which Lyndon issued on the debtor's behalf were procured by Cumberland. Lyndon and Cumberland are one and the same for purposes of this matter (Stip. 1). In all instances the surety is Lyndon, the principal is the debtor, and the obligee is the particular college defendant. Because of various similarities in bond terms and other circumstances, the court has chosen to address the individual college defendants in the following order: EKU, Southern, SIU, and Glenville.

A. Eastern Kentucky University

The debtor and EKU entered into a contract for the debtor's operation of EKU's campus and satellite campus bookstores on May 24, 2000; the contract took effect on July 1, 2000 (Stip. 68). The contract incorporated EKU's Request for Proposal and the debtor's response (Stip. 76). Pursuant to the terms of the contract, the debtor was to pay EKU a minimum annual guarantee of $510,000 or 11% of sales up to $5,000,000 and 12% of sales over that amount, whichever was greater (Stip. 69).

The contract further provided for the debtor's purchase of EKU's existing inventory and the installation of $750,000 in capital improvements (Stip. 72). At the expiration of the contract relationship, EKU or its designee was to buy back the then-existing inventory and reimburse the debtor for any unamortized portion of the capital improvements (Stip. 73). The debtor was to reimburse EKU for employee wages and salaries and agreed to accept university-issued debit cards from students. When such cards were used, EKU was to pay the debited amount to the debtor (Stips. 77 and 78).

The contract required notice of default and an opportunity to cure upon a breach by either party (Stip. 74). The contract also required the debtor to obtain a surety bond in the penal sum of $500,000. The debtor did so through Lyndon which issued Performance Bond No. CSB 2300976 (Stip. 79). The bond provides, upon notice of default by the obligee, for the surety to have the opportunity to indemnify the obligee for the cost to complete the "project," remedy the default, or complete the contract itself. The bond also requires the obligee to send the surety a simultaneous copy of any and all cure notices sent to the principal (Stip. 80).

The debtor failed to remit any monthly commission payments for July through December 2000, although it did begin construction of capital improvements and tendered one check for $18,000 on some unspecified account (Stip. 94). As of the date of termination of the debtor's operations at EKU, the value of the inventory was $1,069,370 and the unamortized value of the improvements to be paid to the debtor was $515,599.82 (Stip. 92). Per the testimony of Charles K. Johnston, EKU's Vice-President for Financial Affairs and Treasurer, as of the date of filing of the debtor's petition, EKU owed the debtor $554,760 for debit card sales and credit sales (TE 05/08/03, pp. 18-19).

On January 19, 2001, EKU sent the debtor a letter in which it demanded payment under its bookstore contract for past due commissions, the inventory, reimbursements, and credit memos. Lyndon was not copied on this letter (Stip. 95). On January 25, 2001, the debtor issued a check in the amount of $902,430.84 to EKU as partial payment for the demand made on January 19, 2001. This payment was in part for monthly lease payments for the period July-December 2000 at the rate of $42,500 per month (Stip. 98). The debtor did not pay any of the amount demanded for the credit memos (Stip. 96). EKU accepted this payment in forbearance of its right to terminate the contract at that time (Stip. 97).

Pursuant to an order entered in the debtor's case on April 25, 2001, EKU entered into a contract with Barnes & Noble ("B & N")to take over operation of its bookstore. EKU did not consult with Lyndon prior to contracting with B & N as a replacement operator. B & N purchased the inventory of the bookstore from the debtor, and paid $340,000 toward the unamortized value of the improvements (Stip. 99). The first time EKU contacted Lyndon was by letter dated March 22, 2001 (Stip. 100; Exh. 28). According to the Debtor's Seventh and Final Report of Transition Results, filed herein on July 17, 2001, B & N paid the debtor the full price of $1,069,370 for the bookstore inventory.

B. Southern University

Southern had a relationship with the debtor dating back to 1990 consisting of a series of one year contracts under which the debtor would operate Southern's bookstore (Stip. 26). The debtor leased the bookstore premises from Southern. The leases were public contracts subject to the requirements of Louisiana's laws for offering, advertising, bidding, and awarding (Stip. 27). Pursuant to a 1994 Request for Proposal, a five year contract to operate Southern's bookstore was awarded to the debtor. The contract was then extended through a series of one year renewals, with the final renewal entered into on July 9, 1999 for the fiscal year 1999-2000 ("the 1999 contract") (Stip. 29; Exh. 6). Pursuant to the terms of the 1999 contract, the debtor was to pay Southern a guaranteed annual commission of no less than $60,000 or the greater of that amount or 9% of gross sales. Payments were to be made monthly with the debtor tendering one-twelfth of annual guarantee each month. If further payment was due, the debtor was to pay Southern the difference within 30 days of the end of the fiscal year, June 30 (Stip. 30).

A condition of the 1999 contract was that the debtor provide Southern with a performance bond in the penal sum of $60,000. The debtor procured Bond No. CSB 0165837, issued July 1, 1999, from Lyndon through Cumberland ("the 1999 bond) (Stip. 31; Exh. 7). A new Request for Proposal was issued on March 27, 2000 ("the 2000 RFP"). The debtor was awarded a one year contract with four annual renewal options. The debtor and Southern entered into this contract for fiscal year 2000-2001 ("the 2000 contract") on April 6, 2000 (Stip. 32; Exhs. 8 and 9).

