W. Wood Prods., Inc. v. W. Pellet Prods., LLC (In re W. Wood Prods., Inc.)

In re: WESTERN WOOD PRODUCTS, INC., A Wyoming profit corporation, Debtor.WESTERN WOOD PRODUCTS, INC., A Wyoming profit corporation, Plaintiff,

v.WESTERN PELLET PRODUCTS, LLC, Defendant.

No. 11-12-10057 JS

Adversary No. 12-1172 J

UNITED STATES BANKRUPTCY COURT DISTRICT OF NEW MEXICO

Date entered on docket: April 4, 2013

MEMORANDUM OPINION

THIS MATTER is before the Court following a two-day trial on the merits held February 28 and March 1, 2013. For purposes of trial the Court consolidated this adversary proceeding with the Debtor's Motion to Reject Contract and Unexpired Lease with Western Pellet Products, LLC (the "Motion to Reject").¹ William F. Davis appeared at trial on behalf of Western Wood Products, Inc. ("Western Wood"). William R. Keleher and Spencer L. Edelman appeared at trial on behalf of Western Pellet Products, LLC ("Pellet Products").

Western Wood and Pellet Products are parties to: 1) a supply agreement for the sale by Western Wood to Pellet Products of wood by-product material produced by Western Wood in the operation of its sawmill; and 2) a lease of real property by Western Wood to Pellet Products on land adjacent to the sawmill. Western Wood contends that Pellet Products has defaulted under the supply agreement and the lease, and is in breach of the supply agreement and lease. Western Wood seeks to reject both the supply agreement and the lease in connection with itsChapter 11 bankruptcy case.² Pellet Products denies that it failed to perform under the supply agreement, denies that it is in violation of the lease, and asserts that Western Wood breached the supply agreement. Pellet Products intends to exercise its rights under 11 U.S.C. § 365(h)(1)(A)(ii) and remain in possession of the real property for the remainder of the term under the lease.

After consideration of the evidence presented at trial, and being otherwise sufficiently informed, the Court finds that 1) Pellet Products is not in default under the terms of the supply agreement or the lease and has not breached the supply agreement or lease; 2) Western Wood breached the supply agreement; and 3) Pellet Products is entitled to damages in the event Western Wood rejects the supply agreement and lease. Because the Motion to Reject was premised on Western Wood's belief that Pellet Products was in breach of the supply agreement and in default under the lease, the Court cannot now make a determination as to whether Western Wood properly exercised its business judgment in seeking to reject the supply agreement and the lease. The Court will set a further evidentiary hearing on the Motion to Reject if Western Wood still wishes to reject the supply agreement and lease.

BACKGROUND AND FACTS

Western Wood owns and operates a sawmill near Raton, New Mexico. It has approximately fifty employees. Ray Levengood is the president of Western Wood, and has been since its inception about twenty years ago. Western Wood started construction of its New Mexico sawmill operation in 2003. It began operating in 2004. It obtains most of its timberfrom Vermejo Park Ranch LLC. From the timber, Western Wood manufactures fence posts and poles. Western Wood generates wood by-product material, consisting of wood chips and sawdust, from the operation of the sawmill. Initially, Western Wood sold its wood by-product material wherever it could, but as production increased, Western Wood needed to secure a year-round cash flow and steady market for its wood by-product material. Western Wood produces approximately 40 tons per day of wood by-product material. Western Wood has an air quality exemption from the State of New Mexico for the operation of its sawmill.³

Sometime before 2007, Pellet Products was formed for the purpose of starting a wood pellet manufacturing operation adjacent to Western Wood's sawmill. Pellet Products contemplated using the wood by-product material from Western Wood to manufacture wood burning stove pellets. Roger Terry formed Pellet Products. He solicited and obtained $800,000 from investors to start up Pellet Products' business. Roy Pillmore and Mr. Levengood were among the original investors. However, Mr. Levengood did not contribute any money for the formation of Pellet Products or in exchange for his equity interest. Instead, he funded his investment with by-product material supplied by Western Wood either at no charge or at a reduced charge. For the first two years of its existence, Mr. Levengood was a member of the board of Pellet Products. He left the board of Pellet Products in 2009.

