HDR Farms Liquidating Tr. v. Applied Botanics LLC (In re HDR Farms Inc.)

IN RE HDR FARMS INCORPORATED DEBTOR

HDR FARMS INCORPORATED LIQUIDATING TRUST PLAINTIFF v. APPLIED BOTANICS LLC f/k/a XSI USA, LLC, et al. DEFENDANTS

No. 20-50888

ADV. No. 21-5166

United States Bankruptcy Court, E.D. Kentucky, Lexington Division

December 28, 2022

MEMORANDUM OPINION AND ORDER

GREGORY R. SCHAAF BANKRUPTCY JUDGE

The Plaintiff filed a Complaint that alleges Defendant Kawel LauBach, a former officer and director of Debtor HDR Farms Inc., breached fiduciary duties and committed fraud by creating and diverting investments to Defendant Applied Botanics LLC f/k/a XSi USA, LLC ("XSi USA"). [ECF Nos. 1, 17.] The Plaintiff also alleged Defendants Annette Cox and Todd Mercer, among others, aided and abetted the breaches and fraud.

Some of the Defendants were not served or dismissed early. The case progressed against LauBach, Cox, Mercer, and the Debtor's former legal counsel, Cozen O'Connor.

Cox and Mercer vigorously defended the allegations during the pleadings stage and discovery period. On April 27, 2022 counsel for Cox and Mercer sent a letter to Plaintiff's counsel arguing that discovery confirmed the Plaintiff's claims were meritless. [ECF No. 267-2, Ex. 1.] The letter also warned Plaintiff's counsel that Cox and Mercer would seek sanctions if the litigation continued. [Id.]

Discovery closed in early May 2022. The Plaintiff's counsel responded to the letter on May 12 and refused to withdraw the claims. [Id.] On May 14, 2022, counsel for Cox and Mercer forwarded a draft of a motion seeking sanctions to Plaintiff's counsel. [ECF No. 267-3, Ex. 2.] The May 14 letter complied with the obligatory safe harbor provision in Rule 9011. Fed.R.Bankr.P. 9011(c)(1)(A).

The Plaintiff did not dismiss the claims and LauBach, Cox Mercer, and Cozen each moved for summary judgment. [ECF Nos. 200, 203, 204, 209.] The Plaintiff filed a combined response to the summary judgment motions. [ECF No. 211.] Cox and Mercer were granted summary judgment on August 30, 2022. [ECF Nos. 261, 262.] LauBach's and Cozen's motions were denied [ECF No. 263], but judgment was entered in their favor after a trial in late October and early November 2022 [ECF Nos. 331, 332].

After summary judgment, Cox and Mercer moved for sanctions against the Plaintiff and its counsel (hereafter, references to the Plaintiff will include its lawyers) pursuant to Federal Rule of Bankruptcy Procedure 9011 and 28 U.S.C. § 1927. [ECF No. 267.] Rule 9011 provides requirements that apply to almost all pleadings and papers filed in a bankruptcy court. Fed.R.Bankr.P. 9011. Section 1927 prohibits lawyers from taking actions that unreasonably or vexatiously multiply the proceedings. 28 U.S.C. § 1927.

The matter was fully briefed. [ECF Nos. 322, 324, 325, 326.] A hearing was held on December 6, 2022, and the matter taken under submission. [ECF Nos. 329, 330.] The record does not support an assessment of sanctions under Rule 9011 or § 1927. The repercussion for the Plaintiff's decisions is judgment for the Defendants.

I. Facts.

A detailed discussion of the facts is included in the Opinion granting summary judgment to Cox and Mercer [ECF No. 261] and the Trial Opinion [ECF No. 331]. That information is adopted herein, and other relevant facts are addressed in the analysis.

II. Discussion.

A. Courts Considering Sanctions Must Use Restraint.

Assessing Rule 9011 sanctions is discretionary. B-Line, LLC v. Wingerter (In re Wingerter), 594 F.3d 931, 936 (6th Cir. 2010). Restraint is required. In re Berghoff, Case No. 06-10375, 2006 Bankr. LEXIS 1145, at *5 (Bankr.N.D.Ohio June 20, 2006); see also In re Fulayter, Case No. 19-53196, 2020 Bankr. LEXIS 1828, *4 (Bankr. E.D. Mich. July 9, 2020) ("Rule 9011 is written in the permissive."); Santa Fe Minerals, Inc. v. BEPCO, L.P. (In re 15375 Mem'l Corp.), 430 B.R. 142, 150 (Bankr. D. Del. 2010). The court in 15375 Mem'l Corp. provided these reasons:

The standard for imposing sanctions under Rule 11 is stringent because such sanctions (1) are in "derogation of the general American policy of encouraging resort to the courts for peaceful resolution of disputes," (2) tend to "spawn satellite litigation counter-productive to efficient disposition of cases," and (3) "increase tensions among the litigation bar and between the bench and the bar."

