Official Committee of Unsecured Creditors of Toy King Distributors, Inc. v. Liberty Savings Bank, FSB (In Re Toy King Distributors, Inc.)

MEMORANDUM OF DECISION

C. TIMOTHY CORCORAN, III, Bankruptcy Judge.

This adversary proceeding represents convoluted and complicated disputes between a failed toy retailer, Toy King Distributors, Inc. (“Debtor” or “Toy King”), on the one hand, and the retailer’s insiders, co-guarantors, and a bank, on the other hand. It involves events occurring over the retailer’s two bankruptcy cases. This retailer failed promptly after confirming a Chapter 11 plan of reorganization in the first case. The confirmed Chapter 11 plan in the second case involved liquidating the retailer. In the liquidation, the unsecured creditors received nothing whatsoever.

The court authorized the official committee of unsecured creditors in the second Chapter 11 case to pursue this adversary proceeding. In the proceeding, the committee seeks to recover against the debt- or’s insiders, co-guarantors, and principal lender, thereby ensuring some recovery for the creditors. Although the committee has not proven all of its claims, the court concludes that the committee has established entitlement to recover $2,903,844.00.

I.TABLE OF CONTENTS.

I. TABLE OF CONTENTS.

II.INTRODUCTION .

III. JURISDICTION.

IV. GENERAL FACTS OF THE CASE .

A. BACKGROUND.

B. MORROW LOOKS AT TOY KING.

C. T.K. ACQUISITIONS ACQUIRES TOY KING ..

D. THE TOY KING I CASE.

1. Toy King files bankruptcy.

2. The First Union claims.

3. The Touche Ross pro forma.

4. The Liberty loan.

5. The C & S line of credit.

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6. Confirmation of Toy King I. ^

to

E. POST-CONFIRMATION EVENTS. Ü1 O

1. Another draw on the C & S line of credit. O

2. The Touche Ross pro forma is finalized. OI O

3. Liberty waives the requirement to obtain a Touche Ross opinion letter.. Ü1 H*

4. The debtor does not have $2 million in equity following the Toy King I confirmation 57

5. The Liberty loan closes. 58

F. TOY KING’S FINANCIAL CONDITION. 60

1. Immediate borrowings. 62

2. Balance sheets . 62

3. Asset valuation. 62

4. Toy King is insolvent. 63

5. Inventory reports. 64

G. OTHER POST-CONFIRMATION DEVELOPMENTS. 66

1. The Liberty credit line is exhausted. 68

2. The C & S line is drawn again. 71

3. Toy King makes plan payments to creditors. 71

4. Trade credit is king. 77

5. The Nintendo loan. 78

H. THE FINAL CHAPTER. 79

1. Christmas is no help . 79

2. Preparing for the inevitable. 81

3. VMI makes an offer. 81

I. THE TOY KING II CASE. 95

1. The trade creditors file an involuntary Chapter 7 petition. 95

2. Closing the Toy King I case. 96

3. Toy King II becomes a Chapter 11 case.

V. CONSIDERATION OF INDIVIDUAL CLAIMS AND MORE SPECIFIC FACTS . CO oo

A. INTRODUCTION . CO oo

B. THRESHOLD LEGAL ISSUES. ^ oo

1. What is the effect of the commitment letter as included in the order of confirmation in Toy King I?. 00 ifs*.

2. Is the debtor the obligor or a guarantor on the Liberty loan?. 00 O)

C. PREFERENCE CLAIMS. 00 ÍO

1. Introduction . 00 CO

2. Payments by the debtor to TKA made during the 90 days immediately before the filing of Toy King II.

a. Introduction.

b. Do the payments to TKA constitute transfers?.

c. Was each transfer to or for the benefit of a creditor?.

d. Were the transfers for or on account of an antecedent debt?.

e. Was the debtor insolvent at the time of the transfers?.

i. Presumption of insolvency.

ii. Liquidation valuation test.

iii. Going concern valuation test.

f. Did the transfers occur on or within 90 days of the filing of the petition?.

<o

g. Did TKA receive more than it would have received in a Chapter 7 liquidation?. M>l>O0

i. Secured claims or unsecured claims?. Oí

ii. Liquidation scenario. Oí

h. Summary for transfers to TKA during the 90-day preference period. Oí

3. Payments by the debtor to TKA made between 90 days before the commencement of Toy King II and the date of confirmation of Toy King I. 52

a. Introduction. 54

b. Was TKA an insider of the debtor?. 57

e. Was the debtor insolvent at the time of the transfers?. 57

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i. Introduction. CD OO

ii. Going concern valuation test. CD OO

iii. Retrojection analysis. CD CD

d.Summary for transfers to TKA during the insider preference period.■. O o

4. Payment by the debtor to M & D made during the 90 days immediately before the filing of Toy King II. rH

a. Introduction. rH

b. Does the payment constitute a transfer of the debtor’s property?.. rH

i. Whose money was it?. tH

ii. Conversion vs. a new filing. tH

iii. National bankruptcy policy. rH

c. Was the transfer to or for the benefit of a creditor?. rH

d. Was the transfer for or on account of an antecedent debt?. rH

e. Was the debtor insolvent at the time of the transfer?. rH

f. Did the transfer occur on or within 90 days of the filing of the petition? . CD O

g. Did M & D receive more than it would have received in a Chapter 7 liquidation?. CD O

h. Summary for transfer to M & D during the 90-day preference period. O

5. Recording of UCC-1 financing statements by Liberty during the 90 days immediately before the filing of Toy King II. to i — I

a. Introduction. t> o rH

b. Does the re-filing of UCC-1 financing statements that specify proceeds for the first time constitute transfers?. o

c. Does the filing of UCC-1 financing statements more than 30 days after inventory has been moved constitute transfers?.

d. Summary for recording of UCC-1 financing statements by Liberty during the 90-day preference period.

6. Execution of amended security agreement by the debtor to Liberty between 90 days before the commencement of Toy King II and the date of confirmation of Toy King I.

a. Introduction.

b. Was Liberty an insider of the debtor?.

e. Summary for the execution of the amended security agreement during the insider preference period. 03 rH

7. Ordinary course of business affirmative defenses to preference claims.. 03 rH

a. Introduction. 03 rH

b. Were the debts incurred in the ordinary course of both the debtor’s and the creditor’s businesses?. TP t — 1 1 — I

i. Debts to TKA. ^ tH i — I

(1) Introduction. rH rH

(2) The Liberty loan. rH rH

(3) The C & S line of credit. CD rH rH

(4) The Nintendo loan. rH rH

(5) The guaranty fees for the C & S line of credit. OO rH rH

(6) Summary for whether debts to TKA were incurred in the ordinary course of business. OO rH 1 — I

ii. Debt to M & D . OO rH rH

e.Were the payments made in the ordinary course of the businesses of both the debtor and the creditors?. rH

i. Introduction. rH

ii. Payments to TKA. rH

(1) Introduction. rH

(2) Payments of interest. rH

(3) Payments of guaranty fees. i — 1

(4) Payments of principal. rH

iii. Payment to M & D. rH

d. Were the payments made in accordance with ordinary business 5

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i. Introduction. 125

ii. Payments to TKA.. 126

iii. Payment to M & D. 126

e. Summary for the ordinary course of business affirmative defenses... 126

FRAUDULENT TRANSFER CLAIMS. 126

1. Transfers by the debtor to TKA and M & D made between the confirmation of Toy King I and the commencement of Toy King II... 126

2. Actual fraud . 127

a. Badges of fraud. 127

i. Introduction. 127

ii. Transfers to insiders. 128

iii. Concealment of transfers. 129

(1) Collective action. 129

(2) During Toy King I. 130

(3) Touche Ross pro forma. 130

(4) Financial statements. 131

(5) First Union claims. 132

(6) December transfers. 132

(7) Conclusion. 133

iv. Transfers for less than reasonably equivalent value. 133

(1) Alternative approaches. 133

(2) Payments to TKA and M & D of principal. 134

(3) Payment to TKA of loan fees and expenses. 135

(4) Payments to TKA and M & D of interest. 135

(5) Payments to TKA of guaranty fees on the C & S line of credit. 138

(6) Summary. 139

v. Insolvency at the time of the transfers. 139

vi. Summary. 139

b. Subjective evaluation of the debtor’s motive. 139

c. Conclusion . 141

3. Constructive fraud. 141

a. Introduction. 141

b. Unreasonably small capital. 142

c. Summary. 143

4. Summary. 143

LIABILITY OF TRANSFEREES OF AVOIDED TRANSFERS. 143 E.

