IN RE: ENVIRONMENTAL HEALTH RESEARCH CASE NO. 96-50197

UNITED STATES BANKRUPTCY COURT

EASTERN DISTRICT OF KENTUCKY

LEXINGTON

IN RE:

ENVIRONMENTAL HEALTH RESEARCH CASE NO. 96-50197

& TESTING, INC.

DEBTOR

MEMORANDUM OPINION

This case was heard by the court on December 20, 1996 on the motion of the "debtor" for an order authorizing the "debtor" to pay professional fees and expenses of counsel for the "debtor" previously allowed.

Upon the commencement of this case on February 6, 1996 the debtor became a debtor in possession with the powers and the "duties" of a trustee as set out in 11 U.S.C. 1106. See also 11 U.S.C. 1101(a)(1), 1107. The interim fee application before the court is for compensation for professional services rendered and expenses incurred subsequent to the commencement of this case. Consequently, the motion before the court is made by the debtor in possession in its capacity as trustee of the assets of the debtor.

Prior to the commencement of this case the debtor paid its attorneys, Bowles, Rice, McDavid, Graff, Love & Getty, $64,000 for previous services and to secure payment of fees allowed by the court. See Statement of Attorney for Petitioner Pursuant to Bankruptcy Rule 2016(b) filed April 29, 1996; Item 9 of Statement of Financial Affairs to debtor's petition.

On February 15, 1996 the debtor in possession made application to employ Richard M. Francis and C. Thomas Ezzell of the firm of Bowles, Rice, McDavid, Graff, Love & Getty as counsel. The application stated that the debtor contemplates using the services of Richard M. Francis, C. Thomas Ezzell, Julia A. Chincheck and Douglas L. Davis in this case. The qualifications of the four attorneys are set out in the application. There was no indication in the application that services were to be performed by Mr. Getty and there is no listing of his qualifications.

On February 23, 1996 the court approved the employment of Richard M. Francis and C. Thomas Ezzell and the firm of Bowles, Rice, McDavid, Graff, Love & Getty as counsel for the debtor in possession, effective as of February 15, 1996.

From the outset of this case there was considerable disagreement between the debtor in possession and Bank One, Lexington NA, for itself and as agent of National City Bank, Indiana, a participant with Bank One in a loan to the debtor (the "Banks"), over the right of the debtor in possession to use cash collateral. The law prohibits a trustee/debtor in possession from using monies subject to a security interest (cash collateral) unless the secured party consents or the court, after notice and a hearing, authorizes such use. 11 U.S.C. 363(c)(2).

Following a hearing on March 22, 1996 on the objection of the Banks to the use of cash collateral by the debtor in possession the parties submitted an agreed order for interim use of cash collateral by the debtor in possession pending a final hearing on the matter. This order was entered by the court on March 27, 1996. Following a continued hearing on May 9, 1996 the parties submitted a second agreed order permitting use of cash collateral by the debtor in possession until September 30, 1996. The latter order, which was entered by the court on May 10, 1996, acknowledges that both the Bank One Debt and the Bank One Shared Debt are secured by a first priority security interest in cash collateral, including rents generated from operation of the laboratory building located in the Research Triangle Park in Durham, North Carolina, and the proceeds of debtor's contract for the performance of certain environmental-related services at Otis Air Force Base in Massachusetts. The debtor in possession was authorized to use cash collateral to make payment of "all actual and necessary expenses incurred in the ordinary course of business" in accordance with a Budget reflecting the anticipated receipt and use of cash on a weekly basis. Neither the Budget nor the agreed order contain any provision or agreement permitting use of cash collateral for payment of fees and expenses of counsel for the debtor in possession.

On July 31, 1996 the debtor in possession made application for employment of Charles Greteman and the accounting firm of Deloitte & Touche, LLP, Des Moines, Iowa as its tax accountant to prepare the debtor's tax returns for 1995 and for subsequent years during the course of its chapter 11 reorganization case. An order permitting employment of these accountants was entered August 12, 1996. The extent of the services this accounting firm has provided and the compensation it may seek for such services is not apparent from the record.

On August 14, 1996 Bowles, Rice, McDavid, Graff, Love & Getty filed an interim fee application for compensation for services rendered and expenses incurred from February 5, 1996 (the day before the commencement of this case) through June 30, 1996. The application requested compensation in the amount of $66,079 and reimbursement of expenses in the amount of $5,904.28. The application acknowledges that prior to the filing of the petition the debtor paid to the law firm the sum of $64,000 from which the firm had drawn down $25,951.04 for legal fees and associated expenses as they accrued prepetition, and that $38,048.96 remained on hand to secure payment of fees and expenses allowed by the court in this case.

