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In re Repository Technologies

April 12, 2010


Appeals from the United States District Court for the Northern District of Illinois, Eastern Division. No. 07 C 1857-Amy J. St. Eve, Judge. Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 07 C 4825-Charles P. Kocoras, Judge.

The opinion of the court was delivered by: Tinder, Circuit Judge


Before EASTERBROOK, Chief Judge, and RIPPLE and TINDER, Circuit Judges.

This opinion addresses two separate cases, each involving disputes surrounding the bankruptcy of Repository Technologies, Inc. ("RTI"), a now-defunct software company. The parties interested in these disputes and their lawyers have been on a litigation death march since April 2006. They have passed through a bankruptcy court, three federal district courts, and two state courts (that we know of) before arriving here. As one might expect from such a barrage of litigation, untangling and resolving the issues presented takes some time and space, so bear with us.

Both cases require us to brave a hornet's nest of jurisdictional issues. In the In re RTI case, these issues turn out to be dispositive, and we must dismiss this case as moot based on the sale of RTI's assets and termination of its business. In contrast, federal jurisdiction exists over the Nelson v. Welch & Crane, Heyman, Simon, Welch & Clar ("CHSWC") case, allowing us to address the merits of whether the district court properly declined to exercise supplemental jurisdiction over the state-law claims of plaintiff William G. Nelson, IV following the dismissal of Nelson's only federal claim from the lawsuit. We conclude that Nelson's federal and state-law claims are so entangled that the district court should have retained supplemental jurisdiction over the state-law claims. We accordingly reverse and remand for the district court to resolve Nelson's entire lawsuit on the merits.

I. Background

A. Facts

RTI marketed, supplied, and maintained software. Unfortunately, RTI did not fare well in the midst of a downturn in the software industry, reporting net losses from 2000 to 2004. When it became clear that RTI's existing credit line with its principal secured lender, West Suburban Bank, was insufficient to meet its business expenses, William G. Nelson, IV, a minority shareholder and member of RTI's Board since 1996, offered to finance RTI's operations. On August 30, 2002, RTI executed a revolving credit note with Nelson providing for a maximum credit amount of $500,000, a 15% annual interest rate, and monthly, interest-only payments until August 1, 2007, when the entire balance was to become due. Nelson simultaneously advanced $500,000 and obtained a security interest in all of RTI's assets, which he subordinated to the Bank's security interest. On December 19, 2003, RTI's Board (with Nelson not participating) authorized an increase in the Nelson credit line to $1.5 million. The parties did not execute new loan documents or security agreements in connection with this extension of the credit line; however, RTI paid 15% interest on all of Nelson's additional advances in accordance with the terms of the original note.

By May 28, 2004, Nelson had advanced approximately $1.74 million to finance RTI's operations. Nelson stopped making advances at that time but also suspended RTI's obligations to pay interest, occasionally telling RTI's president, E. James Emerson, that he did not expect to be repaid until RTI "was no longer in trouble." Ultimately, however, Nelson took steps to call in his debt. On April 4, 2006, Nelson personally paid off the $126,484 balance due on the Bank's loan, elevating himself to RTI's sole secured creditor. On April 11, Nelson resigned as an RTI director and sent Emerson a notice of default, which demanded that RTI pay $509,687 in overdue interest payments in order to avoid an "event of default."

B. In re RTI, Nos. 08-1342 & 08-1443

RTI, unable to pay the interest due on Nelson's loans and hoping to delay a foreclosure action, filed for Chapter 11 reorganization on April 25, 2006. Nelson filed a proof of a secured claim of $2.4 million, see 11 U.S.C. § 501(a), representing the amount due on the loans made by both Nelson and the Bank. RTI also filed an adversary proceeding seeking to recharacterize Nelson's debt as equity and to subject Nelson's interests in RTI to equitable subordination, see id. § 510(c)(1).

The bankruptcy court conducted a trial and, on February 13, 2007, entered a judgment in the adversary proceeding that completely denied RTI's claim for equitable subordination of Nelson's loans. The court did, how-ever, recharacterize $240,000 of Nelson's loans as equity, $240,000 being the amount of Nelson's $1.74 million in total loans that exceeded the $1.5 million credit line formally authorized by RTI's Board. Taking into account this partial recharacterization and subtracting the payments on Nelson's loans already made by RTI, Nelson was left with a secured claim of approximately $1.8 million.

In a separate order, the bankruptcy court dismissed the bankruptcy case in light of RTI's concession that, absent full recharacterization and equitable subordination of Nelson's debt, RTI could not put forth a confirmable plan for Chapter 11 reorganization. See id. § 1129(a)(7)(A)(ii) (providing that the bankruptcy court may approve a Chapter 11 reorganization plan only if "each holder of a claim or interest [such as a secured creditor like Nelson] . . . will receive or retain under the plan . . . property of a value . . . that is not less than the amount that such holder would so receive or retain" in a Chapter 7 liquidation). That order, like the judgment in the adversary proceeding, referred to the court's "Findings of Fact and Conclusions of Law," in which the court rejected Nelson's argument to dismiss the bankruptcy case on the alternative ground that RTI had filed in bad faith. Specifically, the court determined that the "filing of this bankruptcy was a rational reaction to Nelson's actions, and was partially successful. Therefore, the bankruptcy filing cannot be held to be in bad faith." In re Repository Tech., Inc., 363 B.R. 868, 896 (Bankr. N.D. Ill. 2007).