143

Who are the initial transferees?. 144

a. The conduit theory. 144

b. Who is a conduit? . 145

c. Equitable considerations. 147

d. Conclusion. 148

Who are the beneficiaries or immediate transferees of the transfers?.. 148

Liberty’s “good faith” defense to transferee liability. 148

a. Introduction. 148

b. Was Liberty a transferee who took for value, in good faith, and without knowledge of the voidability of the transfers?. 149

i. Introduction. 149

ii. For value. 149

iii. Good faith. 149

iv. Without knowledge of voidability. 152

c. Conclusion. 153

Summarv. 153

6. Liability under Florida law. 154

OTHER STATE LAW CLAIMS. 156

1. Introduction: Section 544 . 156

2. Breach of the Toy King I confirmed plan... 156

a. Introduction. 156

b. Did Liberty breach the confirmed plan? 157

i. Introduction. 157

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ii. Making the Liberty loan. .157

iii. Making the Nintendo loan. .160

iv. Conclusion. .160

c. Did TKA breach the confirmed plan? . .160

i. Introduction. .160

ii. Failing to make a $1 million capital contribution. .160

iii. Charging fees and costs on the Liberty loan. .162

iv. Charging interest upeharges and guaranty fees. . 162

v. Conclusion. . 163

d. Did M & D breach the confirmed plan?. . 164

e. Summary. . 164

Payment of dividends by an insolvent corporation. .164

Breach of fiduciary duties. .165

a. Introduction. . 165

b. Woodward, Hunsaker II, Hunsaker III, and Ranney. . 165

e. Morrow, Angle, and King. . 165

i. Introduction. .165

ii. The duties of care and loyalty. . 166

iii. The business judgment rule. . 168

iv. Did they breach their duties of care? . . 168

(1) Introduction. .168

(2) Causing Toy King to make impermissible dividend distributions or fraudulent financial transactions. .169

(3) Failing to make the $500,000 capital contribution. .169

v. Did they breach their duties of loyalty?. . 170

(1) Introduction. .170

(2) Acquiring the First Union claims. . 171

(3) Inapplicability of the business judgment rule. .173

(4) The Toy King I confirmation order does not insulate the First Union transaction . . 174

(5) Other transfers to Morrow, Angle, and King. . 175

d. Summary. .177

Aiding and abetting the breaches of fiduciary duties. .178

Discharge of Toy King’s guaranty of TKA’s Liberty loan. .179

Toy King’s right of contribution from its co-guarantors. .181

Toy King’s right of subrogation against Liberty. .183

Claims for Toy King’s payment of rent and prepetition salary. .184

.184

G. POST-PETITION CLAIM FOR EXCESS SALARY. .185

1. Introduction . .185

2. Toy King’s payment of salary to Morrow during Toy King II in excess of approved amounts. .185

H. THE SECURED STATUS OF LIBERTY’S CLAIM AND THE AMOUNTS TO WHICH LIBERTY IS ENTITLED TO BE PAID ON ITS SECURED CLAIM. 186

1. Introduction . 186

2. Determining the secured status of Liberty’s claim. 187

3. Does Liberty have a perfected security interest in all of Toy King’s inventory?. 187

a. Inventory in Pennsylvania and Maryland. 187

b. Inventory in Mississippi. 187

i. Effect of the bankruptcy filing when a financing statement was not filed in Mississippi. 187

ii. Who has priority if the perfection lapses? The debtor or the secured party, Liberty?. 189

iii. Conclusion. 189

4. What is the value of Liberty’s collateral?. 190

5. Is Liberty entitled to interest as an oversecured creditor?. 192

6. Is Liberty entitled to attorney’s fees as an oversecured creditor?. 192

7. May the debtor surcharge Liberty? . 193

8. Summary. 194

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EQUITABLE SUBORDINATION I.

1. Introduction .

Equitable subordination theory: a higher standard to subordinate non-insiders and non-fiduciaries. M Ol

The claim against Liberty. M <3

The claims against TKA and M&D. H 00

a. Introduction. H 00

b. Inequitable conduct. H 00

c. Resulting harm or unfair advantage . M M

d. Consistency with the provisions of the Bankruptcy Code.

e. Conclusion.

The claims against the individual defendants .

a. King.

i. Inequitable conduct.

ii. Resulting harm or unfair advantage.

iii. Consistency with the provisions of the Bankruptcy Code.

iv. Conclusion.

b. Morrow, Angle, Woodward, Hunsaker II, Hunsaker III, and Ran-

6. Summary.

7. The appropriate remedy.

J. THE PLAINTIFF’S RECOVERIES.

1. Introduction .

2. Summary of plaintiffs recoveries .

3. Summary of judgment provisions.

4. Allowance of costs to the plaintiff as prevailing party

VI. CONCLUSION.

II.

INTRODUCTION.

The debtor first filed for relief under Chapter 11 of the Bankruptcy Code on July 6, 1988, Case No. 88-1663 (“Toy King I”). Toy King I ultimately resulted in the confirmation of a plan on May 23, 1989. The plan provided for a pro rata distribution to unsecured creditors, most of whom were toy manufacturers. The only shareholder of the reorganized debtor was the corporate parent of the debtor, T.K. Acquisitions, Inc. (“TKA”). The debtor funded the plan with monies borrowed by TKA from Liberty Savings Bank, F.S.B. (“Liberty”). Liberty also loaned monies on a line of credit to TKA which, in turn, made the funds available to the debtor for its operations. Liberty secured its loans by a lien on Toy King’s inventory and other collateral.

The reorganized debtor continued in business, closing some stores and opening others, but operated at a loss through 1989. Toy King was therefore unable to continue as a viable entity. Creditors of the company filed an involuntary Chapter 7 bankruptcy petition on February 12, 1990, Case No. 90-528 (“Toy King II”), the case in which this adversary proceeding is brought. The court converted the case to a case under Chapter 11 and ultimately confirmed a liquidating plan. In the liquidation, Liberty received full payment for its secured claim. The unsecured creditors, however, most of which were also unsecured creditors in Toy King I, received no dividend in the liquidation.

As part of the confirmed liquidating plan, the court authorized the Official Committee of Unsecured Creditors (“creditors committee”) to prosecute the debtor’s claims against entities and persons involved with the debtor. Accordingly, the creditors committee filed this adversary proceeding against Liberty Savings Bank, F.S.B. (“Liberty”), T.K. Acquisitions, Inc. (“TKA”), Don S. Morrow (“Morrow”), Michael Angle (“Angle”), M&D Financial, Inc. (“M & D”), Robert King (“King”), Constance L. Woodward (“Woodward”), Jerome Hunsaker II (“Hunsaker II”), Jerome Hunsaker III (“Hunsaker III”), and

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Melanie Ranney (“Ranney”). Drawn in 16 counts, the complaint seeks to recover monies for the benefit of the estate from the defendants on various theories, including preferences, fraudulent transfers, equitable subordination, and various state law claims, including breach of the confirmed plan in Toy King I and breach of fiduciary duties.

After the filing of this adversary proceeding, the creditors committee also filed an objection to the claim of Liberty Savings Bank (Main Case Document No. 338). On June 7, 1991, the court entered a stipulated order (Main Case Document No. 343) consolidating the objection to claim with this adversary proceeding.

The defendants, other than Liberty, filed an answer that included affirmative defenses and counterclaims. Liberty also filed an answer and counterclaim. The individual defendants abandoned some counterclaims in the pretrial stipulation (Document No. 43). In its final pretrial order (Document No. 59), the court dismissed all remaining counterclaims raised by both the individual defendants and Liberty for reasons stated orally and recorded in open court. In the final pretrial order, the court also narrowed the issues for trial to those as described in the pretrial stipulation (Document No. 43).

1

The trial on these issues occurred over 17 days during a period of more than seven months. The evidence included the testimony of 14 witnesses and the utilization of more than 20 volumes of documents. After considering all of the testimony, particularly the demeanor and credibility of the witnesses, the exhibits admitted at trial, pleadings and stipulations filed by the parties, and oral and written arguments of counsel, including the authorities cited by the parties, the court determines, by a preponderance of the evidence, the facts and issues as more specifically delineated below as required by F.R.B.P. 7052.

