Memorandum of Decision Re: Contract Dispute

IN THE UNITED STATES BANKRUPTCY COURT FOR THE NORTHERN DISTRICT OF CALIFORNIA
In re ACCUSPLIT, INC.,                                                     No. 587 02863-M      Debtor. _______________________/ In re CRONUS PRECISION PRODUCTS,                         No. 587 02960-M INC.,      Debtor. ________________________/ In re W. RON SUTTON,                                                     No. 587 02963-M      Debtor. ________________________/ PENLUPE HOLDINGS, B.V., et al.,      Plaintiffs,    v.                                                                              A.P. No. 1-88-0024 ACCUSPLIT, INC., et al.,      Defendants. _________________________/
Memorandum of Decision
Background
     Debtor Accusplit, Inc., is a manufacturer of electronic timepieces. On May 1, 1985, it entered into a written agreement with plaintiff Penlupe Holdings, B.V., whereby Accusplit would purchase all of the shares of debtor Cronus Precision Products, Inc., which was Accusplit's principal competitor in the domestic sports timing instrument market.      The consideration for the sale was $300,000.00 cash, a note for $350,000.00 secured by the assets of both Cronus and Accusplit, a Non-Competition Agreement with Penlope and plaintiff Stella Pennell, and a Consulting Agreement with plaintiffs Timothy and Simon Pennell. The obligations were guaranteed by the principal of Accusplit, debtor W. Ron Sutton.      This dispute began as a state court action brought by Penlupe and the Pennells to enforce their rights after the debtor defaulted under the note and the two agreements by failing to make the payments. The debtors counterclaimed for breach of contract and fraud, alleging that their damages exceeded the amounts owed under the obligations.      With the filing of the bankruptcy petitions, it became necessary to resolve this matter as expeditiously as possible in order to resolve disputes as to the plaintiffs' rights as secured creditors in the two corporate estates. Accordingly, with the consent of the parties and in the absence of an available judge in San Jose the matter was transferred to the Santa Rosa division of the court for trial. Pursuant to 28 U.S.C. sections 157(b)(2)(B) and (C), this is a core proceeding.
I. Liability Under the Note, Non-Competition Agreement, and Consulting Agreement.
     The parties have stipulated that Penlupe is an oversecured creditor of the estates of Accusplit and Cronus. Pursuant to section 506(b) of the Bankruptcy Code, oversecured creditors may recover reasonable postpetition interest and costs if provided for in the agreement. Accordingly, the Court will proceed to fix the amount of the allowed secured claims as of May 1, 1988, which will include postpetition interest. The creditors will also have contingent unsecured claims against the estate of W. Ron Sutton pursuant to his personal guarantee, but these claims may not include postpetition interest or other costs.      The amount owing on the promissory note, including interest through May 1, 1988, is $420,796.00.      The Noncompetition Agreement contained neither an interest provision nor an acceleration clause. The acceleration clause in the security agreement is somewhat ambiguous, and there is no evidence that the claimants ever elected to accelerate anything other than the note. While there is some authority to the contrary, the Court feels that only consentual and not statutory interest is allowable under section 506(b). In re Ron Pair Enterprises (6th Cir.1987) 828 F.2d 367, 373; In re Nevada Environmental Landfill (Bkrtcy.D.Nev.1987) 81 B.R. 55, 57. Cf. Best Repair Co. v. United States (4th Cir.1986) 789 F.2d 1080, 1082. Therefore, postpetition interest is not allowable and prepetition interest, at the legal rate of seven percent, is allowable only on each missed payment. The amount due on account of the Noncompetition Agreement may be calculated using these guidelines. The same ruling applies to the Consulting Agreement.
II. Setoffs Due to Inventory Problems.
     As part of the written agreement between the parties, Penlupe represented and warranted that the inventory of raw material, work in progress and finished goods were of a quality and quantity usable and salable in the ordinary course of business, except for obsolete and slow moving items and items below standard quality which had been written down on the corporate books. The debtors seek a setoff against the allowed claims based on allegations of breach of this warranty and fraud. While the Court does not find fraud, it does find that certain items of inventory were not as warranted.      Among Cronus' product line at the time of its acquisition by Accusplit were three products known as Timemaster, Timeclip, and Printmaster. The Timemaster was a precision stopwatch with a memory; the Timeclip was a similar product built into a clipboard; the Printmaster was essentially a Timemaster hooked up to a printer.      While there were some problems with the Timeclip product, Accusplit was able to sell off the existing inventory before cancelling production due to weak demand for the product. The Timemaster was substantially as warranted, and is therefore not the subject of legitimate complaint by the debtors.      The Printmaster was something of a dinosaur and never went into any kind of serious production, as a more sophisticated and less expensive product was offered by a foreign competitor. It should have been written down on the books and was not, giving the debtors a valid setoff in the amount of $11,959.68.      There were serious problems with the Timemaster product line. The evidence was overwhelming that this product was very poorly engineered and subject to an extraordinarily high failure rate. Customer dissatisfaction was very high. When confronted with allegations that they had defrauded Accusplit by failing to disclose the serious problems with the Timemaster line, the Pennells defended themselves not by arguing that there were no problems to disclose, but rather by showing that they had discussed the problems with Accusplit before the agreement was consummated. While this testimony dispelled any claim of fraud, it reinforced the finding that the Timemaster product line was serioulsy flawed.      