UNITED
STATES BANKRUPTCY COURT
SOUTHERN DISTRICT OF NEW YORK
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In re: Chapter 7
Case No. 03-10096 (ALG)
FREESTAR TECHNOLOGIES, INC.
Debtor.
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APPEARANCES
CORRIGAN & MORRIS LLP
201 N. Figueroa Street, Suite 690
Los Angeles, California 90012-2629
- and -
DAVIDSON & LoPRESTI, LLP
545 Fifth Avenue, Suite 1205
New York, New York 10017
Attorneys for Involuntary Debtor
By: Stanley C. Morris, Esq.
Brian T. Corrigan, Esq.
Anthony A. LoPresti, Esq.
COLE, SCHOTZ, MEISEL,
FORMAN & LEONARD
25 Main Street
Hackensack, New Jersey 07602-0800
Attorneys for Petitioning Creditors
By: Michael D. Sirota, Esq.
Stuart Komrower, Esq.
Kristin Elliott, Esq.
MEMORANDUM OF DECISION
ALLAN L. GROPPER
UNITED STATES BANKRUPTCY JUDGE
FreeStar Technologies, Inc., the alleged debtor ("FreeStar"),
has moved to dismiss an involuntary Chapter 7 petition filed
against it by vFinance, Inc. ("vFinance"), David Stefansky,
Richard Rosenblum, Marc Siegel, Boat Basin Investors LLC ("Boat
Basin"), and Papell Holdings, Ltd. ("Papell" and with the others,
collectively, the "Petitioning Creditors"). The motion is premised
on FreeStar's assertion that the Petitioning Creditors hold
debts that are the subject of a bona fide dispute under Û303(b)(1)
of the Bankruptcy Code and that it is paying its undisputed
debts as they come due, within the meaning of Û303(h)(1).
By agreement of the parties, the Court has taken up first the
question whether the Petitioning Creditors include, as required
by Û303(b)(1), "three or more entities, each of which is either
the holder of a claim against [the alleged debtor] that is
not contingent as to liability or the subject of a bona fide
dispute...if such claims aggregate at least $11,625 more than
the value of any lien on property of the debtor securing such
claims held by the holders of such claims". The parties submitted
extensive affidavits and over 100 exhibits; neither party requested
an evidentiary hearing on this issue. While many of the facts
are subject to wide disagreement, the facts essential to a
determination of the instant motion are either admitted or,
if they are contested, the dispute merely underscores the fact
that the Petition is not advanced by entities, holding claims "not
contingent as to liability or the subject of a bona fide dispute.?" Accordingly,
the Petition will be dismissed.
BACKGROUND
The Alleged Debtor is a Nevada corporation headquartered in
Santo Domingo, Dominican Republic, with offices in Dublin and
Helsinki. It claims not to have an office in the United States;
while the Petitioning Creditors cite documents filed with the
Securities and Exchange Commission ("SEC") that reference a
principal place of business in New York City, the matter appears
to be of no moment. As a Nevada corporation, FreeStar can be
a debtor under the Bankruptcy Code, 11. U.S.C. Û109(a), and
it has raised no issue as to whether venue is proper in New
York.
The Petitioning Creditors include Boat Basin and Papell, which
have been generally described by the parties as offshore investment
companies that have transacted business with vFinance in the
past; Messrs. Siegel, Stefansky and Rosenblum, who are described
as the former President and current Senior Vice Presidents,
respectively, of vFinance; and vFinance, a financial services
company and broker-dealer located in New York City. The Petitioning
Creditors made various loans and advances to FreeStar that
were the subject of sophisticated and careful documentation.
Each of the Petitioning Creditors asserts that it holds debt
by way of "Promissory Notes" of FreeStar; the Petition sets
forth the amount of the claimed debt exclusive of "interest
and other charges."1 Since the status of these loans determines
whether the Petition was properly filed, it is necessary to
review in detail the documentation regarding the issuance of
the notes and subsequent developments.2
----------------------------------
1 The amounts claimed by each Petitioning Creditor are as follows:
(i) vFinance $69,000; (ii) Stefansky $103,000;
(iii) Rosenblum $$103,000; (iv) Siegel $40,000; (v) Boat Basin
$135,000; and (vi) Papell $187,000.
2 Certain of the following description adopts a portion of
an opinion issued by District Judge Sweet in an action
commenced in the District Court (S.D.N.Y. Index No. 03 Civ.
0493) by five of the six Petitioning Creditors against
Paul Egan, the principal of FreeStar ("Egan"); First American
Stock Transfer ("First American"), FreeStar's stock
transfer agent; First American's principal, Phillip Young;
Margaux Investment Management Group, S.A., an
investment company hired by FreeStar; and ten John Does. The
significance of this parallel action will become
clear below.
------------------------
March 2002 Convertible Notes
The Petitioning Creditors first advanced funds to FreeStar
under a $270,000 financing agreement dated March 25, 2002.