Also on February 13, 2007, after the bankruptcy court dismissed RTI's case, Nelson filed a complaint in federal district court before Judge Coar, seeking damages and injunctive relief for RTI's breach of its loan contract with Nelson. The following day, at 9:15 a.m., the court granted Nelson's motion for a temporary restraining order ("TRO") freezing all of RTI's assets pending the resolution of Nelson's contract claims. Just prior to that time, however, RTI transferred approximately $100,000 to the law firm of Crane, Heyman, Simon, Welch & Clar ("CHSWC"), which had represented RTI in the bankruptcy case. The court also granted Nelson's motion to appoint a receiver to operate RTI's business in order to protect Nelson's interest in RTI's assets. On March 20, Nelson conducted a Uniform Commercial Code ("U.C.C.") sale of RTI's assets to himself as the successful bidder for $475,000, and the receiver transferred RTI's assets to Nelson. On June 7, the court approved the receiver's final report on the sale and liquidation of RTI's assets and, on Nelson's motion, dismissed Nelson's remaining contract claims without prejudice.

Meanwhile, Nelson had also appealed the bankruptcy court's judgment in the adversary proceeding to the district court before Judge St. Eve, see 28 U.S.C. § 158(a), who, on January 15, 2008, affirmed all of the bankruptcy court's factual findings and legal conclusions. In re Reposi-tory Tech., Inc., 381 B.R. 852 (N.D. Ill. 2008). In particular, the court denied Nelson's motion to strike as dictum the bankruptcy court's finding that RTI had not filed for bankruptcy in bad faith.

Nelson has appealed the district court's judgment in the adversary proceeding to this court, see 28 U.S.C. § 158(d), arguing that the bankruptcy court erred in partially recharacterizing his loans as equity. Nelson also urges this court to strike as dictum the bankruptcy court's statement that RTI did not file for bankruptcy in bad faith. RTI has cross-appealed, arguing that the bankruptcy court should have recharacterized all of Nelson's loans and equitably subordinated Nelson's interests in RTI.

C. Nelson v. Welch & CHSWC, No. 08-2164

On July 11, 2007, Nelson filed a complaint in the Illinois Circuit Court of Cook County against David K. Welch and CHSWC ("defendants"), alleging that the defendants had (1) conspired with RTI's majority shareholders, E. James and Kathleen Emerson, to use RTI's Chapter 11 bankruptcy case to enrich themselves, (2) tortiously interfered with RTI's loan contract with Nelson, and (3) abused the bankruptcy process. Seizing on the federal abuse of the bankruptcy process claim, the defendants removed the case to federal district court before Judge Kocoras. See 28 U.S.C. § 1334(b) (granting district courts "original but not exclusive jurisdiction of all civil proceedings arising under title 11, or arising in or related to cases under title 11"); id. § 1452(a) (providing for the removal of a claim over which the "district court has jurisdiction . . . under section 1334 of this title"). Preferring to stay out of federal court, Nelson amended his complaint to remove the allegation that the defendants "abused the process of the Bankruptcy Court," but the district court nonetheless denied Nelson's motion to remand to state court for lack of federal jurisdiction. The court concluded that it still had "arising in" jurisdiction over the case under § 1334(b) because, even after the formal deletion of the abuse of process count from the complaint, Nelson's claims "revolve[d] around his assertion that Welch and his firm engaged in abuse of bankruptcy process."

While Nelson's suit against Welch and his firm was pending before Judge Kocoras, back in the bankruptcy case, Judge St. Eve had affirmed the bankruptcy court's finding that RTI had not filed its Chapter 11 petition in bad faith. On February 8, 2008, Judge Kocoras concluded that Judge St. Eve's decision precluded Nelson's abuse of process claim and dismissed that claim with prejudice. The defendants then moved to dismiss Nelson's entire complaint on the merits, citing to Judge Kocoras's earlier jurisdictional analysis that the complaint was based on an abuse of the bankruptcy process. Curiously, though, the judge determined that Nelson retained "state law claims" that stemmed "from events that happened outside the bankruptcy context" and relinquished supplemental jurisdiction over those claims to the Illinois Circuit Court. See 28 U.S.C. § 1367(c)(3).

The defendants have appealed the remand of Nelson's supplemental claims to state court. They argue that, because the district court's dismissal of Nelson's abuse of the bankruptcy process claim was dispositive of his state-law claims, the court should have retained supplemental jurisdiction over the state-law claims in order to dismiss them on the merits.

In the discussion that follows, we will address separately the appeals from RTI's adversary proceeding and Nelson's ...

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