This is a lengthy decision. Much of the financial and other factual detail is set forth in the notes. Because the notes themselves are lengthy, the court has prepared the notes as endnotes rather than as footnotes. These notes, of course, are an integral part of the decision.

III.

JURISDICTION.

The court has jurisdiction of the parties and the subject matter pursuant to 28 U.S.C. §§ 1334 and 157(a) and the standing order of reference entered by the district court. This proceeding is a core proceeding within the meaning of 28 U.S.C. § 157 (b), and the parties have consented to the entry of final orders and judgment by this court subject, of course, to appellate review under 28 U.S.C. § 158 .

IV.

GENERAL FACTS OF THE CASE.

A.

BACKGROUND.

Sam Levy incorporated Toy King Distributors, Inc., in Florida in 1959. He was the principal shareholder. Toy King’s primary business was the sale of toys at retail through leased space in shopping centers. The company’s headquarters and distribution warehouse were in Orlando, Florida. Its retail stores were in several states.

Between 1984 and 1986, the company grew rapidly from 34 stores to 62 stores located primarily in the Southeast. In addition to the retail sale of toys, Toy King expanded its business to include the sale of children’s apparel. The company also acquired a fleet of trucks and undertook the transport of its goods throughout the

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Southeast from its warehouse facility in Orlando. The company initially received inventory at this warehouse and, from there, distributed it to the various stores. Inventory for new stores was specially segregated in the warehouse.

By the end of 1986, largely due to its rapid expansion, Toy King was experiencing chronic business problems. The company posted a loss of $965,919 at the end of its 1986 fiscal year.

2

At the same time, Mr. Levy’s health was failing. Mr. Levy died in early 1987. His estate owned approximately 75 percent of the debtor’s stock, and family litigation ensued with respect to the ownership of the company.

In an effort to resurrect the troubled business, the estate’s executor hired Robert 0. King as president of Toy King that same year. King was well known in the trade, having been chief toy buyer and marketing man for A.M. Best for more than ten years.

3

King had developed, and continued to have, a good working relationship with many of the toy manufacturers’ credit managers. King had no prior relationship with Toy King.

King took a number of steps to improve the profitability of the debtor. He replaced the corporate comptroller and implemented a computer supported inventory control system. He also discontinued the children’s clothing operations and liquidated the inventory connected with those operations. Finally, he discontinued the trucking operation and began to utilize commercial freight lines to transport inventory.

B.

MORROW LOOKS AT TOY KING.

Despite these improvements, by the end of 1987 the company was still operating at a loss. Following the 1987 Christmas season, Toy King’s trade and other credit was substantially curtailed, and it had drawn down most of its lines of credit. In the spring of 1988, King placed an advertisement in the

Wall Street Journal

seeking investors.

Don S. Morrow was one of the respondents. Morrow was a certified public accountant in Florida and Georgia.

4

He had over five years of experience both as an auditor and accountant with Haskins & Sells, a nationally recognized accounting firm. He also had at least ten years of experience in evaluating acquisition prospects and turnaround candidates. He had no experience, however, in the retail toy industry.

King and Morrow met for the first time in April 1988. At that time, Morrow examined the books, records, and business of Toy King. Morrow determined that the financial difficulties of the company required a voluntary arrangement with the major toy manufacturers and supplier creditors.

Accordingly, King and Morrow attended the Toy Manufacturers of America Credit Managers annual convention in New York City on June 23, 1988. The Toy Manufacturers of America is a trade association, and most toy manufacturers are members. Once a year, there is a convention to showcase new products and take orders. Credit managers employed by the toy manufacturers also meet with toy retailers at the convention to negotiate credit lines and terms for the upcoming year.

These credit lines are of vital importance in the industry because toy retailers characteristically operate at a loss for most of the year. The toy retail business is seasonal, and historically toy retailers recoup losses and turn a profit from sales that occur in November and December. It is not uncommon for 40 to 50 percent of

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the industry’s sales to occur in the month of December.

Because of the seasonality of the industry, toy retailers generally do not pay for inventory purchases under a 30, 60, or 90-day term arrangement as is common with other kinds of retailers. Instead, toy manufacturers routinely make available favorable dating terms to accommodate the historical sales pattern. When dating terms are used, the seller ships goods to the buyer and bills for those goods at a later date agreed upon by the seller and buyer. For example, goods shipped in August through November would be billed in January, and goods shipped in December through February would be billed in late spring or early summer. Thus, a toy retailer is able to receive inventory during the loss months and pay for it following the profit months.

Although most toy retailers utilize short term credit lines to fund their operations during the months they are operating at a loss, it is virtually impossible to operate a toy retail concern without trade credit. The amount of cash needed to fund operations and purchase inventory during loss months is prohibitive.

Consequently, Morrow hoped to determine whether the toy manufacturers attending the convention would extend credit to Toy King if it were under new management. King and Morrow participated in several meetings at the convention with credit managers of major toy manufacturers. The consensus reached as a result of these meetings was that Toy King needed to be reorganized under Chapter 11. The credit managers agreed to work with King and Morrow to attempt to create a viable plan of reorganization.

C.

T.K. ACQUISITIONS ACQUIRES TOY KING.

In July 1988, Morrow exercised his option to purchase 75 percent of the stock of Toy King Distributors, Inc., from the estate of Sam Levy. He paid $50,000.

5

He later transferred his stock in Toy King to T.K. Acquisitions, Inc., a corporation incorporated for this purpose.

6

At this time, Morrow and Michael Angle were the principal shareholders of TKA, and each owned more than 20 percent of the stock of that company. Angle, like Morrow, was a certified public accountant. Morrow and Angle were also directors and officers of Toy King. Both were responsible for the financial management of the debtor, including the preparation of the debtor’s internal balance sheets.

King was also a director and officer of Toy King and, at some point, acquired stock in the debtor, although his stock comprised less than ten percent of the shares. He was responsible for the day-to-day operations of the debtor.

Around this time, Morrow and Angle also incorporated Acquisition Management, Inc. (“AMI”).

7

This company provided management services to both TKA and the debtor for a fee.

D.

THE TOY KING I CASE.

1.

Toy King files bankruptcy.

On July 8, 1988, Toy King filed a Chapter 11 petition in this court, Case No. 88-1663. The United States trustee appointed an unsecured creditors committee. Toy manufacturers comprised the entirety of the unsecured creditors committee. The committee retained counsel and an accountant.

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The debtor’s only secured creditor was First Union National Bank (“First Union”). First Union held a mortgage on the debtor’s warehouse and also had a security interest in some personalty. In addition, First Union was the largest unsecured creditor. Other than First Union, the majority of the unsecured creditors were manufacturers and suppliers in the toy industry.

Following the filing of the bankruptcy case, the unsecured creditors committee and principals of the debtor began to negotiate a consensual plan. The debtor promulgated a proposed plan of reorganization and submitted it to its creditors by the end of September 1988. Thereafter, there were a number of meetings, extensive and often heated, to negotiate the proposed dividend to unsecured creditors. As part of the process, the debtor provided several different plans that included projections and possible capitalization for a reorganized debtor.

8

At several of these meetings, Morrow indicated there was a likelihood of further investment in TKA by himself and others following a successful confirmation of the Toy King bankruptcy case.

During these meetings, the unsecured creditors negotiated for a plan that would enable the debtor to continue as a going concern and preserve it as a potential customer. The unsecured creditors, therefore, balanced the net dividend to be paid through the plan, together with the potential profit that would accrue to the unsecured creditors from an ongoing relationship with the debtor, with what they would receive if the debtor were liquidated. Had the unsecured creditors believed that the reorganized debtor would not be viable as an ongoing customer, they would have negotiated for a dividend commensurate with liquidation value or sought to have the case converted to a case under Chapter 7 for the purpose of liquidation. Because future credit relations with the debtor were important to the unsecured creditors, however, they were prepared to accept a dividend that was something less than liquidation value.

Ultimately, in December 1988, after much deliberation and negotiation, a 17.5 percent “pot” plan was agreed between the debtor and the unsecured creditors committee. Under this agreement, an amount equal to 17.5 percent of the debtor’s unsecured debt would be placed in a “pot” and distributed to unsecured creditors on a pro rata basis. The debtor estimated that these prepetition dividends would total $1.6 million. Following this agreement, the accountant and counsel for the unsecured creditors committee became much less active in the case. After this point, the work performed for the unsecured creditors committee by these professionals was in furtherance of confirming the agreed plan rather than in evaluating feasibility and operations of the debtor.

