Escala, LLC

UNITED STATES BANKRUPTCY COURT
DISTRICT OF NEW MEXICO
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06/10/06
Escala, LLC
04-17376
Memorandum Opinion on Credit Bid Rights.
Received on: 2005-03-08 15:51:40.000
2005-03-08 00:00:00.000
2005-03-08 00:00:00.000
James Burke
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UNITED STATES BANKRUPTCY COURT
FOR THE DISTRICT OF NEW MEXICO
In re:
ESCALA, LLC,
Debtor. No. 7-04-17376 SA
MEMORANDUM OPINION ON CREDIT BID RIGHTS
BACKGROUND
On October 8, 2004, one creditor filed an involuntary
petition against Escala, LLC (“Escala” or “Debtor”) (doc. 1).
On November 4, 2004, Escala filed a Motion to Convert Case to
Chapter 11, with the approval of the sole petitioning creditor
(doc. 18). The Court entered a stipulated order on the same
day granting the motion and ordering that it constituted the
Order for Relief under chapter 11 of the Bankruptcy Code (doc.
19).
Debtor’s assets (“Assets”) include a hotel and land in
downtown Albuquerque, New Mexico, fixtures and improvements, a
liquor license, furniture, equipment, inventory, supplies,
trade names and intellectual property, contracts, leases,
books and records and other assets. Debtor was operating at a
substantial loss. Based on Debtor’s business judgment, it
began negotiations to sell substantially all of the Assets at
an auction to be conducted in February or March, 2005. Debtor
filed a motion (doc. 60) on November 23, 2004, seeking
approval of the process. After notice and a hearing, the
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Court entered an Order approving the motion on December 17,
2004 (doc. 111)(the “Auction Order”).
Because various creditors claimed liens on some of the
Assets, paragraph 7 of the Auction Order established a
procedure for credit bidding at the auction:
The Court approves the following Credit Bid Rights
Procedure:
a. Any party in interest that objects to a creditor holding
a claim secured by a lien against any of the Assets (a
“Holder”) bidding at the Auction and offsetting its
secured claim against the purchase price, as specified
under Bankruptcy Code §363(k) (“Credit Bid Rights”),
shall have until the date that is the later of fifteen
(15) days after entry of this Order or January 6, 2005 to
object to a Holder exercising Credit Bid Rights at the
Auction.
b. A Holder shall have the right to exercise Credit Bid
Rights at the Auction if no timely objection is filed
pursuant to subsection (a) above.
c. If a timely objection is filed pursuant to subsection (a)
above (the “Objection”), unless the Holder disclaims an
interest in exercising Credit Bid Rights, the Court will
set a preliminary hearing on the Objection to take place
within approximately twenty (20) days after entry of this
Order, as the Court calendar permits, and will enter
appropriate orders to expedite discovery so that a final
hearing may be held at least (10) business days before
the Auction to hear and determine the Objection.
d. At or following such final hearing, but before the date
of the Auction, the Court will estimate the claim to
which an Objection was filed for purposes of allowance,
pursuant to Bankruptcy Code §502(c), to determine the
amount of the allowed claim that may be credit bid. Such
claims estimation will include determination of any
objection to allowance of a claim to be credit bid (i)
that the claim should be equitably subordinated, (ii)
that the lien securing the claim should be avoided in
whole or in part, (iii) that the debt upon which the
claim is based should be recharacterized as equity, or
(iv) on any other grounds contesting the extent, amount,
validity, priority or avoidability of the claim or any
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liens securing the claim. Such claims estimation shall
be a binding, final determination for all purposes in
this bankruptcy case, including with respect to
distribution of estate assets to the Holder on account of
its secured claims. Such claims estimation may be
conducted by contested matter under Bankruptcy Rule 9014,
and need not be adjudicated in an adversary proceeding.
THE MATTER BEFORE THE COURT
This matter is before the Court on the Motion of Dirk
DePree to Determine Allowance and Amount of Claim (doc. 119,
Jan. 3, 2005). Dirk DePree appears through his attorneys
Lewis and Roca, LLP (Robert H. McKirgan) and Lewis and Roca,
Jontz, Dawe, LLP (R. Thomas Dawe). Briefly, Dirk DePree seeks
a determination that he has Credit Bid Rights pursuant to his
proof of claim in the amount of $1,001,749.00 for his secured
claim on Escala’s Assets. As discussed in detail below, his
secured claim resulted from his personal guarantee of Escala’s
debt to Bank 1st, which holds a first mortgage lien on the
Assets; Bank 1st collected on the guarantee.
Also before the Court is the Unsecured Creditors
Committee’s (“UCC”) Objection to Holders Exercising Credit Bid
Rights (doc. 127, Jan. 6, 2005). The UCC appears through its
attorney The Law Office of George “Dave” Giddens, P.C. (George
Dave Giddens). The UCC objects to the holders of second and
third mortgages exercising Credit Bid Rights for two reasons:
1) the second and third mortgages should be recharacterized as
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1At the close of the UCC’s case, Dirk DePree orally moved
to dismiss. The Court took this motion under advisement and
completed the trial. Based on the Court’s disposition in this
Memorandum Opinion, the Court will not address the oral
motion.
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equity interests, resulting in a loss of purported secured
creditor status, and, alternatively 2) the second and third
mortgages should be equitably subordinated to the claims of
the unsecured creditors. The Holders of the third mortgage
disclaimed their Credit Bid Rights. Ex. 64.
UCC filed a Response in Opposition to DePree’s motion to
determine allowance and amount of claim (doc. 156, Jan. 21,
2005). Dirk DePree filed a Response to UCC’s Objection to
holders exercising credit bid rights (doc. 164, Feb. 2, 2005).
Dirk DePree filed a pretrial legal memorandum (doc. 178, Feb.
15, 2005) and the UCC filed a post-trial legal memorandum
(doc. 184, Feb. 23, 2005).
The Court conducted trial of these matters on an
expedited basis on February 16, 17, 18 and 22, 20051. Having
considered the evidence, the pleadings, the arguments of the
parties, and being sufficiently advised in the premises, the
Court issues this Memorandum Opinion on Credit Bid Rights.
The Court has jurisdiction of the subject matter and of the
persons who are parties pursuant to 28 U.S.C. §§ 1334 and 157.
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This is a core proceeding. 28 U.S.C. § 157(b)(2)(A), (B),
(K), (N) and (O).
FINDINGS OF FACT
GENERAL FACTS
1. Escala, LLC, a New Mexico limited liability company
(“Escala”) is the Debtor in this Chapter 11 case. Escala
does business as La Posada de Albuquerque Hotel (“Hotel”,
not be confused with the proposed Prado Hotel) in
downtown Albuquerque, New Mexico.
2. Renaissance Holdings, LLC (“Renaissance”) is a New Mexico
limited liability company that currently owns all of
Escala.
3. Bank 1st (“Bank”) holds a first mortgage on the Hotel.
Ex. 7. Bank had a participant in this loan, Matrix
Capital Bank; references to Bank include, as appropriate,
references to the participant.
4. Dirk DePree holds a second mortgage on the Hotel. Ex.
40.
5. Mark DePree, Dirk DePree, the DePree Family Limited
Partnership, a Michigan limited partnership (“DFLP”) and
Bradbury Stamm Construction, Inc. (“BSCI”), a New Mexico
corporation hold a third mortgage on the hotel. Ex. 50.
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The holders of the third mortgage have disclaimed their
right to credit bid at any auction of the hotel. Ex. 64.
6. Mark DePree and Dirk DePree are brothers and also general
partners in the DFLP with their brother Paul DePree (and
perhaps others).
7. In this opinion, the “DePree Group” refers to Mark
DePree, Dirk DePree, DFLP, Paul DePree, the trusts
established for Mark DePree’s children, and an
unidentified group of investors that Mark DePree and/or
Dirk DePree brought to Renaissance who allegedly voted in
alignment with the DePree Group.
8. Prinova Capital Group, Inc. (“PCGI”) has 15 to 20
shareholders, including Vincent Garcia. PCGI owns all of
Prinova Investments, Ltd., a New Mexico corporation
(“PI”).
9. Dirk DePree never was an owner, officer or member of PI.
10. Mark DePree and, by virtue of the community property law
of the state of New Mexico, his spouse Julie DePree may
have at one time owned 25% of the shares of PI but
neither was ever an officer, director or manager of PI.
Neither currently is a member of PI. Compare T-MD 2/16
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2The Court uses a digital audio recording system to make
the record at hearings. References to testimony will be
indicated as T-(initials of witness) and date and approximate
time. Witnesses were: Mark DePree (“MD”), Vincent Garcia
(“VG”), Steven Garrett (“SG”), Tilden Drinkard (“TG”), Roger
Nagel (“RN”) and Dirk DePree (“DD”).
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11:302 and 2/22 1:54 (the PI transaction was never
consummated and Mark DePree never received a K-1) to T-VG
2/16 3:30 (Mark DePree owned 25% of PI but was never an
officer or director) and Ex. 70 (application for liquor
license showing Mark DePree’s 25% ownership interest).
The Court finds it more likely than not that this
transaction, while contemplated by the parties, was never
consumated.
11. Tilden Drinkard is the sole owner of Layne Hotel
Management Corporation (Layne). Tilden Drinkard is a
member in Renaissance.
12. Profcor, Inc. (“Profcor”) is a company owned by Vincent
Garcia and his wife.
13. Factors Plus is a company owned by Vincent Garcia. The
Bank cross-collateralized its line of credit to Factors
Plus with Escala’s loan and mortgage on the Hotel, such
that a default on one would be a default on the other.
14. Renaissance was formed effective May 12, 1999 with PI as
its manager. Ex. 2, page 26.
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15. Escala was formed effective June 12, 2000 with PI as its
sole member and manager. Ex. 4, pages 25 and 26.
16. During the period under discussion, Renaissance had
various subsidiary LLC’s and businesses including Prado
Hotel, LLC, Parking Company of Albuquerque, LLC, and
Acropolis Development LLC. Escala subsequently also
became a subsidiary of Renaissance. These four entities,
collectively, are the “Related Development Entities.”
See Ex. 19, Loan Agreement at page 18.
17. Neither Mark DePree or Dirk DePree were ever paid a
salary by Renaissance or Escala. T-MD 2/22 1:45; T-DD
2/22 2:34.
18. Dirk DePree, all told, loaned, contributed to the capital
of Renaissance, and had assets (that he pledged to secure
Escala’s debts) seized, in the amount of approximately
$1.6 million. Over the years, he received one payment of
$1,400 on a note. He has never received any profits,
dividends, or any property in return. T-DD 2/22 2:35.
FACTS IN CHRONOLOGICAL ORDER
19. The setting for this dispute centers on Block 9 of the
New Mexico Town Company plat (filed in 1882), bounded by
what are now Central and Copper Avenues and by Second and
Third Streets. The dispute arises out an expanding
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vision by Messrs Garcia, Drinkard and Mark DePree to
redevelop and improve an entire historic block of
downtown Albuquerque. The project included, at Second
and Copper, the La Posada de Albuquerque hotel (which
started out in 1939 as the first hotel built by Conrad
Hilton), the old First National Bank building at Third
and Central to be called the Prado Hotel, and a parking
structure (the Acropolis projects) to be constructed at
Third and Copper to service both hotels and to include
offices, retail space and live/work condominiums. The
project was to be implemented and managed through the
aptly named Renaissance Holdings, LLC.
20. On July 4, 1998, the “Founders”, consisting of Vincent
Garcia, Mark DePree and Tilden Drinkard entered into an
agreement (“Founders’ Agreement”) with Profcor, which
held a purchase agreement to acquire the old bank
building. Ex. 1. The Founders’ Agreement contemplated a
sale of the bank building to the Founders, set out the
responsibilities and duties of the Founders, and provided
that Vincent Garcia would own 51%, Mark DePree would own
44% and Tilden Drinkard would own 5%. The Founders’
Agreement also placed a value on the services that were
to be provided: Vincent Garcia, $12,750; Mark DePree,
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$11,000; Tilden Drinkard, $1250. The Founders’ Agreement
does not refer to any other entities in existence or to
be formed in the future. At the time of the Founders’
Agreement, the Founders did not discuss acquisition of
any other properties or the formation of any entities.
T-MD 2/16 1:55.
21. On or about May 12, 1999 Renaissance was formed and its
operating agreement became effective. Ex. 2. The
manager was PI or its successor. ¶2(o). Renaissance was
formed to own and operate a hotel in Albuquerque. ¶3.01.
Article 4 lists the members which include Vincent Garcia,
PI, Mark DePree, trusts for Mark DePree’s children,
Tilden Drinkard, BSCI, DFLP and others. Dirk DePree was
not a member of Renaissance or involved with Renaissance,
except that he signed the agreement for DFLP as a general
partner. See page 26. See also T-VG 2/16 3:30. Mark
DePree was an active member and director. Id.
22. Article 5 contains a provision to indemnify managers,
employees and agents to the fullest extent permitted by
law except for any claims of fraud, deceit, gross
negligence, willful misconduct or illegal acts. Ex. 2, ¶
5.07.
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23. Vincent Garcia testified that although the Renaissance
operating agreement listed PI as manager, PI always acted
at the direction of and for the benefit of Renaissance.
See ex. 6 and ex. 12, page 1 (PI acting on behalf of
Renaissance.) So, although PI was the manager on paper,
it never took any independent actions without instruction
from the de facto management group for Renaissance. T-VG
2/16 3:30-3:40. Renaissance’s management was always
performed by a “board of managing directors” (“Board”),
Ex. 11, page 3, which, in May 1999, consisted of the
Founders. The Board had expanded to include Dirk DePree
by no later than September 2000. Id. See also infra
note 3.
24. In May, 1999 Renaissance acquired the bank building. T-
VG 2/16 3:30. The plan was to convert the bank building
into an upscale “boutique” hotel to be called the Prado.
25. During the spring of 2000, Mark DePree first became
involved with the Hotel. T-MD 2/16 2:05. It was public
knowledge that the Hotel was in a chapter 11 and for
sale. The Founders believed it would be beneficial to
have two hotels on the same block for economies of scale.
Id. See also T-VG 2/16 3:50. The idea was to buy the
Hotel at a good price with good financing. Id. The
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Founders made an offer to the bankruptcy court to acquire
the hotel by satisfying all creditor claims (thought to
be approximately $6.0 million), provided they could
settle each claim individually. Id. The bankruptcy
court approved the offer, and the project moved forward.
26. Tilden Drinkard previously operated the Hotel for
previous owners under the name “La Posada” from 1991 to
1995. He still had the historical operating records. He
also obtained newer information from the then owners, the
Chapter 11 Debtors. He prepared pro-formas. He
testified that, eventually, the Hotel would have adequate
net operating income (i.e., after all operating expenses)
to pay the debt service anticipated. T-TD 2/17 4:50.
27. Vincent Garcia was the “point person” in charge of the
Hotel acquisition, and in charge of putting together the
capital structure. Mark DePree assisted in organizing
the capital structure. Dirk DePree was not involved in
organizing the capital structure. T-TD 2/18 11:10; T-MD
2/22 1:10. Dirk DePree had no involvement in forming
Escala. T-MD 2/22 1:10; T-DD 2/22 2:03.
28. Based on all of the evidence presented in the four-day
trial of this matter, the Court finds that none of the
individuals in these proceedings intended to, or
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recklessly caused, any harm to creditors. The Court
arrives at this finding after reviewing all the
witnesses’ testimony, their demeanor, and the documents
introduced into evidence. In retrospect, the venture
about to be described was perhaps aggressive, but all
individuals’ actions appeared to be based on reasonable
business judgment in light of the facts existing or known
at the time, particularly in the halcyon days of the
summer of 2000.
29. On May 22, 2000, Bank issued a loan commitment for the
purchase of the Hotel by a LLC to be formed. The loan
would be for the lesser of $3.5 million or 78% of lender
approved appraised value, for a term of 30 months, at
Wall Street Journal prime plus 1.25% with a minimum rate
of 9.75%. Payments were based on a twenty-year
amortization. Repayment of the Bank debt would be
secured by a first mortgage on the Hotel and a lien on
most, if not all, of the Hotel’s personal property and
intangibles. The commitment required personal guarantees
of the entire $3.5 million loan by Vincent Garcia and
Mark DePree (and their spouses) and a $1 million personal
guarantee from Dirk DePree to be secured by a pledge of
$1.2 million of marketable securities he owned. (The
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“extra” $200,000 was designed to take into account
fluctuations in the market value of the securities. T-VG
2/16 4:28.) The commitment also provided that the
balance of the subordinated debt owed to the seller of
the Hotel could not exceed $300,000 at closing. Ex. 3.
Dirk DePree was not involved with Bank in the
negotiations for this commitment. T-VG 2/16 4:00. At
this time, Vincent Garcia had a connection to Dirk DePree
only through his brother Mark DePree. Vincent Garcia
approached Dirk DePree in April, 2000 to discuss the
Hotel and a possible pledge of securities to secure the
acquisition; Dirk DePree agreed to pledge his stock. T-
VG 2/16 4:15. As the UCC’s expert witness Roger Nagel
pointed out, the Bank at this time was breaking into the
commercial lending market in Albuquerque and so was
willing to finance transactions that were somewhat
riskier than the other more esconced banks were willing
to finance. T-RN 2/18 2:35. (At the same time,) the
Bank sought to insure that its loan was and would
continue to be amply collateralized. The Court finds
that without Dirk DePree’s guaranty and the pledge of
stock to back up that guarantee, there would have been no
loan from the Bank.