Pursuant to the terms of the 2000 contract, the debtor's minimum annual guarantee was $175,000 to be paid in equal monthly installments. The amount of the bond was increased to $150,000 as Performance and Payment Bond No. CSB 3400595 (Stips. 33 and 43;

Exhs. 9 and 11). Paragraph 6 of the bond provides that Southern was required to send Lyndon a simultaneous copy of any and all cure notices sent to the debtor (Stip. 44; Exh. 11). The debtor was to pay the $175,000 guaranteed annual commission amount or the greater of that amount or 9.5% of gross sales up to $2,000,000 and higher percentages on gross sales over $2,000,000. The debtor was to make payments monthly, tendering one-twelfth of the annual guarantee each month. If further payment was due, the debtor was to pay Southern the difference within 30 days of the end of the fiscal year, June 30 (Stip. 34).

The debtor agreed to make a capital improvement investment up to $200,000 for renovation of the bookstore (Stip. 37). The capital improvements were to be amortized on a straight line basis over the five year period of the contract. If the contract terminated for any reason before the end of the five year period, Southern or a subsequent contractor was to reimburse the debtor for the unamortized portion of the investment (Stip. 38; Exh. 9). The debtor completed installation of the improvements (Stip. 40). According to the debtor's Seventh and Final Report of Transition Sale Results, the unamortized value of the improvements as of the termination of the contract was $129,480 (Stip. 41; Exh. 10). The 2000 contract was issued pursuant to the 2000 RFP, which provided that upon termination of the contract the lessee (the debtor) would sell the existing bookstore inventory to Southern at the lessee's cost (Stip. 42; Exh. 8, 3.11(h)). The debtor's Seventh and Final Report of Transition Sale Results showed the value of the inventory to be $574,931 as of the date of filing (Stip. 42; Exh. 10).

Over the term of the 1999 and 2000 contracts, the debtor routinely made monthly payments late, and Southern continuously accepted them (Stips. 45 and 47). At no time prior to the debtor's bankruptcy filing did Southern place the debtor in default under either contract (Stip. 46). The 1999 contract expired under its own terms, and the 2000 contract was terminated by order of this court (Stips. 48 and 49). On November 27, 2000 Mayo Brew, then Southern's Corporate Scholarship Coordinator (and previously Director of Auxiliary Services) wrote to the debtor concerning the fact that no payments had been made on the 2000 contract. The letter was not copied to Lyndon (Stip. 50; Exh. 12).

Flandus McClinton, Southern's Vice Chancellor for Finance and Administration, testified that according to Southern's books and records, the amounts set forth in Exhibit 14 reflect the amounts due under the 1999 and 2000 contracts and the payments received (Stip. 52). On January 18, 2001, the debtor submitted a check in the amount of $72,916.70 "for lease payments 7/00, 8/00, 9/00, 10/00, 11/00." Stip. 53; Exh. 15).

On May 4, 2001, the court entered its order authorizing the sale of Southern's bookstore inventory to Follett (Stip. 56). The purchase price for the store fixtures was $129,480 (Stip. 58). Following entry of the order approving the sale, Southern entered into an operating agreement with Follett to take over operation of the bookstore. The date of that contract was July 1, 2001 (Stip. 60; Exh. 16). Southern did not consult with Lyndon on the negotiations with or consummation of the contract with Follett Higher Education Group, Inc. ("Follett") (Stip. 62). On May 7, 2001, Southern's counsel notified Lyndon and the Debtor by letter of Southern's claims against the two bonds. The letter stated that it served as notice of default and demand upon the surety (Stips. 63 and 64; Exh. 17). Lyndon replied to this letter with a letter stating that it was investigating the matter (Stip. 65; Exh. 18). Southern's counsel sent Lyndon a letter dated July 30, 2001 calling upon Lyndon to make payment under the bonds, but Southern has not received any payment from Lyndon (Stips. 66 and 67; Exh. 19).

C. Southern Illinois University

On June 2, 2000, the debtor entered into an agreement for the operation of the campus bookstore for SIU. The initial term of the contract was five years, with two additional two year terms, at SIU's option (Stip. 102; Exh. 29). Pursuant to the terms of the contract, the debtor was to pay SIU commissions of 11% of gross sales over $5,000,000, or an annual minimum commission of $310,000, whichever was greater. Payment was to be made within 30 days of the end of the month. The debtor also agreed to reimburse SIU for employee wages and salaries and other incidentals (Stip. 103).

The debtor was to provide a surety bond in the penal sum of $310,000. The bond was procured from Lyndon, but the bond form itself was provided by SIU (Stip. 104, Exh. 30). The bond does not require that SIU notify Lyndon that the debtor failed to meet its obligations under the bond (Stip. 105). The language of the bond included Lyndon's agreement that no change or extension of time, or alteration or addition to the terms of the contract would affect its obligations on the bond. Lyndon also agreed to waive notice of any such changes or extensions (Stip. 106).

The debtor made the first and second monthly payments and payments for incidentals, and further paid for the value of SIU's beginning inventory in an amount exceeding $800,000 (Stip. 107). The debtor failed to make payments for the period August-October 2000. The debtor obtained architectural plans but never began construction of $650,000 in capital improvements to the bookstore. These capital improvements were to be completed on or before May 31, 2001 (Stip. 108).