A hearing was held on this interim fee application on September 13, 1996 on notice to all creditors and parties in interest. At this hearing the Banks, by counsel, did not object to the amount of the fee application, but did object to payment of any portion of the fee from cash collateral. While the court had some reservations about the amount of the fee, particularly the charges of Mr. Getty at the rate of $200 per hour, a higher rate than any other member of the firm, often for interoffice conferences (talking to other members of the firm about the case), the court nevertheless approved the interim fee application and authorized the firm to apply the balance of its $38,048.96 retainer to the fee. The court did not authorize payment of the remaining portion of the fee from cash collateral.

The principal remaining asset of the debtor at the time of commencement of this case was an office building located in Research Triangle Park at Durham, North Carolina. The property is encumbered by several liens. Certain laboratory equipment inside the building was separately encumbered.

The Banks (Bank One, Lexington NA and National City Bank, Indiana) held a valid first priority deed of trust lien against the property to secure payment of an indebtedness of $5,712,000.

Bank One, Lexington NA held a valid second priority deed of trust lien against the property to secure payment of an indebtedness in the amount of $681,279.10, representing the aggregate amount of certain outstanding letters of credit.

The Environmental Protection Agency (the "EPA") had placed a lien on the property to secure payment of a fine in the amount of $1,000,000 imposed when the debtor pled guilty to an information charging it with attempted bribery of an EPA official. The balance owed on the lien of EPA on the debtor's office building when bankruptcy intervened was approximately $980,000.

Additionally, there was a lien on the property to secure payment of $140,000 in real estate taxes which the debtor owed for 1994, 1995 and 1996.

In addition to the foregoing liens on the real property, the CIT Group, Equipment Financing, Inc. held a lien on certain laboratory equipment inside the building to secure payment of $878,192.20, representing the balance due on a master equipment lease. Norwest Financial Leasing, Inc. held a lien on equipment generally described as laboratory rack washer and sterilizer installed in the building. The Norwest lien on this equipment secures the balance due on an equipment lease in the approximate amount of $130,000. There was evidence that this equipment could not be removed without significant damage to the building. Carolantic Bank was owed approximately $48,000 on leased equipment located in the building. The debtor had defaulted on payments on all of these leases as well as on payments on mortgages on real estate. According to the schedules to the petition approximately thirteen lawsuits were pending against the debtor, including the action by Bank One, Lexington NA for itself and National City Bank, Indiana to foreclose on the building in Research Triangle Park.

The Banks' foreclosure action was commenced in September 1995 after the debtor had reneged on the terms of a forbearance agreement pursuant to which the property was to be sold no later than August 31, 1995. Upon commencement of the foreclosure action the General Court of Justice, Superior Court Division of Durham County, North Carolina appointed as receiver Equity and Investors Management Corp. to take possession of and operate the property. The receiver was appointed September 19, 1995 and took possession of the property on September 20, 1995. This was more than 120 days before the debtor filed for relief under chapter 11 of the Bankruptcy Code on February 6, 1996. The sale of the property in the state court foreclosure action was delayed by the discovery of hazardous materials that had been left on the property by a former tenant. These materials were disposed of by the receiver at a cost of approximately $44,000, after which the foreclosure sale was rescheduled. The sale was then stayed by the commencement of this bankruptcy case. On these facts the state court receiver was not required to surrender possession of the property to the debtor in possession. 11 U.S.C. 543(d)(2). The property has remained in the care, custody and control of the state court receiver since the commencement of this bankruptcy case. At the hearing on the motion of the debtor in possession for authority to pay the balance due on the interim award of fees and expenses of counsel, no evidence was presented to indicate the debtor in possession incurred any costs or expenses in preserving or disposing of the North Carolina property that resulted in any benefit to the Banks. Indeed, the actions of the debtor in possession in delaying foreclosure have thus far been detrimental rather than beneficial to the Banks.

The contract for the environmental cleanup at Otis Air Force Base in Massachusetts was being performed by a subcontractor, McLaren/Hart Environmental Engineering Corporation, which is asserting a postpetition administrative expense claim of $365,612.86 for work done in completing the contract.