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30. On or about June 12, 2000 Escala was organized and the
operating agreement became effective. Ex. 4. The
manager was PI or its successor. ¶2(o). Escala was
formed to own and operate a hotel in Albuquerque. ¶3.01.
The sole member of Escala was PI. ¶4.01. Article 5
contains a provision to indemnify managers, employees and
agents to the fullest extent permitted by law except for
any claims of fraud, deceit, gross negligence, willful
misconduct or illegal acts. ¶ 5.07.
31. On June 14, 2000 (as modified on June 21, 2000), Vincent
Garcia and Dirk DePree reduced their guarantee agreement
to writing. Ex. 5.; Ex. 109 contains Dirk DePree’s
signature. Dirk DePree was to pledge $1.2 million of
marketable securities securing a $1 million guarantee in
accordance with Bank’s commitment letter. The parties
would execute documentation as required by the Bank and
any participating banks. Certain contingencies are
listed, including “4) [Dirk] DePree agrees to provide
advice and consultation to Renaissance from the effective
date forward at no cost to the Company, and to serve on
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3 Dirk DePree testified that at the time of the pledge he
only wanted to be kept informed on Escala’s business.
Thereafter, Dirk DePree started visiting the properties, he
got more involved in the businesses, and by 2001 he was an
active manager. T-DD 2/22 2:21. He was never directly
involved in the management of Escala as a hotel, and his only
function was that as oversight of Escala as a member of the
Board of Renaissance. Id. Dirk DePree’s testimony about his
role is somewhat belied by the February 2, 2001 minutes of the
Renaissance board, which recite that Dirk DePree lead a
discussion that recited that Renaissance had been led by a
“board of managing directors” comprised of Mark DePree,
Vincent Garcia, Tilden Drinkard and Dirk DePree since
September 2000. And the written agreement between Vincent
Garcia and Dirk DePree for the guarantee and pledge, exs. 5
and 109 (“Contingency 4"), contemplates a role for Dirk DePree
beginning in June 2000.
4 Dirk DePree testified that he absolutely would not have
paid $1 million cash for 15% of this business. He had never
even been presented a valuation of it. T-DD 2/22 2:05. This
is consistent with the parties’ anticipation that the
guarantee would never be drawn on and with Dirk DePree’s
consistently husbanding and protecting his financial resources
in this project.
5 Vincent Garcia testified that at this time, however,
Renaissance did not actually own anything. PI owned the
hotel, although from the outset the parties planned to
transfer the Hotel and other assets into Renaissance. T-VG
2/17 1:50.
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the Company’s advisory board if such a board is
assembled.”3
32. The agreement provided for an initial nonrefundable
“commitment fee” of $9,000. As a “Fee” Dirk DePree would
receive 15% ownership4 in the “consolidated” Renaissance
development5, which would include: 1) the bank building,
if and when developed or used, 2) the Acropolis parking
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6 That the $9,000 was merely a “signing fee”, so to speak,
is illustrated by the final language of “Contingency 5" on
page 3 of the agreement for the guaranty and pledge (Exs. 5
and 109):
“5) Subject to the right of [Renaissance] to secure,
and Bank 1st’s willingness to accept a replacement
guarantor or replacement collateral prior to
closing, in which case Dirk DePree shall be paid the
$9,000 earned commitment fee for having committed to
provide the guarantee and collateral pursuant to
this agreement and term sheet and in accordance with
the terms of guarantee and additional collateral
required in the commitment of Bank 1st to provide
financing for the acquisition of La Posada de
Albuquerque, and in such event that DePree does not
act as guarantor, due to said replacement, DePree
shall have no ownership interest pursuant to this
agreement.”
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structure lease and purchase agreement with the City of
Albuquerque, 3) the Acropolis retail and office
development, 4) the Hotel, and 5) any other developments
of Renaissance located on the square block of the Hotel.
In essence, the agreement reached between Vincent Garcia
and Dirk DePree, which bore some resemblance to the
Silicon Valley deals that Dirk had previously been
involved in, was that Escala would pay Dirk DePree $9,000
for the possibility or option of using his guarantee and
pledge to induce the Bank to make the loan.6 If Escala
actually used the guarantee and pledge (merely) to obtain
the loan, Dirk was to receive the 15% interest in
Renaissance. Given what some might describe as the
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“vulture capital” aspect of the agreement with Dirk
DePree, it is not surprising, as the parties recited at
trial, Vincent Garcia balked at the 15% requested by Dirk
DePree and intended to shop around for a better deal.
33. As explained in more detail below, the agreement did not
address what might happen if the Bank ever executed on
Dirk DePree’s securities, because it appears that the
parties assumed that would never happen. The Bank loan
was to be for a term of 30 months. The Court finds that
the parties all intended the Bank financing to be
essentially a “bridge loan” to enable the acquisition,
with the intent to pursue permanent financing elsewhere.
See T-DD 2/22 2:00 (Vincent Garcia represented to Dirk
DePree that he would be guaranteeing an “interim loan.”);
see also id. 2:08 (It was to be a short term loan, and
Vincent Garcia’s intent was to refinance in 12 months and
get the guarantee released.)
34. Vincent Garcia testified that the understanding with Dirk
DePree was that Dirk would set aside securities of $1.2
million to secure the $1 million guarantee, and in
exchange for the risk he was to receive 15% of
Renaissance, with the understanding that there would be a
refinance and release of collateral. T-VG 2/16 4:30.
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Vincent Garcia said that his understanding of the loan
documents was, that because subordinated debt was limited
to $300,000, any debt to Dirk DePree would have to be
equity. He admitted, however, that the documents do not
say this.
35. The loan commitment, Ex. 3, paragraph 9, and the Loan
Agreement, Ex. 7, anticipate a $300,000 loan from or
continuing obligation to the seller (debtor-in-possession
La Posada Investors), secured if necessary by a second
real estate mortgage junior to the Bank’s mortgage. At
closing Escala’s debt was not supposed to exceed the $3.5
million to the Bank and the $300,000 to La Posada
Investors. Id.
36. Dirk DePree’s undisputed testimony was that there was no
discussion with anyone at this time that this transaction
was to be considered a contribution to equity, even if
the Bank took the guarantee and pledge as further
security for the loan. T-MD 2/22 2:10.
37. The testimony is conflicting whether Vincent Garcia and
Dirk DePree discussed what would happen in the event the
Bank realized on the securities. Dirk DePree
unequivocally testified that this was never discussed.
T-MD 2/22 2:03. During trial, Vincent Garcia was asked
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Q: “You never discussed with Dirk DePree what would
happen if the Bank took the stock?” A: “Not true. He
understood the risks.” However, Vincent Garcia executed
an affidavit on January 17, 2005 in connection with this
case. Ex. 62, endnote D, Paragraph 8 of which states:
8. During the course of the negotiations for
the collateral pledge, it was never discussed,
considered or agreed that any portion of the
collateral would be treated as a loan from Dirk
DePree to Renaissance, Escala or any of the
subsidiary companies or that Dirk DePree would
be entitled to be repaid any portion of the
collateral or would receive any further
consideration or compensation in the event the
bank seized all or any of the collateral.
(Emphasis added.) The Court finds it more likely than
not that Vincent Garcia and Dirk DePree never discussed
what would happen in the event the Bank took the
collateral.
38. The Bank obtained an appraisal on June 20, 2000 for the
Hotel that showed a value of $5.4 million “as is” and
$5.8 million “as renovated.” Ex. 115. This appraisal
was not introduced for the truth of the value of the
Hotel; rather, it was to establish that the Bank had
obtained an appraisal and later made decisions based on
it. In fact, the Bank used this appraisal as a basis for
the mortgage loan. T-SG 2/17 9:15.
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7 Mark DePree testified that Escala obtained the life
insurance policies for these parties and paid the premiums.
T-MD 2/22 1:50.
8 This common provision in guarantee documents is a result
of Levit v. Ingersoll Rand Financial Corp. (In re V.N.
Deprizio Construction Co.), 874 F.2d 1186, 1200-01 (7th Cir.
1989)(holding that preference recovery period for outside
(continued...)
Page -21-
39. On August 1, 2000, Escala closed on the Hotel for
$4,182,000. T-VG 2/17 3:55. The loan documents appear
at Exhibit 7. The Business Loan Agreement provides for a
$3.5 million loan to Escala, calls for assignments of
life insurance policies7 from Vincent Garcia, Mark DePree
and Tilden Drinkard, and calls for guarantees from
Vincent Garcia, Mark DePree, and PI each in the amount of
$3.5 million and a guarantee from Dirk DePree for $1
million. The rest of exhibit 7 contains the note, a copy
of the recorded mortgage, an assignment of rents,
security agreements, and other documents executed after
the closing.
40. Exhibit 8 is Dirk DePree’s Guarantee and pledge dated
August 1, 2000. It provides that if Escala should become
insolvent and Bank’s debt is not fully secured, then Dirk
DePree would waive any claim he had against Escala for
subrogation, so that he would not be considered a
creditor within the meaning of 11 U.S.C. § 547(b).8 The
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8(...continued)
creditors is one year when the payment confers a benefit on an
inside creditor, including a guarantor). However, section
547(b)(4)(B) was amended by § 283(m) of the Bankruptcy Act of
1986. That section now states that the creditor paid must be
the insider. See Pereira v. Lehigh Savings Bank, SLA (In re
Artha Mgt. Inc.), 174 B.R. 671, 674 (Bankr. S.D. N.Y.
1994)(“[T]he Deprizio Doctrine has recently been precluded by
legislative enactment.”) The Court finds that inclusion of
this Deprizio doctrine clause in the guarantee was inserted
only for Bank’s benefit and does not represent an intentional
waiver by Dirk DePree of his common law or state law rights of
subrogation.
9 As will be shown below, in fact Bank later seized the
pledged securities. On cross examination, the Bank officer
was asked why Bank seized Dirk DePree’s securities if it were
not undersecured. He testified that at the time of the
seizure the note was past due and not being performed, that
the Bank had the right to seize, and it exercised that right.
T-SG 2/17 9:45. He also testified that it was easier to seize
the collateral than to foreclose on the Hotel. Id. 9:49. The
Court finds this explanation entirely credible, and finds that
the seizure is not evidence of an undersecured status.
Page -22-
evidence at trial was uncontradicted9 that Bank was never
undersecured. T-SG 2/17 9:10, 9:20. And ultimately,
when the Bank executed on Dirk DePree’s securities in
February, 2004, the Bank consented to Dirk DePree’s
second mortgage. Ex. 41.
41. On or about August 1 or August 6, 2000, Layne took over
management of the Hotel. Tilden Drinkard testified that
the Hotel was financially strapped from the beginning.
The Hotel needed repairs and maintenance. The Hotel
needed new beds, laundry facilities, televisions, etc.
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Page -23-
There were insufficient funds to make these repairs and
improvements. Tilden Drinkard found a lease program to
obtain the assets, at financing rates ranging from 18 to
21% annual interest. All leases were approved by the
Managers. T-TD 2/18 8:20-8:35.
42. Exhibit 10 is Escala’s 12/31/2000 balance sheet prepared
by Tilden Drinkard. It shows a net worth of $163,000.
It also shows a loss for the period 8/1/2000 to
12/31/2000 of $376,000. T-TD 2/18 8:45.
43. On January 24, 2001 Escala gave Dirk DePree a promissory
note in the amount of $100,000, dated 12/11/2000 and
bearing interest from that date. Ex. 9. Vincent Garcia
testified that at the end of 2000 Escala needed cash and
Dirk DePree offered to lend it. T-VG 2/17 9:55.
44. On March 6, 2001 Susie Fenstermacher, Vice President of
PI (see Ex. 2 page 26), as agent of Renaissance faxed the
12/31/2000 Renaissance balance sheet and profit and loss
statement to Dirk DePree and Mark DePree. Ex. 111. The
balance sheet showed net equity of $1.3 million on that
date. Dirk DePree is not listed as a member.
45. On March 13, 2001, Renaissance, Escala, Prado Hotel,
Parking Co. and PI entered an agreement that approved and
agreed to the transactions set out in the “Proposed
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Page -24-
Restructuring of Renaissance” approved by the members of
Renaissance on March 13, 2001. Ex. 14. PI by Vincent
Garcia signed the agreement on behalf of Escala. The
Proposed Restructuring Agreement appears at Exhibit 12.
The effect of the Restructuring was for Renaissance to
obtain ownership of the bank building, the Hotel, and a
parking structure, and all investors in all these
properties would be confirmed as being members of
Renaissance. Ex 12, page 2. Paragraph III(B) states:
Assuming the approval of the Restructuring by
the Renaissance membership, it is anticipated
that all guarantors and secondary obligors of
obligations of Renaissance and the Subsidiaries
(e.g., Prinova, the Garcias, the DePrees and
Dirk DePree)(collectively, the “Guarantors”, as
shown on Exhibit B) will seek to have such
guarantees and other obligations released.
Renaissance will use reasonable efforts to
assist in such efforts, including, where
permitted by creditors, having the respective
Subsidiaries assume the guarantee obligations.
In addition, Renaissance will agree to indemnify
the Guarantors against all liability and expense
arising from the failure of the primary obligors
to pay the obligations. The Restructuring will
not, however, be contingent in any respect on
the Guarantors’ success or lack thereof in
obtaining releases.
Renaissance shall also indemnify
Prinova against any expense to Prinova
arising out of a failure by Renaissance or
any Subsidiary to pay an obligation
incurred by Prinova for the benefit of
Renaissance or the Subsidiary and assigned
to Renaissance or the Subsidiary as part of
the Restructuring.
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10 Mark DePree testified that the four Board members
discussed the contents of Exhibit B, and Vincent Garcia did
not suggest that Dirk DePree’s guarantee should be excluded.
T-MD 2/22 1:15. All four Board members voted for this
provision. Id.
Page -25-
Exhibit A lists Dirk DePree as a Consolidated Renaissance
member with a 12.14% interest. Exhibit B lists Dirk
DePree as a “Gurarantor” [sic] on the Hotel for $1
million.10 Exhibit C contains a balance sheet for Escala
as of 12/31/2000 that shows net equity of $138,000.
46. On direct examination, Vincent Garcia stated that the
deal he entered with Dirk DePree regarding the pledge was
that any amount seized by Bank would be treated as a
capital contribution to Renaissance. On cross
examination he was asked, if the deal was to capitalize
any amount taken, why would Dirk DePree be listed as a
guarantor with indemnity rights. Vincent Garcia admitted
that, if the deal had been for an equity contribution,
Dirk DePree would not be listed as a guarantor with
indemnity rights. T-VG 2/17 2:26.
47. After March 13, 2001, the Board commenced a series of
transactions to execute documents and transfers, on a
schedule. T-VG 2/17 10:00.
48. By May, 2001, the DePree Group controlled over 50% of the
votes of Renaissance. T-VG 2/17 3:00. The Group could
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Page -26-
have made Mark DePree sole manager at that time or any
time thereafter. Id.
49. The First Amended and Restated Operating Agreement of
Renaissance became effective on May 31, 2001. Ex. 15.
Section 13.04 provided that the operating agreement could
only be amended by a 2/3rds vote of the member interests.
The amended agreement also officially placed management
in a Board of Directors that consisted of Dirk DePree,
Mark DePree, Vincent Garcia and Tilden Drinkard. Vincent
Garcia testified that the changes reflected regarding
management were made to have the documents conform to how
the business had been actually operated virtually from
the closing date of the Hotel. T-VG 2/17 10:10.
50. On or about August 1, 2001, the first anniversary of the
Bank loan, Dirk DePree started to become concerned that
the loan had not been refinanced. T-DD 2/22 2:13.
51. The events of September 11, 2001 had a devastating impact
on Escala’s business, T-MD 2/16 3:15, T-VG 2/17 10:15,
10:25, amplifying its already woeful undercapitalization.
52. Around Christmas, 2001, Escala was having significant
problems and needed cash. T-MD 2/16 2:15; T-VG 2/17
10:25.
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11On cross examination, Mr. Nagel (the UCC expert witness)
admitted that the “Due to Renaissance” account had more
characteristics of equity than did Dirk DePree’s mortgage. T-
RN 2/18 4:35.
12Depreciation is a non-cash outlay, yet is considered an
expense. See, e.g., Burress v. Standard Fire Ins. Co., 642
F.Supp. 62, 66 (N.D. Miss. 1986)(Cash flow and income are
different. Due to depreciation, a company can have positive
cash flow but negative income.)
Page -27-
53. Escala’s 12/31/2001 balance sheet appears at Exhibit 16.
It shows negative capital of $304,000. It also shows a
negative account receivable from Renaissance (i.e., a
liability from Escala to Renaissance) of $387,000. T-TD
2/18 9:03. If this amount payable to Renaissance were
considered capital invested by Renaissance, as urged by
Dirk DePree11, there would have been a small positive
capital balance at the end of 2001. Furthermore, the
balance sheet shows accumulated depreciation12 and
amortization of $461,000. The December 11, 2000 Escala
note to Dirk DePree for $100,000, Ex. 9, was not included
on this balance sheet. Rather, it was booked as a
Renaissance liability because Renaissance had decided to
treat it as an investment in Escala. T-VG 2/17 10:20.
54. On January 18, 2002, Vincent Garcia and Mark DePree (and
spouses) and Renaissance signed an acknowledgment of
ownership in Renaissance. Ex. 101. This document lists
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13 Paul DePree negotiated the loan on behalf of DFLP after
Mark DePree and Dirk DePree requested the loan. T-MD 2/22
1:18. Part of the decision to make the loan was based on the
indemnification agreement, and part based on a desire by DFLP
to “tie down” things that hadn’t been, which would impact on
Renaissance’s profitability. Id. 1:25.