Notes were issued to Papell and Boat Basin in the amounts of
$200,000 and $70,000, respectively, maturing in March 2003
and convertible into equity of FreeStar under certain circumstances.
FreeStar received funds of $228,000, with the remaining $42,000
representing brokerage commissions and fees payable to vFinance
and its counsel. Egan personally guaranteed the Notes and secured
his guarantee with a pledge of 4,000,000 shares of FreeStar
common stock.
The March Notes required FreeStar to file a registration statement
within 60 days, presumably so the notes would be convertible
into freely tradeable stock. Upon FreeStar's default in filing
such a statement, the holders declared the Notes due and payable
and proceeded to enforce Egan's guaranty and to foreclose on
the 4,000,000 shares of FreeStar stock pledged in support of
the guaranty. The holders' rights and obligations upon foreclosure
were set forth in a carefully tailored Stock Pledge Agreement,
dated March 25, 2002 and signed by the holders as secured parties,
by Egan as Pledgor and by FreeStar. As applicable here, Egan
as Pledgor represented and warranted "that there are no restrictions
upon transfer and pledge of the Pledged Shares pursuant to
the provisions of this Agreement except the restrictions imposed
by Rule 144 under the Securities Act of 1933, and that such
restrictions on resale shall not be applicable if an Event
of Default occurs under the Notes, and the Secured Party exercises
its remedies under the Guaranty and forecloses on the Pledged
Shares." Û5(A)(ii). Section 10 of the Security Agreement further
provided the following with respect to the
secured parties' rights and remedies upon an Event of Default:
each secured party could exercise
the remedies provided for under the New York Uniform Commercial
Code ("UCC"), "except that the Secured Party waives any right
to a deficiency pursuant to Section 9-608 thereof or otherwise" (Û10(b)(i));
each secured party could retain all dividends, payments and
other distributions on the stock (Û10(b)(ii)); each secured
party could cause any or all of the pledged shares to be transferred
into its own name (Û10(b)(iii)); and each secured party could
exercise its right of sale of the collateral under the UCC
(Û10(b)(iv)). Importantly, the Security Agreement then provided
the following with respect to the valuation of the collateral
and the procedures that had to be followed in connection with
the secured parties' exercise of their rights:
Notwithstanding anything in this Agreement to the contrary,
the Secured Party may only exercise the rights and remedies
set forth in this Section 10 with respect to up to the aggregate
number of shares of Common Stock into which the outstanding
Notes are then convertible, and simultaneously with such exercise
the amount owing by the Company under the Notes shall be reduced
by an amount equal to the then applicable Conversion Price
(as defined in the Note) multiplied by the number of Pledged
Shares with respect to which the Secured Party has exercised
its foregoing rights and remedies. For the purposes of any
such sale, the Conversion Price set forth in any Notice of
Conversion (as defined in the Note) issued in connection with
the sale of the Collateral shall be controlling, regardless
of the actual price received for the sale of the Collateral.
There shall be no obligation on the part of the Secured Parties
to sell the Collateral at one sale. The sale of Collateral
may take place on as many occasions as Secured Parties deem
fit in order to pay in full the Secured Obligations.
Û
10(c).
Pursuant to this provision, foreclosure on Egan's stock of
FreeStar would in most respects mirror conversion. A secured
party could foreclose only on the number of pledged shares
into which its note could be converted and, simultaneously
with the foreclosure, the amount of the note would be reduced
by the then applicable Conversion Price (as defined in the
Note) multiplied by the number of pledged shares foreclosed
on. For purposes of the sale, the Conversion Price set forth
in "any Notice of Conversion (as defined in the Note)" would
control, notwithstanding a different price received by the
secured party in connection with the foreclosure sale. This
provision at a minimum made the foreclosure on Egan's pledged
shares the economic (if not the legal) equivalent of a conversion
of the convertible notes (in that it set a ceiling on the number
of shares that could be foreclosed and provided for an automatic
reduction in the amount of the note, as if the note had been
converted). It also fixed the proceeds from any foreclosure
sale at an amount equivalent to the conversion price fixed
in a Notice of Conversion under the Notes, and it provided
that such Notice, "shall be controlling, regardless of the
actual price received for the sale of the collateral." The
apparent difference between foreclosure on Egan's shares and
conversion is that the lenders would receive stock that was
marketable in whole or in part.
Acting pursuant to these provisions, by notice dated May 29,
2002, Papell and Boat Basin notified FreeStar of their foreclosure
rights and on June 7, 2002 the 4,000,000 shares were reissued
in their names but with trading restrictions. After protest
from the holders' counsel, who claimed in a letter dated June
10, 2002 that the shares had been registered, First American
as FreeStar's transfer agent reissued the shares as unrestricted.
