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These decisions from federal courts from around the country touch upon topics ranging from bankruptcy to securities fraud. The cases deal with issues such as what constitutes a “bad faith” Chapter 11 petition, who has standing to sue for violation of disclosure obligations under the Securities Exchange Act of 1934, and the status of an insolvent S corporation’s forgiven debt under the Internal Revenue Code. ************************* BANKRUPTCY CH. 11 FILED TO ADDRESS SHAREHOLDERS’ LAWSUIT PROPERLY DISMISSED The 8th U.S. Circuit Court of Appeals has affirmed the bankruptcy court’s dismissal of a debtor’s Chapter 11 petition based on bad faith where it appeared that the petition was filed in response to a lawsuit filed by shareholders rather than in an attempt to reorganize. Cedar Shore Resort Inc. v. Mueller ( In re Cedar Shore Resort Inc.), No. 00-1389 (8th Cir.; Dec. 13, 2000). A series of complications that befell a vacation resort company left it unable to meet its loan obligations and contemplating a bankruptcy filing. Instead, an agreement to restructure the loan with the company’s main lender was reached and the board of directors voted not to file for bankruptcy, despite an outside consultant’s recommendation. Before a shareholder vote on this plan could be held, however, two of the company’s shareholders filed suit in state court against the company, its management firm and the company’s officers and directors. Following the lawsuit, and without investigating the plaintiffs’ claims, the board of directors conducted a meeting and voted to now reorganize under Chapter 11. It was later determined by the debtor that the plaintiffs’ claims were derivative in nature and without merit. As a result, the debtor reached a settlement with its officers, directors and management company whereby the debtor agreed to release its claims in exchange for an agreement not to seek indemnification. The debtor then sought court approval of its plan, which was basically the same as its prior restructuring agreement with the lender. The plaintiff shareholders objected and moved to have the petition dismissed, arguing that it was filed in bad faith. The bankruptcy court agreed, and dismissed the suit under Bankruptcy Code � 1112(b). The court found that the petition was not filed in an effort to reorganize, but in response to the shareholders’ lawsuit. The 8th Circuit affirmed. Although � 1112(b) authorizes the dismissal of a Chapter 11 petition for cause if it is in the best interest of creditors and the estate, it does not contain a good-faith requirement. Nevertheless, the court stated, other circuits, most recently the 3rd Circuit in In re SGL Carbon Corp. , 200 F.3d 154 (1999), have recognized an implicit good-faith requirement. In SGL Carbon, the court ruled that “cause” exists to dismiss a reorganization filed by a financially healthy company facing potential financial losses in litigation. Here, the instant debtor was also not in financial trouble and anticipated turning a profit in 2000. The debtor argued in favor of the position taken by the 4th Circuit, that while there is an implicit good-faith requirement under the Bankruptcy Code, a petition should not be dismissed unless there is no legitimate possibility a debtor could reorganize. The court here stated, however, “[d]ebtors seeking the protection of the Code should act in conformity with the Code’s underlying principles of equity and fairness, and any debtor who files bankruptcy in bad faith should not be permitted to enjoy the protections of Chapter 11, even though the debtor might be capable of effectuating a reorganization.” ************************* SECURITIES FRAUD STATEMENTS REGARDING IMMINENT SALES CONTRACTS CREATES TRIABLE FRAUD ISSUE The 3rd Circuit has ruled that a corporate officer who allegedly made repeated statements concerning the company’s “imminent” contracts in order to secure investment financing created a triable issue for securities fraud under � 10(b) of the 1934 Securities Exchange Act. EP MedSystems Inc. v. EchoCath Inc., No. 98-6461 (3rd Cir.; Dec. 26, 2000). The plaintiff, a small medical products company, sued a small research and development company, claiming that it was induced to invest more that $1.4 million based on personal assurances made by the defendant’s CEO that marketing contracts with four prominent companies were “imminent.” The defendant never entered into any such contract and never received any income from marketing any products. The district court dismissed the plaintiff’s complaint, however, based on cautionary language in several of the documents that the defendant filed with the Securities Exchange Commission. The court found that the misrepresentations the plaintiff claimed in its complaint were immaterial as a matter of law and that the plaintiff did not properly plead scienter, reasonable reliance or loss causation. The 3rd Circuit reversed. The court noted that this case was different from most securities fraud actions in that the alleged misrepresentations did not affect