Page -28-
all members and their ownership interests as of that
date.
55. Exhibit 17 is Escala’s 1/31/2002 balance sheet. It shows
a negative equity of $408,000.
56. In February 2002 Vincent Garcia was unwilling to loan any
further money to Renaissance because of a growing
conflict with the DePree Group. T-VG 2/17 3:20.
57. In February 2002 no other members of Renaissance were
willing to loan money to Renaissance. T-MD 2/22 1:30.
See also T-DD 2/22 2:18 (during the entire history of
this company no members expressed willingness to loan to
Renaissance).
58. On February 1, 2002, Renaissance and the Related
Development Entities entered a loan agreement with DFLP13,
Dirk DePree, and Mark DePree for $250,000, to be used for
the Hotel, Acropolis, LLC, and Prado Hotel, LLC. Ex. 19.
The agreement called for guarantees from each Related
Development Entity and a mortgage on specified Acropolis,
LLC assets. It also required the parties to execute and
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14 Properties had not been transferred to Renaissance on
the schedule anticipated. For example, Escala had not been
transferred from PI, because Escala owned a liquor license,
and had not paid all the gross receipts taxes that it owed
because it had always lacked the funds. New Mexico laws
require taxes to be paid as a condition for the transfer of a
liquor license.
Page -29-
deliver an “Affirmation and Confirmation of Restructuring
Agreement”14 (¶5.06a) and an “Agreement for Contribution
to Capital and Indemnification” from Escala and
Renaissance to Dirk DePree (¶5.07). Renaissance and the
Related Development Entities also had to use their best
efforts to refinance the Hotel and obtain a release of
Dirk DePree’s guarantee.
The Board met to discuss this transaction. Vincent
Garcia initially resisted the indemnification, but all
four directors voted to approve the loan and all four
signed off on it. Ex. 100. Exhibit 100 provided that
$200,000 of Dirk DePree’s collateral would be contributed
to Renaissance, increasing his capital account but not
resulting in the issuance of any new Renaissance units to
him. Renaissance and Escala agreed to indemnify Dirk
DePree from all losses incurred if Bank foreclosed on the
pledged stock. Paragraph 5 secured the indemnification
with guarantees from the Related Development Entities,
then set a priority for the source of indemnification
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Page -30-
payments: 1) membership units of Renaissance with a fair
market value of collateral taken by Bank, 2) if not paid
by #1, then proceeds from the sale of certain condominium
units, and 3) to the extent not paid by #1 or #2, by
replacement collateral.
Vincent Garcia testified that he thought the
Agreement for Contribution to Capital and Indemnification
was inappropriate. First, he felt that this was
“extracted” by the DePree Group in exchange for the loan.
Second, he felt it was not proper to be indemnified for a
“capital contribution.” T-VG 2/17 10:30. He did admit,
however, that the Board approved the entire loan
transaction. Ex. 19. See also T-VG 2/17 10:35.
Tilden Drinkard testified that he voted to approve
the loan in its entirety because, without it, Escala
would be facing immediate financial ruin and would be
“dead in the water.” T-TD 2/18 9:25.
59. On February 1, 2002, Alan Hall, Renaissance’s attorney,
emailed the Board regarding the proposed Agreement for
Contribution to Capital and Indemnification. Ex. 18.
Exhibit 18 was admitted not for its contents or truth of
its contents, but only to establish that the Board had
legal advice before the vote. See also T-TD 2/18 12:15
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Page -31-
(Members of the Board had legal advice on this
indemnification agreement before the meeting, then voted
in favor of it.)
60. It was Mark DePree’s idea to have the $200,000 converted
to equity. T-MD 2/16 2:25.
61. Vincent Garcia testified that, after the February 2002
loan to Renaissance the management of Renaissance
changed. He felt increasingly excluded from decisions
and access to the properties and records. He claims that
Mark DePree and Dirk DePree were making decisions on
their own in violation of the operating agreement. Both
he and Tilden Drinkard expressed their concerns. T-VG
2/17 11:15. See also, below on October 3, 2004.
62. In or around February, 2002, the Bank claimed that
Vincent Garcia was in default on his line of credit for
Factors Plus. Vincent Garcia denied there was a default.
T-VG 2/17 3:25. Mark DePree testified that the Bank
threatened to default Escala if Factors Plus was not
brought current. T-MD 2/16 2:15; T-VG 2/17 3:25; T-TD
2/18 1:45. Vincent Garcia did not recall if this problem
had anything to do with the February 1, 2002 loan
agreement. T-VG 2/17 3:25.
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Page -32-
63. During September, 2002, Dirk DePree and Mark DePree
obtained a bank loan in the amount of $150,000 from New
Mexico Bank and Trust company in their own names, put the
money into the bank building for a model unit, and paid
for advertising. T-MD 2/16 2:40; T-VG 2/17 4:17.
Vincent Garcia testified that both DePrees intended that
Renaissance would repay it. Id.
Tilden Drinkard’s testimony elaborates. He
testified that after 9/11/2001 everyone agreed that a
boutique hotel concept would not work for the bank
building, and that Renaissance decided to turn it into
condominiums. T-TD 2/18 10:12. Vincent Garcia
recommended Dana Crawford, a marketing person, and later
engaged her to organize a gala event/open house of the
bank building with Mark DePree and Dirk DePree. Id.
Shortly before the event was to take place, Tilden
Drinkard learned that there was no model unit to show the
estimated 600 guests. Id. at 10:15. He thought this was
“madness.” Id. On cross examination, Tilden Drinkard
admitted that he believed the building needed a model
unit and that the companies needed money to do it, so
Mark DePree and Dirk DePree financed the project in their
own names. Id. 11:34.
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15Central 219, LLC is apparently yet another related LLC.
219 Central Avenue is the old bank building. When asked if
Central 219 owned the unit, Mark DePree said that that was
“contemplated.” See supra Finding 24 (Renaissance owned the
bank building.)
Page -33-
Mark DePree also testified regarding this issue. In
mid-September the Board told Mark DePree and Dirk DePree
that they could not proceed with the gala event without a
model unit. T-MD 2/16 2:43. So, the DePrees borrowed
the necessary funds from New Mexico Bank and Trust
personally, to construct the model unit and satisfy
Vincent Garcia’s and Tilden Drinkard’s anxiety. Id. All
the funds went into the Central 219, LLC15 checking
account and most of it was used for Central 219, LLC.
Id. 2:45. Some funds went to Escala during the winter
months. Id. None of the funds went to either Mark
DePree or Dirk DePree. Id.
There was no evidence presented that the DePrees hid
any of this from the Board or that this was not a proper
business expense. The Court finds that this is not
evidence of bad faith or breach of duty. The witnesses
generally agreed that the DePrees were later repaid when
Renaissance sold the entire building as a single asset.
This transaction did not involve Escala.
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16 Mark DePree testified that he could recall no contract
entered into on behalf of Escala unilaterally before he was
sole manager. T-MD 2/22 1:40. Dirk DePree testified that he
never entered a contract on behalf of Escala. T-DD 2/22 2:25.
17 Mark DePree testified that he never sold any
condominiums in either the Acropolis project or the bank
building without authority of the four members of the Board.
T-MD 2/22 1:40. Dirk DePree testified that he never sold any
condominiums without Board authority, and that no condominiums
in the bank building were ever sold. T-DD 2/22 2:25. He also
testified that, as for Acropolis, the Board had delegated him
the duty to get them sold. None were sold without permission
of the Board however. Id. 2:30. In any event, none of the
items sold were Escala assets.
Page -34-
64. On October 3, 2002, Vincent Garcia and Tilden Drinkard
sent Mark DePree and Dirk DePree a letter expressing
their concerns about the latters’ actions taken in
violation of the Renaissance operating agreement. Ex.
25. This letter makes no reference, however, to any
unauthorized transactions on behalf of Escala. On cross
examination, Vincent Garcia stated that there were many
unauthorized contracts, but he could not name or identify
one. T-VG 2/17 3:46. He also did not know if any of
these contracts involved Escala.16 Id. 4:10. He thought
some sales contracts involved Acropolis, LLC
condominiums, but then said that none of those actually
closed.17 Id. Later, however, Vincent Garcia testified
that in fact one Acropolis sale did close. Id. 4:20.
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18Tilden Drinkard also testified that he did not contend
that Dirk DePree benefitted from entering any alleged
unauthorized contracts without authority. T-TD 2/18 1:50.
Page -35-
Tilden Drinkard testified that Dirk DePree entered
one sales contract for a unit of Acropolis without Board
authority. T-TD 2/18 11:30. The Board ratified the
contract and the sale closed. Tilden Drinkard also
testified that Dirk DePree entered a second contract to
sell an Acropolis unit to Attorney A. Sanchez, but the
unit had been previously deeded to Vincent Garcia as
payment of a developer fee. Id.; T-DD 2/22 2:30.
Attorney Sanchez sued, and the case was settled for
$10,000 or $15,000. T-TD 2/18 1:45. Dirk DePree
believed it settled for $10,000, and that this amount was
paid by Mark DePree, Dirk DePree and Vincent Garcia
individually. T-DD 2/22 2:33. Neither Escala or
Renaissance paid anything. Id. The UCC did not
introduce any documents that support any claims that Mark
DePree or Dirk DePree entered unauthorized contracts on
Escala’s behalf, or of any damage caused therefrom18. In
fact, Exhibit 11 appears to contradict the theories
behind these claims. Exhibit 11 contains selected
minutes from weekly Renaissance Board meetings, many of
which contain specific delegations of authority to all
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Page -36-
the Board members, see also T-TD 2/18 11:25, although
there is nothing in the minutes that says conclusively
that those delegations of authority were for more than
leading the effort on specific operations, with the
continuing obligation to report back to and obtain
approval from the Renaissance board. On cross
examination, Tilden Drinkard also could not remember any
specific contract of Escala entered into by Dirk DePree
without authority. Id. 11:30.
65. Vincent Garcia testified that in December, 2002, the
financial condition of both Escala and Renaissance was
very poor, that Renaissance had “close to zero” net
worth, or maybe negative net worth, and that Escala had
negative net worth. T-VG 2/17 11:30.
66. On February 5, 2003, the Bank’s note was due. Ex. 7-L,
Promissory Note, page 1, second paragraph.
67. On March 21, 2003, as had been anticipated since the
formation of Renaissance, Prinova assigned all its
interests and rights in Escala to Renaissance and
resigned as manager. Ex. 28. See also T-VG 2/17 3:30.
68. On April 16, 2003, Bank’s participant bank obtained an
appraisal of the Hotel that placed a value on it of $3.8
million. Ex. 116. This exhibit was admitted only for
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19 Vincent Garcia testified that he voted against the
amendment. On cross examination he stated that he voted
against it because it was an attempt by the DePree Group to
get his money in as fresh cash. He expected it would cost him
about $400,000.
Page -37-
the purpose of showing that an appraisal was done and
that subsequent documents relied on it, not as evidence
of the actual value.
69. On May 1, 2003, Renaissance held a members meeting at
which the DePree Group presented a resolution to amend §
8.02 of the operating agreement to raise capital and to
discuss conversion of debt to equity. The minutes appear
at Exhibit 31 and the Agenda at exhibit 32. Any
resolution would require a 2/3rds vote to pass. T-MD
2/16 11:42. The DePree Group did not have 2/3rds
control, and voted for the amendment. Vincent Garcia19
and Tilden Drinkard abstained. Ex. 31, page 6. An
effect of the amendment and any proposal to convert debt
to equity would have allowed the DePree Group to gain
more ownership of Renaissance without putting in new
money. T-MD 2/16 1:45. At the meeting, the members also
passed a resolution removing the four person board and
appointing Mark DePree as the single manager of
Renaissance. Ex. 31, page 6. The members also approved
a resolution approving the sale or exchange or
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Page -38-
disposition of substantially all assets of Renaissance.
Id. page 7.
70. Vincent Garcia testified that after the May 1, 2003
meeting, while no longer a manager of Renaissance, he was
still a member with a right of access to information. He
requested information many times, but rarely got any. T-
VG 2/17 11:35.
71. On June 19, 2003, Mark DePree, as manager of Renaissance,
sent a capital contribution notice, pursuant to § 8.02(a)
of the operating agreement. Ex. 117. A few members sent
in checks, but Mark DePree did not cash them due to
controversies surrounding a valuation of Renaissance and
issues relating to taking notes for capital in lieu of
cash, and issues related to how to treat members
interests if capital was not contributed (the formula for
interest reduction did not work with a negative valuation
of the company). T-MD 2/16 2:48.
72. On July 1, 2003, the Bank, Escala, Vincent Garcia, Mark
DePree, Renaissance and Dirk DePree entered an extension
and forbearance agreement. Ex. 102. At this time, the
note to the Bank was in default and property taxes were
delinquent on the Hotel property. In exchange for
certain payments, and an executed stock power from Dirk
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Page -39-
DePree authorizing the immediate sale of the pledged
securities (to be used only in the event of a future
default), Bank extended the maturity date to September
10, 2003, or a later date if there was a valid and
enforceable contract to purchase or refinance the Hotel.
73. During the Summer of 2003, and especially in August, Dirk
DePree and others were assisting in attempts to refinance
the Hotel. T-DD 2/22 3:15. Three banks were close to
issuing loans, id. 3:19, but none of the sought after
refinancing worked out.
74. Sometime during the summer of 2003 Dirk DePree, on advice
of his personal attorney, asked Escala for a second
mortgage. Mark DePree discussed this with John Baugh,
Renaissance’s attorney, and he advised that it would not
be proper to grant a second mortgage until the Bank
seized the collateral. T-DD 2/22 2:20.
75. In the Fall of 2003, Tilden Drinkard was aware of the
attempts undertaken to refinance the Hotel, and prepared
documents to assist a person that had been hired to
obtain the refinance. T-TD 2/18 10:40.
76. In September, 2003, Renaissance, pursuant to its
operating agreement, appointed a committee to perform a
valuation of Renaissance. The committee used Escala’s
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Page -40-
CPA firm in an advisory capacity. The committee
consensus was that Renaissance had negative net worth of
$1.976 million. Ex. 37. The Court notes that the
valuation substantively consolidated all subsidiaries
assets and liabilities, without any indication if the
parent Renaissance was actually liable for the
subsidiaries’ (all LLCs) debts. However, the committee
did approve this valuation, and the Court accepts it as
is. The exhibit also showed Escala’s assets at $3.8
million and liabilities at $4.2 million. It is unclear
if the intercompany “due to’s/due from’s” were eliminated
in this consolidated valuation.
77. On September 10, 2003, the Bank’s extension ended. Ex.
102.
78. In October, 2003 (date unclear), Renaissance assigned
$500K of proceeds from the sale of the bank building to
DFLP and BSCI. Ex. 33 [missing page 2]. See also T-MD
2/16 11:00. Mark DePree believed each received $250,000
at closing.
79. On October 17, 2003, the Bank granted another extension
to December 9, 2003. Ex. 7(O).
80. On October 27, 2003, Vincent Garcia emailed a request for
information to Dirk DePree, demanding certain
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Page -41-
information. Ex. 65. This email was a response to an
earlier email by Dirk DePree to Vincent Garcia explaining
why an earlier request for information had been denied.
Dirk DePree’s email was actually composed by John Baugh,
Renaissance’s attorney, on behalf of Dirk DePree and set
forth concerns about providing this information to
Vincent Garcia. The Hotel was for sale, Vincent Garcia
was in competition with one or more other parties to
purchase it, and Renaissance purportedly was concerned
about an insider obtaining an unfair edge in any
acquisition. While the grounds for denying the
information may be questionable, from this exhibit the
Court finds no bad faith on the part of the DePrees.
81. In November, 2003, Mark DePree made two appointments with
Vincent Garcia and Tilden Drinkard to provide information
to them, and they missed both meetings, T-MD 2/22 1:48,
although the exhibits suggest that the limitations on
time and place imposed by Mark DePree may have
contributed to that problem. Ex. 65. In general, Mark
DePree denies concealing any information from the
members. T-MD 2/22 1:48. During this period of time,
Vincent Garcia was suing Escala. John Baugh, the
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Page -42-
attorney, told Mark DePree that Vincent Garcia should
direct requests through his attorney. Id.
82. In December, 2003, there were a series of email exchanges
amongst various individuals discussing activities related
to refinancing the Hotel. Ex. 107. The parties were
expecting a $6.0 million appraisal on the Hotel, and were
anticipating obtaining a loan for $3.0 million, which
would have been approximately a 50% loan to value ratio.
Tilden Drinkard believed reasonable financing could be
found. Ex. 107, page 2.
83. On December 9, 2003 the Bank’s October 17, 2003 extension
ended. Ex 7(O), page 3.
84. In January, 2004, Escala stipulated with Bank to a “drop
dead” date of September 30, 2004 on the Hotel note and
mortgage. T-MD 2/16 11:18.
85. On or about February 1, 2004, the Bank executed on the
stock pledge. Ex.59, page 2.
86. On February 3, 2004, Escala granted a second mortgage to
Dirk DePree. Ex. 40. Mark DePree testified that
execution of this mortgage was done pursuant to the
contract for indemnification executed in February, 2002.