During the bankruptcy case, the debtor maintained its operations and obtained inventory on new credit advances secured by a court-approved super-priority lien in favor of the toy manufacturers.

9

This super-priority lien secured post-petition credit advances by toy manufacturers with a lien on assets of the debtor acquired post-petition and proceeds from those assets that was superior to the claims of administrative expense claimants and superior to the liens of any others holding a lien on those assets. The debtor also sought court approval of a special arrangement with Nintendo whereby the super-priority lien of that creditor would secure prepetition debt of approximately $200,000 as well as post-

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petition advances used for new purchases. As part of this accommodation, the debtor also agreed to dismiss a pending preference action against Nintendo in which the debtor sought repayment of $90,000. The court disapproved this arrangement.

10

As a consequence, Nintendo refused to extend credit to the debtor during the bankruptcy case notwithstanding the super-priority hen protection in place.

The debtor also obtained inventory from the parent company, TKA. TKA purchased this inventory directly from manufacturers and then transferred it to the debtor at cost. TKA did not receive a super-priority hen for these purchases on the debtor’s behalf. The debtor, however, paid TKA a $50,000 “surety fee.” TKA incorporated this “surety fee” into advertising costs that it charged to the debtor. The debtor paid these advertising “costs” to TKA in the usual course of its business during the pendency of the bankruptcy case. There is no evidence that this “surety fee” was disclosed to creditors or approved by the court.

Toy King filed its proposed plan of reorganization and its disclosure statement on December 27, 1988. The disclosure statement stated that 10,000 shares of $10 par value stock would be created following confirmation and 1,000 of the shares would be purchased by TKA after confirmation for the total sum of $10,000. Neither the plan nor the disclosure statement provided for any other infusion of new capital into the debtor. Under “Means for Executing the Plan” at Article V, on page four, the plan provided that “[t]he Debtor plans to use TK Acquisitions, Inc.,

to make a loan

or

arrange a loan

to be made by another entity

in order to fund the Plan.”

(Emphasis added). There was no mention of preferred stock in either the plan or the disclosure statement.

The disclosure statement also reflected that operating losses of almost $700,000 were anticipated for the 1989 fiscal year. In addition, the disclosure statement contained a section that listed compensation for officers.

11

This section listed the name, title, and amount of compensation without explanation or elaboration. Morrow’s compensation was stated as $60,000, Angle’s was $15,000, and King’s was $115,000.

2.

The First Union claims.

Following the conclusion of negotiations with the committee, First Union, the un-dersecured holder of various mortgages on the debtor’s warehouse, approached the debtor and struck a bargain with regard to its claims. According to Morrow and Angle, First Union was anxious to sever its connection with the debtor and did not wish to wait until confirmation for distribution on its claims. The debtor agreed to transfer to the bank the real property and fixtures encumbered by the lien and security interest of First Union and to arrange for the immediate payment of First Union’s unsecured claims at a discount.

Morrow and Angle formed and incorporated M & D Financial, Inc. (“M & D”), for the purpose of purchasing the unsecured claims of First Union. Both were officers and directors of M & D, and each owned more than 20 percent of the common voting stock of that company until December

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23, 1989. On that date, Angle sold his interest in TKA and M & D to Morrow and resigned as an officer and director of M & D and the debtor. At some point, Woodward obtained a five percent interest in M & D.

First Union agreed to sell its unsecured claims totaling $2,373,615 to M & D for the sum of $125,000. Under this arrangement, M

&

D would pay $125,000 for the right to receive under the plan $415,382.62, representing 17.5 percent of the face amount of the total First Union unsecured claims, for a net “profit” to M & D of $290,382.62. This equates to a 232 percent profit on M & D’s investment. Although First Union made this favorable opportunity available to the debtor, Morrow and Angle structured the transaction for their personal benefit.

Debtor’s counsel sent a letter dated December 29, 1988, to counsel for the unsecured creditors committee advising him of the proposed sale.

12

The specifics of the sale, most importantly the anticipated profit that would accrue to the purchaser, were not contained in the letter. The letter stated without elaboration that “[t]he deal with First Union must be done by tomorrow.” The closing was scheduled for the next day, Friday, December 30, 1988. The timing of the closing on a Friday in the midst of the holiday season, 24 hours or less from the date the letter was sent, effectively eliminated any opposition on the part of the creditors committee.

13

The record is devoid of any evidence that anyone received actual notice of the proposed sale prior to the scheduled closing date.

The debtor filed a motion for substitution of claimant, seeking to substitute M & D for First Union as the holder of the claims, on January 9, 1989 (Main Case Document No. 261 in Toy King I).

14

The motion was supported by a stipulation executed by First Union. The motion did not disclose M & D’s close connection with the debtor, nor did it disclose the financial details of the substitution.

15

The court

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granted the motion on an ex parte basis on January 12, 1989 (Document No. 263 in Toy King I).

Notwithstanding the principals’ representations of urgency and First Union’s alleged impatience, M & D did not actually make the payment to First Union for the claims until April 11, 1989. At the time M & D paid First Union for the acquisition of its unsecured claims, Morrow and Angle had been in active negotiations for more than a month to obtain financing for the debtor’s plan. In fact, M & D made the payment to First Union on the very day that the court approved the debtor’s disclosure statement and thus at a point when there appeared to be little significant risk of non-payment of the underlying claims. The defendants offered no explanation for the almost three month delay in making the payment to First Union.

Although M & D made the $125,000 payment to First Union, it did so with funds provided by Morrow and Angle that they borrowed individually from a commercial lender. M & D gave Morrow and Angle a promissory note to document their loan to M

&

D.

3.

The Touche Ross proforma.

Morrow, on behalf of the debtor, engaged the services of the Touche Ross

16

accounting firm to prepare a financial statement reflecting the effect of the Toy King confirmation on the debtor’s balance sheet. Morrow planned to use this statement to obtain monies to fund the plan and for post-confirmation trade credit.

Touche Ross made pro forma adjustments to the debtor’s audited statements that it had prepared for the 1988 fiscal year to reflect the effect of the bankruptcy confirmation as if it occurred at the end of that fiscal year. Touche Ross made these adjustments based upon information and assumptions provided by Morrow.

For example, Morrow estimated that the debtor would have prepetition liabilities immediately following confirmation in the amount of $1,168,107 and a subordinated note of $294,382 for a total of $1,462,489 in projected liabilities to be paid under the plan. Morrow also indicated that the debtor’s assets would be increased by $1,010,000 in cash through capital contributions, $1 million of which would be through preferred stock and $10,000 of which would be through common stock. Morrow anticipated that TKA would purchase the preferred stock using post-confirmation borrowings.

Morrow also requested that Touche Ross use the “quasi-reorganization” accounting convention to restate the debtor’s reorganized debt as new shareholder’s equity. After considerable research into the propriety of using this accounting convention in the debtor’s circumstances, Touche Ross acceded to Morrow’s request.

Under the “quasi-reorganization” accounting convention, assets are carried on the balance sheet at their historical values. The company’s liabilities that are discharged through the reorganization, however, are zeroed out of the balance sheet, with a corresponding increase in shareholder’s equity, first reducing net losses and next creating net equity.

The use of “quasi-reorganization” accounting was controversial at the time. It was disapproved by the Financial Accounting Standards Board and the Auditing Standards Board for use by companies subject to scrutiny by the Securities and Exchange Commission. At the time of the confirmation of Toy King, however, it was not prohibited for use by closely held companies. Because Toy King was a closely held company, the debtor’s use of “quasi-reorganization” accounting was permitted by accounting standards. Long after the events in question here, the use of “quasi-

*42

reorganization” accounting fell into complete disfavor. It is not acceptable for use in any circumstances at the present time.

Touche Ross completed its preliminary pro forma report on April 21, 1989. Although Touche Ross had prepared six footnotes that provided additional information about the debtor and the assumptions upon which the pro forma was based, it did not include these footnotes in its completed preliminary report.

The preliminary pro forma showed that, if the reorganization occurred on January 29, 1989, the debtor would have $2,935,777 in net worth; $1,925,777 from the “quasi-reorganization” accounting methodology and $1,010,000 from additional paid-in capital and new common stock.

4.

The Liberty loan.

During the pendency of the bankruptcy case, the debtor had been engaged in negotiations with various banks in an effort to obtain further financing to fund the plan. Preliminary negotiations with Liberty began in March 1989. Although Liberty had no prior connection with the debtor, it had a business relationship with Morrow and Angle and respected both as members of the local business community in Macon, Georgia.

