National Farm Financial Corporation

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MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-1-
UNITED STATES BANKRUPTCY COURT
FOR THE NORTHERN DISTRICT OF CALIFORNIA
In re
NATIONAL FARM FINANCIAL
CORPORATION,
Debtor.
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Case No. 07-31580 TEC
Chapter 11
MEMORANDUM DECISION RE UNITED STATES TRUSTEE’S
MOTION TO APPOINT CHAPTER 11 TRUSTEE
On February 4, 2008, the court held a hearing on the motion of
the United States Trustee for the appointment of a trustee in this
chapter 11 case. 	Patricia A. Cutler appeared for the United States
Trustee. 	Patrick A. Murphy and Robert A. Julian appeared for the
debtor in possession. 	Thomas R. Kreller appeared for judgment
creditor PSM Holding Corp. 	Upon due consideration, and for the
reasons stated below, the motion is granted.
FACTS
Debtor in possession, National Farm Financial Corporation
(Debtor), is a holding company whose only asset is 100 percent of
the shares of Business Alliance Insurance Company (BAIC). 	The Chao
Signed and Filed: February 12, 2008
________________________________________
THOMAS E. CARLSON
U.S. Bankruptcy Judge
________________________________________
Entered on Docket
February 12, 2008
GLORIA L. FRANKLIN, CLERK
U.S BANKRUPTCY COURT
NORTHERN DISTRICT OF CALIFORNIA
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1 Unless otherwise noted, all statutory references are to the
United States Bankruptcy Code, Title 11, United States Code.
MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-2-
Family Trust owns 100 percent of the shares of Debtor. 	Julie and
Larry Chao are the sole beneficiaries and co-trustees of the trust.
Julie and Larry Chao are the sole members of Debtor’s board of
directors. 	Larry Chao is the president of both Debtor and BAIC.
In September 2005, Debtor entered into a contract to sell its
BAIC shares to PSM Holding Corp. (PSM). 	When Debtor refused to
perform, PSM sued Debtor, BAIC, and Larry Chao for damages in the
United States District Court for the Central District of
California. 	After a 15-day jury trial, the court entered a
judgment in favor of PSM that imposed joint and several liability
on all three defendants in the amount of $43 million (the
Judgment). 	The court reduced the award to $40 million on the
defendants’ post-trial motion, but otherwise refused to set aside
the Judgment.
Unable to post an adequate bond to stay enforcement of the
Judgment pending appeal, Debtor filed a chapter 11 petition on
December 5, 2007. 	Larry Chao filed a chapter 11 petition on
January 7, 2008. 	BAIC is not eligible to file for bankruptcy
protection because it is a domestic insurance company.
§ 109(b)(2). 1
On December 5, 2007, Debtor filed an adversary proceeding
against PSM seeking to enjoin PSM from enforcing the Judgment
against BAIC during the pendency of this chapter 11 case. 	The
court declined to grant a preliminary injunction, primarily on the
basis that Debtor had not shown a likelihood of confirming a
chapter 11 plan. 	The court did grant a temporary restraining order
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MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-3-
through February 8, 2008, and later extended that order through
February 13, 2008.
In the course of seeking a preliminary injunction, Debtor
asserted that both Julie Chao and Larry Chao asserted claims
against Debtor. 	The United States Trustee filed the current motion
for appointment of a trustee on the basis that Julie and Larry Chao
have a conflict of interest in asserting claims against the debtor
in possession at the same time they are the sole members of the
board of directors of the debtor in possession. 	The United States
Trustee also urged that a trustee should be appointed on the basis
of acrimony between Debtor and its creditors.
Judgment creditor PSM joined in the motion of the United
States Trustee. 	In its papers, PSM urged an additional basis for
the appointment of a trustee: that the jury had found that Debtor
had defrauded PSM. 	Debtor filed a motion to strike the joinder, on
the basis that it raised new issues. 	Debtor also asserted numerous
objections to the evidence offered by PSM. 	There is no need to
rule on the motion to strike or the evidentiary objections, as the
court resolves this motion on the basis of the issues originally
raised by the United States Trustee.