Then, about a month later, the holders sent a notice of conversion
which purportedly set the foreclosure price at $.06912 per
share. This was done pursuant to Û4(c)(i) of the notes, which
permitted the conversion price to be set at 80% of the "Market
Price", with Market Price defined as the lower of the average
price of the stock on the OTC Bulletin Board during the 10
trading days prior to March 25, 2002 (the date of issuance
of the notes) or the five trading days prior to the date of
receipt by FreeStar of the notice of conversion. At the time
it appears there was no dispute that the applicable "foreclosure
price" was properly set at $0.06912 per share (based on the
price during the 10 days prior to March 25) and that the aggregate
sum of $271,571.06 covered the debt almost precisely.3 The
holders also received unrestricted shares. Presumably based
thereon, none of the March debt is included in the claims asserted
in the Petition by the Petitioning Creditors. As further discussed
below, FreeStar now claims that Papell and Boat basin "over-
converted" the March Notes, resulting in an "overpayment" of
$188,352 and $56,488, respectively, and that they should not
have received unlettered stock. However, these assertions appear
to have first been raised in connection with the current disputes
among the parties.
June-September 2002 Convertible Notes
On August 29, 2002 FreeStar entered into a second convertible
note financing on substantially the same documentation. FreeStar
issued six 8% convertible notes, each dated as of June 27,
2002, in the following amounts: (i) Papell $117,000; (ii) Boat
Basin $65,000; (iii) vFinance $58,000; (iv) Rosenblum $60,000;
(v) Stefansky $60,000; and (vi) Siegel $40,000.4 FreeStar asserts
that it received in return $100,000 in new funds, defeasance
of $60,000 in loans that Rosenblum, Stefansky, Siegel and Boat
Basin had advanced in June as short-term bridge loans pending
completion of the documentation, and defeasance of another
$50,000 short-term loan from Boat Basin, and that the balance
of $190,000 was retained by the lenders (including vFinance)
as brokerage commissions and fees.5 As with the March notes,
Egan guaranteed FreeStar's obligations, and this time he pledged
14.4 million shares of FreeStar stock in support of the guaranty.
Again, FreeStar committed to file a registration statement
within 60 days, again it defaulted, and five of the six
-------------------------------------------------------
3 It seems to have been the intent of the transaction to link
the debt to the stock price in this fashion. The holder
would be protected by being able to set the sale price at 80%
of the Market Price at the time the loan was made,
providing for a potential return of principal and 20% interest,
provided the trading price of the stock did not decline.
4 These amounts are included as part or (in the case of Siegel)
the entirety of the individual Petitioners' claims as set
forth in the Involuntary Petition.
5 Rosenblum, Stefansky, and Siegel also received 1,000,000
shares of FreeStar stock, apparently as a commission or
fee for their June bridge loans of $60,000.
------------------------------
lenders proceeded against the Egan shares held as collateral
pursuant to a Stock Pledge Agreement that in all material respects
was the same as the March agreement.6 On this occasion, they
sent conversion notices to FreeStar promptly, on December 9,
2002.7 On December 11, 2002, the lenders submitted to FreeStar's
stock transfer agent Egan's stock certificate for 14.4 million
shares, stock powers that had been signed by Egan, a copy of
an opinion of Brian Faulkner, counsel to Egan and FreeStar,
with respect to the ability to freely trade the Egan shares,8
and a letter of their counsel demanding that all 14.4 million
shares be transferred into her clients' names.9 The transfer
agent issued 14.4 million unrestricted shares to the Petitioning
Creditors in the denominations requested in counsel's letter,
on December 16, 2002. Even before they received the shares,
the Petitioning Creditors had commenced selling them on the
open market through a broker, Pond Equities ("Pond"), and between
December 10, 2002 and December 30, 2002, they had sold 7,707,332
of the shares.
The December 2002 Convertible Notes
On December 20, 2002, the Petitioning Creditors (other than
Siegel) made another loan to FreeStar, in the aggregate amount
of $237,000.10 It was documented in the same manner as the
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6 vFinance did not foreclose on its collateral but, as discussed
below, all 14.4 million shares posted as collateral have
been foreclosed upon by the other lenders in the transaction.
The Stock Pledge Agreement provides that the
collateral is pledged to the "Secured Parties" generally "and
to each of them to the extent of the Note held by each".
Stock Pledge Agreement, Û1. As further discussed below, it
is assumed that the other lenders are holding the
proceeds of the foreclosure for the rateable benefit of vFinance.
7 The conversion notices indicated the parties were to receive
shares in the following amounts: (i)Rosenblum
1,554,575; (ii) Stefansky 1,554,575; (iii) Siegel 1,036,000;
(iv) Boat Basin 1,682,416; and (v) Papell 2,983,325. In
the June-September Notes, the applicable date for calculating
Market Price was ten days prior to June 27, 2002 or
three trading days prior to date of receipt of the notice of
conversion.