Penlupe defends itself by arguing that Accusplit knew about the Timemaster problems before the sale and that the problems, while serious, were no more serious than those Accusplit was encountering with its own products. Both these arguments miss the point that Penlope warranted that the Timemaster inventory was usable and salable in the ordinary course of business. By this term in the contract, Penlupe agreed to bear the risk that the Timemaster series was so flawed that it was unmarketable. Neither Accusplit's knowledge of a potential problem nor the fact that such problems may be common in the electronics industry are defenses to the claim that the products were not as warranted.      However, a finding that Penlope breached its warranty does not lead the Court to the conclusion that Accusplit is entitled to rescission and a seven-figure damage award. The defective products were only a small part of the overall package acquired by Accusplit, and did not affect its primary objectives in entering into the contract of achieving economies of scale and eliminating a principal competitor.      The evidence established that the problems with the Timemaster line were completely solvable if the sum of $33,755.00 were expended in retooling to correct the numerous problems. Accusplit elected to discontinue the Timemaster line rather than expend the sums necessary to correct the problems because it had comparable products of its own which it could substitute for the Timemaster products.      The evidence established that if Accusplit had expended the sums necessary to correct the problems with the Timemaster line, it would have had to scrap inventory worth $63,144.47 which would be replaced by corrected parts. Rather than make the expenditure to correct the product, Accusplit elected to write off and scrap both the useless inventory and another $113,010.50 in inventory which could have been used if the decision had been made to fix rather than discontinue the Timemaster line. Accusplit therefore seeks damages for the total Timemaster inventory writeoff of $176,154.47.      While Accusplit was free to exercise its business judgment in deciding whether to continue the Timemaster product line or replace it with its own similar product, it is not entitled to damages which exceed the cost of making the inventory salable. Thus, Accusplit cannot claim the entire $113,010.50 in salvagable inventory as an item of damage when this inventory could have been made usable by an expenditure of $33,755.00. The Court therefore finds that the proper measure of damages in this case is the useless inventory ($63,144.47) plus the cost of salvaging the remaining inventory ($33,755.00). To this total of $96,899.47 the Court adds $1,710.26 in "bill back" charges incurred when orders of further parts for the Timemaster line were cancelled. The Court remains unconvinced as to the other items of damage claimed by the debtors, and therefore resolves those claims against the debtors.      Having found that the Timemaster product line could have been made marketable by an expenditure of $33,755.00, there is no basis for awarding Accusplit the seven figures in lost profits which it seeks. The Court notes that Penlupe only warranted that the existing inventory was salable, not that the product line would be profitable. Accusplit established neither actual lost profits nor a right to be reimbursed for them.
III. Miscellaneous Disputes.
     Under the terms of the agreement, Penlupe warranted that all the taxes would be paid current to the date of the transfer of Cronus to Accusplit. Through a mixup, taxes in the amount of $3,748.30 were not paid. Penlupe's claim will be reduced by this amount.      Accusplit alleges that an accounting error was made which understated the amount of accounts payable by some $13,000.00. Accusplit, which has possession of the books, did not trace the transaction in question nor show that the books were out of balance. Penlupe produced a plausible explanation. Accordingly, the Court resolves this dispute against Accusplit.      Under the terms of the agreement, receivables were warranted to be valid. Accusplit argues that $5,353.01 of the receivables were for samples given to salespeople and were therefore not true receivables. However, the testimony established that Accusplit could have recovered the money when it terminated the Cronus sales force. The Court therefore resolves this dispute against Accusplit.      Under the terms of the agreement, Penlupe warranted that its balance sheet reflected adequate reserves for doubtful accounts. Accusplit claims that an amount significantly in excess of the reserve proved to be uncollectable. The Court doubts Accusplit's figures, and finds that the reserves were fully adequate notwithstanding any actual loss Accusplit may have suffered. The Court therefore resolves this dispute against Accusplit.
Summary
     The debtors are entitled to a setoff against the Penlupe claim on the note in the amount of $129,655.26, calculated as follows:
       Printmaster           $ 11,959.68        Timemaster             96,899.47        bill backs                  1,710.26        tax claim                   3,748.30                                    __________        balance               $114,317.71        interest to 5/1/88    15,337.55                                  ___________        TOTAL              $129,655.26
     Therefore, the net claim of Penlupe on the note is $420,796.00 less $129,655.26, or $291,140.74, as of May 1, 1988.      The allowable claim on the Non-Competition Agreement is $360,000.00 plus interest at the rate of seven percent on the missed payments up to the date the bankruptcy petitions were filed.      The allowable claim on the Consulting Agreement is $34,800.00 plus interest at the rate of seven percent on the missed payments up to the date the bankruptcy petitions were filed.      The Court will issue a separate memorandum regarding the St. Moritz matters. The Court makes no finding at this time as to whether any party is a prevailing party entitled to attorneys' fees and costs. Such issues may be raised by appropriate motion to be heard in San Jose on either May 23 or June 13, 1988.      This memorandum constitutes findings and conclusions pursuant to FRCP 52(a) and Bankruptcy Rule 7052. Counsel for Penlupe shall submit an appropriate form of judgment which counsel for Accusplit shall approve as to form.
Dated: April 27, 1988                                                                              _______________________                                                                                                                      Alan Jaroslovsky                                                                                                                      U.S. Bankruptcy