Following the United States Trustee’s motion for appointment
of a trustee, Debtor added three outside directors, appointed those
new directors to a special litigation committee of the board, and
authorized that committee to make all decisions related to the
claims asserted by Julie and Larry Chao. 	Both the United States
Trustee and PSM contend that appointment of the special litigation
committee is not a sufficient response. 	The committee does not
resolve the conflict of interest raised by the Chaos’ assertion of
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MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-4-
claims against Debtor, they argue, because the committee members
were selected by the Chaos. 	The committee does not resolve the
broader conflict between Debtor and PSM, they argue, because the
charter of the committee is too narrow. 	The committee was not
accorded jurisdiction over settlement of the appeal of the
Judgment, the terms of a plan, and other issues on which Debtor and
PSM are, or may soon be, at loggerheads.
DISCUSSION
Conflict between a debtor and its creditors can constitute
cause for appointment of a chapter 11 trustee. 	In re Marvel
Entertainment Group, Inc., 140 F.3d 463, 472-73 (3rd Cir. 1998);
Cajun Electric Power Cooperative, Inc. v. Central Louisiana Elec.
Co., Inc. (In re Cajun Power Cooperative, Inc.), 74 F.3d 599, 600
(5th Cir. 1996) (adopting on reh’g the opinion of dissent in 69
F.3d 746 (5th Cir. 1995)). 	There is no per se rule under which
debtor-creditor conflict requires the appointment of a trustee.
Marvel, 140 F.3d at 473; Cajun Electric, 74 F.3d at 600. 	Rather,
the courts must be given discretion to appoint a trustee on a case-
by-case basis, when the conflict extends beyond that which always
exists between debtor and creditors and threatens the breakdown of
reorganization efforts. 	Marvel, 140 F.3d at 472-73.
The circumstances of the Marvel case are like those of the
present case in several respects. 	The creditors in that case
asserted that the board of the debtor in possession sought to
preserve the Perelman group’s control of the debtor. 	Id. at 467.
The debtor in possession filed suit to subordinate the claims of
creditors who opposed that outcome. 	Id. at 468. 	The opposing
creditors stated that they believed the board was “incapable of
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MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-5-
neutrality.” 	Id. at 469. 	The court held that cause existed for
appointment of a trustee on the basis of the trial court’s findings
that the debtor in possession and creditors took “dramatically
different stances on many issues” (id. at 473), that the debtor in
possession was “not entirely without blame for the breakdown of
reorganization” (id.), that the debtor in possession had failed to
fulfill its fiduciary duty to deal fairly with creditors in the
subordination litigation (id. at 474), and that “there is no
reasonable likelihood of cooperation between the parties in the
near future” (id. at 473).
The present case is a two-party dispute in which the positions
of Debtor and its major creditor have become polarized. 	Debtor has
stated quite clearly that its objective is to enable the Chao
Family Trust to retain control of BAIC, the Debtor’s wholly-owned
subsidiary. 	Judgment creditor PSM likely wants to acquire BAIC or
to have the shares reduced to cash to pay PSM’s $40 million
Judgment.
Debtor will have great difficulty confirming a plan under
which the Chaos retain control of BAIC. 	PSM’s Judgment represents
more than 99 percent of the scheduled general unsecured claims.
Because PSM’s claim is based on a judgment, Debtor will not likely
be able to prevent PSM from voting its claim. 	Fed.R. Bankr. P.
3018(a); In re Marin Town Center, LP, 142 B.R. 374, 379-80 (N.D.
Cal. 1992) (allowance for voting purposes left to reasonable
discretion of court). 	PSM can thus block acceptance by any class
in which it is placed. 	§ 1126(c). 	Shareholders of the Debtor (the
Chao Family Trust) cannot retain any property (the BAIC shares)
unless PSM consents or is paid in full. 	§ 1129(b)(2)(B). 	Debtor
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2 Debtor has had ample opportunity to be heard regarding the
legal issues discussed below. 	Debtor discussed these issues in
support of its request for a preliminary injunction, and briefed
them further in a motion for reconsideration of the order denying a
preliminary injunction.
MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-6-
has no assets other than the BAIC shares with which to pay the $40
million Judgment.
Debtor has exacerbated the debtor-creditor conflict by
asserting several highly questionable legal positions. 	Recognizing
that PSM’s claim is sufficient to block confirmation of any plan
under which the Chao Family Trust retains the BAIC shares, Debtor
asserts that PSM’s claim should be subordinated to Julie Chao’s
equity interest. 	If accomplished, this would enable Julie Chao to
retain the BAIC shares.