8 Faulkner, in an opinion dated September 17, 2002, analyzed
the number of FreeStar shares then outstanding and
the average weekly trading volume for the past four weeks,
and in light of SEC Rule 144, opined that Egan could
sell 1,615,375 shares without restrictive legend.
9 The lenders requested that the 14.4 million shares be issued
to them in the following amounts: (i) Stefansky
2,526,336; (ii) Rosenblum 2,526,336; (iii) Siegel 1,684,080;
(iv) Boat Basin 2,736,720; and (v) Papell 4,926,528.
10 Papell advanced $70,000, Boat Basin, $70,000; Rosenblum
$43,000, vFinance, $11,000; and Stefansky, $43,000.
These amounts, added to the principal amounts of the June-September
Notes (see page 6, above), equal the amounts
claimed by the Petitioning Creditors against FreeStar in the
Petition.
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March and June-September transactions. The Egan guarantee was
secured by the shares that had
already been foreclosed upon. In the words of an affidavit
submitted by Stefansky on the instant
motion:
Although Petitioning Creditors were entitled to only 8.8 million
shares to cover FreeStar's and Egan's defaults [on the June-September
Notes], the transfer agent converted the entire 14.4 million
shares into free trading stock and issued the entire amount
proportionately to Petitioning Creditors
.... Given FreeStar's pending request for yet another loan,
the understanding was that Petitioning Creditors would hold
the remaining approximate 5.6 million shares as collateral
for a new credit advance to FreeStar in the amount of $237,000.00
which Plaintiffs, in fact, advanced on December 20, 2002.
Stefansky Affid. 2/12/03 at n. 10.11 Counsel for the Petitioning
Creditors agreed at the hearing on
this matter that the amount advanced in December was based
on the current market price and the
number of shares already foreclosed on. On the same day that
the December loan was made, the first step was taken in a series
that led directly to the filing of the Petition. FreeStar's
counsel, Brian Faulkner, wrote to the transfer agent and noted
that his legal opinion, required as part of the creditors'
transfer documentation, had stated that only 1,615,375 shares
could be freely traded during any three month period. On behalf
of FreeStar he demanded that any certificates in excess of
this amount be issued only in restricted form. Thereafter,
First American put a stop order on all the certificates that
had been issued in connection with the foreclosure of the 14.4
million shares and, later, marked the freely tradeable shares
as "cancelled" and substituted restricted or
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11 FreeStar apparently claims that the Petitioning Creditors
over-converted the notes in the following amounts: (i)
Boat Basin 1,682,416 shares for an excess of $98,000; (ii)
Papell 2,988,325 shares for an over-conversion of
approximately $318,000; (iii) Rosenblum 1,554,525 shares for
an excess of $60,084; (iv) Siegel 1,036,000 shares for
an excess of $68,712; and (v) Stefansky 1,554,575 shares for
a $60,085 overage.
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legended shares.12 The Petitioning Creditors had already sold
7,707,332 shares of the stock through Pond and had deposited
the unrestricted certificates with Pond. Pond was informed
that those shares should be deemed restricted, and when the
Petitioning Creditors were unable to make delivery of unrestricted
shares, Pond started to buy shares of FreeStar to cover. At
that time, the price of FreeStar shares had apparently risen
from 10.5 cents per share to 19 cents per share, causing Petitioners
significant potential losses. On January 7, 2003, the Petitioning
Creditors submitted to First American an opinion of their counsel
that all of the shares could be issued without a legend, but
FreeStar and its transfer agent refused to remove the restrictive
legends.
The Bankruptcy Petition and District Court Action
The Petitioning Creditors responded with the instant petition,
filed on January 9, 2003. Two weeks later, on January 22, five
of them filed a complaint in District Court against Egan, FreeStar's
transfer agent, Phillip Young, Margaux Investment Management
Group, S.A. and John Does 1-10. (S.D.N.Y. Index No. 03 Civ.
0493 (RWS).) The complaint (of which this Court has taken judicial
notice) charges, among other things, that the plaintiffs are
lawful owners of the 14.4 million shares of FreeStar stock,
and it seeks both damages and injunctive relief. 13 On January
21, 2003 the plaintiffs moved for a preliminary injunction,
claiming that they were irreparably damaged by being forced
to cover their sales of 7,707,332 shares of FreeStar stock
and that they had not only a probability of success on the
merits ¿ they had an "overwhelming likelihood of success on
the merits." (Plaintiffs' Memorandum of Law in Support of Their
Motion for Preliminary Injunction at p.5.)
----------------------
12 The record contains the affidavit of Philip Young, principal
of FreeStar's transfer agent, attaching the relevant
certificates. They are stamped both "Canceled" and "Restricted," and
it is impossible to tell which stamp was put on
the certificate first. Young avers in the same affidavit, "As
of today's date [February 3, 2003], Petitioners own
collectively 19.4 million shares of Freestar stock."