T-MD 2/22 1:35. He executed the mortgage on behalf of
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Page -43-
Escala after seeking legal advice. Id. The second
mortgage states, in part:
This Mortgage secures to Mortgagee: (a) the
payment and performance by Mortgagor of all
obligations owed to Mortgagee under that certain
Agreement for Contribution to Capital and
Indemnification ...; (b) the payment of all
other sums, with interest, advanced under
paragraph 12 to protect the security of this
Mortgage; and (c) the performance of Mortgagor’s
covenants and agreements under this Mortgage and
the Indemnification Agreement. The lien of this
Mortgage shall not exceed Two Million Dollars
($2,000,000.00) at any one time. ...
...
Mortgagor further covenants and warrants as follows:
1. Performance and Payment of Obligations Under
Indemnification Agreement. Mortgagor shall
promptly perform and pay when due all amounts,
duties and obligations of Mortgagor under the
Indemnification Agreement.
...
12. Protection of Mortgagee’s Rights in the
Property. If Mortgagor fails to perform the
covenants and agreements contained in this
Mortgage, or there is a legal proceeding that
may significantly affect Mortgagee’s rights in
the property (such as a proceeding in
bankruptcy, probate, for condemnation or to
enforce laws or regulations), then Mortgagee may
do and pay for whatever is necessary to protect
the value of the Property and Mortgagee’s rights
in the Property. Mortgagee’s actions may
include paying any sums secured by a lien which
has priority over this Mortgage, appearing in
court, paying reasonable attorneys’ fees and
entering on the Property to make repairs.
Although Mortgagee may take action under this
paragraph 12, Mortgagee does not have to do so.
Any amounts disbursed by Mortgagee under this
paragraph 12 shall become additional debt of
Mortgagor secured by this Mortgage.
...
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20. Transfer of the Property or a Beneficial
Interest in Mortgagor. Mortgagee may, at
Mortgagee’s option, declare immediately due and
payable all sums secured by this mortgage upon
the sale or transfer, without Mortgagee’s prior
written consent, of all or any part of the
Property, or any interest in the Property.
Dirk DePree filed this Second Mortgage for record on
February 3, 2004. Ex. 59, Foreclosure Judgment on Cross-
Claims, finding 4. The Second Mortgage does not call for
monthly payments or have a due date. However, the Court
notes that in January, 2004, Escala had already
stipulated with the Bank to a drop dead date of September
30, 2004.
87. Exhibit 42, pages 1 and 2, contain a preliminary balance
sheet for Escala as of February 29, 2004. It reflects a
“due to Dirk DePree” of $1.014 million. This represents
the securities taken by Bank under the guarantee. On
this date, Escala’s liabilities exceeded assets by $1.5
million. It shows a Note Payable to Renaissance of $1.36
million. Accumulated depreciation and amortization is
listed at $1.205 million. The Hotel is valued at $3.8
million based on the April 16, 2003 appraisal. Ex. 116.
88. On March 29, 2004, Mark DePree, on behalf of Escala,
terminated the contract with Tilden Drinkard and Layne
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Page -45-
for operation of the Hotel. T-TD 2/18 10:45. Trigild
was hired to operate the Hotel.
89. On April 6, 2004, Renaissance and Escala as sellers
entered a Purchase Agreement for sale of the Hotel in the
amount of $4.5 million. Mark DePree signed the agreement
on behalf of both sellers as the manager. Ex. 45.
90. On May 24, 2004, Vincent Garcia sent an email to Mark
DePree that offers to buy the Hotel. Ex. 108. It states
that it is a “very cursory written offer to be followed
by the Definitive Agreement”, which may have “de minimus
changes.” The purchase price was to be $5.75 million,
adjusted for final loan balances of Vincent Garcia (and
spouse), Tilden Drinkard, Layne, Suzie Fenstermacher, PI,
and amounts due to Chaves Grieves Engineers. The minimum
cash price would be $4.75 million and be paid at closing.
The balance of the price would be paid by tendering
membership interests and capital accounts of various
members as adjusted for various loans the members made to
either Renaissance or Escala. The offer further provided
that various lawsuits by members against Escala would be
settled for certain amounts listed and that Vincent
Garcia and his spouse and the DePree Group would mutually
release all claims between them. Closing was proposed to
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Page -46-
be September 15, 2004. Mark DePree responded by asking
for a signed offer. T-MD 2/22 1:50.
91. On June 9, 2004, Escala granted a Third Mortgage to Mark
DePree, Dirk DePree, DFLP and BSCI for $500,000 “or so
much thereof as may have been advanced and outsatnding
[sic] under the Note”, secured by the Hotel. The
mortgage was executed by Escala, by Renaissance, its
managing member, by Mark DePree, its managing member.
The promissory note calls for interest at Wall Street
Journal prime plus 2%, and the entire amount is due on or
before September 30, 2004. Ex. 50. Mark DePree
testified that before executing this third mortgage he
asked other members to loan money. T-MD 2/22 1:35. His
only responses were from BSCI, Dirk DePree and DFLP. Id.
Previously, Dirk DePree and Mark DePree advanced $70,000
for mortgage payments and sales taxes. At this time he
thought a crisis was on the horizon. Escala was
delinquent in taxes and in jeopardy of losing its liquor
license. Then each of Dirk DePree, BSCI and Mark DePree
loaned $25,000 to Escala. These are the amounts
represented in the Third Mortgage. Id. The members did
not get any additional units for their loans, nor were
their capital accounts credited. These loans were all
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20 This twist was not developed in the testimony.
Page -47-
made in anticipation that the Hotel was about to sell for
$4.5 million. Id. There is no evidence that Dirk DePree
had any control over the execution of the third mortgage.
92. Mark DePree testified that, at the time of the Third
Mortgage, Escala had to pay taxes or lose its liquor
license and that Escala had no funds. Escala was
pursuing the sale and a refinance, but they needed the
cash, so he pursued this loan. T-MD 2/16 11:30. Escala
had made a capital call in the summer of 2003, but it met
with resistance so he did not attempt another one. Id.
11:36.
93. On June 30, 2004, Tilden Drinkard and Layne obtained a
temporary restraining order (“TRO”) in the 2nd Judicial
District Court prohibiting the sale proposed in the April
6, 2004 purchase agreement “unless agreed to by the
parties or approved by this Ct. The Next LLC meeting can
be recorded by either party.” Ex. 53. The TRO was based
on a finding that on April 6, 2004, Mark DePree did not
have the authority to bind Renaissance or Escala.20
94. On July 3, 2004 Renaissance had a members meeting that
was taped and transcribed. T-MD 2/16 1:45. The members
reinstated Mark DePree’s authority and ratified his
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Page -48-
actions back to April 16, 2004. The TRO was never
lifted, however, and the sale never closed. Id.
95. On September 30, 2004, the 2nd Judicial District Court
entered judgment on Bank’s foreclosure, and judgment on
the Second and Third Mortgagees cross-claims for
foreclosure. Ex. 58 and 59 respectively. Exhibit 59
provides, in relevant part:
[T]he Court having examined the pleadings on
file herein and the documents attached to the
Crossclaim, having considered the evidence and
being fully advised in the premises, finds the
following facts:
...
3. In early February, 2004, [Bank] seized the
amount of $1,001,749.00 of [Dirk] DePree’s funds
pledged by [Dirk] DePree as collateral for the
borrowing of Escala with [Bank], and applied it
against amounts owed by Escala to [Bank]. Under
the DePree Indemnification Agreement, Escala is
obligated to pay DePree interest on such amount
from the date of seizure at the rate of 10.25%
per annum, the same rate as charged by [Bank]
under its loan documents.
[paragraphs 4 through 7 find that Escala delivered
the Second Mortgage to Dirk DePree to secure the
indemnification obligation, that it was filed with
the court as part of the cross claim, that it had
been recorded in the county land records, and
described the collateral (which, basically, was the
Hotel.)]
...
12. As of September 30, 2004, the amount due [Dirk]
DePree under the Indemnification Agreement is
$1,001,749.00, in addition to interest of $61,114.12
and attorneys fees of $2,571.00.
...
14. [Dirk] DePree has been required to employ
counsel to collect the amount due under the
DePree Indemnification Agreement, to respond to
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Page -49-
the Third Amended Complaint in this matter and
to institute and prosecute this cross-claim and
foreclosure of the Second Mortgage, thereby
incurring attorneys fees, which Escala is
obligated to pay to DePree under the DePree
Indemnification Agreement and the Second
Mortgage.
15. [Dirk] DePree is entitled to judgment
against Escala in the full amount of the
indemnification obligation, together with
interest thereon, attorneys fees, costs of
collection and all other amounts due.
16. The lien of [Dirk] DePree under the
Indemnification Agreement and the Second
Mortgage is a valid lien against the Property,
junior to the lien of [Bank]
...
IT IS THEREFORE ORDERED, ADJUDGED AND DECREED as
follows:
...
A. Cross-claimant [Dirk] DePree shall have
judgment against Defendant Escala, LLC, in the
total sum in the amount of the following:
$1,001,749.00 plus interest in the amount of
$61,114.12 plus interest at the rate of $258.58
per day from and after September 30, 2004, until
entry of this Judgment, plus attorneys fees,
fees, expenses and costs in the amount of
$2,571.00, for a total Judgment of
$1,065,434.12.
B. The unpaid portion of [Dirk] DePree’s
Judgment shall bear interest at the rate of
interest of 10.25% from the date of entry of
Judgment until the Judgment is paid in full.
C. [Dirk] DePree is the holder of a valid lien
on the Property described in the Second
Mortgage, junior to the lien of [Bank], but to
which the interest of Escala and the Third
Mortgage Holders herein and all persons claiming
under them are subordinate and inferior.
...
G. The Indemnification Agreement, Second
Mortgage, ... are hereby ordered foreclosed,
together with all rights in the Property of
Escala and any person claiming by, under or
through Escala...
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21Dirk DePree at first denied he ever did a statement for
an entity named Talisman regarding the Hotel. T-DD 2/22 3:25.
Then he admitted that he prepared the document and circulated
it, but that Talisman was not in existence. Both Vincent
Garcia and Dirk DePree exhibited some memory lapses and
discrepancies in their testimony, but the Court does not
consider that either of these witnesses was not credible or
straightforward.
Page -50-
...
I. [Dirk] DePree is allowed to bid in the amount
of his Judgment or any portion thereof at the
foreclosure sale as the equivalent of cash, if
and only if, the bid includes payment of cash
for the full amount owed by Escala to [Bank]...
J. In the event [Dirk] DePree is the successful
bidder, in addition to the cash bid pursuant to
Paragraph I, above, he is entitled to apply all
or part of his Judgment in payment of the
purchase price.
96. On October 8, 2004, one creditor filed an involuntary
bankruptcy petition against Escala. Doc. 1.
97. Sometime in October, 2004, Dirk DePree prepared a
document to circulate to potential investors who might be
interested in forming a deal to acquire the Hotel21. Ex.
72. Dirk DePree testified that he called it “Talisman
LLP”, but that this entity was never formed, the document
was just an attempt to get prepared to protect himself if
the Bank’s foreclosure went through. T-DD 2/22 3:25.
The proposed structure would be to purchase Hotel for
$4.0 million, $3.0 million of which would be cash by an
investor, and $1.0 million from Dirk DePree’s Second
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Page -51-
Mortgage. Ex. 72, page 2. At this time the Bank’s
mortgage was $2.4 million. Dirk DePree testified that
the excess cash after paying the mortgage was intended to
be distributed to unsecured creditors. T-DD 2/22 3:40.
The UCC urges the Court to deem this an admission by Dirk
DePree that his guarantee was intended to be equity. The
Court declines. This is simply a last ditch effort by
Dirk DePree to preserve his position and not lose
everything.
98. Exhibit 110 is a schedule of Renaissance’s unsecured
debts and Escala’s secured debts as of October 26, 2004.
Total debts were $6.2 million, including Dirk DePree’s
Second Mortgage listed at $1.04 million, loans from Mark
DePree of $544,000, and loans from Dirk DePree of
$277,000. The $6.2 million figure includes all of
Escala’s mortgages and unpaid taxes in the amount of
$3.85 million.
99. On November 4, 2004 the alleged debtor Escala voluntarily
converted to Chapter 11. Docs. 18, 19.
100. On November 29, 2004, Escala filed its statements
and schedules. Escala lists Renaissance as an
unsecured creditor in the amount of $1.36 million.
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Page -52-
101. On December 2, 2004, Dirk DePree filed proof of
claim #2, in an amount to be determined, secured by
real estate, and evidenced by the Foreclosure
Judgment. The Foreclosure Judgment, ex. 59, is also
attached to the proof of claim as Exhibit G. The
Judgment, dated September 30, 2004, is in the amount
of $1,001,749.00, plus accrued interest of
$61,114.12, and attorneys fees of $2,571.00 (Finding
12). Interest accrues on the principal amount at
the rate of 10.25% per year (Finding 3), or $258.58
per day (Decretal A). Therefore, Dirk DePree’s
claim is for $1,065,434.12 plus interest at the rate
of $258.58 per day from and after September 30, 2004
(Decretal A). Under his indemnification agreement
and the second mortgage Dirk DePree is entitled to
costs and reasonable attorneys fees for defending
his rights.
102. On December 17, 2004, Vincent Garcia wrote to Mark
DePree complaining about the performance of Trigild,
the operator of the Hotel. Ex. 61. The letter
refers mostly to documents not in evidence. Even if
it were the case, as alleged, that Trigild
mismanaged the Hotel and its hiring by Mark did
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22 In fairness to the expert Mr. Nagel, the Court is not
saying that his services were of no value, or that he was
“wrong”. This matter came before the Court on a fast-track
pace, by mutual agreement of all parties. The application to
employ him was filed on January 13, 2005. Doc. 130. He did
not have all the documents that were presented to the Court
during the four-day trial, nor the benefit of the pre- and
post-trial briefs, nor the benefit of the four days of
testimony before preparing his report. The Court, with the
luxury of having all the evidence and arguments presented
before considering the report, simply disagrees with the
statement of issues and conclusions.
Page -53-
little or no good for Escala, there is no allegation
that Mark DePree acted in bad faith, and so the
Court does not find the letter probative or
relevant.
103. The Court finds that the expert opinion offered in
this case by Roger Nagel, Ex. 62, and its supporting
documents, Exs. 66-69, are entitled to relatively
little weight22.
104. Roger Nagel testified that he not quantify the
alleged harm to creditors from Dirk DePree’s
conduct. T-RN 2/18 5:00. No other exhibit
calculated damages.
THE EXPERT OPINION
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23Rule 702, Fed.R.Evid., provides:
If scientific, technical, or other
specialized knowledge will assist the trier
of fact to understand the evidence or to
determine a fact in issue, a witness
qualified as an expert by knowledge, skill,
experience, training, or education, may
testify thereto in the form of an opinion
or otherwise.
The rule allows for the admissibility of expert
testimony to aid the Court in understanding the
evidence or deciding an issue of fact. Rule 702,
however, does not make the testimony of the expert,
even if uncontradicted by another expert, conclusive
as to the issue testified to. Security First
National Bank of L.A. v. Lutz, 322 F.2d 348, 355
(9th Cir. 1963). The Court is free to make its own
determination of the issues, regardless of the
expert testimony. "The rule [Rule 702] does not
mean that the trier of fact must rely upon expert
testimony which is unsatisfactory or that the trier
of fact is precluded from making an independent
determination of the facts, regardless of how
complicated or 'specialized' the subject matter may
be." Parents in Action v. Hannon, 506 F.Supp. 831,
836 n. 3 (N.D. Ill. 1980).
In re Opelika Manufacturing Corp., 66 B.R. 444, 450 (Bankr.
N.D. Ill. 1986).
24 The UCC also attempted to qualify him as an expert on
whether the debts in this case should be equitably
subordinated. Dirk DePree objected, and the Court sustained
this objection because the question of fairness or equitable
subordination is a legal conclusion to be reached by the
Court, not an expert witness. See, e.g., United States v.
Simpson, 7 F.3d 186, 188 (10th Cir. 1993):
The [Federal Rules of Evidence] do not, for example,
allow an expert to offer testimony that merely tells
(continued...)
Page -54-
Roger C. Nagel, CPA, was qualified as an expert witness23
for the UCC, on the sole issue of whether transactions should
be classified as debt or equity.24 He explained that there are
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24(...continued)
the jury what results they should reach ... Expert
testimony of this type is often excluded on the
grounds that it states a legal conclusion, usurps
the function of the jury in deciding the facts, or
interferes with the function of the judge in
instructing the jury on the law. See, e.g., Specht
v. Jensen, 853 F.2d 805, 808 (10th Cir. 1988), cert.
denied, 488 U.S. 1008, 109 S.Ct. 792, 102 L.Ed.2d
783 (1989).
Page -55-
two approaches to answering this question: 1) if a CPA is
advising on the fair presentation of financial data under
generally accepted accounting principles (“GAAP”) he or she
looks to GAAP principles, Financial Accounting Standards
Boards pronouncements, and Financial Accounting Concepts
Statements (“FACS”); or, 2) if the CPA is advising on tax or
regulatory issues, he or she looks to the tax laws and
regulations. Mr. Nagel analyzed the facts in this case using
the GAAP approach. He paid particular reference to FACS 2 and
6. FACS 2 deals with the validity of financial statement data
and the notion of “substance over form.” FACS 6 deals with
the characteristics of debt versus equity.
Mr. Nagel was first asked to look at the series of
transactions between the DePree Group and Escala or
Renaissance from August, 2000 to date, to opine on whether the
transactions were more characteristic of debt or equity.
Second, he was asked to examine the “fairness” of the
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25Dirk DePree’s second mortgage did not arise from a cash
advance to Escala or Renaissance. It resulted from his
guarantee of Escala’s Bank loan.
Page -56-
treatment of those transactions on the unsecured creditors.