Western Wood and Pellet Products entered into a Long Term Lease Agreement (the "Lease") on March 31, 2007. See Exhibit 2 and Exhibit C. Under the Lease, Western Wood leased to Pellet Products a 2.56 acre parcel of land located next to the sawmill. The Lease is a ninety-nine (99) year lease beginning March 1, 2007 and ending December 31, 2106, with an annual rental amount of $100, payable on February 1st of each year. Id. The Lease also includesthe following terms: 1) Pellet Products is responsible for payment of "all utilities on the premises . . . including . . . gas, water, electricity, heat, garbage and sewer collection"; 2) Pellet Products will build a factory and facilities on the leased premises for the purpose of manufacturing wood pellet products and other related wood products and services; 3) "[a]ll fixtures built by [Pellet Products] except the buildings, shall not merge with the real estate, but shall remain the property of [Pellet Products]"; 4) Pellet Products will "not use the premises during the term hereof for any purposes contrary to the laws of the State of New Mexico or the United States"; 5) if the Lease is terminated, Pellet Products has six months within which to remove the fixtures; and 6) Pellet Products must maintain a liability insurance policy and a $1,000,000 policy insuring the plant and the property, listing Western Wood as an additional insured to be kept in full force and effect during the Lease term. Id. The Lease also requires Pellet Products to perform all of its obligations under the supply agreements described below. See Exhibit 2. Ray Levengood signed the Lease on behalf of Western Wood, and Roger Terry signed the Lease on behalf of Pellet Products. Id. Mr. Levengood does not remember when or if Pellet Products paid rent in 2008, 2009, or 2010 because his primary focus at that time was to get the plant running. He does recall that Pellet Products delivered a check to Western Wood for the 2012 rent, and that the 2013 rent was paid by check sent by registered mail.

On March 22, 2007, Western Wood and Pellet Products entered into a supply agreement (the "First Supply Agreement"). Mr. Levengood signed the First Supply Agreement on behalf of Western Wood, and Roger Terry signed the First Supply Agreement on behalf of Pellet Products. See Exhibit 1 and Exhibit B. The First Supply Agreement is a one-page document that contains the following provisions:

Western Wood Products Inc. (the Supplier) will supply Western Pellet Products LLC (the Producer) all of the waste products that are chips or materials available to be chipped as aresult of operations of the Supplier. The Supplier may withhold materials to fulfill the current contractual obligation with Zeager Brothers and Silver Dollar shavings.

The Producer will purchase the materials as listed in paragraph one at the rate of thirty dollars per dry ton ($30.00) for the first five years.

The Producer will receive all of its supply for the production of wood pellets from the Supplier. In the event the Producer is unable to obtain an adequate volume of waste material from the Supplier then the Producer may request the Supplier to obtain additional materials at a price and volume agreeable in writing by both parties. Any variation of this agreement will require written authorization from both parties.

First Supply Agreement, ¶¶ 1, 2, and 4.

The First Supply Agreement provided that Western Wood would provide the first 12,000 tons of wood by-product material to Pellet Products "in lieu of cash for 360,000 shares of stock" in Pellet Products. First Supply Agreement, ¶ 3. Under this arrangement, Mr. Levengood would obtain an equity interest in Pellet Products. Id. The First Supply Agreement also contemplated that the price for by-product materials could increase by up to 5% after the first five years, and that, if the cost of business dramatically increased due to circumstances beyond the parties' control causing a hardship on either party, the parties would negotiate a new price. Id. at ¶ 5. Pellet Products anticipated that during the first five years of operation under the First Supply Agreement Pellet Products would complete its start-up phase and achieve full production. A document used to solicit the initial investment in Pellet Products estimated full production to be within three years. See Exhibit A ("As much as 40 tons can be shipped daily when the plant reaches full operation increasing over the next three years to 80 - 100 tons per day.").

Pellet Products began construction of its pellet plant in the spring of 2007. It began production some time in 2008. To create its products, Pellet Products picks up the wood by-product material from Western Wood. The wood by-product material is entered into a feed hopper and gets screened for the purpose of classifying the material into different size particles.Some of the material is sent to the grinder to get resized. Then the material goes to the dryer, and the drying bin. Ultimately, the material is run through the pellet mill which creates the pellets through a machine that presses the material and extrudes the finished pellet product. The dryer is fueled by burning Western Wood's sawdust that is part of the by-product material Pellet Products purchases from Western Wood.

The equipment Pellet Products initially purchased was used and was not in great working condition. Pellet Products has one large pellet mill and one small pellet mill....