13 Among other allegations, it is asserted that the plaintiffs
are "protected purchasers of the 14.4 million shares of
FreeStar" within the meaning of UCC Û8-401. (Complaint, õ93).
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By decision dated February 10, 2003, the District Court found
that FreeStar was a necessary party that had to be made a defendant
in order for the Court to render any relief. Boat Basin et
al. v. First American Stock Transfer et al., 03 Civ. 493 (RWS),
2003 U.S. Dist. LEXIS 1838 at *1. Without determining the merits
of the action, Judge Sweet nevertheless observed (Id. at *2)
that the plaintiffs there (the Petitioning Creditors here)
were "hoisted on their own petard" ¿ their commencement of
this bankruptcy case precluded them from joining FreeStar as
a defendant, and this also prevented them from obtaining immediate
injunctive relief in the District Court case.14 The District
Court stayed the action until FreeStar could be joined.
As will be seen below, the petard hoists even higher: the reasons
the Petitioning Creditors propound in the District Court as
those that provide them with an "overwhelming likelihood of
success" are the very reasons why they fail to be holders of
claims "not contingent as to liability or the subject of a
bona fide dispute."
DISCUSSION
Under Û303(b)(1) of the Bankruptcy Code, as initially adopted
as part of the Bankruptcy Reform Act of 1978, an involuntary
petition could be filed only by the holder of a claim "that
is not contingent as to liability or an indenture trustee representing
such a holder...."Although the statute was silent on whether
a disputed claim could be considered a "claim" for purposes
of Û303(b)(1) or Û303(h)(1) (requiring a finding that the debtor
not be paying its debts as they come due), in In re B.D. International
Discount Corp., 701 F.2d 1071 (2d Cir. 1982), cert. denied,
464 U.S. 830 (1983), the Second Circuit held that "we have
difficulty in believing that Congress intended that a debtor
should be found to be generally not paying its debts as they
become due under Û303(h)(1) or that a claim qualifies under Û303(b),
when the claim is subject to serious dispute." 701 F.2d at
1076.
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14 FreeStar had been omitted as a party defendant, presumably
because of the pendency of the automatic stay of this
bankruptcy case.
--------------------------------
The Court further held that in order to qualify as a petitioning
creditor in an involuntary case, "a claimant need not make
out a case warranting summary judgment...It is sufficient to
establish...that there are good grounds for the claim and that
no defenses have been asserted in substantiable form." Id.
at 1077. Two years after B.D. International, Congress amended Û303
to provide that a claimant
under Û303(b)(1) had to hold a claim that was not "the subject
of a bona fide dispute," as well as
not contingent as to liability. It has been held that Congress
in effect adopted the B.D. International formulation. See In
re Elsa Designs, Ltd., 155 B.R. 859, 864 (Bankr. S.D.N.Y. 1993);
In re Nargassans, 103 B.R. 446, 449 (Bankr. S.D.N.Y. 1989).
The legislative history itself is sparse, consisting of the
statement of Sen. Baucus, proponent of the amendment, who stated
that the Bankruptcy Code should not be used "as a club against
debtors who have bona fide questions about their liability
but who would rather pay up than suffer the stigma of involuntary
proceedings." 130 Cong. Rec. S. 7618 (daily ed. June 19, 1984).
The term "bona fide dispute" was not defined as part of the
legislation, but many courts have used the following test: "if
there is a genuine issue of material fact that bears upon the
debtor's liability, or a meritorious contention as to the application
of law to undisputed facts, then the petition must be dismissed...Under
the standard, it must be determined whether there is an objective
basis for either a substantial factual or legal dispute as
to the validity of the debt." Elsa Designs, Ltd., 155 B.R.
at 863-64, citing inter alia, In re Busick, 831 F.2d 745, 747
(7th Cir. 1987), quoting In re Lough, 57 B.R. 993 (Bankr. E.D.
Mich. 1986).
In the instant case it is the Petitioning Creditors who are,
ironically, the most eloquent champions of the disputed nature
of their debt, and therein lies their petard. In the District
Court action, five of the Petitioning Creditors assert that
they are entitled to a preliminary injunction as they have
an "overwhelming likelihood of success " in their position
there that they appropriately foreclosed all of their debt
into freely-tradable shares of Egan's stock. If they did so
foreclose their stock, they are not holders of notes issued
by the alleged debtor. If they did not, the issue is certainly "the
subject of a bona fide dispute."15 It is no answer that FreeStar
is contesting the District Court action.16 It does not claim
there that the Petitioning Creditors are still holders of debt
of FreeStar or that they failed to foreclose on Egan's stock.
It claims that the Petitioning Creditors foreclosed and got
at least what they bargained for ¿ Egan's stock and the right
to sell a certain number of shares during a three month period,
as set forth in Faulkner's initial opinion. Whether the Petitioning
Creditors are correct does not need to be determined by this
Court, but by Petitioners' own account, the dispute is real
and substantial.