Steve Horne (“Horne”) was the bank officer charged with negotiating with the debtor. Horne was a senior loan officer with lending authority of $250,000. He was also a certified public accountant. At this time, Horne’s department was thinly staffed. He therefore did the loan analysis himself. Horne conducted an initial investigation, including reviewing the loan application package, interviewing the debtor’s principals and management, and conducting a personal inspection of the debtor’s office, warehouse, and other facilities. Morrow provided to Horne projections of the debtor’s operations post-reorganization that showed a best-case scenario of a $464,000 profit and a worst-case scenario of a $20,000 loss. Morrow also provided a copy of the preliminary Touche Ross pro forma balance sheet showing $1.9 million in equity in the debtor post-reorganization as a consequence of the “quasi-reorganization” accounting methodology.

Horne prepared a credit approval/credit memorandum on May 3, 1989, in furtherance of the loan application. In that memorandum, Horne listed the debtor as having a net worth of $1,942,912 as of December 31, 1988. Horne wrote that the loan would be collateralized by cash or cash equivalents in the amount of $660,000; store fixtures with a value of $150,000; $300,000 in real estate; and inventory in the amount of $2,795,000. He further wrote that Morrow would provide an unlimited guaranty, and Woodward and Hunsaker would provide a limited guaranty of $450,000 each.

Horne stated as strengths the debtor’s new management, minimal reliance on inventory by the bank resulting from the pledge of additional collateral, the debtor’s relationship with suppliers, and $2 million in equity that would be in the debtor following confirmation. Horne stated as weaknesses the bank’s partial reliance on inventory, the location of the inventory, the seasonality of the business, and the recurring losses of past years. He graded the prospective loan as a 2S

17

with some risk. He recommended approval, however, of a $1.5 million line of credit to fund the debtor’s plan of reorganization and to provide additional operating funds. On May 4, 1989, Horne sent a memorandum to the senior loan committee to that effect.

*43

In his May 4, 1989, memorandum, Horne stated that “[o]nee the Company comes out of Chapter 11 bankruptcy, it will have net worth in excess of $2,000,000.... ”

The bank’s senior loan committee met on May 10, 1989, to consider the loan. At the meeting, Horne updated the committee on the collateral being offered to secure the loan. Horne indicated that the cash collateral had been increased to $750,000, real estate collateral had been decreased to $250,000, and inventory was still valued at $2,795,000. There was no mention of fixtures offered as collateral to secure the loan. Horne further indicated that Morrow, Angle, and King would sign unconditional guaranties of the loan, while Woodward and Hunsaker would offer limited guaranties of $450,000 each. The senior loan committee approved the loan as described.

Prior to the granting of this loan, Liberty was principally in the business of residential mortgage lending. Its loan to TKA was one of its early forays into commercial lending. The TKA loan was the first to be made by Liberty in aid of a debtor in the midst of a Chapter 11 reorganization.

There was initial discussion between Liberty, TKA, and the debtor about the structure of the Liberty loan. Liberty intended the loan to be made directly to the debtor as obligor but was dissuaded from doing so by TKA and the debtor.

18

There was evidence presented at trial that TKA and the debtor believed that struc-taring the loan with TKA, rather than the debtor, as obligor was more consistent with the disclosure statement and also would inure to the benefit of the debtor by providing some tax benefits. Structuring the loan with TKA as obligor also avoided possible scrutiny by bank examiners because the obligor was not a company in bankruptcy. This tangentially benefited Liberty.

Accordingly, TKA was denominated as the borrower on the Liberty loan.

19

TKA was a shell company with no assets except its stock in the debtor and receivables owed to it by the debtor. All parties to the transaction understood that the monies from the borrowing would ultimately be used by and for the benefit of the debtor. All parties also understood that the debt- or’s revenues from its operations would ultimately be used to service the loan. Toy King and TKA’s shareholders, Morrow, Angle, Woodward, the Hunsakers, and Ranney, were to be guarantors.

Following the final approval of the loan, Liberty issued a commitment letter. This commitment letter, dated May 19, 1989, stipulated that up to $1 million of the total $1.5 million proceeds was to be used to pay plan dividends to prepetition unsecured creditors of the debtor. The remaining monies were to be used by the borrower, TKA, solely to make

capital contributions

to the debtor for “general corporate purposes.”

20

(Emphasis added). The loan

*47

was to be secured by TKA’s stock in the debtor, the debtor’s inventory, and other collateral owned by the individual guarantors. The debtor, Morrow, Angle, and King were unconditional guarantors of the loan, while Woodward, the Hunsakers, and Ranney were limited guarantors.

21

The commitment letter provided that TKA would pay a loan fee of $5,000 to Liberty in addition to all other costs.

The commitment letter also contained a number of conditions and prohibitions that Liberty sought to impose on both TKA and the debtor. The inclusion of these conditions and prohibitions was intended to protect Liberty’s position. For example, Liberty required that TKA pay down the outstanding balance on a line of credit it had just established with Citizens and Southern Bank (“C & S”) that was secured by its stock in the debtor and its accounts receivable. At the time the parties negotiated the loan commitment, TKA owed C & S approximately $180,000.

22

Liberty included this condition to ensure the priority of its secured status.

Liberty also required that both TKA and the debtor maintain their operating accounts at Liberty Bank so that it would be able to monitor both companies closely. In addition, Liberty prohibited TEA and the debtor from paying to themselves any dividends or bonuses, other than dividends to service the loan itself, except by written permission of Liberty. Liberty intended these prohibitions to prevent TKA or the debtor from making payments without the bank’s knowledge and to keep cash in the debtor and its parent.

23

In addition to the conditions and prohibitions imposed on TKA and the debtor, Liberty required M

&

D to subordinate to Liberty’s debt $294,382 of its dividend on the claims it acquired from First Union.

24

With this prohibition, Liberty sought to keep cash in the debtor as well as ensure that its claim against TKA and the debtor would be superior to any other.

Finally, Liberty required that TKA was to obtain an opinion letter from Touche Ross stating that, immediately following the successful confirmation of Toy King I, there would be “at least $2,000,000 of

*48

stockholder’s equity in Toy King.” The bank required this opinion letter as objective assurance that the debtor’s net worth after confirmation would be substantially as represented by Morrow and Angle at the time the Liberty loan was negotiated and as shown by the preliminary pro for-ma. Although Horne testified that this equity requirement was of little importance to Liberty in making the loan, the evidence itself contradicts this assertion. The court does not credit this testimony.

The commitment letter provided that the letter was “a commitment only” and was not a “substitute for the definite loan agreement.” The same paragraph explained that Liberty’s “obligation to loan funds to borrower shall arise only under the terms of such definitive loan agreement and other documentation.”

With regard to the treatment of the Liberty loan proceeds used by TKA to make a capital contribution in the debtor, the commitment letter was inconsistent with the preliminary draft of the Touche Ross pro forma. According to the commitment letter, the funds for TKA’s capital contribution were to come from a $500,000 line of credit. The remaining funds were to be used by the debtor under a letter of credit to pay plan dividends to Toy King I unsecured creditors.

The preliminary draft of the pro forma, however, provided that $1 million was to be infused as a capital contribution in the debtor. Although the pro forma contained no notation as to the source of the $1 million capital contribution, Horne, Morrow, and Michael Zychinski, the Touche Ross accountant, all testified that they understood that the funds for the $1 million capital contribution were to come from proceeds of the Liberty loan. The preliminary pro forma did not include any notation as to the use of the remaining $500,000 of the Liberty facility or indicate how those proceeds would be treated on the debtor’s internal balance sheets.

Horne, Morrow, and Zychinski understood that the Touche Ross pro forma and the Liberty commitment letter were critical documents that were intended to define the structure of the Liberty loan and how it would affect the debtor’s financial condition. They knew also that the debtor’s trade creditors were to receive copies of these documents and would make credit decisions on the basis of the information they contained. Horne and Morrow testified that they believed trade credit was essential to the debtor’s ability to sustain its operations post-confirmation.

5.

The C & S line of credit

The court approved the debtor’s disclosure statement on April 11, 1989.

25

As the date of the confirmation hearing approached, the debtor was in a precarious financial posture. In the midst of TKA’s final negotiations with Liberty, the debtor was overdrawn on its debtor-in-possession account and was at the low ebb of the sales cycle.