He prepared a report (“Report”) on January 26, 2005, which was
admitted into evidence as Exhibit 62. The Report follows the
two questions presented. Part 1 of the Report deals with the
debt/equity question. Part 2 discusses the inequitable
conduct on the part of the DePree Group that Mr. Nagel states
benefitted the DePree Group at the cost of others, hence
justifying subordination. The Court did not consider Part 2
of the Report.
Part 1 of the Report is entitled “Characteristics of
equity investments (versus mortgage loans).” It identifies
eight characteristics that determine whether “cash advances25
to a business enterprise” are equity investments or “loan
proceeds.” The issue in this opinion is whether Dirk DePree’s
second mortgage lien on the Hotel can be credit bid at an
upcoming auction of the Hotel and whether Dirk DePree’s
guarantee to a third party financial institution should be
recharacterized as equity, or equitably subordinated. While
it is true that the DePree Group loaned a great deal of money
to Escala, that is not the issue at hand.
1. “Thin” versus “adequate” capitalization.
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26 Mr. Nagel testified that he had never seen the letter
agreement. T-RN 2/18 4:40.
Page -57-
The first characteristic discussed is “‘Thin’ versus
‘adequate’ capitalization”. The Report states that Escala was
formed as a wholly owned subsidiary of Renaissance. This is
not true. Escala was first owned and managed by PI, which
later transferred it to Renaissance. The Report states that
Dirk DePree paid nothing for his capital interest in
Renaissance, in cash or assets, and provided no services or
expertise other than his guarantee. First, as a matter of
law, a pledge of collateral to secure another’s debt is deemed
to be of value to the primary debtor. Second, Mr. Nagel
admitted he had no idea of what the value of the ownership
interest was that Dirk DePree received. And, the letter
agreement26 for the guarantee provided that Dirk DePree would
provide free services. Next, the Report states that Dirk
DePree’s willingness to expose his personal assets to the
claims of creditors suggested that he viewed his action as a
capital investment. On cross examination, Mr. Nagel admitted
that if the pledge were really equity, it would be available
to all creditors. T-RN 2/18 4:00. Dirk DePree’s assets were
only exposed to the Bank.
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27 The Report in this case conforms to the requirements of
Fed.R.Civ.P. 26(a)(2)(B). This rule requires that an expert’s
report “shall contain a complete statement of all opinions to
be expressed and the basis and reasons therefor; the data or
other information considered by the witness in forming the
opinions...” (Emphasis added.)
Page -58-
The Report next states that the Bank viewed the Escala
mortgage as a “risky” loan (because the term was 30 months as
opposed to 15 or 20 years), so therefore the Bank viewed Dirk
DePree’s guarantee as a form of capital investment. Mr. Nagel
never interviewed anyone at the Bank, however. T-RN 2/18
4:05. Steven Garrett, the Bank President testified that none
of the documents related to the Bank loan required or
considered the pledge to be a contribution to equity. T-SG
2/17 9:30. Nor can the Court infer such an intent from the
documents. Later, Mr. Garrett testified that the Bank had no
objection to Dirk DePree’s second mortgage. Id. 9:40.
The Report states that the property had a history of poor
cash flow and profit.27 The Report provides no disclosure of
the information on which this opinion is based and cites no
authority, other than the next sentence: “It was, after all,
disposed of in a bankruptcy proceeding.” Bankruptcy does not
necessarily mean a history of poor cash flow and profit.
Tilden Drinkard testified, however, that the pro formas showed
they could make the Hotel acquisition work. T-TD 2/17 4:50.
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28 Mr. Nagel cites the U.S. Small Business Administration
“Frequently Asked Questions” website for this proposition, and
attached a copy of the relevant frequently asked question.
Question: “How much money do I need to have in order to
qualify for an SBA loan?” Answer: “A borrower’s capital
contribution generally must be one-fifth to one-third of the
total project cost.” First, there is no evidence that this
was an SBA loan. The Report does not disclose why SBA norms
would apply. Second, the website does not say what the Report
represents it as saying. Rather, the website states that a
range of 66% to 80% is the general norm.
29 The Report provides no disclosure of the information on
which this statement (of what other lenders would have done)
is based and cites no authority.
Page -59-
The Report states lending institutions ordinarily do not
lend more than 75% of value on a property,28 that Escala did
not have sufficient equity, and that other lenders would have
required capital infusions.29 Evidence at trial showed that
the Bank made the loan based on an appraisal that showed there
was a 65% loan to value ratio. Mr. Nagel admitted on cross
examination that he learned this after his Report. T-RN 2/18
4:16. Therefore, the 75% was met. Id.
The Report referenced that Escala litigated claims from
the bankruptcy that were assumed as part of the purchase
price. The Report took this as evidence of an inability to
pay. At trial, the evidence showed that many of these debts
were disputed; some were considered frivolous. T-VG 2/17
3:45. Mr. Nagel admitted that nonpayment of disputed or
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30 “Financial strength can be evaluated through the
application of a variety of financial ratios. These ratios can
be categorized as liquidity ratios, coverage ratios, leverage
ratios, operating ratios, and specific expense item ratios.
In applying a ratio analysis, not all ratios are necessarily
applicable to a particular entity, and the applicable
standards may vary from industry to industry. It must also be
kept in mind that in addition to the mathematical aspect of
the analysis, other factors such as the nature and quality of
the assets need to be considered.” In re Snyder, 105 B.R.
898, 903 (Bankr. C.D. Ill. 1989).
Page -60-
frivolous debts is not evidence of inability to pay. T-RN
2/18 4:20.
The Report discusses the “common standards in commercial
lending” “debt to equity” ratios and discusses Escala’s poor
showing. Neither the Report or testimony clarified the
relative importance of the debt to equity ratio, and this left
the Court with many questions30. The Report then computes the
first end of year debt to equity ratio after an “unexpected
operating loss”. It is unclear how the ratio after a later
unexpected loss impacts on an initial undercapitalization
determination, or how this could impact an initial lending
determination.
The Report incorrectly states that there were never any
additional calls for capital infusions from investors. See
Ex. 117.
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31 The affidavit makes clear that Mr. Garcia was the
president of the managing member of Escala in August 2, 1999.
Mr. Garcia has not been managing member of Escala or on the
Board of Renaissance since May 1, 2003.
Page -61-
The Report finds that there was insufficient working
capital from inception. The Court agrees. Exhibits 66-69
support this conclusion.
2. Intent of the parties.
The second part of the Report opines on the intent of the
parties in connection with the Bank guarantee. It starts by
citing an affidavit from Vincent Garcia as president of the
managing member of Escala31, that “it was never the intent of
the parties for Dirk DePree’s guarantee to be repaid as if it
were a loan in the event the investments were liquidated for
the benefit of the bank.” Paragraph 8 of that affidavit
states, however:
During the course of the negotiations for the
collateral pledge, it was never discussed,
considered or agreed that any portion of the
collateral would be treated as a loan from Dirk
DePree to Renaissance, Escala or any of the
subsidiary companies or that Dirk DePree would be
entitled to be repaid any portion of the collateral
or would receive any further consideration or
compensation in the event the bank seized all or any
of the collateral.
Ex. 62, endnote D (emphasis added). The affidavit does not
state anything about the intent of the parties. All it states
is that it was “never discussed, considered or agreed.”
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Furthermore, if Dirk DePree acquired certain rights as a
matter of law pursuant to the guarantee agreement, Vincent
Garcia’s intentions about those rights are irrelevant. See
discussion below regarding subrogation.
The Report then states “The fact that no loan application
or note or mortgage was drawn up at the time to document such
an agreement is a corroborating indicator of that fact.” This
is an unfounded statement based on an incorrect legal
assumption. The entire loan package with the Bank was
thoroughly documented, including Dirk DePree’s guarantee.
There is no legal requirement that a borrower give a potential
guarantor a loan application. There is no legal requirement
that a borrower give a note to the guarantor at the time of
the guarantee; no liability arises until the borrower defaults
on the obligation to the creditor. See discussion below
regarding subrogation. At the inception of the guarantee
there is nothing to give a note for. Similarly, there is no
need to secure a non-existent note with a mortgage when
nothing is due.
The Report then states “Numerous borrowing transactions
in the ordinary course of business took place from August 1,
2000 until February 1, 2002 in which there was no mention to
other creditors that Dirk DePree had a priority claim against
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32 Various financial statements showed loans from Susie
Fenstermacher, Tilden Drinkard, and perhaps other insiders.
The Court has not reviewed these statements to attempt to
determine the dates of the loans. But, it is clear that Ms.
Fenstermacher, Tilden Drinkard and all insiders were aware of
Dirk DePree’s guarantee, albeit perhaps not the legal
ramifications thereof.
Page -63-
Escala’s assets as a creditor due to his limited guarantee.”
First, the Report provides no disclosure of the information on
which this statement is based. At trial, there was no
evidence of any borrowings between August 1, 2000 and February
1, 2002, other than a loan from Dirk DePree himself, Ex. 9,
and the February 1, 2002 loan from assorted members of the
DePree Group32, Ex. 19. Second, during this period of time,
Dirk DePree had only a contingent claim for subrogation. See
discussion below regarding subrogation. So, there was in fact
no failure to disclose additional liabilities; to the extent
Dirk DePree would have a claim in the future, Bank’s claim
would be reduced by the same amount with no net effect to
creditors.
The Report finds it significant that “[I]t was not until
eighteen months after the commitment to the bank that [Dirk]
DePree began a course of action to protect his personal assets
in the form of a recharacterized loan” because he now knew of
the operating performance and negative cash flow, and by this
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Page -64-
time he had obtained control through a “series of insider
activities.”
First, the Report provides no disclosure of the information on
which this opinion about insider activities is based. Second,
there is no evidence that Dirk DePree was attempting to
recharacterize anything. He had suretyship rights from the
inception of the loan. See discussion below regarding
subrogation. All evidence suggests he was, at all times
relevant, only attempting to get acknowledgment of those
rights, and nothing more.
The Report states that until the pledge was executed on
by the Bank, the books and records consistently revealed Dirk
DePree as an equity owner, not a creditor. As a matter of
law, he was not a “creditor” but only a contingent creditor.
See discussion below regarding subrogation. To the extent he
would later become a creditor, Bank’s claim would be reduced
by the same amount, with no net effect on third-party
creditors.
3. The name given to documents evidencing the nature of the
cash advances.
First, the Court again finds that this transaction was
not a “cash advance.” The Report finds that the “lack of
formality” in documenting the guarantee, and the books and
records reflection of Dirk DePree’s interest only as a member
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with an equity interest, suggest that it was not really a
loan. First, the Bank’s loan and guarantee were fully and
properly documented commercial loan agreements, and all were
approved by the Board. Nothing more was needed. Second, the
books and records properly showed only Dirk DePree’s equity
interest; until the Bank exercised its rights under the stock
pledge Dirk DePree was a contingent creditor with no amount
owed. In fact, the records showed that Dirk DePree’s capital
account was not credited when he pledged the stock. T-RN 2/18
4:45. Had a liability been shown on the books, it would have
been incorrect because the total amount owed was $3.5 million
at all times relevant, not $3.5 million to the Bank and an
additional $1 million to Dirk DePree. Mr. Nagel admitted this
on cross examination. T-RN 2/18 4:45.
The Report finds it significant that the original first
mortgage prohibited additional borrowing without its prior
approval. A guarantee is not “additional borrowing”. A
guarantee does not create a new loan. See discussion below
regarding subrogation.
4. Increased participation in management as a result of the
cash advances.
This portion of the Report discusses Dirk DePree’s
connection to the business (through his brother) before he
guaranteed the debt, and his later increased involvement in
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Page -66-
management. It concludes that after May 31, 2001, the
insiders that were part of the DePree Group operated the
business in a manner that resembled sole ownership. The
testimony at trial supports the conclusion that Dirk DePree
had somewhat increased involvement in management over time,
although he was an integral part of the management structure
starting no later than September 2000. Ex. 11, page 3.
However, the evidence at trial did not support a finding that
the DePree Group ran the business as a sole proprietorship
after May 31, 2001 (the date the First Amended and Restated
Operating Agreement of Renaissance became effective).
Instead, the Board was officially recognized on that date, and
evidence at trial showed that the Board operated after that
time.
5. The ability to obtain loans from outside lending
institutions.
Although it appears likely that Escala was unable to
obtain financing for the Hotel elsewhere, that fact as such
was not established by the testimony and evidence at trial.
6. Presence or absence of a fixed maturity date.
The Report does not state that the guarantee agreement
did not have a maturity date, but the Court so finds. The
Report states that the Feb. 2, 2002 indemnification agreement
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Page -67-
and the second mortgage, given after the stocks were taken, do
not have a maturity date. On February 2, 2002 Escala owed no
debt to Dirk DePree because the stocks were not taken until
2004, therefore no maturity date was needed, or possible.
When the second mortgage was given in February 2004, after the
stocks were taken, Escala had already agreed to a drop dead
date with the Bank of September 30, 2004. This suffices to
establish an effective maturity date on the second mortgage.
7. Source of repayments of principal and interest.
The Report notes that the second mortgage did not call
for payments of principal and interest as would be expected in
a traditional borrowing environment. It states that the only
source of liquidating this debt was from net operating
results, and that due to insufficient cash flows no payments
were in fact made. The Court disagrees with this conclusion.
The Bank loan was for thirty months, and trial testimony
suggests an intent to refinance quickly within less than that
time, and perhaps in as little as twelve months. See supra
Findings 33, 50. The Bank’s loan was to be paid by a
refinance. Dirk DePree’s claim, as derivative of the Bank’s
(either through subrogation or as a second mortgage), would
also be satisfied by refinancing.
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Page -68-
8. The failure of the debtor to repay on the due date or to
seek a postponement.
The Report states that because there was no maturity date
on the second mortgage, there was no date upon which Dirk
DePree could assert his rights to begin legal proceedings.
However, the Extension Agreement, Ex. 102, externally imposed
that date. The record also shows that Escala sought and
obtained postponements on the Bank’s obligation. Furthermore,
Dirk DePree actively participated in Bank’s foreclosure case,
which is inconsistent with an equity position. T-RN 2/18
4:53.
In sum, the Court has made an independent determination
of the facts and placed relatively little weight on the
Report.
CONCLUSIONS OF LAW
Before turning to the three main issues in this case, the
Court will address the UCC’s request at closing argument and
in its post-trial brief that the Court should consider the
history of Escala and Renaissance as a whole and not look in
isolation at Escala. The Court declines. Under New Mexico
law, each LLC is a separate legal entity. § 53-19-10(A) NMSA
1978. The property of an LLC is owned by the LLC, not its
members. § 53-19-29(A) NMSA 1978. The debts, obligations and
liabilities of an LLC are solely the debts, obligations and
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Page -69-
liabilities of the LLC. § 53-19-13 NMSA 1978. No member or
manager of an LLC shall be obligated personally for any debt,
obligation or liability of the LLC solely by reason of being a
member or manager of the LLC, but a manager may be liable for
an act or omission if there is otherwise a basis for
liability. Id.
Renaissance may have claims against its Board or the
Board members for any damages it sustained. These claims
would be the property of Renaissance, however, not of Escala.
And, Escala lacks standing to pursue claims on Renaissance’s
behalf. If Escala has claims against the Board or the Board
members, it must be for damages sustained by Escala on causes
of action that belong to Escala. See Scott v. AZL Resources,
Inc., 107 N.M. 118, 121-22, 753 P.2d 897, 900-901 (1988).
(Every corporation is a separate legal entity. A subsidiary
and its parent are separate entities. In order to pierce the
corporate veil to hold a parent corporation or its
stockholders liable, one must show “improper purpose” before
considering other factors. Ownership of a subsidiary or
commonality of the boards of directors is not sufficient to
ignore the formalities. The party must also demonstrate the
financial setup of the corporation is a sham that causes
injustice. However, if each business conducts business in its
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own name, receives income in its own accounts, and each owns
valuable assets, this demonstrates that they were not sham
corporations. The fact that a company loses money is not
enough to disregard the corporate entity; the losses must
result from mismanagement and fraudulent manipulation.
Supplying money to a losing business is not an improper
purpose.) Based on Scott the Court cannot find from the
evidence at trial that Escala and Renaissance are basically
one entity. Therefore, the Court will respect the formalities
and determine if Escala was damaged, and if Escala through its
unsecured creditors committee is entitled to the relief it
requests. The Court will, however, consider all the evidence
presented at trial to reach its decision.
1. Subrogation.
Subrogation is a term used by the law to
describe the remedy by which, when the property of
one person is used to discharge a duty of another or
a security interest or lien upon property of
another, under such circumstances that the other
will be unjustly enriched by the retention of the
benefit thus conferred, the former is placed in the
position of the obligee or lienholder. Subrogation
does not spring from contract although it may be
confirmed or qualified by contract. Rather, it is a
rule that the law adopts to compel the eventual
satisfaction of an obligation by the one who ought
to pay it. In the suretyship context, subrogation
provides a secondary obligor who performs the
secondary obligation with the obligee's rights with
respect to the underlying obligation as though that
obligation had not been satisfied. See § 28. Since
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Page -71-
the underlying obligation has been satisfied, no
interest of the obligee is prejudiced by permitting
the secondary obligor to enforce the obligee's
rights, and the resulting benefit to the secondary
obligor effectuates the rights of the secondary
obligor against the principal obligor (§§ 21-26).
Subrogation is often called an equitable assignment
or an assignment by operation of law.