Even if there were no dispute pending in another court, FreeStar
argues that the Petitioning Creditors cannot simply rescind
the steps they have already taken in connection with the foreclosure
on Egan's stock and restore themselves to the status of holders
of FreeStar's promissory notes. The Stock Pledge Agreement
requires that the notes be reduced "by an amount equal to the
then applicable Conversion Price (as defined in the Note) multiplied
by the number of Pledged Shares with respect to which the Secured
Party has exercised its foregoing rights and remedies?." There
appears to be no question that five of the six Petitioning
Creditors exercised their rights and remedies under the Stock
Pledge Agreement with respect to a number of shares that would,
when multiplied by the applicable Conversion Price, cover the
face amount of all of their promissory notes, as well as the
notes of their co-investor, vFinance.
---------------------------------
15 It should be noted that the statute uses the term, "the
subject of a bona fide dispute," not the more vague term,
"
subject to a bona fide dispute." The existence of a separate
ongoing lawsuit or other dispute will often satisfy the
test that a s eparate material dispute actually exist and that
the dispute not be one created in response to the
involuntary petition. See, e.g., Efron v. Gutierrez, 226 B.R.
305 (D.P.R. 1998).
16 Although not a party, FreeStar appeared in court and opposed
the motion for a preliminary injunction.
-----------------
The Petitioning Creditors have not attempted to rescind that
transaction, nor have they offered to
surrender Egan's stock as part of the District Court proceeding.17
On the contrary, the Petitioning Creditors have sought a mandatory
injunction to enforce the transaction. Thus, although no determination
need be made on the present record, FreeStar has demonstrated, "in
substantiable form," B.D. International Discount Corp., 701
F.2d at 1077, that the Petitioning Creditors may no longer
hold any debt.18 FreeStar also argues that the Petitioning
Creditors sent conversion notices in connection with their
foreclosure on Egan's shares, that a notice of conversion is
irrevocable under the terms of the Promissory Notes, and that
the Petitioners thereby effectively converted their debt into
stock. FreeStar appears to be on weaker ground in this position.
Not all of the Petitioning Creditors sent conversion notices,
the notices did not cover all 14.4 million shares, and although
the notices were not conditioned on receipt of unrestricted
shares, the intent of the transaction was that the conversion
notices would set the price at which Egan's shares would be
deemed foreclosed. But the fact that FreeStar may be on weaker
ground in connection with this argument does not mean that
there is no bona fide dispute. As noted above, from all appearances,
foreclosure on Egan's shares was intended to be the economic
and legal equivalent of conversion of the debt. The Petitioning
Creditors intended to obtain unrestricted shares by way of
foreclosure on Egan's shares, but it is not at all clear that
they are entitled to restore themselves to the status of debtholders
even if they can demonstrate that FreeStar failed to give them
that to which they were contractually entitled.
------------------
17 In order to rescind, a party must offer to restore the other
party to its original position by returning consideration
received in connection with the transaction to be undone. See
Sokolow, et al. v. Lacher, 299 A.D.2d 64, 747
N.Y.S.2d 441, 447 (1st Dep't 2002); RESTATEMENT (SECOND) CONTRACTS Û283
cmt. c, illus. 3 (1981).
18 This would include vFinance, even though vFinance did not
take all of the explicit steps to foreclose taken by the
other Petitioning Creditors and did not join in the District
Court action. As discussed above, vFinance has been the
beneficiary of the steps taken by the others, and they have
assumed control of all of the collateral for the benefit of
vFinance as well as for their own benefit. vFinance has not
offered to return its share of collateral, and the dispute
with FreeStar goes to the entirety of the claims asserted by
all of the Petitioning Creditors.
----------------
In their papers in this Court, the Petitioning Creditors contend
that they advanced funds to FreeStar, attempted to foreclose
on Egan's stock, but have obtained absolutely nothing. Their
conclusion is that the original debt must still be outstanding
as if nothing had happened. But even on their terms, they are
not empty-handed. They have a lawsuit in which they contend
they have an overwhelming likelihood of success on the merits
to get what they assert they bargained for. They have foreclosed
on Egan's shares, and if the shares are not freely tradeable,
FreeStar claims that is what the Petitioners are entitled to.
In any event, there certainly is a bona fide dispute.19 The
Petitioning Creditors rely on LaRoche v. Amoskeag Bank (In
re LaRoche), 969 F.2d 1299 (1st Cir. 1992), for the proposition
that a creditor can, in good faith, file an involuntary petition
after it has taken steps to foreclose on collateral securing
the subject debt.
