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In re Repository Technologies

January 15, 2008

IN RE REPOSITORY TECHNOLOGIES, INC., DEBTOR/DEBTOR-IN-POSSESSION.
WILLIAM G. NELSON, APPELLANT/CROSS-APPELLEE,
v.
REPOSITORY TECHNOLOGIES, INC., APPELLEE/CROSS-APPELLANT.



Appeal from Bankruptcy Adversary Case No. 06-A-1247.

The opinion of the court was delivered by: Amy J. Steve, District Court Judge

MEMORANDUM OPINION AND ORDER

Before the Court are William G. Nelson's ("Nelson") and Repository Technologies, Inc.'s ("RTI") cross-appeals from: (1) the Judgment Order on Debtor RTI's Adversary Complaint for Recharacterization from Debt to Equity, for Equitable Subordination, and to Recover for Breaches of Fiduciary Duty and (2) the Findings of Fact and Conclusions of Law Following Trial in Adversary Case No. 06-A-1247. Nelson initiated this appeal by filing a Notice of Appeal on February 23, 2007. RTI cross-appealed by filing a Notice of Appeal on March 1, 2007. The Court has jurisdiction to hear the appeal and cross-appeal pursuant to 28 U.S.C. § 158(a)(1) and Federal Rules of Bankruptcy Procedure 8001, et seq. For the following reasons, the Court affirms the Bankruptcy Court's Judgment Order and Findings of Facts and Conclusions of Law.

STANDARD OF REVIEW

On an appeal from the bankruptcy court, "the district court or bankruptcy appellate panel may affirm, modify, or reverse a bankruptcy judge's judgment, order, or decree or remand with instructions for further proceedings." Fed. R. Bankr. P. 8013. "Findings of fact, whether based on oral or documentary evidence, shall not be set aside unless clearly erroneous, and due regard shall be given to the opportunity of the bankruptcy court to judge the credibility of the witnesses." Id. Accordingly, the Court reviews the Bankruptcy Court's findings of fact for clear error and reviews its conclusions of law de novo. In re ABC-Naco, Inc., 483 F.3d 470, 472 (7th Cir. 2007). The Court reviews mixed questions of fact and law de novo. Mungo v. Taylor, 355 F.3d 969, 974 (7th Cir. 2004).

PROCEDURAL BACKGROUND

RTI, the debtor, filed a voluntary Chapter 11 petition on April 25, 2006. On June 27, 2006, Nelson filed an amended motion to dismiss pursuant to 11 U.S.C. § 1112(b), or, in the alternative, for relief from the automatic stay pursuant to 11 U.S.C. § 362(d)(1) or (d)(2). On July 28, 2006, RTI filed Adversary Proceeding No. 06-A-1247 against Nelson. The Bankruptcy Court consolidated the trial of RTI's Adversary Complaint with the trial on Nelson's motion to dismiss. On August 10, 2006, Nelson filed a motion for summary judgment on the Adversary Complaint. After briefing by the parties, the Bankruptcy Court determined that there were triable issues of fact. Consequently, the Bankruptcy Court deferred ruling on Nelson's summary judgment motion until after the completion of the trial.

At the start of trial on August 28, 2006, RTI and Nelson agreed that the facts that the parties had identified in their summary judgment statements would be admitted into evidence as uncontroverted to the extent that the parties did not object to a particular fact. Thereafter, the Bankruptcy Court heard trial testimony on August 29, 2006 and October 24, 2006. The parties also submitted exhibits into evidence. At the close of RTI's case on August 29, 2006, Nelson filed a motion for judgment as a matter of law. The Bankruptcy Court deferred its ruling on Nelson's motion for judgment as a matter of law until the completion of the trial. At the completion of the trial, the Bankruptcy Court struck the motions for judgment as a matter of law and summary judgment as moot and entered the Judgment Order and the Findings of Facts and Conclusions of Law.

STATEMENT OF FACTS

The Court bases its summary of the facts on the Bankruptcy Court's Statement of Facts set forth in the February 13, 2007, Findings of Fact and Conclusions of Law. See 06-A-1247, R. 91-1; In re Repository Tech., 363 B.R. 868 (Bankr. N.D. Ill. 2007).