the price of securities, but rather were made as a direct inducement to receive a capital investment. Based on the unique nature of this claim, the appeals court found that the lower court applied “the requirements of a securities action too strictly” and that the “application of certain legal requirements must be adjusted to fit the particular action.” Here, the court found that the defendant’s assurances could have been viewed as misrepresentations of its current state of negotiations with third parties rather than as a prediction of future events, which are not actionable. In addition, by claiming that the defendant misrepresented the status of its contract negotiations, the plaintiff had adequately pleaded scienter. The court noted that the plaintiff was not in possession of more specific information, as no discovery had yet been allowed and all the relevant information was still in the possession of the defendant. Further, it noted that a trier of fact could conclude that plaintiff’s reliance on the defendant’s representations were reasonable, and that requisite causal connection between the defendant’s assurances and the plaintiff’s lost investment was present. ************************* SHAREHOLDER RIGHTS SHAREHOLDERS OF ACQUIRING COMPANY CAN’T ASSERT CLAIMS UNDER � 13(D) In a case of first impression, the U.S. District Court for the Southern District of New York has ruled that the shareholders of an acquiring company in a merger do not have standing to assert a claim for violating the disclosure obligations of � 13(d) of the 1934 Securities Exchange Act. In re Dow Chemical Securities Bhopal Litigation, No. 00 Civ. 3364 (S.D.N.Y; Dec. 28, 2000). The shareholders of the acquiring corporation in a merger filed a lawsuit contending that the Schedule 13D disclosure that was filed was false and misleading. The shareholders claimed that the disclosure omitted pertinent facts and significant liabilities of the acquisition. The district court dismissed the motion, however. After examining the language of the statute and its legislative history, the court ruled that the shareholders did not have standing. The court stated, “Congress did not intend to create, expressly or by implication, a cause of action for shareholders of an acquiring company under � 13(d).” An acquiring company must send a Schedule 13(d) disclosure to the issuer of the securities, the exchange where they are traded and the Securities Exchange Commission. The shareholders of the acquiring company, the court reasoned, are not the intended recipients of these documents; in fact, the statute does not require that they even receive the disclosures. The court further opined that � 13(d)’s legislative history indicates that Congress did intend to benefit the shareholders of the acquiring company, but rather the acquired one. ************************* TAXATION DISCHARGE OF INDEBTEDNESS BY S CORPORATION IS INCOME THAT INCREASES BASIS The U.S. Supreme Court has resolved a circuit split, ruling that where an insolvent S corporation receives a discharge of indebtedness, this forgiven debt does not constitute gross income; but under � 108(a)(1) of the Internal Revenue Code, it is an “item of income” that passes through to the shareholders, increasing their basis in the corporation’s stock. Gitlitz v. Commissioner , No. 99-1295 (U.S.Sup.Ct.; Jan. 8, 2001). The IRS assessed deficiencies against the taxpayers because they used nontaxed discharge of indebtedness to increase their basis in S corporation stock and then deducted their suspended losses. The tax court initially ruled in favor of the taxpayers, but then reversed upon reconsideration. The 10th Circuit affirmed on different grounds, and the Supreme Court granted certiorari. At issue before the High Court were two questions: First, whether the IRC permits taxpayers to increase basis in their S corporation stock by the amount of their discharge of indebtedness, which is excluded from gross income; and second, if it does, whether the increase in basis occurs before or after the taxpayers are required to reduce the S corporation tax attributes. The Supreme Court reversed the 10th Circuit’s ruling. The Court found that � 108 “simply does not say that discharge of indebtedness ceases to be an item of income when the S corporation is insolvent. Instead it provides only that discharge of indebtedness ceases to be included in gross income.” The Court further held that the 10th Circuit had erred in holding that the discharge amount first had to be used to reduce certain tax attributes of the S corporation under � 108(b) and that the leftover amount could be used to increase the basis. Under � 108(b), attribute reductions are to be made after the determination of the tax imposed for the taxable year of the discharge. “In order to determine the ‘tax imposed,’ an S corporation shareholder must adjust his basis in his corporate stock and pass through all items of income and loss.” As a result, the attribute reduction must be made following the basis adjustment and pass-through.

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