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A corporation’s fear that a possible adverse judgment will drive it to insolvency is not a valid rationale for seeking bankruptcy court protection, a federal judge has held. Northern District of New York Judge Frederick J. Scullin Jr. agreed with Bankruptcy Judge Stephen D. Gerling in dismissing the Chapter 11 petition of Fraternal Composite Services Inc., a company that produces composite portraits for college fraternities and sororities. Fraternal sought protection under Chapter 11 of the Bankruptcy Code one day before a state Supreme Court justice was slated to hold a hearing regarding the buyout of a major shareholder. The Utica, N.Y.-based company claimed it filed bankruptcy because of anticipated future financial distress, even though at the time it filed the firm was solvent, profitable and current on all obligations. “Although the debtor need not be in extremis to file a Chapter 11 petition, it must, at least, be experiencing a level of financial difficulty that, if it did not file at that time, it would likely need to file in the future,” Judge Scullin wrote in Financial Composite Services Inc. v. Karczewski, 5:03-CV-1432. The dispute began on July 1, 1999, when shareholder James J. Karczewski brought an action in Oneida County Supreme Court to dissolve Fraternal Composite Services Inc. Fraternal countered with a proposal to buy Karczewski’s one-third interest, and both parties hired experts to determine the value of that interest. Supreme Court Justice John J. Grow appointed a referee who, after considering the experts’ opinions, valued Karczewski’s interest at $808,500. Each party objected, and the corporation moved to relitigate the issue. One day before Justice Grow was to issue a judgment, Fraternal Composites petitioned under Chapter 11. At that time, there had been no actual judgment entered on the state court action. Judge Gerling found the Chapter 11 premature and filed in bad faith. He concluded that since Grow had not yet ruled on the valuation of Karczewski’s interest, Fraternal’s bankruptcy petition was filed to delay and frustrate the state court action. On appeal, Fraternal argued that its Chapter 11 petition could not be viewed as an attack on a state court judgment because there was no such judgment. It also argued that in a matter like this one, where the debtor faces an uncertain liability, the best solution is to keep the matter in Chapter 11 while the state court determines the amount of the claim. That way, according to Fraternal’s reasoning, the bankruptcy court can establish reasonable payment terms. But Judge Scullin, like Gerling, said Fraternal failed the good-faith test, especially since it was solvent and profitable at the time of the filing. “[T]he mere possibility that a debtor may have to file for Chapter 11 protection in the future does not establish grounds for finding that the debtor filed its petition in good faith,” Scullin said, citing In re SGL Carbon Corp., 200 F.3d 154 (3d Cir. 1999). Scullin acknowledged that Fraternal’s “future may be uncertain,” but observed that “it is not presently experiencing a difficult financial situation that would warrant a finding that its Chapter 11 filing was in good faith.” “Instead, it appears that, rather than risk an adverse judgment in state court … the corporation decided to seek Chapter 11 protection in the bankruptcy court,” he wrote. Richard L. Weisz of Hodgson Russ in Albany, N.Y., appeared for Fraternal Composite Services. Camille W. Hill of Hancock & Estabrook in Syracuse, N.Y., argued for Karczewski.

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