Debtor contends that Julie Chao has a valid claim against
Debtor for the harm done to her equity interest by the conduct of
her husband that led to the Judgment. 	Debtor next contends that
PSM’s claim should be subordinated pursuant to section 510(b) to
the level of common stock of Debtor. 	Finally, Debtor contends that
PSM’s claim should be subordinated to Julie Chao’s claim pursuant
to section 510(c), because of PSM’s unfair conduct in the District
Court litigation. 	For the reasons set forth below, these positions
have little legal support. 2
First, Debtor does not explain how Julie Chao would have a
claim against Debtor. 	Under California law, an action for
malfeasance by an officer or director belongs to the corporation
and is brought against the responsible corporate official. 	See,
e.g., Anderson v. Derrick, 220 Cal. 770, 773-74 (1934); Nelson v.
Anderson, 72 Cal. App. 4th 111, 124-26 (1999). 	Furthermore, to the
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MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-7-
extent Julie Chao suffered harm separate from that suffered by the
corporation, her claim would appear to be against her husband
rather than against the corporation. 	The claim seems to be framed
the way it is, not because that is the most natural and neutral way
to frame it, but because this framing offers a way for the Chaos to
neutralize the effect of PSM’s large claim.
Second, Debtor’s assertion that PSM’s claim should be
subordinated to the level of common stock of Debtor pursuant to
section 510(b) is not supported by a careful reading of that
statute. 	Section 510(b) provides:
For the purpose of distribution under this title, a claim
arising from rescission of a purchase or sale of a
security of the debtor or of an affiliate of the debtor,
for damages arising from the purchase or sale of such a
security, or for reimbursement or contribution allowed
under section 502 on account of such a claim, shall be
subordinated to all claims or interests that are senior
to or equal the claim or interest represented by such
security, except that if such security is common stock,
such claim has the same priority as common stock.
(Emphasis added). 	The purpose of the statute is to prevent a party
that bargains for the risks and benefits of an equity position in a
company from raising itself to parity with the company’s creditors
when the company becomes insolvent. 	In re Betacom of Phoenix,
Inc., 240 F.3d 823, 830-31 (9th Cir. 2001).
The “such security” language in section 510(b) provides that
the claim follows the security and has the same priority as the
security that gave rise to the claim. 	Restating the statutory
language to fit the facts of the present case, section 510(b)
provides that a claim arising from the purchase of the common stock
of Debtor’s subsidiary has the same priority as the common stock of
Debtor’s subsidiary. 	Thus, the recovery on the claim is governed
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3 To the extent a claim exceeds the equity of the subsidiary,
the claim would be subordinated at the parent level. 	Under section
510(b), the claim is given the priority of the subsidiary’s common
stock, and shares of a subsidiary create no interest in the assets
of the parent. 	See In re VF Brands, Inc., 275 B.R. 725, 727
(Bankr. D. Del. 2002).
4 In VF Brands, supra n. 3, the claimant had purchased shares
of a subsidiary of the debtor. 	The subsidiary became insolvent.
Id. at 726 (no distribution to shareholders in its bankruptcy).
The court held that the securities fraud claim against the parent
had the same priority as the shares of the subsidiary. 	The
claimant could not recover from the parent, because shareholders of
a subsidiary have no interest in the assets of a parent
corporation. 	Id. at 727. 	Nothing in the decision suggests that
the claimant would have been affected by section 510(b) in seeking
recovery from the subsidiary, had that company been solvent and its
shares valuable. 	In Lernout & Hauspie Speech Products, N.V. v.
