Bankruptcy Litigation Committee

ABI Committee News

Buyer Beware - Purchaser’s Liability for Failure to Preserve Seller’s Books and Records Relating to Assumed Liabilities

The Bankruptcy Court for the District of Delaware recently entered an opinion in Quintus Corp. v. Avaya Inc. (In re Quintus), No. 04-53074, 2006 WL 3072982 (Bankr. D. Del. Oct. 27, 2006), which is important for counsel to review both for its discussion of when a duty to preserve records arises before the filing of litigation as well as its determination of the appropriate sanctions for the destruction of records. During the pendency of the bankruptcy cases, the debtors entered into an asset purchase agreement (the “agreement”) under which they agreed to sell substantially all of their assets to Avaya Inc. (the “purchaser”) for $30 million in cash and the purchaser’s agreement to assume certain liabilities in an amount not to exceed $30 million. A chapter 11 trustee (the “trustee”) was appointed in the cases after the sale closed. Almost three years after the closing date, the trustee filed an adversary proceeding against the purchaser seeking to recover approximately $1.9 million based on the purchaser’s failure to pay certain liabilities allegedly assumed under the agreement.

The agreement, among other things, imposed a contractual obligation on the purchaser to maintain certain records, including the debtors’ general ledgers, sub-ledgers, and vendor files, for seven years after the closing date. Despite this obligation, the purchaser did not maintain the records as required by the agreement. The loss of records was not accidental, as the bankruptcy judge found that the purchaser “deliberately deleted the debtors’ electronic records in order to give itself more computer space.” Id. at *4.

Both parties moved for summary judgment. In addition to seeking summary judgment, the trustee also asserted that in the event that it did not prevail on the legal issues, it was entitled to sanctions, including the entry of a judgment in its favor on the complaint, based on the purchaser’s failure to produce relevant documents. In considering the trustee’s request for sanctions, the bankruptcy judge held that it must consider the following factors: (1) the degree of fault of the party who altered or destroyed evidence, (2) the degree of prejudice suffered by the opposing party and (3) what degree of sanction is necessary to avoid the substantial unfairness to the opposing party and to deter such conduct by others in the future. Id. at *3, citing Schmid v. Milwaukee Elec. Tool Corp., 13 F.3d 76, 79 (3d Cir. 1994).

The purchaser raised a number of arguments in opposition to the trustee’s request for sanctions. First, the purchaser alleged that hard copies of information requested by the trustee were previously provided to the debtors’ financial advisers. While this issue was disputed, the bankruptcy court noted that “even if [the purchaser] had given some of the records to the debtors’ financial advisers, they would have had no reason to keep them given [the purchaser’s] undertaking to preserve all the records for a period of seven years.” Id. at *4. The purchaser’s destruction was determined to be more egregious due to the fact that it had a contractual duty to maintain the records at the time they were destroyed. Id. at *4.

Second, the purchaser asserted that there was no evidence that it intentionally destroyed documents to suppress the truth. Since the destruction occurred before the lawsuit was filed and, in fact, even before the trustee was appointed, the purchaser argued that the bankruptcy court could not find the existence of a necessary element to sanction a party – and that the destruction of documents was done in anticipation of litigation.

The bankruptcy court rejected this argument, noting that the purchaser had not complied with the obligation to pay all assumed liabilities at the time it destroyed the records. A duty to retain records arose where the purchaser could have anticipated litigation based on its failure to comply with the obligations imposed under the agreement. Id. at *4, citing Silvestri v. General Motors Corp., 271 F.3d 583, 591 (4th Cir. 2001) (“the duty to preserve material evidence arises … when a party reasonably should know that the evidence may be relevant to anticipated litigation”); Shamis v. Ambassador Factors Corp., 34 F. Supp. 2d 879, 888-89 (S.D.N.Y. 1999) (inquiry is whether the party destroying documents “knew or should have known that the destroyed evidence was relevant to pending, imminent or reasonably foreseeable litigation”).

The final issue addressed by the bankruptcy court was whether the destruction of the records was prejudicial to the trustee. Since the proper sanction was dependent on the prejudice suffered by the trustee, the bankruptcy court was required to consider the trustee’s sanctions motion within the context of the summary judgment motions. Quintus at *4. Pursuant to the terms of the agreement, the purchaser assumed “all liabilities listed on the company balance sheet … and all liabilities accrued or recorded after the balance sheet date in the ordinary course of business consistent with the past practices to the extent not satisfied after the closing date …). Id. at *5 (emphasis in original). The issues raised by the summary judgment motions were the scope of the obligations assumed by the purchaser and the parties’ intentions as to meaning of the term “accrued.” The bankruptcy court agreed with the purchaser, holding that the purchaser had only assumed those liabilities that were reflected on the debtors’ books and records. Id. at *8.

The parties, however, disagreed about what liabilities were reflected on the debtor’s books and records. The bankruptcy court held that the documents destroyed by the purchaser were crucial to this dispute and, therefore, the trustee was prejudiced by the loss of the records. Id. at *12.

The bankruptcy court then considered appropriate sanctions under Rule 37 of the Federal Rules of Civil Procedure and the bankruptcy court’s inherent powers. Appropriate sanctions include (1) an inference that the evidence would have been unfavorable to the party that destroyed it, (2) the preclusion of any evidence to contradict the missing evidence and (3) the entry of a judgment in favor of the other party. Id. at *12.

The bankruptcy court noted that the documents destroyed reflected the amounts owed to creditors. Therefore, the documents were not merely relevant but went “to the heart of the trustee’s suit; what claims were assumed by [the purchaser] remain unpaid.” Id. at *12. The bankruptcy court held that the most severe sanction was warranted, holding that it would enter a default judgment against the purchaser.

The bankruptcy court further noted that the result would have been the same even if the most severe sanction had not been warranted. Id. at *13. If the bankruptcy court had merely inferred that the destroyed documents would have been unfavorable to the purchaser and had precluded the purchaser from presenting evidence that the debtors’ records did not include some or all of the claims filed in the bankruptcy cases, the bankruptcy court would still have entered a judgment in the same amount.