TKA obtained a line of credit from C & 5 on May 8, 1989, for the purpose of funding the debtor. TKA executed a promissory note in favor of C & S that provided for a $400,000 line of credit with a maturity date of December 15, 1989, and interest payments due quarterly on the third day of the month, beginning in June, 1989. The C

& S

line of credit was secured by the accounts receivable of TKA and unconditionally guarantied by Morrow, Angle, and Constance L. Woodward, another TKA shareholder. The debtor had no liability on the C

&

S line of credit, either as obligor or guarantor.

TKA made an immediate draw on the C

6

S line of credit in the amount of $180,000 and made the proceeds available to the debtor. The debtor in turn execut

*49

ed an unsecured note, Note 1, in favor of TKA at an interest rate that exceeded the interest rate being paid by TKA on the underlying C

&

S obligation by at least one percent. The promissory note executed by the debtor was a demand note without a specific due date for the payment of principal.

26

The debtor did not seek the court’s approval of this post-petition borrowing, although Morrow testified that he was aware that such approval was required. It appears from the record that creditors did not receive notice of this post-petition borrowing. This borrowing was also not reflected as a liability on the debtor’s financial statement filed in the pending bankruptcy case and signed under penalty of perjury by King.

6.

Confirmation of Toy King I.

In connection with confirmation of the plan, the debtor mailed ballots to all creditors with a ballot return deadline of May 16,1989. Counsel for the unsecured creditors committee wrote a solicitation letter to unsecured creditors urging acceptance of the plan. The plan was overwhelmingly approved. Of 101 unsecured creditors, 96 voted in favor of the plan, and only five, representing less than $6,000 in unsecured debt, voted against the plan. M

&

D voted its claims, which it had acquired from First Union, in favor of the plan.

The confirmation hearing in Toy King I took place on May 23, 1989. Morrow testified at the confirmation hearing on behalf of the debtor. He testified that the debtor would effectuate the plan with a $10,000 capital stock purchase and a loan commitment from the parent company. Morrow also testified that all creditors were to be paid as proposed by the plan. Morrow testified that the plan proposed to pay unsecured creditors under a letter of credit 90 days after the confirmation of the debtor’s plan. When directly asked if the debtor had made promises to any creditors, other than what was to be paid through the plan, Morrow testified: “No, it has not.” The debtor’s evidence with respect to feasibility was uncontroverted at the hearing.

The debtor offered the commitment letter into evidence at the confirmation hearing. There was no discussion or testimony about the specifics of Liberty’s loan or the terms and provisions of Liberty’s commitment letter. The commitment letter had not been distributed or made available to creditors prior to the confirmation hearing. The debtor had not made the commitment letter a part of the debtor’s plan of reorganization. Nevertheless, the loan described in the commitment letter is what made the plan feasible and thereby confirmable.

27

There was no discussion at the hearing about, nor did the plan or commitment letter mention, the debtor’s borrowing from TKA on TKA’s C & S line of credit.

The court expressed concern at the hearing that the plan made no provision for the payment of interest to those unsecured creditors who were to be paid 90 days or more after confirmation. The court confirmed the plan subject to a modification that provided for the payment of interest at the rate of nine percent to unsecured creditors who were not paid immediately upon confirmation.

The court entered the order confirming the plan on May 23, 1989, the same day as the confirmation hearing. The effective date of the plan was June 12, 1989. The order of confirmation provided:

(B) that the Debtor

shall be authorized

to execute and to deliver to Liberty Savings Bank, FSB, Macon, Georgia any instruments and documents necessary to evidence, secure and relate to Debtor’s guaranty or obligations in connection with the proposed letter of credit to be provided to Debtor and line of credit to be provided T.K. Acquisitions, Inc. pur

*50

suant to and in accordance with the terms of that certain commitment letter of Lender to T.K. Acquisitions, Inc. dated May 19, 1989,

which is incorporated herein by reference.

(Emphasis added).

The court added this language to the confirmation order at the specific request of Liberty.

Through some error, the commitment letter was not attached to the order confirming the plan as was contemplated by the terms of the confirmation order. Nevertheless, the parties to this proceeding have stipulated that the commitment letter in evidence is a true and accurate copy of the commitment letter that was intended to be attached to the confirmation order. Although the debtor did not mail the commitment letter to creditors with a copy of the confirmation order, the parties stipulated that most creditors of the debtor received or obtained a copy of the commitment letter at some point in time close to the date of the Toy King I confirmation.

No party took an appeal from the May 23, 1989, confirmation order or sought to modify it. The plan was then substantially consummated.

E.

POST-CONFIRMATION EVENTS.

1.

Another draw on the C & S line of credit.

One week after the confirmation of Toy King I, TKA again drew on the C & S line of credit in the amount of $80,000. TKA loaned the proceeds to the debtor which in turn gave a promissory note to TKA on the same terms as the first note. This note was Note 2. During this period, TKA also made other draws on the C & S line of credit and made the funds available to the debtor without any written documentation.

28

2.

The Touche Ross pro forma is finalized.

Touche Ross finalized its pro forma by June 4, 1989. The final version of the pro forma included the six footnotes omitted from the preliminary pro forma. These footnotes provided additional information about the debtor and the assumptions upon which the pro forma was based. For example, one of the footnotes stated that Touche Ross did not include contingent liabilities of the debtor for rejection of certain leases in its balance sheet in an amount of up to $414,000.

The final version of the pro forma also included two new footnotes. The first new footnote was a going concern qualification. A going concern qualification reflects a reasonable doubt that the entity in question has the ability to survive for a one-year period without additional capital or debt financing.

29

The second new footnote noted that the debtor’s case had been confirmed and that no objections to the confir

*51

mation had been filed within the ten-day appeal period.

Touche Ross appended to the pro forma an independent auditor’s report of historical financial statements. In that report, dated April 21, 1989, Touche Ross rendered an opinion that “the financial statements referred to above present fairly, in all material respects, the financial position of Toy King Distributors, Inc. as of January 29, 1989, and the results of its operations and cash flows for the year (52 weeks) then ended in conformity with generally accepted accounting principles.”

Touche Ross also appended to the pro forma an independent auditor’s review report on pro forma financial information. In that report, dated June 5, 1989, Touche Ross cautioned that “[a] review is substantially less in scope than an examination, the objective of which is the expression of an opinion on management’s assumptions, the pro forma adjustments and the application of those adjustments to historical financial information. Accordingly, we do not express such an opinion.”

In the finalized pro forma, therefore, Touche Ross rendered an opinion only as to the accuracy and reasonableness of the debtor’s historical financial information as of January 29, 1989, that came from its audited books and records. Touche Ross did not render an opinion about the accuracy, reasonableness, or propriety of management’s assumptions concerning the effect of a reorganization on the debtor’s financial condition, although it did indicate that “nothing came to our attention that caused us to believe that management’s assumptions do not provide a reasonable basis” for the pro forma adjustments.

Liberty received a copy of the finalized pro forma in its entirety prior to the closing of the Liberty loan.

In early June 1989, TKA paid into the debtor the $10,000 new capital,

30

the debt- or cancelled the old stock, and the newly reorganized debtor acquired right and title to all of debtor’s property subject to the confirmed plan of reorganization.

3.

Liberty waives the requirement to obtain a Touche Ross opinion letter.

Prior to the closing of the Liberty loan, a representative from Touche Ross called Horne and asked him whether the bank required the opinion letter. Horne reviewed the finalized pro forma and compared it to the debtor’s internal balance sheets. The debtor’s May 28, 1989, balance sheet included both the $1,010,000 capital contributions and the $1.9 million equity derived from use of the “quasi-reorganization” accounting methodology that were assumptions used in the pro forma. The May 28, 1989, internal balance sheet showed a net loss of $421,000, resulting in a corresponding reduction in the net equity. Thus, the May 28, 1989, balance sheet showed net equity in the debtor in the approximate amount of $2.5 million. Horne understood that $1 million of this equity was to be funded through the Liberty loan.

After reviewing these papers, Horne concluded that the debtor’s balance sheets corroborated the information and assumptions used in drafting the pro forma. He therefore determined that the opinion letter was unnecessary. Accordingly, TKA did not engage Touche Ross to prepare an opinion letter, and Touche Ross did no further work on behalf of TKA or the debtor that is relevant to this proceeding.