Baker, 264 B.R. 336 (Bankr. D. Del. 2001), the claimant purchased
shares of the parent corporation and asserted a claim against the
subsidiary. 	Nothing in the decision suggests that the claimant
would have been affected by section 510(b) in asserting a claim
against the value of the parent stock if those shares had been
MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-8-
by whether the subsidiary is solvent. 	If the subsidiary is
insolvent, there is no equity in the subsidiary’s shares for the
claim to attach to. 	If the subsidiary is solvent, as in the
present case, the claim is not subordinated to the extent of the
equity of the subsidiary. 3
Debtor cites certain cases for the proposition that a claim
arising from the purchase of shares of a debtor’s subsidiary must
be subordinated to creditors of the debtor as well as to creditors
of the subsidiary. 	The cases relied upon do not support that broad
proposition. 	In none of the cases did the court indicate that the
subsidiary was solvent. 	In none of the cases did the court hold
that the claim did not “follow the security,” and that a claim
arising from the purchase of shares of a solvent subsidiary could
not be satisfied from the equity of the subsidiary remaining after
claims against the subsidiary were paid. 4
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valuable. 	Indeed, the debtor in that case argued that the claim
“follow[ed] the security” and had the same priority as the shares
purchased. Id. at 341. 	In re THC Financial Corp., 679 F.2d 784
(9th Cir. 1982) is another case in which the claimant purchased
shares of the parent company and asserted a claim against its
subsidiary. 	The court held that the claim had to be subordinated
to the creditors of the subsidiary. 	Nothing in the decision
suggests that claimant could not have “followed the security” had
the shares of the parent had value. 	In re Wisconsin Barge Line,
Inc., 76 B.R. 142 (Bankr. E.D. Mo. 1987) involved the purchase of
shares of a subsidiary, but did not discuss whether the subsidiary
was solvent and does not suggest that claimant would have been
denied the value of the shares had the subsidiary been solvent.
MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-9-
Debtor’s reliance on law review articles is also misplaced.
Professors Slain and Kripke urge only the general policy that
claims related to the purchase of shares be classified with equity
in the application of the absolute priority rule. 	John J. Slain &
Homer Kripke, The Interface Between Securities Regulation and
Bankruptcy, 48 N.Y.U. L. Rev. 261 (1973). 	This approach permits
claims arising from the sale of shares of a debtor’s subsidiary to
be paid from any equity of the subsidiary remaining after creditors
of the subsidiary are paid. 	Id. at 296. 	Professor Georgakopoulos
urges courts to reject the interpretation urged by Debtor. 	He
argues that claims related to the shares of a debtor’s subsidiary
should be subordinated only to the creditors of that subsidiary,
and may be paid from the equity of the subsidiary. 	Nicholas L.
Georgakopoulos, Strange Subordinations: Correcting Bankruptcy’s §
510(b), 16 Bankr. Dev. J. 91 (1999).
The subordination of fraud claims seeks to return the
priority of sellers of common stock to buyers of common
stock, in part because they accept the risks inherent in
common stock. 	The buyers of the subsidiary’s stock,
however, do not accept any of the risks associated with
holding stock of its parent.
Id. at 109.
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28 	5 Cal. Corp. Code § 1001(a).
MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-10-
When this general principle is applied to fraud claims
arising from the purchase of common stock of
subsidiaries, the reference that these claims must be
subordinated to the level of common stock means not
common stock of the parent, but common stock of the
subsidiary . . . common stock claims of the subsidiary
are senior to all claims of parent creditors. . . .
Id. at 121.
Third, Debtor’s assertion that PSM’s claim should be
subordinated to Julie Chao’s equity interest pursuant to section
510(c) lacks any colorable basis. 	Debtor argues that the
corporation could not sell all its assets without a shareholder
vote, 5 that no shareholder vote was taken, and that PSM acted
improperly by not making Julie Chao a party to the District Court
action and by obtaining a judgment for breach of contract in these
circumstances. 	Debtor acknowledges that the District Court
addressed whether Larry Chao’s actions were sufficient to bind
Debtor. 	E.g., Memorandum of Law in Support of Debtor’s Motion to
Extend Automatic Stay, Adv. Proc. 07-3134, Docket No. 2, at 5.
Debtor cites no precedent in which conduct like that alleged here
has been the basis of equitable subordination. 	This is not
surprising. 	In substance, Debtor argues that equity requires that
the Judgment against Debtor for breach of a contract be
subordinated to the interests of Debtor’s shareholders, on the
basis that the Judgment creditor failed to join a person who was
not a party to the contract sued upon. 	Equity does not require
such a bizarre reversal of position.