-------------------------
19 Egan represented in the Stock Pledge Agreement that "there
are no restrictions upon transfer and pledge of the
Pledged Shares pursuant to the provisions of this Agreement
except the restrictions imposed by Rule 144 under the
Securities Act of 1933, and that such restrictions on resale
shall not be applicable if an Event of Default occurs
under the Notes, and the Secured Party exercises its remedies
under the Guaranty and forecloses on the Pledged
Shares." He may have breached this representation, but that
does not make FreeStar liable therefore. FreeStar also
gave irrevocable instructions to its transfer agent as follows:
This letter shall serve as our irrevocable authorization and
direction to you to
record the transfer of the Pledged Shares to the Holders of
the Notes upon their
respective exercise of rights as a Secured Party under the
Stock Pledge
Agreements, from time to time, upon surrender to you of (i)
one or more of the
stock certificates evidencing the Pledged Shares, and (ii)
stock transfer powers
properly executed by the registered owner of such Pledged Shares,
in the form
attached hereto as Exhibit B relating to the certificate or
certificates so
surrendered for transfer, (iii) the opinion of counsel to the
Company or the
Holders in the form attached as Exhibit C hereto, indicating
that upon
disposition of such shares, the new certificate issued as a
consequence of the
disposition and evidencing the transferred shares will be free
of restrictive
legend, pursuant to the provisions of Rule 144 under the Securities
Act of 1933,
as amended.
(See Young Affidavit Exhibit 3).
The Petitioning Creditors claim that FreeStar violated these
instructions in that they did not obtain
unrestricted shares. But the instructions speak of the opinion
of counsel to the Company, in the form attached as
Exhibit C, which opinion stated only that a limited number
of shares could be traded in any three-month period.
Judge Sweet commented in his opinion that the Petitioning Creditors
have never explained how shares that were
restricted when owned by Egan could become freely tradeable
when owned by Petitioners. See Boat Basin, 2003
U.S. Dist. LEXIS at *11, fn. 1.)
-------------------
There, the Court held that a Bank's action in placing stock
held as collateral in its own name, while
expressly reserving its other rights and remedies against the
obligor, did not constitute a proposal
to accept and retain the collateral in full satisfaction of
the indebtedness under the Uniform Commercial Code and did
not result in "full payment" of the debt. 969 F.2d at 1302-03.
The Court noted that the pledge agreement gave the Bank authorization
to transfer the stock into its own name and that this is a
common remedy, giving the secured creditor the right to vote
the shares and receive dividends. The Court further found that
there had been no "explicit act of foreclosure," much less
a satisfaction of the debt, and that the debtor, LaRoche, remained
the beneficial owner of the shares. Id. at 1304. The situation
at bar is different in several crucial respects. Here, there
has been an "explicit act of foreclosure," and one that arguably
resulted in elimination of the debt as such and
transformation of the Petitioning Creditors' interest in FreeStar
into an equity interest. Moreover,
even if the Petitioning Creditors here had only transferred
Egan's stock into their names, without
taking any further steps toward foreclosure, the result would
have divested them of their status as
creditors. Unlike the stock pledge provisions in the LaRoche
case, the carefully wrought Stock Pledge Agreement in the instant
matter provided that upon a transfer of Egan's stock into the
names of the Petitioning Creditors, the creditors were obligated
to assign their notes to Egan.
Stock Pledge Agreement Û10(d). FreeStar asserts, in fact, that
the Petitioning Creditors were required to assign their notes
to Egan when his stock was placed in their names by the transfer
agent, and that this is another reason why the Petitioning
Creditors no longer hold debt and could not properly file the
Petition herein. It is not at all clear that the assignment
requirement was intended to apply when stock was transferred
into the names of creditors after a foreclosure, as opposed
to prior to foreclosure (as in LaRoche). But, again, this is
a point of contention, and another reason why the claims asserted
by the Petitioning Creditors are the subject of a bona fide
dispute. A creditor is not prevented from exercising its right
under the Bankruptcy Code to file an involuntary petition by
the existence of collateral, or, as in LaRoche, after it has
taken certain limited steps to protect its interest in the
collateral. 20 Moreover, the existence of a guarantee does
not prevent a creditor from filing an involuntary petition
against the principal obligor. See In re Sjostedt, 57 B.R.
117 (Bankr. M.D. Fla. 1986). But the Petitioning Creditors
have cited no authority that suggests that an involuntary petition
can be filed by creditors who have arguably completed a foreclosure
on collateral pledged by a guarantor of their debt and, as
part of the transaction, surrendered their debt. The Court
need not determine at this point whether the Petitioning Creditors
did in fact surrender their debt, but it does find that there
is a bona fide dispute on the issue. Moreover, the Petitioning
Creditors have cited no authority that holds that they can
pursue litigation that would assuredly result in the conversion
of their debt to equity while at the same time petition the
obligor into bankruptcy.
An involuntary petition is much more than just another, alternative
debt collection device available to a dissatisfied creditor.