On November 6, 2000, an SIU official e-mailed various employees of the debtor in regard to the withholding of payment of SIU's obligations for departmental billings until the debtor's failure to comply with the financial terms of the contract was addressed. Lyndon was not notified of, nor did it receive a copy of, this e-mail (Stip. 109; Exh. 31). The debtor tendered a check in the amount of $159,261 in December 2000 to cover its past due commissions and reimbursements (Stip. 110; Exh. 32). As of the date of filing of the debtor's petition it had not paid commissions for December 2000 or January or February 2001 (Stip. 111). SIU filed an unsecured claim for pre-petition damages in the amount of $129,272.96 (Stip. 113).

The contract between the debtor and SIU was rejected by order entered on May 4, 2001. At the time of rejection four years and less than a month remained on the initial term of the contract (Stip. 114). On May 2, 2001, SIU entered into a contract with Follett to take over operation of the bookstore. SIU did not consult with Lyndon regarding negotiations with Follett and contends it had no obligation to do so (Stip. 115, Exh. 33). The contract with Follett provides for commission payments to SIU of 9% of gross sales up to $3,500,000, 10% of gross sales between $3,500,000 and $5,000,000, and 11% of gross sales over $5,000,000, or a guaranteed annual payment of $250,000, whichever is greater (Exh. 33, 12).

D. Glenville State College

Glenville and the debtor entered into a contract for the debtor to operate Glenville's bookstore on June 9, 2000 (Stip. 2). Pursuant to the terms of the contract, the debtor was to pay Glenville an annual commission of 8.5% of gross sales up to $1,000,000 and 9.25% of gross sales over $1,000,000, or a guaranteed annual payment of no less than $75,000 (Stip. 4). The first date on which any monthly commission payment in the amount of $6,250 was due Glenville was August 21, 2000. The debtor failed to remit this or any other monthly payment (Stip. 10).

In addition, the debtor was required to purchase the inventory in place from Glenville at the time it took over operation of the bookstore. The debtor never tendered any payment for the inventory in place when it took over operation of the bookstore (Stips. 4 and 12). The debtor was also to reimburse Glenville on a monthly basis for certain payroll and other related expenses. These payments were never made (Stips. 4 and 11).

The debtor further agreed to expend up to $250,000 in capital improvements to the bookstore facility, with that amount being amortized over a ten year period on a straight line basis. In the event the relationship between the debtor and Glenville ended prior to the end of the ten year amortization period, Glenville or a subsequent operator was to pay the debtor the unamortized value as of that date (Stip. 5).

Glenville required the debtor, pursuant to the contract, to provide a performance bond in the principal sum of $75,000 which the debtor procured from Lyndon (Stips. 6 and 7; Exh. 3). The bond form was drafted by Glenville or the state of West Virginia on behalf of Glenville (Stip. 8). The bond provides that if Glenville declared a default Lyndon had the option of remedying the default, completing the contract or saving Glenville harmless from any claims, judgments or liens arising from Lyndon's failure to either remedy the default or complete the contract (Stip. 9). Scott Montgomery, Glenville's chief procurement officer, testified in a deposition that noone at Glenville wrote to the debtor seeking payment. Most communications with the debtor were verbal, and the debtor sent its regional operations manager to Glenville a few times to work out problems. Glenville contacted the debtor a minimum of a couple of times a week, but noone contacted the debtor before April 13, 2001 (Stips. 13 and 15; Exh. 4). Mr. Montgomery further testified that the debtor assured Glenville that payment would be made, and Glenville did not contact the debtor between the time of the first missed payment and the filing of the debtor's petition. Glenville focused instead on other issues concerning bookstore operations (Stip. 14; Exh. 4). Each of the debtor's failures to remit monthly payments for reimbursement of employee wages and salaries and other miscellaneous expenses constituted a failure of the debtor to satisfy its obligations under the contract. Glenville did not declare the contract in default and seek to exercise its remedies prior to the filing of the bankruptcy. Glenville instead tried to develop a long term relationship with the debtor (Stip. 16).

The debtor's failure to pay for the inventory after taking possession of and commencing to sell it constituted a failure to satisfy the debtor's obligations under the contract. Glenville did not declare the contract in default on account of this failure nor seek to exercise its remedies prior to the bankruptcy filing on February 28, 2001. Upon learning of the bankruptcy, Carl Rogers, a Lyndon claims administrator, investigated Lyndon's records and learned that Lyndon had issued bonds in favor of Glenville, SIU, EKU and Southern (Stip. 17). Glenville, through the Office of the Attorney General of West Virginia, sent Lyndon a letter dated April 13, 2001 (Stip. 19). Lyndon did not pay Glenville the $75,000 bond amount (Stip. 22).

On May 16, 2001, after an order was entered on May 4, 2001 terminating the bookstore contract with the debtor, Glenville entered into an operating agreement with Follett for it to take over the operation of the bookstore (Stip. 21). As a result of the debtor's defaults under the bookstore contract, it is indebted to Glenville for the following amounts: $320,546.94 for the purchase of the beginning inventory; $68,635.29 for commissions on sales from 7/1/00 to 2/28/01; $33,098.55 for bookstore employee wages from 7/1/00 to 2/18/01; $339.42 for telephone charges from 7/1/00 to 2/28/01; and $61,579.02 for post-petition and contract rejection damages (Stip. 24).