Following a four-day trial held on September 20, 21, 23 and 24, 1996 on the motion of the Banks for relief from stay in order that the state court foreclosure action against the debtor's building in Research Triangle Park at Durham, North Carolina might proceed, the court granted relief from stay. The court granted relief from stay on two grounds: (1) for cause, and (2) because the debtor had no equity in the property and the property was not necessary to an effective reorganization of the debtor. The court's findings of fact and judgment granting relief from stay were entered on October 8, 1996. This court refused to stay the judgment pending appeal.

The district court, following a hearing, did grant a stay pending appeal, apparently upon representations of counsel for the debtor in possession that the banks were adequately protected by the guarantee of their indebtedness by the president and sole shareholder of the debtor, Pritam S. Sabharwal, and his wife Jean D. Sabharwal. See Order of the District Court entered November 21, 1996.

At the trial before the bankruptcy court the debtor did not plead or offer any evidence of the Sabharwal's personal wealth as a defense to the Banks' motion for relief from stay. The evidence before the court, hereinafter discussed, indicates the Sabharwals are insolvent. Moreover, in this instance, relief from stay was granted for cause, other than lack of adequate protection, based on mismanagement and misconduct of Dr. Sabharwal, one of the third party guarantors.

During the hearing on December 20, 1996 concerning whether the debtor in possession should be authorized to pay from cash collateral the balance due on the interim award of fees and expenses of counsel, the parties announced they had that morning entered into an agreement on the basis of which the stay pending appeal had been dissolved and the property in North Carolina had been sold at foreclosure and had been purchased by the Banks. The agreement between the parties was described as confidential and was not introduced into evidence. The parties represented that under the terms of the agreement Dr. Sabharwal, as assignee or designee of the debtor, was allowed 120 days to redeem the property for $4.5 million, upon the occurrence of which, the Banks would forgive the balance of the indebtedness, approximately $1.8 million owed by the debtor and the Sabharwals, and the debtor in possession would be permitted to retain approximately $350,000 of the $700,000 in cash collateral accumulated since the commencement of this case, which sum apparently would then be available for payment of administrative expenses of this case, including perhaps some portion of the fees and expenses of counsel for the debtor in possession. The accumulated cash collateral is proceeds of payments for work done at Otis Air force Base by the unpaid subcontractor, McLaren/Hart. Counsel for the Banks pointed out that under the agreement the release of the $350,000 is not to occur until Dr. Sabharwal redeems the North Carolina property by paying the Banks $4.5 million within 120 days. Moreover, the $350,000 is less than the amount of McLaren/Hart's postpetition administrative expense claim which, while disputed, is unresolved.

The evidence at the trial before this court on the motion of the Banks for relief from stay revealed that in connection with the loan made by the Banks to EHRT the Sabharwals had given the Banks a financial statement indicating a net worth of $65,267,589, of which $60,000,000 was attributed to the value of stock owned in EHRT and $6,335,821 was attributed to a note receivable from EHRT. See the Banks' Exhibits 5 and 6. The stock of EHRT is now worthless, as is the note receivable from EHRT. The assets of the Sabharwals now consist primarily of real estate holdings other than the Research Triangle Park building, which belonged to EHRT. The aforementioned Exhibits 5 and 6 also show that the Sabharwals owe $8,796,766 in notes payable to banks, primarily to Bank One and that they have very little equity in the real estate they own. Thus the Sabharwals appear to have a deeply negative net worth. Counsel's representation at the hearing before the District Court on EHRT's motion for a stay pending appeal that the Banks are adequately protected by the personal wealth of the Sabharwals is contrary to the evidence in the record on appeal in this case. The Banks' Exhibits 5 and 6 were made available to counsel for the debtor in possession prior to trial in the Bankruptcy Court. Consequently, counsel's representations to the District Court concerning the personal wealth of the Sabharwals was inexcusably and recklessly negligent or knowingly false.

The aforementioned Exhibits No. 5 and 6 also reveal that in 1994 after EHRT had been fined for attempted bribery of an EPA official and barred from receiving further contracts with EPA, which contracts had been the source of approximately 80% of EHRT's income, EHRT conveyed to Dr. Sabharwal individually two tracts of real estate in California in which EHRT had an interest valued at $1,260,705. For income tax purposes the Sabharwals treated this transfer to Dr. Sabharwal as a non-cash dividend from the corporation. These exhibits also indicate that in 1993 Dr. Sabharwal received another dividend in the amount of $4,628,000 from EHRT, of which $3,025,000 was in the form of forgiveness of a debt he owed to EHRT.

