Contributed by Charlie Chen
In the United States Supreme Court’s plurality opinion in Hamdi v. Rumsfeld, Justice O’Connor wrote that “a state of war is not a blank check for the President when it comes to the rights of the Nation’s citizens.” Just as a wartime President does not have a blank check to displace the constitutional rights of citizens, a creditor in bankruptcy court, even one ostensibly holding the equivalent of a blank check, does not have the right to assert an unreasonable claim against a debtor’s estate.
Granted, a state of war is a much graver situation than being in bankruptcy and the rules governing the relationship between our Nation’s citizens and the President differ in many ways from a debtor and its creditors. Nevertheless, the court’s decision in In re Sunnyland Farms, Inc. reminds us that a creditor’s proof of claim must be supported by sufficient evidence, even if the creditor was given the equivalent of a blank check from the debtor.
In In re Sunnyland Farms, Inc., the United States Bankruptcy Court for the District of New Mexico considered the debtor’s objection to a proof of claim filed by a creditor (“Capussi”) which included as evidence a security agreement signed by the debtor in the purported amount of $2 million. The court heard opposing testimony from (i) the debtor’s principal (“Stockwell”) who testified that he gave Capussi a signed blank security agreement based upon the understanding that the parties would “figure out” later how much was actually owed and (ii) the creditor, Capussi, who claimed that Stockwell had given him a signed blank security agreement and said “whatever you need Jerry, write it in there,” whereupon Capussi inserted $2 million as the amount owed and Stockwell did not object.
After hearing the testimony from both parties, the court sustained the debtor’s objection to Capussi’s proof of claim and reduced the allowed claim to $108,000. In its decision, the court determined that the debtor successfully challenged the prima facie validity of Capussi’s proof of claim and Capussi failed to carry his burden of persuading the court that his proof of claim should be allowed in full.
The debtor was a New Mexico corporation that acquired assets of another company in 2003, which included greenhouses in New Mexico. Capussi was a neighbor of Stockwell and had been in the greenhouse farming business for many years. Around the time of the debtor’s acquisition, Stockwell approached Capussi and requested assistance in starting a greenhouse business in New Mexico. While Capussi initially did not want to become involved, he ultimately assisted the debtor in its greenhouse business, including helping with business plans, talking to potential vendors, traveling to New Mexico, providing meeting facilities, finding an expert witness for litigation matters, and attending several settlement mediations. Despite working on the debtor’s greenhouse business for several years, the parties did not have an agreement, written or oral, about how the debtor would compensate Capussi for his efforts.
Shortly after the debtor’s acquisition closed in 2003, one of the debtor’s employees inadvertently started a fire at one of the greenhouses. The debtor was unaware that the electricity to the greenhouse had been shut off by the Central New Mexico Electric Cooperative (the “CNMEC”), and, thus, water could not be pumped to fight the fire and the greenhouse was destroyed. The fire devastated the debtor financially and its operations were halted between 2003 and the petition date. In 2005, the debtor commenced a lawsuit in state district court against CNMEC, alleging that the utility wrongfully disconnected the debtor’s electricity service. After a bench trial, the state district court awarded the debtor approximately $22 million in damages. CNMEC subsequently appealed the judgment.
In the interim, the debtor attempted to address its obligations to a number of creditors. Stockwell requested his attorney to prepare form security agreements that were provided to the debtor’s primary unsecured creditors. The stated intent was to provide some assurance to these creditors that they would be repaid once the appeals process had run its course. In most cases, Stockwell met in person with each creditor and mutually agreed upon the amount of indebtedness. The amount was then written into the form security agreement and signed by Stockwell. However, Capussi’s security agreement was handled differently. While it was not disputed that Stockwell had met personally with Capussi to discuss the security agreement, conflicting testimony was offered as to what occurred at that meeting.
Specifically, Stockwell testified that he left the blank security agreement with Capussi based upon the understanding that an “accounting” of some kind would be used to later determine the amount owed. Stockwell testified that he did not authorize Capussi to insert $2 million into the security agreement. Furthermore, Stockwell testified that Capussi cannot use his right arm so that it would have been more likely that he, rather than Capussi, would fill in the amount of indebtedness. In contrast, Capussi testified that Stockwell provided the signed blank security agreement and stated “whatever you need Jerry, write it in there.” Capussi further testified that he wrote in $2 million during the meeting and showed that amount to Stockwell who did not raise any objections.