E. Other facts in evidence

Carl Rogers, a bond administrator for Lyndon, testified at the October 30, 2002 portion of the trial of this matter that he was aware of the debtor's bankruptcy filing in February 2001, but that the first time he became aware that Lyndon had bonds open on bookstore contracts held by the debtor was after receiving the March 22, 2001 letter from EKU's counsel. He further testified that he attended two bankruptcy court proceedings (TE 10/30/02, pp. 90-92). He also testified that he knew in April 2001 (probably by reading about it in the newspaper) that the debtor was liquidating its assets, but Lyndon took no steps in the bankruptcy case (TE 10/30/02, p. 93-94, 99-101). He turned the matter over to Mr. Burrows sometime in April 2001(TE 10/30/02, pp. 92, 94).

Charles Burrows, claims manager for Lyndon, testified on the same date that Lyndon was aware of the filing of the debtor's bankruptcy case in March or April 2001 (TE 10/30/02, p. 25). He testified that he did not know that Lyndon had any potential liability under the Southern bond until after Southern's counsel's letter of May 7, 2001 was received (TE 10/30/02, p. 159). He also testified that while he was aware that Carl Rogers believed that claims were inevitable on all five bookstore bonds, he did not necessarily draw the same conclusion (TE 10/30/03, p. 160).

Katherine Coleman, then EKU's general counsel, testified that after she sent the March 22, 2001 letter to Lyndon, she spoke with Carl Rogers by telephone. She recalled that their conversation must have been before the hearing on EKU's motion to accept or reject the contract as Mr. Rogers told her that he would attend that hearing. She testified that he attended that hearing; she saw him in the hallway and in the courtroom (TE 05/08/03, p. 57). The record in this case shows that this hearing took place on April 3, 2001.

5. Analysis and Conclusions of Law

A. Eastern Kentucky University

EKU maintains that it was damaged in the amount of $914,983.08 as a result of the debtor's bankruptcy, $700,000 of that amount being attributable to credit memos (TE 05/08/03, p. 16). EKU states that it owed the debtor $554,759.96 on the date of filing, making the balance of its loss $360,222.84. Aside from its argument concerning setoff below, Lyndon does not controvert these amounts. EKU did not consider the debtor to be in default after it made a payment of over $900,000 in January 2001. EKU notified Lyndon by letter of March 22, 2001 that the debtor had filed for bankruptcy and that it was making a claim on the bond posted by the debtor, and maintains that it has established its right to payment. EKU argues that Lyndon's refusal to pay based on its contention that EKU did not give the required notice of default is not supported by the facts or the law.

In a case cited by Lyndon, United Bonding Ins. Co. v. Sperry & Hutchinson Co., Ky., 465 S.W.2d 291 (1971), the court enunciated certain principles of suretyship, including that "[o]bligations imposed for the benefit of a paid surety will be construed most strongly against it." Id. at 293. The issue of reasonableness of the parties' actions is discussed in Simmons Const. Co. v. Powers Regulator Co., Ky., 390 S.W.2d 901 (1965), a case cited by EKU. There a subcontractor claimant on a contractor's bond had extended the time within which the contractor could pay for materials furnished. The compensated surety contended it was not liable on the bond, but the court found that a compensated surety is released in this instance "only to the extent that he is harmed by the extension [of time]." Id. at 904. The court went on to state:

As we view it, the dispositive factual questions ought to be not only whether the sureties were injured but, if so, whether . . ., the creditor, giving due regard to the interest of the sureties, acted reasonably in its efforts to collect from [the contractor]. The possibility that [the contractor's] position might worsen, or that it did, should be merely one of the circumstances bearing on the reasonableness of the creditor's conduct. It is well known in the business world that a debtor limping but still alive is likely to pay a better percentage than a sudden bankrupt.



Simmons Const. Co. v. Powers Regulator Co., 390 S.W.2d at 904. The court believes that it is necessary to consider the reasonableness of the parties' actions here as well.

Lyndon has argued that EKU should have given the debtor notice and opportunity to cure as soon as it became apparent that monthly commissions were not being paid in the summer of 2000, and further that EKU did not comply with the terms of the bond when it did not copy Lyndon on the demand letter it sent to the debtor in January 2001. The debtor made a substantial payment within several days of receiving the letter, and, as set out above, EKU accepted this payment in forbearance of its right to terminate the contract at that time. After the payment was made, EKU did not consider the debtor to be in default.

EKU's actions reflect its overriding concern in its dealings with the debtor, i.e., to keep the bookstore open so that goods and services could be provided to EKU students without interruption. In addition, up to that time, the debtor had the apparently well-deserved reputation of being one of the most successful college book companies in the country. It was not unreasonable for EKU to believe that it could work things out with the debtor, especially since bookstore operations never ceased, and for EKU not to make a claim on the bond until the debtor filed its bankruptcy case.