During these events, Liberty knew it was entering uncharted waters by making

*52

a large loan for the use of a company emerging from bankruptcy reorganization. Liberty also knew that the loan was for the benefit of, and would be repaid from, the operations of the debtor. The net equity covenant contained in the commitment letter was critical to the debtor’s ability to pay that loan in the event that the debtor did not perform as expected. Liberty knew that the debtor had lost money for the three years prior to the reorganization and that there was a going concern qualification with respect to the debtor’s future performance stated in the pro forma.

Liberty had confidence in Morrow and Angle, however, and relied upon their representations as to the debtor’s financial condition as assurance that the bank was protected in making the loan to TKA.

Willard M. Iman (“Iman”) testified as the plaintiffs banking expert. He opined that Liberty was imprudent in making the Liberty loan to TKA without first obtaining an opinion letter from Touche Ross that corroborated the net worth that was projected to be in the debtor after its reorganization. Iman stated that Liberty was especially imprudent in the face of losses before confirmation that caused a 20 percent erosion of the equity as shown in the pro forma and in light of the going concern qualification. The court credits this testimony on all of these points.

4.

The debtor does not have $2 million in equity following the Toy King I confirmation.

Although both sides stipulated that the commitment letter contained a net worth covenant as a condition of the Liberty loan, there is a dispute as to the what the debtor’s equity was to include. The defendants assert that the equity requirement included the capital contribution from the loan proceeds anticipated to occur after the closing of the loan and shown on the pro forma and debtor’s balance sheet under assets as a stock subscription receivable and under shareholder’s equity as preferred stock. Horne testified repeatedly throughout the trial to that effect.

The plaintiff, on the other hand, asserts that a plain reading of the commitment letter in conjunction with generally accepted accounting principles mandate a conclusion that the equity requirement did not include the $1 million capital contribution shown in the pro forma and the balance sheet. Robert J. McCarthy (“McCarthy”), the plaintiffs accounting expert, testified that generally accepted accounting principles would not permit the debtor to put $1 million into assets until the event occurred that caused that money to be available to the debtor. Accordingly, the debtor could not show $1 million in assets prior to the funding of the Liberty loan to satisfy a condition of the loan itself. The court credits this testimony and does not credit Horne’s testimony on this point.

In addition, the evidence suggests that in fact Horne himself did not look to the $1 million capital contribution arising from the Liberty loan to satisfy Liberty’s equity requirement. For example, Horne’s notes made in furtherance of the loan approval exclude the $1 million capital contribution from his estimation of the debtor’s net equity.

Moreover, it is clear from the evidence that the parties to the Liberty loan could not have reasonably believed under any set of facts that $1 million of the loan could be infused into the debtor as a lump sum capital contribution as part of a single transaction or event even after the Liberty loan closed. The parties knew that $1 million of the loan was to be held in a letter of credit in favor of the debtor to be incrementally drawn down to pay the plan dividends to unsecured creditors. All parties to the loan understood that the letter of credit would be drawn down over a period of at least 90 days. Horne, Morrow, Angle, and Zychinski, the Touche Ross accountant, were all certified public accountants with a better than average understanding of basic accounting princi-

*53

pies. Each one knew or should have known that the letter of credit could not be posted as an asset on TKA’s or the debt- or’s balance sheets until it was actually drawn upon and then only in the amount of the specific draw. Accordingly, Liberty, TKA, the debtor and all individuals involved in negotiating and executing the Liberty loan knew or should have known that the $1 million capital contribution shown as a stock receivable creating $1 million in shareholder’s equity was not accurate or realistic.

In addition, the parties to the Liberty loan knew or should have known that it was unlikely that the debtor could service the Liberty loan through dividend payments on its stock owned by its shareholder, TKA. The parties understood that the debtor was projected to post a loss for every month and would therefore be unable to declare dividends in any amount. McCarthy testified as to all of these points, and the court credits his testimony.

On the other hand, it would have been feasible from an accounting perspective for TKA to use $500,000 of the Liberty loan proceeds to make a capital contribution in the debtor after the Liberty loan closed. This could have been effected by TKA taking an immediate draw in the full amount on that line of credit and then using the proceeds to make a purchase of preferred stock in the debtor in the amount of $500,000. This treatment would also have been completely consistent with the requirements of the commitment letter.

TKA could not structure its capital contribution in the debtor in this way, however, because TKA had a direct obligation to C & S that had to be satisfied from the $500,000 line of credit proceeds at the closing of the Liberty loan. TKA was required to draw down the line of credit to pay C

& S

directly and thus could not use those monies to purchase preferred stock in the debtor. Horne, Morrow, and Angle all knew that TKA had an obligation to C

&

S in some amount. Each knew therefore that TKA could not make a capital contribution in the debtor using the full proceeds of the $500,000 line of credit.

For the foregoing reasons, the court concludes that the $2 million equity required as a condition of making the Liberty loan was to exclude any monies from the Liberty loan itself.

As stated in Section IV.E.3. above, Horne relied upon the Touche Ross pro forma as verification of the debtor’s net equity following the Toy King I confirmation. The net equity shown in the pro forma derived solely from the adjustments made as a consequence of management’s projections and assumptions provided to Touche Ross, including the “quasi-reorganization” accounting convention. Without those adjustments the debtor’s historical financial statements, which were audited and as to which Touche Ross rendered an opinion, showed the debtor as having a substantial negative net worth. Accordingly, the equity that Liberty was relying on in its loan analysis came solely from assumptions and projections provided by Morrow. Touche Ross offered no opinion as to the management assumptions used in formulating the pro forma.

As to the Touche Ross pro forma and the assumptions upon which it is based, it is clear from the evidence that Morrow crafted the assumptions provided to Touche Ross for its use in drafting the pro forma in a way that would give maximum positive effect to the debtor’s net worth while at the same time ignoring or discounting anything that would have an adverse effect.

As the court noted above, Morrow was inaccurate and unrealistic in his projections of a $1 million cash or cash equivalent capital contribution. Morrow also projected the prepetition dividend liabilities in an amount that was $200,000 less than he estimated in the debtor’s disclosure statement prepared at around the same time, and substantially less than the claims that were filed and allowed as of

*54

that date. Morrow used, instead, an arbitrary amount that he estimated would be the debtor’s full liability after the debtor completed its claims litigation. These adjustments served to depress the debtor’s liabilities and inflate the debtor’s assets.

Morrow fixed the debtor’s post-petition liabilities at a point in time when the debt- or’s sale cycle had come full circle, thereby ignoring the liabilities and losses that he knew the debtor would incur in the pre-Christmas months. He also refused to estimate the debtor’s liabilities ensuing from lease rejection damages because they were “contingent,” a specious and somewhat ironic reason considering that the pro forma was prepared at a time when the only fact that was not “contingent” was that the debtor would operate at a loss. Finally, Morrow failed to show as a liability of the debtor the $500,000 that TKA was to loan the debtor from the proceeds of the Liberty loan.

Thus, Morrow was able to create an inflated statement of the debtor’s net worth by giving an exaggerated and unrealistic effect to the capital contribution through the stock subscription receivable while at the same time omitting or downplaying projected liabilities.

Had TKA engaged Touche Ross to prepare an opinion letter that attested to the reasonableness of management’s assumptions and the debtor’s financial statements as to the debtor’s net worth, Touche Ross would have conducted an examination that would have looked at these assumptions and financial records in depth. McCarthy testified that such an examination would have included an examination of TKA’s and the debtor’s financial statements to determine the propriety of the related transaction shown as a $1 million capital contribution. He also testified that an examination would have required scrutiny of the debtor’s books and records to determine with specificity the debtor’s actual liabilities in existence at the time of the examination. The court credits all of McCarthy’s testimony on those points.

It is reasonable to conclude, therefore, that, had Touche Ross conducted such an examination, it would have adjusted the pro forma balance sheet to exclude the $1 million capital contribution, while at the same time increasing the liabilities in some amount. These adjustments, together with the $421,000 net loss that the debtor posted between January 29,1989, and May 28, 1989, would have shown net equity in the debtor in an amount much less than the required $2 million.

31

McCarthy also testified that, in his expert opinion, the debtor did not have $2 million in equity following the Toy King I confirmation. The court credits McCarthy’s testimony on this point.

Accordingly, the court determines that the debtor did not have $2 million in equity immediately following the Toy King I confirmation and prior to closing the Liberty loan. The court further concludes that Touche Ross would have been unable to render an opinion that verified equity of $2 million in the debtor as required by the commitment letter.

5.

The Liberty loan closes.