I. The Parties

At the time RTI filed its bankruptcy petition, it was a Delaware corporation with its principal place of business in Lisle, Illinois. RTI marketed, supplied, and maintained software pursuant to the terms of various software licensing agreements with its customers. During the relevant time period, Nelson was a shareholder of RTI, Chief Executive Officer of RTI, and served on RTI's Board of Directors. Nelson also served as RTI's Chairman through April 11, 2006. Since 1996, RTI's Board of Directors has had between three to five directors. Besides Nelson, other board members have included RTI's principal shareholders -- James Emerson and Kathleen Emerson.

II. RTI's Business

RTI obtained revenue from three primary sources: (1) new sales of software licenses; (2) upgrades of pre-licensed software to customers with specialized needs; and (3) maintenance and customer support of existing software licenses. James Emerson, RTI's President, had the responsibility of keeping RTI's books and records, including payroll and the tracking of employee reimbursements and expenses. James and Kathleen Emerson owned 37.02 percent and 29.82 percent of the equity interests in RTI, respectively.

III. The Nelson Claim

On July 31, 2006, Nelson filed its secured proof of claim in RTI's bankruptcy case in an amount in excess of $2,346,072 ("Nelson Claim"). The Nelson Claim reflects loans Nelson made to RTI personally and money from the outstanding balance on a note which Nelson purchased for face value from West Suburban Bank.

A. Nelson's Loans & Advances to RTI

At a Special Meeting of RTI's Directors on July 10, 2002, the directors discussed whether RTI should enter into a credit agreement with Nelson. Nelson left the meeting to allow the other directors to discuss and vote on the issues discussed, and -- as the prospective lender -- Nelson did not vote on whether RTI should borrow funds from him. The remaining directors, including James and Kathleen Emerson, voted in favor of entering into a line of credit to be advanced by Nelson.

On August 30, 2002, RTI -- through its president James Emerson -- executed a Revolving Credit Note with Nelson ("Nelson Note), which granted RTI a line of credit up to $500,000 at an interest rate of 15% with interest due monthly until August 1, 2007, when the entire balance was scheduled to become due. Also on August 30, 2002, RTI executed a Commercial Revolving Loan and Security Agreement ("Nelson Security Agreement") that granted Nelson "a security interest in, all assets of the Debtor . . . to secure payment to [Nelson] of the Obligations . . ." As of the date of the filing of RTI's bankruptcy case, the Nelson Security Agreement imposed a lien on all of RTI's assets. Initially, Nelson advanced at least $500,000 to RTI under the Nelson Note and Nelson Security Agreement.

On December 19, 2003, the RTI Directors held a regular meeting at which all RTI Directors attended. At the meeting, a director moved to increase the Nelson Line of Credit to $1,500,000. The motion carried by a vote of 3 to 0 with 2 abstentions. Both Kathleen Emerson and Nelson abstained from the vote. Despite the increased line of credit, the parties did not execute any new loan documents, security agreements, or UCC-1 financing statements in conjunction with this additional loan. Prior to the December 19 meeting, Nelson had already advanced $740,000 over his initial loan of $500,000. In short, from July 11, 2002 through May 28, 2004, Nelson had advanced funds to RTI that totaled between $1,740,000 and $1,785,000 although the Board never authorized more than the $1,500,000.

Nevertheless, RTI kept an internal record entitled "Revolving Credit Statement, William G. Nelson" in which it recorded the Nelson Loans and also recorded all interest payments it made to Nelson with respect to those loans. RTI paid interest on the Nelson Loans through June 2, 2004. It paid such interest on the entirety of the Nelson Loans outstanding at the time of each payment at the rate of 15% per annum, which was the rate provided by the original Nelson Loan documents.

RTI's balance sheet listed the Nelson Loans as a liability. The 2004 Corporate Tax Return that RTI's accountants prepared and filed on behalf of RTI reported that the Nelson Advances comprised a liability in the amount of $1,785,000. Further, in an attachment to a letter to RTI Investors, dated February 27, 2006, RTI indicated that it had notes payable to its director, Nelson, in the amount of $1,785,000. In open court on December 28, 2006, however, counsel for the parties stipulated that the total of Nelson's advances was only $1,740,000.

At the time of each advance, Nelson was a director and shareholder of RTI and, for a period, was RTI's salaried Chief Executive Officer. Nelson gave money to RTI as more cash was needed to pay bills and payroll that could not otherwise be paid. Nelson advised RTI that he did not expect to be paid on his debt until RTI "was no longer in trouble," that the funds advanced by him were not that significant to him, and that -- if needed -- he could simply take the loss emanating from not being repaid. Nelson, however, never waived his ultimate right and intent to collect his advances to RTI when RTI's business improved.