On the other hand, Lyndon became aware of the debtor's bankruptcy filing early on (possibly as early as February 2001 when the case was filed), according to the testimony of Carl Rogers. Aside from his informal attendance at a couple of hearings in the case, neither he nor any other representative of Lyndon took any steps to even gain any further information concerning this bankruptcy, although his attendance demonstrates a realization on his part that this bankruptcy case had significance for Lyndon. Lyndon, however, was apparently unaware that it had open bonds on the debtor's operation of the various college bookstores until the filing of the bankruptcy. Once Lyndon became aware that a principal it had bonded had filed a bankruptcy case, it appears to the court that it was incumbent upon Lyndon to get involved and take steps to protect its interests. To sit back and do nothing and later claim lack of notice released it from liability on its bond does not constitute reasonable conduct. Lyndon has cited Dragon Const., Inc. v. Parkway Bank & Trust, 678 N.E.2d 55, Ill. App. (1997) for the proposition that failure to give the surety notice of attempt to cure and hiring a successor without consulting the surety are material breaches of contract which render the bond null and void. The Dragon court held that the obligees' failure to give the surety the required seven-day notice of termination of the contract, and their hiring of a successor contractor before the surety received late notice (and without consultation with the surety) rendered the performance and labor and material bonds null and void. Id. at 58.

The matter at bar differs in several ways. While EKU did not copy Lyndon on its January 19, 2001 letter to the debtor, it also did not summarily terminate its contract with the debtor as the obligees did in Dragon. As a matter of fact, EKU agreed to forego the exercise of its right to terminate in return for the payment the debtor made in January 2001. While the obligees' action in Dragon may fairly be considered to be a material breach of their contract, the court does not agree that EKU's failure to provide Lyndon with a copy of the subject letter constitutes a material breach. See Simmons Const. Co., supra. EKU was satisfied with the debtor's response at that point, and intended to go on with the contract. Further, the replacement contract with B & N was worked out after Lyndon had notice of the debtor's bankruptcy filing, failed to become involved, and failed to take advantage of any opportunity to mitigate its damages. The court does not find Dragon to be dispositive of the notice issue.

Lyndon's primary argument in regard to EKU, however, is that it may take advantage of the setoffs existing between the debtor and EKU. Courts have consistently held that a surety to a bankruptcy debtor who has paid the debts of its principal may do so. See, e.g., Gluck v. Seaboard Surety Co. (In re E. Freight Ways, Inc.), 577 F.2d 175, 180 (2nd Cir. 1978); In re Yale Express Sys., 362 F.2d 111, 115 (2nd Cir. 1966). Pursuant to 11 U.S.C.  553, a creditor of the debtor retains any right it may have to offset a mutual debt owing by the creditor to the debtor that arose before the commencement of the case against a claim of that creditor against the debtor that arose before the commencement of the case. When a surety such as Lyndon seeks setoff, rather than a creditor such as EKU, the surety must demonstrate that there is mutuality between it and the debtor. In In re Larbar, 177 F.3d 439 (6th Cir. 1999), the court held that

. . .a surety who pays the debts of its principal (here the bankruptcy debtor Larbar) is entitled to step into the shoes of the creditor and assert the creditor's rights of setoff against the debtor in order to recover the payments the surety has made. (Citations omitted). Accordingly, [the surety] is able to step into the shoes of Incisa and the Commonwealth of Kentucky (the creditors) and to assert their rights to setoff the mutual profits and losses on their contracts with Larbar.

Because there were mutual obligations between the Commonwealth of Kentucky and Larbar, and because [the surety] can step into Kentucky's shoes and assert its right of setoff, the mutuality requirement of  553 as to this set of contracts is satisfied.



Id. at 446.



Lyndon contends that if the value of the inventory at the time of filing had been set off, as well as what was owed the debtor on the bookstore accounts as set out above, that the debtor would owe EKU nothing and Lyndon would have no liability. EKU responds that Lyndon makes its argument in the context of the status quo as of the date of filing, and does not account for the fact that when B & N took over operation of the bookstore after the court-ordered sale it purchased the inventory from the debtor. B & N also paid some $340,000 directly to the debtor toward the value of the unamortized improvements, thereby reducing the amount EKU owed on that account.

Rather confusingly, Lyndon argues in terms of the debtor's right to setoff. As set out above, it is the creditor, EKU in this instance, which retains a right to set off mutual debts in a bankruptcy. In any event, EKU has accounted for the amount it still owes the debtor, subtracting it from the amount owed by the debtor and thereby reducing EKU's claim against the bond. The court agrees with EKU's analysis of the setoff process, and concludes that Lyndon is liable on the bond in the amount of $360,222.84.

B. Southern University

Southern claims losses of $126,230.03 on its 1999 contract with the debtor, and contends that it should recover the full $60,000 amount of the bond on that contract. Southern also claims losses of $145,833.34 on its 2000 contract with the debtor, and contends that it should recover that amount from the $150,000 bond on that contract. Finally, Southern claims $146,459.41 for unpaid excess commissions for July 1, 2000 through February 28, 2001. Southern claims total losses of $433,106.05, although the sums set out above total $418,522.78. Since Southern does not explain the difference between these two figures, the court will take the latter as the correct amount.