Restatement (Third) of Suretyship & Guaranty (“Restatement”) §
27 cmt. a. “[P]robably there are few doctrines better
established than that a surety who pays the debt of another is
entitled to all the rights of the person he paid to enforce
his right to be reimbursed. This rule, widely applied in this
country [is] generally known as the right of subrogation.”
Pearlman v. Reliance Ins. Co., 371 U.S. 132, 136-37
(1962)(footnotes and citations omitted.) A guarantor is “a
favorite of the law,” and entitled to a strict construction of
his or her agreement. Levenson v. Haynes, 123 N.M. 106, 112,
934 P.2d 300, 306 (Ct. App.), cert. denied, 123 N.M. 168, 936
P.2d 337 (1997)(quoting Shirley v. Venaglia, 86 N.M. 721, 724,
527 P.2d 316, 319 (1974)). Consequently, the guarantor’s
liability should not be extended by implication beyond the
express limits or terms of the instrument or its plain intent.
Id. And, for protection of a guarantor, equitable subrogation
is a “highly favored doctrine and is to be given a liberal
application.” Minnesota Trust Co. of Austin v. Yanke (In re
Yanke), 230 B.R. 374, 379 (8th Cir. BAP 1999).
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New Mexico courts apply the principles set out in the
Restatement. Venaglia v. Kropinak, 125 N.M. 25, 30, 956 P.2d
824, 829 (Ct. App. 1998)(“[F]or authoritative guidance on the
common law of [guarantees] we look to the Restatement [(Third)
of Suretyship and Guaranty (1996)]”). See also, e.g.,
Levenson, 123 N.M. at 111, 934 P.2d at 305.
A pledge of stock to secure another’s debt gives the
pledgor (“guarantor”) suretyship status. Restatement § 1 cmt.
g, illus. 6. Suretyship status gives the guarantor a
significant set of rights against both the debtor and the
creditor. Id. cmt. a. The guarantor obtains these rights “as
a matter of status in the transaction rather than by express
agreement.” Id. The suretyship status creates two implied
contracts: one between the debtor and the guarantor, and one
between the guarantor and the creditor. Id.
A breach occurs when the debtor fails to perform its
contract to the creditor. Restatement § 22. The debtor has a
duty to reimburse the guarantor to the extent the guarantor
performs the guarantee. Id.
Restatement § 21(2) states that, upon breach, the
guarantor is entitled to relief that will properly protect its
rights. This is justified because as between the debtor and
the guarantor, the debtor should bear the cost of performance.
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Restatement § 21 cmt. a. The guarantee serves as an
inducement for an action by the creditor, and is beneficial to
the debtor. Id. The guarantor can enforce performance by the
debtor upon breach. Restatement § 21 cmt. i. It is
inequitable for the guarantor to be compelled to suffer the
inconvenience and temporary loss that performance under the
guarantee will entail. Id. Therefore, absent defenses of the
debtor to perform its duties, the guarantor is entitled to
appropriate relief protecting its interests. Id. This is
called “exoneration.” Id. Exoneration should properly
protect the interests of the debtor, the creditor, and the
guarantor. Id. cmt. k. “Among the courses open to a court
are ... to require that the [debtor] give the [guarantor]
adequate security for its ultimate reimbursement.” Id.
Restatement § 27 discusses when a guarantor has
subrogation rights: “(1) Upon total satisfaction of the
underlying obligation, the [guarantor] is subrogated to all
rights of the [creditor] with respect to the underlying
obligation to the extent that performance of the [guarantee]
contributed to the satisfaction.” So, under common law a
guarantor is not entitled to subrogation rights of the
creditor until the underlying obligation is completely
discharged. Id. cmt. b.
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This does not mean, however, that the guarantor must pay
the entire remaining obligation himself, or immediately. See
Furlong v. Leybourne, 138 So.2d 352, 356 (Fla. Dist. Ct. App.
1962) (Declaratory judgment action declaring that if party
should make any payments on bank’s mortgage in the future,
upon bank’s satisfaction, they would be subrogated to extent
of payments made and could foreclose at that time.); Nat’l
Surety Corp. v. Cherokee County Bank, 57 F.Supp. 370, 372
(N.D. Ala. 1944)(Rule of full payment is satisfied if the
creditor is paid in full, even if part of the debt was paid by
the debtor or others.); Fowler v. Lee, 106 Fla. 712, 716, 143
So. 613, 614 (1932)(same.); Richard A. Lord, 23 Williston on
Contracts § 61:54 (4th ed.)(“Williston”)(“The surety’s right of
subrogation does not ordinarily arise until the debt is paid
in full... It is not necessary, however, that the surety make
full payment. It is sufficient that any unpaid balance for
which the surety was not obligated has been paid to the
creditor by the principal or some other person properly paying
it.”)(Footnotes omitted.)
The rule requiring full payment is for the sole
protection of the creditor. Mid-States Ins. Co. v. American
Fidelity and Casualty Co., 234 F.2d 721, 731 (9th Cir. 1956);
Fowler, 106 Fla. at 715-16, 143 So. at 614. This allows the
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creditor to remain in full control of the debt and its
collection. Mid-States Ins. Co., 234 F.2d at 731; Pep’e v.
McCarthy, 249 A.D.2d 286, 287-88, 672 N.Y.S.2d 350, 352 (N.Y.
App. Div. 1998). Consequently, the rule may only be invoked
by the creditor. Pep’e, 249 A.D.2d at 288, 672 N.Y.S.2d at
352; Benschoter v. First Nat’l Bank of Lawrence, 218 Kan. 144,
155, 542 P.2d 1042, 1051 (1975); Schmid v. First Camden Nat’l
Bank & Trust Co., 130 N.J. Eq. 254, 271, 22 A.2d 246, 256
(N.J. Ch. 1941). And, even the creditor may not invoke the
rule if there would be no prejudice to the creditor. Missouri
ex rel. Paden v. Carrel, 597 S.W.2d 167, 177 (Mo. Ct. App.
1979); Mutual Life Ins. Co. of New York V. Grissett, 500
F.Supp. 159, 163 (M.D. Ala. 1980). See also United States
Fid. & Guar. Co. v. Maryland Cas. Co., 186 Kan. 637, 644-45,
352 P.2d 70, 77 (1960)(If creditor would not be deprived of
anything, the rule regarding full payment has no application.)
Compare 23 Williston § 61:54 (“In a case where a surety
partially discharges a debt secured by a first mortgage, the
granting of subrogation rights to the surety, without the
surety having paid the entire first mortgage debt, is not
prejudicial to the rights of the holders of junior liens.”);
and Johnson v. Sowell, 80 N.M. 677, 680, 459 P.2d 839, 842
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(1969)(Court enforces partial subrogation of mortgage because
courts of equity always recognize partial assignments.)
Finally, the protection of the rule requiring full
payment can be waived if the creditor acquiesces to the
subrogation. Thornton v. Syracuse Savings Bank, 961 F.2d
1042, 1047 (2nd Cir. 1992); Mid-States Ins. Co., 234 F.2d at
731 ; Benschoter, 218 Kan. at 155, 542 P.2d at 1051. In this
case, the Bank explicitly agreed to the recording of the
second mortgage. Ex. 41.
Restatement § 28 discusses the rights obtained through
subrogation:
(1) To the extent that the [guarantor] is subrogated
to the rights of the [creditor], the [guarantor] may
enforce, for its benefit, the rights of the
[creditor] as though the underlying obligation had
not been satisfied:
(a) against the [debtor] pursuant to the underlying
obligation;
...
(c) against any interest in property securing either
the obligation of the [debtor] ... against whom the
rights of the [creditor] may be enforced;
...
(2) Recovery under this section is limited as
follows:
(a) the total recovery of the [guarantor] pursuant
to subsection (1) may not exceed the [guarantor’s]
cost of performance of the [guarantee]; ...
“When a [guarantor] is subrogated to the rights of the
[creditor] with respect to the underlying obligation, the
result is essentially the same as if the [creditor] had
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33 Generally this is not required. See, e.g., Memphis &
L.R.R. Co. v. Dow, 120 U.S. 287, 301 (1887).
Page -77-
assigned those rights to the [guarantor]. Indeed, subrogation
is often referred to as equitable assignment or an assignment
by operation of law.”
Id. cmt. a. Subrogation treats the guarantor as though its
performance of the guarantee was consideration for an
assignment of the creditor’s rights. Id. cmt. b. See, e.g.,
Yanke, 230 B.R. at 379 (Payment by a surety is deemed to be a
purchase of the claim from the creditor; although payment
extinguishes the remedy and discharges the security as
respects the creditor, it does not have that effect as between
the surety and the debtor.) If it is necessary for the
guarantor to have a formal assignment to enforce rights of the
creditor33, the creditor must execute any instruments necessary
to enable the guarantor to enforce those rights. Id. Cmt. h.
See also Reimann v. Hybertsen, 276 Or. 95, 98, 553 P.2d 1064,
1065 (1976)(Court orders creditor to assign mortgages to
accommodation maker.)
The Restatement Third of Property (Mortgages) § 7.6
dictates the same result:
One who fully performs an obligation of another,
secured by a mortgage, becomes by subrogation the
owner of the obligation and the mortgage to the
extent necessary to prevent unjust enrichment. Even
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though the performance would otherwise discharge the
obligation and the mortgage, they are preserved and
the mortgage retains its priority in the hands of
the subrogee.
“The effect of subrogation is to assign the mortgage and
the obligation by operation of law; when the mortgage is paid
the [guarantor] is entitled to receive upon request a formal
written assignment.” Id. cmt. a. See also Tiffany, Real
Property § 1506.
The right of subrogation does not create a new debt.
Putnam v. Commissioner, 352 U.S. 82, 85 (1956):
The familiar rule is that, instanter upon the
payment by the guarantor of the debt, the debtor's
obligation to the creditor becomes an obligation to
the guarantor, not a new debt, but, by subrogation,
the result of the shift of the original debt from
the creditor to the guarantor who steps into the
creditor's shoes.
See also Fidelity & Deposit Co. of Maryland v. Hobbs, 144 F.2d
5, 8 (10th Cir. 1944):
It is well settled that, when a contract of
suretyship is made, there arises, in the absence of
an express agreement, an implied contract that the
principal will indemnify the surety for any payment
the latter may make to the creditor in compliance
with the contract of suretyship. This implied
contract arises when the suretyship is made, and not
when the payment is made by the surety thereunder.
The relation of debtor and creditor exists between
the principal and surety from the time the contract
of suretyship is made. The payment relates back to
the time when the contract was entered into by which
the liability to pay was incurred, fixes the amount
of damages for which the principal is liable to the
surety and matures the cause of action therefor.
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and F.D.I.C. v. Hiatt, 117 N.M. 461, 468, 872 P.2d 879, 886
(1994)(citing Putnam, 352 U.S. at 85)(Montgomery, C.J.,
Dissenting). Rather, subrogation continues the existing debt.
Compare Restatement § 62 cmt. c:
The secondary obligor’s right of subrogation is the
right to enforce the obligee’s claim against the
principal obligor. Thus, the statute of limitations
with respect to the secondary obligor’s rights
obtained through subrogation is the same as the
statute of limitations with respect to those rights
if enforced by the obligee.
Similarly, the right of subrogation does not create a new
lien. 23 Williston § 61:52; Restatement § 28 cmt. a. Rather,
subrogation continues the preexisting lien. 23 Williston §
61:54 (“[T]he sureties’ right becomes an inchoate one as soon
as they have entered into the relation of suretyship, and the
equitable assignment of their principal’s rights and remedies,
when completed by their performance of the principal’s
obligation, relates back, as against each other and their
principal, to that earlier time.”); Restatement § 28 cmt. a.
At common law, courts apply a five part test to determine
if a party has subrogation rights:
(1) The codebtor must have made payment to protect
his or her own interests;
(2) the codebtor must have not been a volunteer;
(3) the payment must satisfy a debt for which the
codebtor was not primarily liable;
(4) the entire debt must have been paid; and
(5) subrogation must not cause injustice to the
rights of others.
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CCF, Inc. v. First Nat’l Bank & Trust Co. of Okmulgee (In re
Slamans), 69 F.3d 468, 472 n.2 (10th Cir. 1995).
Bankruptcy law recognizes subrogation. Section 509
states, in full:
Claims of codebtors.
(a) Except as provided in subsection (b) or (c) of
this section, an entity that is liable with the
debtor on, or that has secured, a claim of a
creditor against the debtor, and that pays such
claim, is subrogated to the rights of such creditor
to the extent of such payment.
(b) Such entity is not subrogated to the rights of
such creditor to the extent that--
(1) a claim of such entity for reimbursement or
contribution on account of such payment of such
creditor's claim is--
(A) allowed under section 502 of this title;
(B) disallowed other than under section 502(e)
of this title; or
(C) subordinated under section 510 of this
title; or
(2) as between the debtor and such entity, such
entity received the consideration for the claim held
by such creditor.
(c) The court shall subordinate to the claim of a
creditor and for the benefit of such creditor an
allowed claim, by way of subrogation under this
section, or for reimbursement or contribution, of an
entity that is liable with the debtor on, or that
has secured, such creditor's claim, until such
creditor's claim is paid in full, either through
payments under this title or otherwise.
The Tenth Circuit acknowledged a split in the courts over
whether one must meet the requirements of common law
subrogation in addition to those set forth in section 509.
Slamans, 69 F.3d at 472 n.2. Indeed, this is an open
question. See In re Fiesole Trading Corp., 315 B.R. 198, 203-
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04 (Bankr. D. Mass. 2004) (Collecting cases and discussing the
four approaches used by courts to integrate equitable
subrogation with section 509); Celotex Corp. v. Allstate Ins.
Co., (In re Celotex Corp.), 289 B.R. 460, 470-72 (Bankr. M.D.
Fla. 2003)(same.)
One difference between the two types of subrogation is
the requirement that the debt be paid in full. Many cases
have noted that section 509 is available for partial payments.
The language of 509(a) and (c) suggest this is the intent.
Section 509(a) subrogates “to the extent of such payment.”
Section 509(c) defers payments to the subrogated party “until
such creditor’s claim is paid in full, either through payments
under this title or otherwise.” (Emphasis added.) Cornmesser
v. Swope (In re Cornmesser’s Inc.), 264 B.R. 159, 163 (Bankr.
W.D. Pa. 2001). Furthermore, a creditor paid in full before
the bankruptcy would no longer be a creditor of the debtor.
Stephenson v. Salisbury (In re Corland Corp.), 967 F.2d 1069,
1078 (5th Cir. 1992); 4 Alan J. Resnick and Henry J. Sommer,
Collier on Bankruptcy ¶509.02[3] at 509-5 (A codebtor that has
paid in full before the bankruptcy has total subrogation and
is the only creditor.)
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Other cases hold that the debt must be paid in full.
See, e.g., In re Southwest Equip. Rental, Inc., 193 B.R. 276,
283 (E.D. Tenn. 1996).
The other difference between the two types of subrogation
is the requirement under common law that subrogation not cause
injustice to the rights of others. Slamans, 69 F.3d at 472
n.2 (fifth part of test). Section 509(a) automatically
subrogates those that meet the requirements in this section,
and equitable considerations are not part of this section.
Rather, section 509(b) provides that an entity will not be
subrogated to the extent that the claim is subordinated under
section 510. See Cuda v. Nigro (In re Northview Motors,
Inc.), 202 B.R. 389, 401 (Bankr. W.D. Pa. 1996)(“[The]
argument that the equities in this case do not favor
subrogation by the Cudas shall be dealt with in the context of
equitable subordination under § 510(c) rather than as an
additional requirement under § 509(a).”). See also Fiesole
Trading, 315 B.R. at 204 (“Because § 509 clearly delineates
the requirements for an exceptions to subrogation, this Court
will not superimpose state law doctrines to expand or contract
the right to subrogation provided for under the Bankruptcy
Code.”)
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In Slamans the Court found that the party seeking
subrogation did not qualify under section 509(a), and
therefore specifically did not decide whether the lower courts
must apply the five part equitable test “in addition to” the
requirements of section 509. Slamans, 69 F.3d at 472 n.2.
(Emphasis in original.)
Subrogation applies to satisfaction of debts prepetition
as well as postpetition. In re Bugos, 760 F.2d 731, 734 n.4
(7th Cir. 1985). See also In re Corland Corp., 967 F.2d at
1077-78 (emphasis in original):
Stephenson paid the Bank directly only after Corland
declared bankruptcy. ... We must consider the impact
of subrogation. The Bank would have had a
prepetition claim against the estate under the
Corland Note. Stephenson, as guarantor, paid the
Bank the amount owed and is now subrogated to the
Bank's claim. Thus Stephenson is subrogated to the
Bank's prepetition claim, and stands in the shoes of
a prepetition creditor. See Matter of United
Sciences of America, Inc., 893 F.2d 720, 724 (5th
Cir. 1990); In re Flanagan Bros., Inc., 47 B.R. 299,
303 (Bankr. D. N.J. 1985). Neither court below nor
the Trustee has cited any authority for the
proposition that postpetition payments on a guaranty
are ineligible for setoff. Indeed, where, as here, a
guarantor pays a debtor's creditor in full, §
509(a)'s right of subrogation has meaning only if
the payment is made postpetition; otherwise, there
would be nothing to subrogate because a pre petition
payoff to the creditor would leave the creditor with
no claim against the estate. See 3 Collier ¶ 509.02
at 509-6-7. We are satisfied that Stephenson's
claim against Corland "arose" prepetition for
purposes of setoff under § 553.
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and In re The Medicine Shoppe, 210 B.R. 310, 315 (Bankr. N.D.
Ill. 1997).