In re Nordbrock, 772 F.2d 397, 400 (8th Cir. 1985); In re SBA
Factors of Miami, Inc., 13 B.R. 99, 101 (Bankr. S.D. Fla. 1981);
In re Cates, 62 B.R. 179, 181 (Bankr. S.D.Tex.1986); In re
Hope Communications, Inc., 59 B.R. 939, 943 (Bankr. W.D.La.
1986). An involuntary petition commences a collective proceeding
whose existence is intended to benefit all creditors, that
may have many adverse ramifications to an operating company,
------------------------------------------
20 Section 303(b)(1) states explicitly that a secured creditor
may join in a petition if the claims of the Petitioning
Creditors "aggregate at least $11,625 more than the value of
any lien on property of the debtor securing such claims
held by the holders of such claims."
------------------------
including an adverse affect on its stock price, and that is
not lightly undone.21 The Petitioning Creditors cannot file
a company into bankruptcy while simultaneously asserting in
another court that they have an "overwhelming likelihood of
success" on their claim that they are in fact stockholders.
Section 303(b)(1) requires the existence of three creditors
whose debt is not "the subject of a bona fide dispute" precisely
so that a litigant in another contested proceeding involving
the debtor cannot lightly make the dispute the subject of a
full-fledged bankruptcy case, "given the severity of an involuntary
bankruptcy as a remedy." 2 COLLIER ON BANKRUPTCY õ303.02[2][b][i]
(15th ed. 1999). Usually, it is the debtor that raises the
issue and contends that it is not liable on the alleged debt.
Under the unusual circumstances present here, it is the Petitioning
Creditors themselves who are the most eloquent proponents of
the disputed nature of their claims. In any event, there is
a bona fide dispute as to whether the Petitioning Creditors
are really shareholders and not creditors at all, and this
Petition must accordingly be dismissed.22 In light of the foregoing
disposition, it is not necessary to determine whether FreeStar's
alleged counterclaims against the Petitioning Creditors are
sufficient to raise a bona fide dispute that would negate the
debt that arose under its promissory notes. As indicated above,
FreeStar argues in support of its motion to dismiss this case
that it has claims against the Petitioning Creditors that they
were overpaid in connection with their foreclosure on Egan's
stock, that the fees and costs they charged in connection with
their loans were unconscionable and illegal, and that Siegel
failed to perform under a consulting contract with FreeStar.
-----------------------------------------------
21 FreeStar asserts that in this case, the filing was intended
to depress its stock price and make it cheaper for Pond to
buy in stock and cover the Petitioning Creditors' default in
delivery of marketable stock after the foreclosure. The
Court makes no finding that the Petitioning Creditors had this
intent, but the fact that an involuntary petition may
have such an effect on stock price is another reason why one
should not be filed lightly.
22 Under the prior Bankruptcy Act, it was held that a creditor
could not be a petitioner in an involuntary case if it
participated in the act of bankruptcy on which the petition
was predicated (for example, if it procured or consented
to the appointment of a State court receiver). In Matter of
De Gelleke Co., Inc., 411 F. Supp. 1320 (E.D. Wisc.
1996), the Court noted that "The underlying rationale for the
rule has been variously expressed as estoppel, election
of remedies and volenti non fit injuria," and that its premise
is that the alleged bankrupt "enjoys some concomitant
right to be free from parallel proceedings begun by the same
creditor where one proceeding is dependent on the
other." 411 F. Supp. at 1323 (footnotes omitted). Here, the
parallel proceedings are inconsistent, rather than
dependent, but it would be equally unfair for these Petitioning
Creditors to be able to put FreeStar into bankruptcy
while at the same time asserting in another court that they
are shareholders. The requirement that a debt not be
subject of a bona fide dispute insures that an alleged debtor
not be whipsawed in this fashion. In re Braten, 86 B.R.
340, 343 (Bankr. S.D.N.Y. 1988).
--------------------------
The existence of a possible counterclaim, especially a counterclaim
that is not already "the subject of a bona fide dispute," does
not necessarily mean that a claim is insufficient to form the
basis of an
involuntary petition under Û303(b)(1). See In re Audio Visual
Workshop, Inc., 211 B.R. 154, 158
(Bankr. S.D.N.Y. 1997); see also In re Onyx Telecommunications,
Ltd., 60 B.R. 492, 497-98 (Bankr. S.D.N.Y. 1985). The strength
of the counterclaim, the circumstances under which it was first
asserted and whether it would eliminate the whole or only part
of the debt are all relevant in determining whether an involuntary
petitioner's claim is "the subject of a bona fide dispute." See
Efron v. Gutierrez, 226 B.R. at 314. The Court makes no finding
as to whether FreeStar's alleged
counterclaims are of sufficient weight, in and of themselves,
to invalidate this Petition.
Counsel for FreeStar is directed to settle an order on three
days' notice dismissing the involuntary petition.
Dated: New York, New York
February 26, 2003
/s/ Allan L. Gropper _
UNITED STATES BANKRUPTCY JUDGE