Southern received a payment from the debtor in the amount of $72,916.70 by check dated January 18, 2001. The Liquidating Supervisor for the debtor, Bernard Katz, filed an adversary proceeding against Southern on February 3, 2003, alleging that this was a preferential transfer. On October 31, 2003, an agreed order of dismissal with prejudice was entered in that adversary proceeding pursuant to a settlement agreement allowing Southern to pay $57,500 in full satisfaction of the amounts demanded in the adversary complaint. Southern has therefore had the benefit of $15,416.70 of the amount the debtor paid on January 18, 2001. Further, Southern owed the debtor $129,480 at the time of the debtor's bankruptcy filing for the unamortized value of the capital improvements made under the 2000 contract, and $574,931 for the value of the bookstore inventory, for a total of $704,411. Follett purchased the bookstore fixtures for $129,480, the amount owed for the unamortized value of the improvements. It purchased the inventory for $574,931. Follett therefore paid the $704,411 that Southern owed the debtor.

Lyndon contends here, as it did against EKU, that it may take advantage of the setoff existing between Southern and the debtor. The court would apply the same analysis concerning the application of  553 and the requirement of mutuality. In addition, here, as with EKU, this argument only benefits Lyndon to the extent that the court agrees with it that Southern owed the debtor more than the debtor owed Southern. As set out above, once Follett paid the debtor the value of the bookstore inventory and the unamortized improvements, Southern no longer owed that amount. Southern's losses would be reduced, however, by the $15,416.70 it retained from the $72,916.70 preference claim it settled for $57,500, making its total loss $403,106.08. This amount is still greatly in excess of the sum of the amounts of the 1999 bond and the 2000 bond, $210,000. Southern also contends that it is entitled to attorney fees of 10% of its claimed loss pursuant to Louisiana statute. Neither the 2000 RFP, nor the 1999 and 2000 contracts and bonds provide for the recovery of attorney fees. Further, while it has been stipulated that the leasing process was conducted pursuant to Louisiana state law (Stip. 27), the contracts do not provide that they will be interpreted according to the law of Louisiana. It therefore does not appear that Southern should be able to recover attorneys fees.

As concerns the issue of notice, Lyndon's contentions are similar to those it advanced against EKU. Lyndon argues that Southern's failure to copy it on letters sent to the debtor on November 27, 2000 and January 16, 2001 was a material breach which exonerates Lyndon. Lyndon does not specify, but the court assumes it is referring to the 2000 bond. The court would apply the same reasoning as applied in regard to EKU. Lyndon would have to demonstrate that Southern acted unreasonably in failing to copy it on this letter and that it was harmed thereby, especially in light of Lyndon's failure to respond in any meaningful way to the filing of the debtor's bankruptcy.

The above-referenced letters do not communicate demands for cure so much as requests that the recipient investigate the matter of the unpaid commissions. Southern had a relatively long-term, ongoing relationship with the debtor that it hoped to keep going in order to assure the uninterrupted operation of the bookstore. It was not unreasonable for Southern to decline to declare a default at this time, and to treat the letters not as "notice and opportunity for cure" but as inquiries concerning a breach that did not rise to the level of default. Lyndon also argues that Southern never declared a default, a term of both contracts that was a prerequisite for recovery on the bond, but only made a request for payment several months after the bankruptcy was filed. In fact, the letter of May 7, 2001, from counsel for Southern to Lyndon does declare a default. Further, a letter from Carl Rogers dated May 15, 2001, acknowledges the May 7, 2001 letter as a notice of default. The court finds that Lyndon is liable in the amount of $210,000, the sum of the 1999 and 2000 bond amounts.

C. Southern Illinois University

SIU claims damages in the following amounts: $129,272.96 for unpaid prepetition commissions and expenses; $62,600 in commission differential for 2001-2002; $68,900 in commission differential for 2002-2003; $132,000 in commission differential for 2003-2005 (based on estimated sales); and $60,000 in capital expenditures differential, for a total of $452,772.96. SIU contends that Lyndon has breached the terms of and is liable under the bond in the penal amount of $310,000 issued on behalf of the debtor on a form provided by SIU. SIU takes the position that the indemnity bond covers all work, commission payments and capital investment and expenditures addressed in the bookstore contract, and further contends that the bond does not require any type of notice to Lyndon.

Lyndon maintains that the bond itself is a construction bond and only covers the work of remodeling the bookstore, referring to language in the bond which it claims supports its position, including:

The condition of the foregoing obligation is such, That, whereas the [debtor] has entered into a written contract designated as Purchase Order No. 19541-6483 . . . dated 06/02/00 with the Board of Trustees, Southern Illinois University for the performance of work designated as lease of University Bookstore, as specified, located at Southern Illinois University, Carbondale, Illinois in the state of Illinois, in conformity with the drawings, general conditions and specifications furnished by Southern Illinois University, which contract, drawings, general conditions and specifications are hereby referred to, and made a part thereof the same to all intents and purposes as if written at length herein.



The most remarkable thing about this language is that it clearly incorporates the terms of the contract between SIU and the debtor into the bond. In addition, while there are certain phrases that suggest that it addresses construction activity, the court finds it more significant that the bond identifies the "performance of the work designated as lease of University Bookstore." The debtor's lease of the bookstore, as set out in the contract, involved first and foremost the operation and management of the bookstore and the payment of commissions on bookstore sales, as well as making capital expenditures for improvements on the bookstore facility. The language of the bond, taken together with the language of the contract, makes it clear that the bond covers all activities addressed in the contract.