430 B.R. at 150 (citations omitted).

Sanctions are also considered a severe remedy under 28 U.S.C. § 1927. Rogers v. Bodenbender, Case No. 3:15-cv-2514, 2016 U.S. Dist. LEXIS 176620, at *15-16 (N.D. Ohio Dec. 21, 2016)). One court explained:

The sanctions authorized under section 1927 are not to be lightly imposed; nor are they to be triggered because a lawyer vigorously and zealously pressed his client's interests. The power to assess the fees against an attorney should be exercised with restraint lest the prospect thereof chill the ardor of proper and forceful advocacy on behalf of his client. To justify the imposition of excess costs of litigation upon an attorney his conduct must be of an egregious nature, stamped by bad faith that is violative of recognized standards in the conduct of litigation. The section is directed against attorneys who willfully abuse judicial processes.

Colucci v. New York Times Co., 533 F.Supp. 1011, 1013-1014 (S.D.N.Y. 1982) (footnotes omitted).

The movants must prove their allegations and restraint is required when considering the need for sanctions. In re Gorges, 590 B.R. 771, 795 (Bankr. E.D. Mich. 2018) (suggesting a preponderance of the evidence standard).

B. Rule 9011 Sanctions are Not Assessed.

Rule 9011 requires a signature on substantially all papers filed in court that certifies: (1) the paper is not filed for an improper purpose (e.g., harassment; delay); (2) the requested relief is warranted by existing law (or there is a reasonable argument for change); and (3) the facts alleged are supported by evidence. Fed.R.Bankr.P. 9011(a)-(b). The certification is made "to the best of the person's knowledge, information, and belief, formed after an inquiry reasonable under the circumstances." Fed.R.Bankr.P. 9011(b). A bankruptcy court may issue sanctions if an attorney, law firm, or party violates this rule. Fed.R.Bankr.P. 9011(c).

Cox and Mercer argue the Plaintiff violated Rule 9011(b)(1) by filing the Complaint for an improper purpose. They also argue the Plaintiff violated Rule 9011(b)(3) because the Plaintiff did not properly investigate prior to filing and lacked a sound basis for the allegations in the Complaint.

1. The Allegation of Improper Purpose Does Not Support Sanctions.

Rule 9011 prohibits filing a complaint for an improper motive, including "to harass or to cause unnecessary delay or needless increase in the cost of litigation." Fed.R.Bankr.P. 9011(b)(1). The review considers "objectively ascertainable" facts, and it does not matter how careful the investigation when there is an improper purpose. Baermann v. Ryan (In re Ryan), 411 B.R. 609, 615 (Bankr. N.D.Ill. 2009). If the filing has some other purpose that does not indicate bad faith, however, sanctions might not follow. In re Kunstler, 914 F.2d 505, 518 (4th Cir. 1990); Sussman v. Bank of Israel, 56 F.3d 450, 459 (2d Cir. 1995).

Cox and Mercer claim the Plaintiff improperly sued them because they had deep pockets and could pay a judgment. [ECF No. 267-1 at 4.] Considering a potential target's financial condition is not unreasonable on its face. Suit against a party that does not have resources to pay a judgment is not beneficial or efficient. But a suit solely to target a party that can pay, maybe to force settlement, would suggest an improper purpose.

There is little case law addressing a deep pockets argument for sanctions. Sanctions are not assessed if there is some merit to an argument beyond the target's financial resources. Hadley v. Gerrie, 124 B.R. 679, 686 (D.V.I. 1991), aff'd sub nom. Gas House, Inc. v. Unicorp Am. Corp., 952 F.2d 1392 (3d Cir. 1991). A court might also consider the deep pockets argument when deciding the amount of sanctions. See Nat'l Union Fire Ins. Co. of Pittsburgh, Pa. v. Cont'l Illinois Corp., 113 F.R.D. 637, 644, n. 16 (N.D. Ill. 1987) (the likelihood deep pocket litigants will fight improper claims might mitigate the need for or amount of sanctions).

The movants focus on the problems with the Plaintiff's diversion theory to suggest bad intent. The Plaintiff primarily sought to recover investments attributed to Cox and Mercer that LauBach allegedly diverted to XSi USA. The Plaintiff was unsuccessful because it could not prove knowledge of the alleged breaches or that Cox and Mercer intended to invest in HDR Farms rather than XSi USA. [ECF No. 261.]

Diversion was not, however, the Plaintiff's only theory for recovery. The Plaintiff also alleged the investments provided a path for LauBach to leave HDR Farms at the expense of the creditors and investors. [See ECF No. 17 at ¶ 145.] The Plaintiff referred to this as the "financial runway" for LauBach to move to XSi USA. [ECF No. 267-2.]

An objective review of the record suggests at least a bare minimum justification for the allegations in the Complaint beyond a possible motivation to target Cox and Mercer for their deep pockets. [See also ECF No. 66 (finding the amended complaint plausibly states a claim against Cox and Mercer).] Justice is not served by imposition of sanctions for the claim of an improper purpose in this case.

2. The Allegation of an Insufficient Pre-Filing Investigation Does Not Support Sanctions.

Cox and Mercer argue discovery "revealed that counsel for the Trust did not have a reasonable or good faith basis formed after a reasonable inquiry for signing the First Amended Complaint …." [ECF No. 267-1 at 1-2.] A lawyer who files a pleading or paper "is certifying that...