A debtor in possession assumes the same fiduciary duties as a
chapter 7 or chapter 11 trustee. 	7 Collier on Bankruptcy (15th
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MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-11-
ed., rev’d) § 1108.09(2). 	Among these obligations is the duty to
be impartial. 	Id. at § 1108.09(4). 	The managers of a chapter 11
debtor must consider the interests of creditors as well as
stockholders. 	Id. at § 1108.09(4)(c). 	Thus, for example, a debtor
may not refuse a reasonable settlement offer on the basis that it
provides only enough to pay creditors. 	By taking the risk of going
to trial solely to obtain a recovery for equity, the debtor in
possession breaches its duty to deal impartially with the interests
of creditors and stockholders. 	In re Bowman, 181 B.R. 836, 843-45
(Bankr.D. Md. 1995).
The duty to deal impartially with all parties applies to the
expenditure of estate funds on litigation. 	A debtor in possession
may “object to the allowance of any claim that is improper.”
§§ 704(a)(5), 1106(a)(1). 	Both the duty to preserve estate assets
and the duty of impartiality require that the debtor in possession
not expend estate funds on unfounded objections to claims for the
purpose of aiding shareholders. 	In the same vein, the debtor in
possession should not expend estate funds on any other litigation
against a creditor that does not represent an impartial evaluation
of the competing legal interests of that creditor and other
interested parties.
I do not at this time rule finally on the merits of the
positions Debtor has asserted, or find that every aspect of those
positions is wholly without merit. 	I do find that Debtor, perhaps
affected by the natural polarity of a two-party case, has not
impartially weighed the competing claims of the Chaos and PSM, but
has instead asserted the most aggressive positions possible in
favor of the Chaos and against PSM.
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6 It is not clear whether the clear-and-convincing-evidence
standard is good law. 	The Supreme Court held in 1991 that the
preponderance-of-the-evidence standard should generally be used in
bankruptcy proceedings. 	Grogan v. Garner, 498 U.S. 279 (1991).
The clear-and-convincing-evidence standard for appointment of a
trustee urged by Debtor appears in cases decided before Grogan.
See In re Sharon Steel Corp., 871 F.2d 1217, 1226 (3rd Cir. 1989).
The court need not decide this question, because the evidence
presented by the U.S. Trustee satisfies both standards.
7 The Chaos are, of course, free to take any position and file
any action or motion in support of their interests that does not
violate Fed. R. Bankr. P. 9011. 	As a debtor in possession,
however, Debtor must act impartially as a trustee, and is not free
to use the assets of the estate to pursue the goals of the Chaos
alone, but must act in the interest of the estate as a whole and
weigh impartially the interests of PSM along with those of the
Chaos.
MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-12-
I find by clear and convincing evidence that cause exits for
the appointment of a chapter 11 trustee, because of the nature and
source of the conflict that has arisen between Debtor and its major
creditor. 6 	Marvel, supra, 140 F.3d 473-74. 	In so finding, I make
the following subsidiary findings of fact. 	First, the positions of
Debtor and PSM have become highly polarized. 	This conflict is not
of such long duration as that in Marvel and Cajun Electric, but it
is likely to persist. 	Debtor and PSM have clearly defined and
starkly conflicting objectives in this chapter 11 case. 	Second,
Debtor’s actions to date indicate that it is not likely to weigh
impartially all reasonable possibilities for resolving the case.
Debtor has taken unfounded positions with the objective of
preserving the Chaos’ control over BAIC. 	In so doing, Debtor has
not impartially weighed the interests of creditors as well as
shareholders. 	The interest of the estate is to maximize the value
of its assets, not to ensure a particular disposition of those
assets. 7 	Third, only a truly independent trustee appointed by the
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8 It does not appear that either the Chaos or PSM will be able
to elect a trustee because their claims are insider claims or are
disputed. 	§§ 702(a), 1104(b)(1).
MEMORANDUM RE U.S. TRUSTEE’S MTN
TO APPOINT A CHAPTER 11 TRUSTEE 	-13-
United States Trustee will reliably perform the fiduciary duty to
maximize the value of the estate and to consider all possible
options for a consensual resolution of the case. 8
**END OF MEMORANDUM**
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Court Service List
Patricia A. Cutler, Esq.
Office of United States Trustee
235 Pine St., Ste. 700
San Francisco, CA 94104
Patrick A. Murphy, Esq.
Robert A. Julia, Esq.
Law Offices of Winston and Strawn LLP
101 California Street, 39th Floor
San Francisco, CA 94111
Thomas R. Kreller, Esq.
Milbank, Tweed, Hadley & McCloy
601 South Figueroa Street, 30th Floor
Los Angeles, CA 90017
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