As regards the issue of notice, there is no requirement in the bond that SIU give Lyndon notice. Lyndon argues that because the contract requires SIU to give the debtor 30 days notice of failure to perform and opportunity to cure, and the contract is incorporated into the bond, that SIU was required to give Lyndon notice. It cites Dragon Const., supra in support of its position. As SIU points out, in that case there was a requirement in the bond that the surety be given notice. Dragon Const., Inc. v. Parkway Bank & Trust, 678 N.E.2d at 56. Here there is no requirement, either in the bond or in the contract incorporated into the bond, that the surety be given notice of failure to perform. There is no support for Lyndon's contention that it is exonerated on this bond for SIU's failure to take an action it was not required to take.

As concerns which of SIU's damages were intended to be covered by the bond, SIU argues that all required and discretionary expenses for operation of the bookstore are included as they are set out in the contract and RFP which are incorporated into the bond. Lyndon contends that the bond only covers basic commissions, inventory, and telephone and employment expenses, and not "secondary transactions." Lyndon also denies that SIU is entitled to be paid for the differential between the commissions and capital expenditures required by the contract with the debtor and those in the replacement contract with Follett.

In response SIU refers to various provisions of the contract and of the RFP which required the debtor to reimburse operational expenses to SIU, and to be responsible for expenses for items such as printing costs and other media, advertising, postage and special promotions. SIU goes on to state that in any event the $36,767.51 in "secondary transactions" disputed by Lyndon is included in SIU's claim for pre-petition expenses in the amount of $226,797.53. If the $97,524.57 setoff amount shown on its proof of claim (based on amounts due to the debtor from SIU) is applied first to the "secondary transactions," the amount representing those transactions can be eliminated from the bond claim, leaving a claim of $129,272.96 for pre-petition commissions and expenses covered by the bond.

As concerns the differences in commissions and capital expenditures, SIU contends that in order for Lyndon to avoid liability for them it would have to prove that they are not covered by the bond. SIU points out that on its face the bond protects against non-payment of commissions and capital investment over the term of the contract. SIU calculates the total to be $1,240,000 in commissions and $650,000 in capital investment requirements, based on the fact that over four years were left on the contract. By way of the replacement contract with Follett, SIU reduced its claim for future lost commissions to $263,5000 and its claim for lost capital investment to $60,000.

Lyndon argues that any difference in commissions and capital investment under the contract with the debtor and the replacement contract is not its responsibility since SIU negotiated the replacement contract without Lyndon's involvement. As has already been pointed out, Lyndon declined any opportunity to become involved in the process of finding replacement contractors for its principal, the debtor, despite its knowledge of the bankruptcy early on. There is simply no support for Lyndon's position in this regard.

Assuming that SIU was damaged by loss of commissions and capital investment, SIU and Lyndon disagree as to the measure of damages. SIU contends that the measure is the difference between the amounts called for in contract with the debtor and the replacement contract. Lyndon maintains that these differentials are too speculative in the case of commissions, and that they do not account for the amortization of the capital improvements, which makes the proper measure of damages in regard to the improvements the value of the property at the end of the amortization period.

Generally speaking, the measure of damages in a breach of contract action is the amount it would take to place the injured party in the same position it would have been if the contract had been performed. SIU offered evidence that its bookstore sales levels have consistently increased over the years, no matter who was operating the bookstore, and Lyndon did not controvert these figures. In Oakleaf of Ill. v. Oakleaf & Assocs., 527 N.E.2d 926, Ill. App. (1988), the court held that

[t]he amount of lost profits need not be established with absolute certainty; mathematical precision is not possible in calculating prospective profits. ... Nevertheless, recovery of profits cannot merely depend upon conjecture or speculation. ... Recovery can be obtained where criteria exist by which probable profits can be estimated with reasonable certainty or approximated by competent proof.


Id. at 933. It appears that the calculation of future profits that SIU would have realized under its contract with the debtor is not so speculative as to prevent it from recovering these amounts from Lyndon.

As for the $650,000 investment in capital improvements called for in the contract with the debtor, that investment is $60,000 less under the replacement contract. SIU contends that this is the proper measure of damages. T.J. Rutherford testified that the debtor never made any capital improvements to the bookstore. Rutherford further testified that after Follett completed its improvements, the major feature lacking was a new ceiling for the bookstore. He did not testify that a new ceiling would have cost $60,000, nor did he testify that there were $60,000 worth of improvements that SIU expected but could not be implemented under the replacement contract with Follett. Therefore, while it is tempting to simply identify the $60,000 difference in the promised investment in capital improvements and the investment that was received under the replacement contract as the measure of damages, it appears to the court that there is insufficient evidence in the record to demonstrate that SIU was damaged in this amount. Even without considering the $60,000, however, SIU's damages amount to $392,772.96, which is more than the bond amount of $310,000. It therefore appears to the court that Lyndon is liable on the total amount of its bond.