Relying upon the plain language of section 502(a) of the Bankruptcy Code, Rule 3001(f) of the Federal Rules of Bankruptcy Procedure, and the controlling case law on the burden of proof requirements for claim objections, the court concluded that the debtor had successfully challenged the prima facie validity of Capussi’s proof of claim and Capussi failed to carry his burden of persuading the court that his proof of claim should be allowed in full.
As an initial matter, the court considered and dismissed Capussi’s hearsay objection to Stockwell’s testimony regarding what he said to Capussi at the meeting where Stockwell presented the security agreement. The court overruled Capussi’s hearsay objection because Stockwell’s testimony was to provide completeness or context, and not to prove the truth of the matter asserted. Specifically, the court determined that Stockwell’s out-of-court statements to Capussi provided context for Capussi’s statements to Stockwell (testified to by Stockwell and Capussi, without objection). Without this context, the court believed that the evidence of what was said at the meeting would be one-sided and of limited use. Consequently, the court admitted Stockwell’s testimony for completeness or context, and not for the truth of the matters asserted.
Next, the court found that the debtor had carried its initial burden of challenging Capussi’s proof of claim. The court noted that Capussi’s properly filed proof of claim constituted prima facie evidence of the validity and amount of his claim against the debtor. However, the court believed that the debtor also satisfied its burden to provide evidence of equal probative force to overcome this prima facie evidence. The court cited several factors in its analysis, including:
- Capussi’s out-of-pocket advances and expenses were less than 5% of the $2 million claimed in October 2008;
- The parties did not have an agreement regarding how Capussi was to be compensated;
- For the other creditors that received security agreements, the debt amounts were much smaller and appeared to be rationally related to amounts owed;
- Capussi was not able to articulate why the debtor would agree to a debt of $2 million;
- For such a large debt amount, it appeared logical to the court that Capussi would insist on Stockwell initialing the hand-written amount;
- Stockwell testified that the security agreement had no debt amount filled in when he left Capussi’s offices;
- In 2012 Capussi asked if he could tell his bankers the debtor owed him $2 million, and Stockwell said no.
The court then analyzed whether Capussi had carried his final burden of persuasion as to the validity of his proof of claim, and concluded that he had not. Specifically, the court emphasized that Capussi’s only evidence to support the amount asserted in his proof of claim was the security agreement and his own testimony. The court could not find independent evidence which showed that Capussi was owed the full amount of his proof of claim or that Stockwell had agreed to such an amount. In addition, Stockwell provided uncontradicted testimony that the security agreements with other creditors included his signature or initials next to the hand-written debt amount. This testimony was further supported by a review of the proofs of claim filed by other creditors.
In addition, the court chided Stockwell and Capussi for their conduct which gave rise to the underlying dispute. Specifically, the court noted that “neither the Debtor nor Capussi observed any of the normal business formalities usually associated with a substantial debt.” Specifically, Stockwell was “foolish to leave what was essentially a blank check with Capussi. Capussi was foolish to work for years on the New Mexico greenhouse project with no agreement how he would be compensated, and then to fill in by hand the $2 million debt figure, without getting Stockwell to initial the hand-written amount.” Although the court believed that neither party was blameless, the court concluded that Capussi had the ultimate burden of presenting evidence as to the amount owed by the debtor. The court found that Capussi had failed to do so, and, thus, he was unable to carry his burden of persuasion.
The decision in Sunnyland serves as a useful reminder of the importance of properly documenting the specific terms of a business relationship, including compensation, at the onset of a new venture to avoid disputes down the road when financial difficulties arise. It is also worth repeating that a debtor should never give a creditor a signed security agreement with the amount of secured indebtedness left blank. Doing so can lead to misunderstandings between the debtor and creditor regarding the amount of secured indebtedness, which is precisely what happened in this case. Stockwell and Capussi could easily have avoided the whole dispute if they had properly documented in writing the terms of their business relationship at the beginning of the debtor’s operations, including how Capussi would be compensated for his efforts. In addition to making the parties obligations to each other clear and unambiguous, a written agreement could have provided a methodology for Stockwell to calculate the amount owed to Capussi (and Capussi would not have been given the equivalent of a blank check).