EHRT as debtor in possession (trustee) and counsel for the debtor in possession have a fiduciary duty to investigate the propriety of the foregoing transfers of property from the debtor corporation to Dr. Sabharwal. It seems evident that with Dr. Sabharwal in charge of the debtor in possession and counsel operating under his direction they are unlikely to pursue or institute any action to avoid these transfers or recover the California properties for the debtor's estate. Instead, it is apparently their game plan to sell or further leverage the California properties to obtain funds to redeem the North Carolina property and to relieve the Sabharwals individually from the deficiency indebtedness to the Banks resulting from the foreclosure on the North Carolina property. Such a course of action is not consistent with the fiduciary obligations of counsel for the debtor in possession or EHRT as debtor in possession to protect the interests of all general creditors of the debtor. If the California properties are sold or further leveraged before the propriety of the transfer of the properties from the debtor to Dr. Sabharwal is investigated, the recovery of these properties for the benefit of the general creditors of EHRT may become impossible. It is for this reason that the court views the delay in converting this case to a case under chapter 7 as detrimental to the general creditors of the debtor other than the Banks. The purpose of this case was to rehabilitate the debtor EHRT which now obviously is impossible; the case should not be used as a vehicle for the rehabilitation of the Sabharwals, at the expense of the general creditors of EHRT.

In any event, ordering payment of any further fees to counsel for the debtor in possession from cash collateral at this time on the basis of the record before the court would be highly improvident.

CONCLUSIONS OF LAW:

The only applicable provision of the Bankruptcy Code is 11 U.S.C. 506(c) which permits the trustee (debtor in possession) to recover from property securing an allowed secured claim the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim.

It is settled law that cash collateral (monies subject to a security interest) cannot be invaded to pay administrative expenses of a bankruptcy case absent consent of the secured party or proof that the expenses in some manner benefited the secured party. In re New England Carpet Co., 744 F.2d 16 (2d Cir. 1984); In re Flagstaff Food Service Corp., 739 F.2d 73 (2d Cir. 1984); Matter of Trim-X, Inc., 695 F.2d 296 (7th Cir. 1982).

There is little doubt that the Banks' prepetition security interest in the debtor's accounts receivable continued postpetition. 11 U.S.C. 552(b)(1).

The debtor in possession has not made a case at this time for payment of the fees in question from cash collateral in which Bank One and National City Bank, Indiana hold a valid perfected security interest.

There is simply no evidence that the actions of counsel for the debtor in possession have in any manner thus far benefited the Banks. Indeed, at the hearing on the motion before the court Mr. Getty argued only that his efforts had benefited the debtor and the Sabharwals. He did not explain how his efforts had benefited the debtor and avowed he did not represent the Sabharwals.

Secured creditors are not required to pay administrative expenses that benefit only the debtor, officers or shareholders of the debtor, or other creditors. There must be a showing that the administrative expenses benefited the secured creditor who is asked to bear the expenses.

Dated:

By the court -

 

_____________________________

JOE LEE, CHIEF JUDGE

 

Copies to:

 

Richard A. Getty, Esq.

David Faughn, Esq.

Richard M. Francis, Esq.

John Sawyer, Esq.

Gregory A. Schaaf, Esq.

Susan Hoffman, Esq.

Elizabeth Brittain, Esq.

 

 

UNITED STATES BANKRUPTCY COURT

EASTERN DISTRICT OF KENTUCKY

LEXINGTON

 

 

 

 

IN RE:

 

ENVIRONMENTAL HEALTH RESEARCH CASE NO. 96-50197

& TESTING, INC.

 

DEBTOR

 

 

ORDER

 

 

In conformity with the memorandum opinion of the court this day entered, IT IS ORDERED that the motion of the debtor in possession, Environmental Health Research & Testing, Inc., for an order authorizing it to pay previously allowed professional fees and expenses of Bowles, Rice, McDavid, Graff, Love & Getty, counsel for the debtor in possession, is denied.

Dated:

By the court -

 

____________________________

JOE LEE, CHIEF JUDGE

 

 

Copies to:

 

Richard A. Getty, Esq.

David Faughn, Esq.

Richard M. Francis, Esq.

John Sawyer, Esq.

Gregory A. Schaaf, Esq.

Susan Hoffman, Esq.

Elizabeth Brittain, Esq.