D. Glenville State College

Glenville claims damages in the following amounts: $320,546.94 for purchase of beginning inventory; $68,635.29 for commissions on sales from 7/1/00 to 2/28/01; $33,098.55 for unreimbursed wages of bookstore employees; $339.42 for unreimbursed telephone charges; and $61,579.02 for post-petition and contract rejection damages for a total of $484,199.22. This amount is greatly in excess of the bond amount of $75,000; Lyndon has not forfeited the bond to Glenville. Glenville argues that the plain language of the bond entitles it to be paid the proceeds.

The bond provides that once Glenville declares the debtor to be in default, Lyndon has two alternatives: remedy the default or complete the contract and hold Glenville harmless for any claims that arise because of failure to timely remedy the default. Glenville gave notice of default on April 13, 2001. Lyndon was aware of the debtor's financial situation before that, however, possibly as early as February 2001. Glenville argues that Lyndon's failure to act promptly effectively eliminated the alternative of completing the contract. Three weeks after Glenville gave notice of default, the contract between Glenville and the debtor was terminated by court order. Glenville entered into a replacement contract with Follett within two more weeks. Glenville argues that whatever remedies are still available require that it be paid the $75,000 bond amount.

Lyndon argues that it should be exonerated on the bond because Glenville did not give notice of the debtor's default in a timely manner. Glenville contends that its contract with the debtor did not require a declaration of default upon the first missed payment, and in any event it was not required to give notice of default to Lyndon because the bond has no notice provision. Glenville cites in support of its position Elkins Manor Assoc. v. Eleanor Concrete Works, Inc., 396 S.E.2d 463, W.Va. (1990) for the proposition that no notice is required where the bond does not provide for specific notice of default to the surety. Glenville's argument here seems to be addressing the sort of notice provision found in EKU's bond which required that simultaneous notice of breach and opportunity to cure be given to Lyndon. Glenville's bond does not have such a notice provision, but it does have a requirement that a default be declared before a claim can be made on the bond, as set out below.

Lyndon counters that the bond requirement that a declaration of default be made in order to trigger the surety's liability amounts to a notice provision. It cites in support of its position L & A Contracting v. S. Concrete Servs., 17 F.3d 106 (5th Cir. 1994). There the court ruled that where the obligee sent letters to the surety on a construction bond complaining of the principal's inadequate performance, but never declaring a default, such letters were insufficient to trigger the surety's liability where the bond required a "declaration of default." Id. at 111. The performance bond obtained by the debtor in regard to the operation of Glenville's bookstore also has a provision requiring a declaration of default, as do all the bonds at issue here, and Glenville made such a declaration on April 13, 2001.

In regard to Lyndon's contention that Glenville should have made a declaration of default much earlier than it did, the court's reasoning in L & A Contracting, supra appears to be even less supportive of Lyndon's position. In the course of analyzing the sufficiency of the obligee's declaration of default, the court discussed the difference between "breach" and

. . .the legal nature of the 'default' that is required before the obligee's claim against the surety matures. Although the terms 'breach' and 'default' are sometimes used interchangeably, their meanings are distinct in construction suretyship law. Not every breach of a construction contract constitutes a default sufficient to require the surety to step in and remedy it.



L & A Contracting, Inc. v. S. Concrete Servs., 17 F.3d at 110. Lyndon appears to take the position that any and every instance of a possible breach by the debtor should have been interpreted by Glenville as a default requiring a declaration of such to the surety. As L & A Contracting makes clear, however, breach and default are not necessarily the same thing. Similarly, giving notice of breach and opportunity to cure, and making a declaration of default are not the same thing. Finally, the fact of Lyndon's knowledge of the debtor's bankruptcy filing at a very early stage weakens any arguments it has regarding notice. The court agrees with Glenville's position, and finds that Lyndon is liable on its bond in the amount of $75,000.

E. Summary and conclusion

The court has determined after examining all the record in this matter than Lyndon is liable on its bonds in regard to each of the college defendants. Lyndon made various arguments regarding notice, all of which are adversely impacted by the fact of its knowledge of the debtor's bankruptcy filing soon after it occurred. Apparently Lyndon did not even know that it had written bonds for the debtor until after the filing. In the face of the hundreds of thousands of dollars worth of bonds involved, Lyndon's lack of awareness of its own commitments is difficult to understand.

Lyndon downplays the effect of the bankruptcy on the colleges' ability and opportunity to engage in "self-help." Once the bankruptcy was filed, the colleges were subject to the requirements of the Bankruptcy Code as expressed by orders of the court. Lyndon's contention in response is that the colleges should have declared defaults long before the debtor ever filed. These arguments concerning when the colleges should have declared defaults seem many times to confuse breach of contract with default. They do not recognize the concept of varying degrees of breach and the fact that not every breach requires a declaration of default. As stated above, it was not unreasonable for the colleges to forego declarations of default and termination of contracts in attempts to work things out with the debtor. At the times involved, the debtor's protestations of cash flow problems were believable. The fact is that the debtor experienced a shocking and catastrophic financial failure which it could not survive. In the face of this reality, Lyndon chose not to take any steps to protect itself. The colleges should not have to pay the price for Lyndon's failure.

An order in conformity with this opinion will be entered separately.


Copies to:


Attorney(s) for the plaintiff

Attorney(s) for defendant Eastern Kentucky University

Attorney(s) for defendant Southern University

Attorney(s) for defendant Southern Illinois University

Attorney(s) for defendant Glenville State College