2. Recharacterization.
When a putative loan to a corporation is
recharacterized, the courts effectively ignore the
label attached to the transaction at issue and
instead recognize its true substance. The funds
advanced are no longer considered a loan which must
be repaid in bankruptcy proceedings as corporate
debt, but are instead treated as a capital
contribution.
Sender v. The Bronze Group, Ltd. (In re Hedged-Investments
Assoc., Inc.), 380 F.3d 1292, 1297 (10th Cir. 2004).
“Recharacterization cases turn on whether a debt actually
exists, not on whether the claim should be equitably
subordinated.” Id. (quoting Bayer Corp. v. Masco Tech, Inc.
(In re AutoStyle Plastics, Inc.), 269 F.3d 726, 748-49 (6th
Cir. 2001)). “The ultimate issue then is whether the
transaction had the substance and character of an equity
contribution or of a loan.” Herzog v. Leighton Holdings, Ltd.
(In re Kids Creek Partners, L.P.), 212 B.R. 898, 932 (Bankr.
N.D. Ill. 1997), aff’d, 233 B.R. 409 (N.D. Ill. 1999), aff’d,
200 F.3d 1070 (7th Cir. 2000). Recharacterization effectively
subordinates the entire claim to all creditors by
reclassifying it as equity. Equitable subordination, as
discussed below, is a remedial device based on equitable
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principles that subordinates only to the extent necessary to
offset the harm the other creditors suffered as a result of
the inequitable conduct.
In Sinclair v. Barr (In re Mid-Town Produce Terminal,
Inc.), 599 F.2d 389, 390 (10th Cir. 1979) the Tenth Circuit
addressed the equitable powers under the Bankruptcy laws to
deny a dominant shareholder’s security interest in company
assets and subordinate a promissory note to the claims of that
company’s creditors. “In a case like this the usual procedure
is to first determine whether the transaction was a
contribution to capital rather than a loan.” Id. at 393. The
Tenth Circuit remanded the case for the bankruptcy court to
analyze recharacterization as an issue separate from equitable
subordination, and to consider three factors: (1) the initial
operating capital, (2) the length of time the business was in
operation at the time of the loan, and (3) whether the parties
treated the transaction as a loan or as a capital investment.
Hedged-Investments, 380 F.3d at 1298 (citing Midtown, 599 F.2d
at 393). Hedged-Investments acknowledged that since Mid-Town,
other circuits and tax cases have applied a multi-factor test,
and then adopted it for use in the Tenth Circuit. Id. The
factors now employed to distinguish true debt from camouflaged
equity are:
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(1) the names given to the certificates evidencing the
indebtedness;
(2) the presence or absence of a fixed maturity date;
(3) the source of payments;
(4) the right to enforce payment of principal and
interest;
(5) participation in management flowing as a result;
(6) the status of the contribution in relation to
regular corporate creditors;
(7) the intent of the parties;
(8) "thin" or adequate capitalization;
(9) identity of interest between the creditor and
stockholder;
(10) source of interest payments;
(11) the ability of the corporation to obtain loans
from outside lending institutions;
(12) the extent to which the advance was used to
acquire capital assets; and
(13) the failure of the debtor to repay on the due
date or to seek a postponement.
Stinnett's Pontiac Serv., Inc. v. Comm'r of Internal
Revenue, 730 F.2d 634, 638 (11th Cir. 1984).
Id.
Other cases have applied yet other factors, not included
on this list. For example, in Central Cooperatives, Inc. v.
Irwin (In re Colonial Poultry Farms), 177 B.R. 291, 300
(Bankr. W.D. Mo. 1995) the Court also examined whether the
failure to treat the loan as capital caused the business’
ultimate financial failure. (Hereafter, “Causation”). And, in
In re Cold Harbor Assoc., L.P., 204 B.R. 904, 918-19 (Bankr.
E.D. Va. 1997), the Court looked to see if loans made to the
company were made in proportion to stock ownerships.
(Hereafter, “Proportionality”). In Official Committee of
Unsecured Creditors v. Credit Suisse First Boston (In re Exide
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Technologies, Inc.), 299 B.R. 732, 741-42 (Bankr. D. Del.
2003) the Court considered whether the loan was secured.
(Hereafter, “Collateral”).
None of the factors is dispositive, and the significance
of each varies with the circumstances. Hedged-Investments,
380 F.3d at 1298. These factors analyze whether the
transaction reflects the characteristics of an arm’s length
negotiation. Matthew Nozemack, Note, Making Sense out of
Bankruptcy Courts’ Recharacterization of Claims: Why not use §
510(c) Equitable Subordination?, 56 Wash. & Lee L. Rev. 689,
708 (1999) (“Nozemack”). See also Kids Creek Partners, 212
B.R. at 931 (The criteria test whether the transaction bears
the earmarks of an arm’s-length commercial lending
agreement.); Cold Harbor Assoc., 204 B.R. at 915 (The “primary
factor” is whether the transactions bears the earmarks of an
arm’s length negotiation.)(citing Pepper v. Litton, 308 U.S.
295 (1939)); Colonial Poultry Farms, 177 B.R. at 299 (The
criteria test an arm’s-length bargain.)
The relevant time in a recharacterization analysis is the
inception of the loan. Cold Harbor, 204 B.R. at 915; Colonial
Poultry, 177 B.R. at 300; Nozemack, 56 Wash. & Lee L. Rev. at
710.
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Too heavy an emphasis on the undercapitalization factor
produces the “unhealthy deterrent effect” of discouraging
legitimate loans to failing businesses by insiders; business
owners should not fear that if their efforts fail the court
would give disproportionate weight to the poor capital
condition of the company. Hedged-Investments, 380 F.3d at
1298 n.1.; Nozemack, 56 Wash. & Lee L. Rev. at 715 (Often an
insider is the only source of funds for a struggling company.
If an insider creditor faces recharacterization even without
inequitable conduct, it would be hesitant to loan money when
the company needs it the most.) Accord Kids Creek Partners,
212 B.R. at 932 (Same, and suggesting that if the debtor’s
business is unique, unusual or based on a particular
opportunity to obtain rights to develop a particular valuable
property, those factors might justify small initial capital to
develop and plan even if the business is undercapitalized for
its ultimate needs.)
All of the cases found by the Court on the issue of
recharacterization deal with direct loans to the business.
See, e.g. Hedged-Investments, 380 F.3d at 1295 (“a loan
advanced to [Debtor]”); Mid-Town, 599 F.2d at 391 (“The sum of
$20,000 was advanced to Mid-Town.”); Nozemack, 56 Wash. & Lee
L. Rev. at 705-06 (Noting that recharacterization usually
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arises in the context of “additional funds” loaned to a
corporation after the initial capitalization.); cf. Uri v.
Commissioner, 949 F.2d 371, 374 (10th Cir. 1991)(Taxpayers were
not allowed to adjust basis in their stock of corporation for
guarantees of bank loan to their “thinly capitalized”
corporation.) In this case, the UCC is attempting to
recharacterize a guarantee of a bank debt. The Court is not
convinced this remedy is or should be available. However, the
Court will proceed as if this were possible.
3. Equitable subordination.
Bankruptcy Code Section 510(c) states:
(c) Notwithstanding subsections (a) and (b) of this
section, after notice and a hearing, the court may--
(1) under principles of equitable subordination,
subordinate for purposes of distribution all or
part of an allowed claim to all or part of
another allowed claim or all or part of an
allowed interest to all or part of another
allowed interest; or
(2) order that any lien securing such a
subordinated claim be transferred to the estate.
Equitable subordination is an unusual remedy which should
be applied only in limited circumstances. Autostyle Plastics,
Inc., 269 F.3d at 745 (“[W]e use great caution in applying the
remedy...”); In re Mr. R’s Prepared Foods, Inc., 251 B.R. 24,
28 (Bankr. D. Ct. 2000)(citing Fabricators, Inc. v. Technical
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Fabricators, Inc. (In re Fabricators, Inc.), 926 F.2d 1458,
1464 (5th Cir. 1991)).
The leading case on equitable subordination is Benjamin
v. Diamond (In re Mobile Steel Co.), 563 F.2d 692 (5th Cir.
1977). That court stated the standard formulation of the
common law of equitable subordination: (1) inequitable
conduct, (2) injury to creditors or unfair advantage, and (3)
consistency with the bankruptcy code. Id. at 699-700. Even
upon a showing of all three factors, equitable subordination
is not required, but merely permitted. Farr v. Phase-I
Molecular Toxicology, Inc. (In re Phase-I Molecular
Toxicology, Inc.), 287 B.R. 571, 579 (Bankr. D. N.M.
2002)(citing Autostyle Plastics, Inc., 269 F.3d at 744).
In Sloan v. Zions First Nat’l Bank (In re Castletons,
Inc.), 990 F.2d 551, 559 (10th Cir. 1993), the Tenth Circuit
adopted the Mobile Steel standard and placed special emphasis
on the inequitable conduct prong. Hedged-Investments confirms
the continuing validity of that emphasis, “We adhere to the
general rule, therefore, that equitable subordination is not
justified absent a finding that the party sought to be
subordinated engaged in inequitable conduct.” Hedged-
Investments, 380 F.3d at 1301.
A. Inequitable Conduct.
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Hedged-Investments stated the test to be applied in
determining “inequitable conduct”:
(1) fraud, illegality, and breach of fiduciary
duties; (2) undercapitalization; or (3) claimant's
use of the debtor as a mere instrumentality or alter
ego." Fabricators, Inc. v. Technical Fabricators,
Inc. (In re Fabricators), 926 F.2d 1458, 1467 (5th
Cir. 1991) (interpreting the Mobile Steel standard
and finding the claimant had committed fraud
amounting to inequitable conduct by inducing other
creditors to continue extending new credit to the
troubled debtor company). See also CTS Truss, Inc.
v. FDIC (In re CTS Truss, Inc.), 868 F.2d 146,
148-49 (5th Cir. 1989) (formulating the categories
as cases "in which a fiduciary of the debtor misuses
his position to the disadvantage of other creditors;
those in which a third party, in effect, controls
the debtor to the disadvantage of others; and those
in which a third-party defrauds other creditors").
Id.
The level of scrutiny by the Court for inequitable
conduct varies depending on whether the party sought to be
subordinated is an insider or not. Castletons, 990 F.2d at
599; Hedged-Investments, 380 F.3d at 1301. An insider is not
automatically subordinated.
We are unwilling to find a dominant shareholder may
not loan money to a corporation in which he is the
principal owner and himself become a secured
creditor. To hold the debt may be subordinated on
that basis alone would discourage owners from trying
to salvage a business, and require all contributions
to be made in the form of equity capital. We do not
think that is desirable as social policy, nor
required by the cases.
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Mid-Town, 599 F.2d at 392. See also Hedged-Investments, 380
F.3d at 1298 n. 1 (stating that a “main concern” in Mid-Town
that excessive suspicion about loans made by owners and
insiders of struggling businesses would discourage legitimate
activities.); Mid-Town, 599 F.2d at 392 (“The modern cases
generally hold that claims for loans by majority shareholders
will not be subordinated to claims of other creditors absent
inequitable conduct.” (citing cases and Colliers)).
If the claimant is an insider, the party seeking
subordination need only show unfair conduct and a degree of
culpability on the part of the insider. Hedged-Investments,
380 F.3d at 1301. If the claimant is not an insider or
fiduciary, the party seeking subordination needs to
demonstrate egregious conduct such as gross misconduct
tantamount to fraud, misrepresentation, overreaching or
spoliation. Id. (citing Castletons, 990 F2d at 559).
B. Injury to creditors or unfair advantage.
A party pursuing equitable subordination must also prove
that the challenged creditor injured other creditors or
obtained an unfair advantage. Mobile Steel, 563 F.2d at 700
(Citing cases.); Machinery Rental, Inc. v. Herpel (In re
Multiponics, Inc.), 622 F.2d 709, 720 (5th Cir. 1980); Phase-I
Molecular Toxicology, Inc., 287 B.R. at 580; Mr. R’s Prepared
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Foods, 251 B.R. at 29 (Noting that in the Second Circuit both
advantage and injury must be shown to subordinate. And,
holding that, as a matter of law, a guarantor that pays a
guarantee is subrogated to all rights and remedies of the
original creditor so other creditors are not damaged by the
subrogation.); compare Carter-Waters Oklahoma, Inc. v. Bank
One Trust Co., N.A. (In re Eufaula Indus. Auth.), 266 B.R.
483, 488 (10th Cir. BAP 2001)(Equitable subordination is a
remedial doctrine that should be applied only to the extent
necessary to offset the harm that creditors suffered as a
result of the inequitable conduct.); Mobile Steel, 563 F.2d at
701 (Same.); Castletons, 990 F.2d at 560 (Lower court’s
finding that trustee failed to show unfair advantage or damage
to other creditors was not clearly erroneous.)
C. Consistency with the bankruptcy code.
Equitable subordination of the claim must not be
inconsistent with the provisions of the Bankruptcy Code.
Mobile Steel, 563 F.2d at 700 (Citing cases.)
APPLICATION OF THE LAW TO THE FACTS IN THIS CASE
1. Subrogation.
When Dirk DePree pledged his securities to the Bank he
obtained suretyship status as a matter of law, with all the
rights attendant to that status. He could have waived rights
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contractually at that time, and did waive one right, i.e., to
subrogation in the event Escala became insolvent and Bank was
undersecured. That contingency did not take place, so he has
all rights as a surety including the right to be subrogated to
the extent of his payment. This right is inchoate until Bank
is paid in full.
In February, 2004 when Bank executed on the stock pledge,
Dirk DePree was immediately entitled to exoneration. Escala’s
granting a second mortgage was a proper form of exoneration.
This second mortgage was also proper under the indemnification
agreement, which had been properly approved by the Members and
Board. Execution of this second mortgage was probably
unnecessary, because Dirk DePree would have been subrogated at
the sale of the property under common law, and would have
stepped into Bank’s shoes to collect his indemnification.
Alternatively, he could have asked the Bank to assign him
their rights, contingent on full payment in the future.
The February, 2004 seizure by the Bank created no new
debt by Escala. Similarly, no new lien arose as a result of
the seizure. Both before and after the seizure Escala still
owed the same amount. The Hotel was still encumbered for the
full amount of the mortgage. As a matter of law, the seizure
resulted in an equitable assignment, or an assignment by
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operation of law, of that portion of Bank’s debt that was paid
by Dirk DePree, to Dirk DePree as guarantor. Also as a matter
of law, Dirk DePree became entitled to enforce his debt
against the collateral after Bank was paid in full. No formal
documents were required.
Dirk DePree participated in Bank’s foreclosure suit by
filing a cross-claim, and obtained a Judgment on the cross-
claim. See Ex. 59, Foreclosure on Second Mortgage, Order.
Pursuant to the Judgment Dirk DePree is allowed to bid in the
amount of his Judgment or any portion thereof at the
foreclosure sale as the equivalent of cash, if and only if,
the bid includes payment of cash for the full amount owed by
Escala to Bank. This satisfies the common law requirement
that the creditor be paid in full before the surety is
subrogated. Although Dirk DePree pursued his legal remedies
under the Second Mortgage, the same result would be obtained
just through assertion of his subrogation rights.
Bank has not objected to Dirk DePree’s claim. In fact,
Bank acquiesced to his acquisition of a second mortgage. Ex.
41. And, Dirk DePree’s second mortgage, behind Bank’s, cannot
harm the Bank. No one except Bank can complain about his
status. Dirk DePree’s assertion of a secured claim, behind
Bank, is not prejudicial to anyone.
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34 Escala purchased the Hotel and executed a mortgage for
$3.5 million. That is all Escala will pay, $2.5 million to
Bank and $1.0 million to Dirk DePree. At no time was the
claim against the Hotel less than $3.5 million. Other
creditors never had any right to the $1.0 million in
contention here. Furthermore, no creditor was mislead into
granting a junior mortgage on the assumption that the Bank
debt was only $2.5 million. In contrast, Dirk DePree
immediately recorded a second mortgage to give the world
notice that the total encumbrance was the same. In fact,
failing to recognize this mortgage would result in a windfall
to other creditors of $1.0 million to which they were never
entitled.
Page -96-
Dirk DePree satisfies the five part test to determine
whether a person has common law subrogation rights. He paid
Bank to protect his own interests. He was compelled to pay
under his guarantee and was not a volunteer. Escala was
primarily liable on the Bank’s debt. Bank’s debt will be paid
in full by the time Dirk DePree’s rights are asserted. And,
subrogation will not injure the rights of others.34
Under Section 509(a), Dirk DePree secured a claim of the
Bank against Escala, he paid that claim, and is subrogated to
the extent of his payment. Bankruptcy subrogation applies to
satisfaction of debts prepetition as well as postpetition.
Under section 509(c) he is subordinated to the Bank’s
remaining claim “until” Bank’s claim is paid in full.
Pursuant to the foreclosure judgment, Bank must be paid in
full before Dirk DePree can assert his rights.
Conclusion
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Either under the common law doctrine of subrogation or
subrogation under the Bankruptcy Code, Dirk DePree has a
valid, perfected, and foreclosed second lien on the Hotel
property.
2. Recharacterization.
The Court reviews the evidence existing on or about the
time of the challenged transaction, which is the spring of
2000 through August 1, 2000. Before addressing the Hedged-
Investments factors, the Court generally observes that the
transaction challenged is the guarantee of Bank’s debt.
Overall, this transaction appears to be an arms’ length
transaction. Nevertheless, the Court should examine the
following factors:
(1) the names given to the certificates evidencing the
indebtedness.