B. The Bank Note

On or about October 1, 2004, RTI executed a Promissory Note in favor of West Suburban Bank in the amount of $202,461. Also on October 1, 2004, RTI executed a Commercial Security Agreement granting the Bank a lien against "[a]ll Inventory, Chattel Paper, Accounts, Equipment and General Intangibles" of RTI, which was properly perfected. Meanwhile, RTI stayed current on its obligations with respect to the Bank Note from October 2004 through the filing of its bankruptcy petition on April 25, 2006. At all times that the Nelson Loans were outstanding, RTI had financing from the Bank.

In March 2006, Nelson, while still serving as a director of RTI, contacted the Bank to acquire the Bank Note for himself. Nelson then purchased the Bank's interests in the Bank Note and the West Suburban Security Agreement for the face value of the outstanding principal due and owing under those obligations -- which amounted to $126,484. On April 10, 2006, the Bank assigned its interest in the Bank Note and the West Suburban Security Agreement to Nelson. Nelson did not receive any special benefit due to his status or affiliation with RTI during the process of acquiring the Bank Loan.

As of the bankruptcy filing date, Nelson, as successor to the Bank Note, held a valid secured claim in the amount of $126,484.01, plus any accrued interest and possible attorney's fees and costs. Earlier, on September 1, 2002, RTI, the Bank, and Nelson executed a Subordination Agreement which completely subordinated each loan and advance from Nelson to RTI to the interests of the Bank. It barred Nelson from forcing collection or enforcing his security position without the Bank's consent. At the time of this subordination, the Bank was RTI's major, non-contingent creditor. The Subordination Agreement permitted RTI to pay interest payments on the Nelson debt as long as it was not in default on the Bank Loan. The Subordination Agreement also permitted the Bank to assign the loan to anyone at any time without notice to RTI.

Nelson purchased the Bank Loan on or about April 4, 2006 -- while he was still a director of RTI -- by paying off the Bank Loan balance from his own personal funds. On April 10, 2006, while still serving as a director, Nelson obtained an assignment of the Bank's UCC-1 financing statements from the Bank. On April 12, 2006, Nelson received the Bank's Note (with the assignment) and Security Agreement relating to it.

Nelson's acquisition of the Bank Loan at a time when RTI was current on the loan increased Nelson's claims against RTI by the amount of the Bank Loan and elevated Nelson into the position as the only secured creditor of RTI. At no point prior to April 11, 2006, did Nelson ever inform RTI, its Board, or its Officers that he had acquired the Bank Loan with his personal funds or that he had obtained an assignment of the Bank Loan and Bank liens on RTI's assets.

IV. Nelson's Resignation & Delivery of Default Notice

On April 11, 2006, Nelson resigned as a director of RTI. Also on April 11, 2006, but subsequent to the delivery of his resignation, Nelson delivered to James Emerson a Notice of Default. The Default Notice asserted Nelson's secured claim and informed RTI that it had failed to make approximately $509,687 in scheduled interest payments on the Nelson Loans since June 2004. It further noted that neither the terms of the Nelson Line of Credit nor the Nelson Security Agreement required Nelson to notify RTI that it was in default with respect to the agreements. Other than informing RTI of the default, the Default Notice did not contain any other statements regarding Nelson's future intentions. In addition, the Default Notice did not contain any specific threats regarding enforcement of the terms of the Nelson Line of Credit or the Nelson Security Agreement through litigation or other enforcement action, but did demand that RTI make the Nelson Loans current within 15 days, or Nelson would consider a default to have occurred under terms of the documents. The Bankruptcy Court concluded that Nelson's statement implied that after the 15-day deadline, he would have all rights to redress held by him as a secured creditor following default.

After tendering his resignation and the Default Notice, Nelson did not seize or take further steps in an attempt to seize RTI's assets, nor did he file foreclosure proceedings or take any other overt action to collect the amounts due under the Nelson Loans. Because RTI did not have the financial ability to bring the Nelson Loan current within 15 days, RTI filed the present bankruptcy action to obtain protection from any possible action by Nelson. At no time did Nelson actually form a new corporation to accept, hold, or manage the assets or business of RTI. Nelson, however, consulted his counsel about the possibility of doing so. Nelson also contemplated replacing RTI management and putting its assets into a new company under new management.

Upon receipt of the Default Notice, RTI requested that Nelson extend the deadline for curing the default. Nelson's response was that unless RTI agreed to turn over its assets to a new entity to be formed and controlled ...


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