Normally this factor examines first, whether there
are documents, and second, whether they were properly
executed. See Exide Technologies, Inc., 299 B.R. at 740-
41. In this case, there are properly executed notes and
guarantees, and letter agreements that document the
challenged transaction as a pledge securing Escala’s note
to the Bank. They meet all the proper formalities for a
commercial loan. This indicates a true debt.
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(2) the presence or absence of a fixed maturity date.
The presence of a fixed maturity date and a definite
obligation to repay indicate a debtor-creditor
relationship. Stinnett’s Pontiac Service, Inc., 730 F.2d
at 638.
The guarantee agreement does not have a fixed
maturity date. The Court believes that most guarantees
do not normally have a fixed maturity date. The
underlying loan does, however, have a fixed maturity
date. By implication, if Escala complied with the
mortgage, the guarantee would expire by its own terms
when the mortgage was paid. Escala had a definite
obligation to pay Bank, and a common law obligation to
pay Dirk DePree if he paid the Bank on behalf of Escala.
This factor indicates a true debt.
(3) the source of payments.
The importance of the source of the payments,
“is that if repayment is possible only out of
corporate earnings, the transaction has the
appearance of a contribution of equity capital,
but if repayment is not dependent upon earnings,
the transaction reflects a loan to the
corporation." [Estate of Mixon v. U.S., (In re]
Estate of Mixon[)], 464 F.2d [394] at 405 [(5th
Cir. 1972)]. See also Harlan v. United States,
409 F.2d 904, 909 (5th Cir. 1969).
Stinnett’s Pontiac Service, Inc., 730 F.2d at 638.
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35 Tilden Drinkard testified that the pro formas showed
the project would eventually pay debt from net operating
income.
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The underlying loan was to be paid from operations35,
infusions of money from the related entities and a
refinance in 12 to 30 months. See also Phase-I Molecular
Toxicology, Inc., 287 B.R. at 577 (Payment of a bridge
loan is not dependant solely on the future success of a
debtor’s business.) The parties never contemplated
having to make payments on the guarantee, because no one
expected the securities to be levied on. This indicates
a true debt.
(4) the right to enforce payment of principal and
interest.
“If a fixed obligation to repay the advances exists,
the transaction appears to be a loan.” Stinnett’s
Pontiac Service, Inc., 730 F.2d at 639 (citations
omitted).
Bank had the right to enforce payment by Escala on
the note, and had the right, upon breach, to realize on
the guarantee. After payment, Dirk DePree had a right to
assert the Bank’s rights against Escala. This indicates
a true debt.
(5) participation in management flowing as a result.
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Increased participation in management as a result of
advances indicates a capital contribution. Stinnett’s
Pontiac Service, Inc., 730 F.2d at 639.
Before Dirk DePree agreed to guarantee Escala’s
loan, he had no connection with the entities. In the
letter agreement regarding the pledge, it states “DePree
agrees to provide advice and consultation to
[Renaissance] from the effective date forward at no cost
to the Company, and to serve on the Company’s advisory
board if such a board is assembled.” After the loan
closed, Dirk DePree had increasing responsibilities in
Renaissance, which eventually owed Escala. This
indicates a capital contribution.
(6) the status of the contribution in relation to
regular corporate creditors.
This factor considers whether the loan was
subordinated to general creditors, Hedged-
Investments, 380 F.3d at 1299, or secured and
unavailable to general creditors, Cold Harbor, 204
B.R. at 918. Subordination of the alleged debt
implies a capital contribution. Stinnett’s Pontiac
Service, Inc., 730 F.2d at 639. The guarantee in
this case was not subordinated. In fact, it was
secured as a matter of law by the assets secured to
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the Bank under the doctrine of subrogation. The
pledged securities were unavailable to general
creditors. This indicates a true debt.
(7) the intent of the parties.
The Court finds the intent of the parties is
reflected in the documents. All parties intended that
Dirk DePree would guarantee Bank’s debt for Escala. This
was confirmed by trial testimony. This indicates a true
debt.
(8) "thin" or adequate capitalization.
This is a borderline call. Escala was
undercapitalized. Dirk DePree had no involvement with
the establishment of Escala or in formulating its capital
structure. Weak capitalization alone is not
determinative. However, the Court has also found that
this was essentially a bridge loan to get the business up
and going, to do planning and development, with the
intent to refinance in 12 to 30 months. Pro formas
predicted eventual ability to pay expenses and debt.
Furthermore, it was clear to the Court that the parties,
at the time of the loan, expected the capitalization to
be sufficient for a while. If the purpose of this
exercise is to determine whether the parties were
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intending a loan at the time, the Court finds that they
were, and this factor would indicate a true debt. If,
however, the purpose is for the Court to determine
whether the parties should have intended a loan based on
the capitalization, this is a closer call and would
indicate a capital contribution. Upon reflection,
however, the Court still thinks that overall, this factor
indicates than it is a true debt.
(9) identity of interest between the creditor and
stockholder.
At the time of the guarantee discussions, Dirk
DePree was not a stockholder or member of Escala. In
exchange for his guarantee he became a member of
Renaissance, which eventually would own Escala. On
balance, this indicates a capital contribution.
(10) source of interest payments.
At the time of the guarantee, no one expected that
it would be realized on. It was an unmatured obligation
so no payments were due. This factor would not be
relevant.
Alternatively, if the guarantee were realized on,
under a subrogation theory, Dirk DePree would eventually
be entitled to the same funds that were already earmarked
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36In its post-trial brief, the UCC states that “Escala
could not obtain a loan when it came time to pay off the Bank
1st Loan.” While that may be true, it sheds no light on the
circumstances surrounding the initial guarantee in August,
2000, which is the relevant time period.
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for the Bank, which no one questions was a real debt.
Therefore, this would be a true debt.
(11) the ability of the corporation to obtain loans
from outside lending institutions.
At the time of the guarantee36, Vincent Garcia was
shopping the market for a less expensive deal with other
potential guarantors, and apparently found none. This
could indicate the parties intended a capital
contribution. However, this factor tests whether other
commercial lenders would advance funds. There is an
established market of commercial lenders. Although it
appears likely that Escala was unable to obtain financing
for the Hotel elsewhere, that fact as such was not
established by the testimony or evidence at trial.
However, in this case, Escala was seeking a guarantor.
There is not a real market of potential guarantors. The
Court does not put much weight on this factor in this
case.
(12) the extent to which the advance was used to
acquire capital assets.
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The guarantee helped Escala obtain the Hotel.
However, the guarantee itself did not acquire the hotel.
The guarantee guaranteed payments to Bank if, in the
future, Escala defaulted on its interest and principal
payments to Bank. When the guarantee was later
exercised, it reduced the debt to Bank and did not buy
any assets. This indicates it was a debt transaction.
(13) the failure of the debtor to repay on the due
date or to seek a postponement.
This part of the test clearly looks at behavior
after the inception of the loan. This is useful
information that can provide evidence of the parties
intent at the earlier time. If there is no due date, or
if there is no demand after the due date, this suggests
that there was an intent that the loan would not be
repaid. Stinnett’s Pontiac Service, Inc., 730 F.2d at
640. In this case, Escala failed to pay Bank on the due
date, but repeatedly sought and obtained extensions.
This indicates a debt transaction. Furthermore, when
Dirk DePree’s pledge was exercised, he immediately took
steps to obtain replacement security and later foreclosed
on that, all of which indicates a true debt.
Causation.
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In the case the Court cannot find that the business
failed because this guarantee was not treated as a capital
contribution. Many events contributed to Escala’s
failure. The events of September 11, 2001 and their
tragic impact on the Hotel was one major factor. Perhaps
management was negligent in some respects. Perhaps the
Members became estranged to the point where they did not
want to deal with each other or with Escala’s or
Renaissance’s financial needs any longer. The failure to
refinance before the due date of Bank’s loan was a major
factor in the failure. Probably the enterprise grew too
fast. The Court cannot find that the initial
capitalization by itself caused the eventual failure,
although it was a major factor. This indicates a true
debt.
Proportionality.
Loans and guarantees were not made proportionately by
the equity owners. In fact, Escala only had one owner at
any given time; PI then Renaissance. Dirk DePree was the
only guarantor that secured his pledge. At the relevant
time he loaned no money directly to Escala. Others loaned
money directly to Escala but did not pledge securities or
assets (other than insurance policies purchased by and
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paid for by Escala). The amounts guaranteed and loaned
appear to have no relationship to ownership in
Renaissance. This indicates a true debt.
Collateral.
The guarantee was a secured claim against the Hotel
through subrogation. This indicates a true debt.
Conclusion
Considering all of the above factors, the Court finds that
the guarantee transaction was more in the nature of an arm’s
length commercial debt transaction than an equity contribution.
3. Equitable Subordination.
The first task in this section is to determine whether
Dirk DePree was an insider. “Insider” is defined by the
bankruptcy code, 11 U.S.C. § 101(31), as including, if the
debtor is a corporation, its directors, officers, persons in
control, relatives of directors, officers or persons in
control, affiliates and insiders of affiliates, and managing
agents. Affiliates, 11 U.S.C. § 101(2), are entities that
directly or indirectly own 20% or more of a debtor.
The parties devoted substantial energies disputing whether
and when which entity controlled, owned, directed, managed, or
operated which other entities, and argued whether the governing
documents take priority over reality. In the end, the Court
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37The Court will not address Dirk DePree’s argument that
he is not an insider because the legal documents must be given
meaning and they show that PI had legal control over Escala at
the time of the pledge. He argues that the intent of third
parties to form an entity over which he might have control in
the future is insufficient to overcome the writings. The
Court concludes below that, even under the heightened
standards for insiders, Dirk DePree should not be equitably
subordinated.
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finds that Dirk DePree was an insider. The Founders started
this venture, acquiring various properties, setting up LLCs,
transferring assets and ownership interests, and repeatedly
documenting their intents. Mark DePree, a Founder, was always
in at least the position of a “person in control.” Dirk DePree
was his “relative” so was an insider37. By the end, Dirk
DePree was at least a “person in control” of Renaissance, which
was an affiliate of the Debtor, so he was an insider of an
affiliate.
Under Hedged-Investments, the Court will determine if
there was (1) inequitable conduct, (2) injury to creditors or
unfair advantage, and (3) whether subordination would be
consistent with the Bankruptcy Code, placing emphasis on the
inequitable conduct inquiry.
A. Inequitable conduct.
Because Dirk DePree is an insider, the Court uses a
heightened scrutiny for inequitable conduct. The UCC must
present “material evidence of unfair conduct and demonstrate
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38At closing argument, the UCC’s attorney conceded that
the UCC was not claiming fraud or illegal activities. Rather,
the UCC claimed that the Debtor was undercapitalized and that
the insiders “ran up the debt” and used their powers to secure
their positions inequitably. However, the only transaction
challenged in this proceeding is Dirk DePree’s original
guarantee at the inception of Escala. And, his actions did
not cause this debt, he only guaranteed a debt properly
entered into by the Debtor. Furthermore, even if debts were
run up during the DePrees’ tenure, there are no allegations or
proof that the debts were other than proper debts of the
Debtor.
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some culpability on [Dirk DePree’s] part.” Hedged-Investments,
380 F.3d at 1302 (citations and internal punctuation omitted.)
The behavior proscribed is: (1) fraud, illegality, and breach
of fiduciary duties; (2) undercapitalization; or (3) claimant’s
use of the debtor as a mere instrumentality or alter ego. Id.
Undercapitalization alone, however, is insufficient, unless
accompanied by the insider’s exploitation of secret information
or misrepresentation of the Debtor’s financial health. Id. at
1302-03.
There are no allegations of and no evidence of fraud,
illegality, or Dirk DePree’s use of Escala as an
instrumentality or alter ego. Therefore, the UCC must
establish breach of fiduciary duties and/or culpable
undercapitalization38. The Court finds that the UCC has not
proven either by a preponderance of the evidence.
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“In order to plead a cause of action for breach of
fiduciary duty, there must be shown the existence of a
fiduciary relationship, its breach, and damage proximately
caused by that breach. The absence of any one of these
elements is fatal to the cause of action.” Pierce v. Lyman, 1
Cal.App.4th 1093, 1101, 3 Cal.Rptr.2d 236, 240 (Cal. Ct. App.
1991). Accord Moody v. Stribling, 127 N.M. 630, 636 and 638,
985 P.2d 1210, 1216 and 1218 (Ct. App.), cert. denied, 127 N.M.
389, 981 P.2d 1207 (1999).
First, the Court finds no breaches of fiduciary duty to
the Debtor. While there were allegations that Dirk DePree
acted outside of the authority of the Board of Renaissance and
entered unauthorized contracts, all of those allegations dealt
with transactions Dirk DePree allegedly entered for non-debtor
entities. And, those transactions were not put into evidence
or quantified as to any damage that resulted. There were no
allegations, or evidence at trial, that Dirk DePree or the
DePree Group usurped business opportunities for their own gain
or competed with Renaissance or Escala.
The UCC presented a great volume of evidence about the
DePree Group, and documented its increasing control over
Renaissance over time. The UCC suggests that the DePree Group
gained this status through financial coercion, by making
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39 It may be actionable by other members or directors,
however. See Walta v. Gallegos Law Firm, P.C., 131 N.M. 544,
552, 40 P.3d 449, 457 (Ct. App.), cert. denied, 131 N.M. 619,
41 P.3d 345 (2002) (Shareholder can bring individual claim
against majority shareholder for “freeze out” if done in
breach of a fiduciary duty owed the shareholder.)
40 In fact, it is statutorily authorized. See § 53-19-
16(C) NMSA 1978 (A member or manager may lend money to an LLC
and shall have the same rights and obligations as if he were
not a member or manager.)
Page -110-
unreasonable demands in exchange for the increasing amounts of
money the group was loaning to keep Renaissance and the
entities alive. The Court finds that intentionally gaining
control over a business does not automatically demonstrate a
breach of fiduciary duty to the creditors39. Even if this
could be construed as a breach, the UCC has not proved any
damages flowing from the change in control. And, lenders are
usually free to impose whatever conditions (within the limits
of the law) they choose when they are loaning money. See
Hedged-Investments, 380 F.3d at 1303. There is no evidence that
any loans were unlawful or overreaching.
The other possible claim for breach of fiduciary duty is
Dirk DePree’s guarantee of the Bank’s loan in 2000. Nothing
prevents an insider from loaning money to a company40. This is
not a breach of duty or conduct that would warrant
subordination. Phase-I Molecular Toxicology, Inc., 287 B.R. at
581 (Insider did not act inequitably by obtaining a security
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interest in all of debtor’s assets at a time when it knew that
debtor was insolvent and could not obtain a loan from any other
lender.)
Second, the Court can find no culpable
undercapitalization. When Dirk DePree guaranteed the debt he
did not advance money to the Debtor, and did not increase
Debtor’s debts. The Bank debt was properly documented,
disclosed, and the mortgage filed of record. There is no
evidence that Dirk DePree exploited secret information, or
misrepresented Escala’s financial health to anyone. To the
contrary, the only evidence presented at trial was that
internal financial statements were given to the Bank and
several possible sources of refinancing, and they were not
harmed.
B. Injury to creditors or unfair advantage.
The Court does not find any injury to creditors or unfair
advantage to Dirk DePree. The only specific complaint raised
by the UCC was that, if Dirk DePree had not obtained the Second
Mortgage, there would have been $1.0 million for unsecured
creditors. However, as discussed above, Dirk DePree had
subrogation rights from the very beginning of his involvement
with this project. The $1.0 million was never available to the
unsecured creditors whether he obtained the second mortgage or
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not. No other damages to creditors were explained, documented,
proved or quantified.
Dirk DePree has not obtained an unfair advantage. As to
his guarantee, he was compensated for a risk. Because of that
risk his assets were seized by the Bank, and he has lost the
use of $1.0 million for several years. This is not an
advantage, or a disadvantage. It was simply the result of his
guarantee contract. Other than the guarantee, all evidence
shows that Dirk DePree was never compensated for his services,
he never received any property or dividends from any entity,
and that he personally loaned considerable amounts of money to
the entities, including Debtor, for which he will never be
repaid.
C. Whether subordination would be consistent with the
Bankruptcy Code.
Because the Court finds no inequitable conduct, and no
damage to creditors or unfair advantage to Dirk DePree, the
Court will not address whether subordination would be
consistent with other provisions of the Bankruptcy Code.
Conclusion
Dirk DePree’s second mortgage on the Hotel property should
not be equitably subordinated. The Court will enter an Order
consistent with this Memorandum Opinion.
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Honorable James S. Starzynski
United States Bankruptcy Judge
I hereby certify that on March 8, 2005, a true and correct copy
of the foregoing was electronically transmitted, faxed,
delivered, or mailed to the listed counsel and/or parties.
George D Giddens, Jr
Attorney for Unsecured Creditors Committee
10400 Academy Rd NE Ste 350
Albuquerque, NM 87111-1229
William F Davis
Chair, Unsecured Creditors Committee
PO Box 6
Albuquerque, NM 87103-0006
R Thomas Dawe
Attorney for Dirk DePree
PO Box 1027
Albuquerque, NM 87103-1027
Robert H McKirgan
Attorney for Dirk DePree
40 N Central Ave Ste 1900
Phoenix, AZ 85004-4429
Paul M Fish
Attorney for Bank 1st
PO Box 2168
Albuquerque, NM 87103-2168
Robert H Jacobvitz
Attorney for Debtor in Possession
500 Marquette NW Ste 650
Albuquerque, NM 87102-5309
Alice Nystel Page
Office of the United States Trustee
PO Box 608
Albuquerque, NM 87103-0608
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