TKA and Liberty finalized the Liberty loan in mid-June following the completion and release of the Touche Ross pro forma. TKA and Liberty executed a master promissory note that provided for the payment of interest, on the first day of each calendar month, at a fixed rate on the first $700,000 and at two percent above the prime rate on the remaining balance due. The principal was due and payable on June 30,1990, although there was no penalty for prepayment. The defendants represented that the parties had a verbal agreement that at least $900,000 of the principal

*55

would be paid prior to December 31, 1989, notwithstanding the June 30, 1990, maturity date. The master promissory note further provided that it was to be construed and enforced according to the laws of the State of Georgia.

TKA, Liberty, and Toy King also executed a revolving credit and security agreement on June 9, 1989, which incorporated by reference the master note. The documents included provisions for loan supplements or extensions to be incorporated within the terms of the documents with a borrowing limit of no more than $1.5 million in aggregate indebtedness at any time.

The debtor pledged inventory, account balances, stock, and all products and/or proceeds of any of the foregoing as security for the payment of the master note and “all obligations whatsoever of borrower or Toy King.” Liberty filed Uniform Commercial Code financing statements in Alabama, Florida, South Carolina, Virginia, and Wisconsin in June 1989. These financing statements did not specifically identify proceeds and products as part of the bank’s collateral.

Toy King, Morrow, and Angle signed joint and several unconditional guaranties. As collateral for the loan, Morrow pledged undeveloped real property, two life insurance policies, and shares of stock in an acquisition company. Angle pledged undeveloped real property

32

and two life insurance policies. King did not sign a guaranty-

Woodward, the Hunsakers, and Ranney all signed limited guaranties. Each limited guaranty was capped: Woodward’s in the amount of $350,000; Hunsaker II’s in the amount of $175,000; and Hunsaker Ill’s and Ranney’s in the amount of $87,500 each. These limited guaranties totaled $700,000. Each of the limited guarantors pledged as collateral a master repurchase agreement with a face amount of the capped limited guaranty exposure. Accordingly, Liberty held cash, cash equivalents, or real estate as collateral in the undisputed amount of at least $1 million.

.Liberty did not denominate any of the pledged collateral as primary or secondary. Every guarantor was jointly and severally liable to Liberty.

33

Each guaranty was identical in its language with the exception of the dollar limitation contained in the limited guaranties. The provisions of each guaranty were applicable to “all renewals, amendments, extensions, consolidations and modifications” to the loan documents.

34

Also, each guaranty specifically provided that the guarantor waived and agreed not to assert or take advantage of

... any defense based on the failure of Lender to give notice of the existence, creation or incurring of any new or additional indebtedness or obligation or of any action or non-action on the part of any other persons or non-action on the part of any other person whosoever, in connection with any obligation hereby guaranteed ... any defense based upon failure of Lender to commence an action

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against Borrower ... the failure of Lender to perfect any security or to extend or renew the perfection of any security; or ... any other legal or equitable defenses whatsoever to which Guarantor might otherwise be entitled.

35

Finally, each guaranty stated that it was a “guaranty of payment and performance and not of collection. The liability of Guarantor under this Guaranty shall be direct and immediate and not conditional or contingent upon the pursuit of any remedies against Borrower.... ”

As additional protection for Liberty, the guarantor defendants pledged a life insurance policy on King’s life.

Finally, M

&

D executed an agreement that subordinated to Liberty $294,382 of its right to payment on the claims it had acquired from First Union. This represented the balance that would remain after an initial payment of $121,000.62.

36

Thus, the loan as finalized differed in several material ways from the loan that was approved by the senior loan committee. The most important change, of course, was the change in obligor from the debtor to TKA with the debtor becoming an unconditional guarantor of the loan. The finalized loan was also not supported by an unconditional guaranty by King. In addition, the finalized loan was supported by limited guaranties in an amount $200,000 less than approved.

37

Iman testified that, in his opinion, Liberty was imprudent in making a loan on terms different than those approved and

*57

memorialized in the May 10, 1989, senior loan committee minutes. The court credits this testimony.

The loan closed on June 14, 1989. At about this time, Woodward acquired 20 percent or more of the shares of TKA, and the Hunsakers and Ranney each acquired less than 20 percent of the shares of TKA stock.

38

F.

TOY KING’S SUBSEQUENT FINANCIAL CONDITION.

1.

Immediate borrowings.

The debtor operated at a loss throughout the pendency of the Toy King I bankruptcy case.

39

As discussed earlier, its financial condition worsened before confirmation, necessitating further borrowing from the parent.

40

This borrowing enabled the debtor to operate through confirmation and until the closing of the Liberty loan.

At the closing of the Liberty loan, TKA immediately drew on the $500,000 line of credit in the amount of $320,530.15. Of this sum, $18,707.22 was paid out in closing fees and costs, including attorney’s fees. Liberty also made a direct payment to C & 5 in the amount of $301,822.93 to pay down TKA’s obligation to C

&

S. As a result of this payment, TKA had no obligation to C

6

S after this date, although the line of credit remained open.

Despite the pay down of the C

&

S line of credit, TKA did not execute or deliver to the debtor a satisfaction of Notes 1 and 2. Instead, it continued to hold those notes, allocating them as being supported by the Liberty loan instead of the C

&

S line of credit. Essentially, TKA substituted the Liberty loan indebtedness for the C

&

S line of credit indebtedness as the underlying obligation of the parent.

After payment of loan-related expenses and the payment to C

&

S, only $179,469.85 remained on the Liberty line of credit to be used for the ordinary operating expenses of the reorganized debtor. Because the bulk of the $500,000 line of credit simply replaced the borrowing on the C

& S

line of credit that occurred immediately before and after confirmation, the Liberty loan resulted in scant positive net effect on the debtor’s financial condition.

2.

Balance sheets.

According to the debtor’s balance sheets, however, the financial condition of the debtor appeared to be healthy. The balance sheet of May 28, 1989, stated the debtor’s assets as $5,222,483, liabilities as only $2,718,146, and shareholder’s equity as $2,504,336. It appeared from the balance sheet, therefore, that the debtor had substantial equity and was in a good position to weather the slow sales months to come.

The court, however, credits the testimony of McCarthy that the debtor’s balance sheets are not credible or reliable evidence of the debtor’s true financial condition. McCarthy based his opinion, in part, on the debtor’s use of the “quasi-reorganization” accounting convention. Because that convention overstates assets while reducing liabilities, the shareholder’s equity that results from the application of the “quasi-reorganization” accounting convention is phantom equity. It is essentially unrealizable. In McCarthy’s opinion that the court credits, therefore, the debtor’s use of the “quasi-reorganization” accounting con

*58

vention resulted in a substantial exaggeration of the debtor’s net worth.

McCarthy testified that “purchase” or “fresh start” accounting would more accurately state the debtor’s true financial position upon confirmation. Using “fresh start” accounting, the assets of the debtor would have been valued at their allocable part of the amount used to purchase the company, in this case $10,000, representing what a willing buyer, here the new shareholders, were willing to pay for the business.

41

The court credits this testimony for the purpose of determining the solvency or insolvency of the debtor.

McCarthy also opined that the debtor’s balance sheets contained material omissions or misrepresentations that resulted in an overstatement of assets and an understatement of liabilities.

He testified that the balance sheets should have excluded the “stock subscription receivable” or “parent company receivable” shown as an asset.

42

McCarthy also testified that inventory was inflated, shrinkage was not reflected accurately, and the debtor improperly listed unearned discounts and allowances.

McCarthy testified further that liabilities shown on the balance sheets understated the debtor’s borrowings from the parent company, unamortized loan costs, sales taxes, expenses associated with opening of new stores, and lease rejection expenses in connection with closing of old stores.

In addition, the debtor’s balance sheets booked some of the monies received from TKA from the Liberty loan as liabilities, some as equity, and some not at all. For purposes of payment, however, the debtor repaid all of the monies received from or on behalf of TKA as if they were loans or liabilities. McCarthy testified that liability cannot be equity and the monies the debt- or received from the parent company were therefore not consistently or accurately reflected on the balance sheets.

Finally, McCarthy opined that, at the very least, the debtor was thinly capitalized at all times following confirmation. The court credits McCarthy’s testimony on all of these points.

3.

Asset valuation.

R. Steven Haas, plaintiffs expert on valuation, testified that the debtor’s inventory and fixed assets, as reflected on its balance sheets, were overstated in value. Haas testified that the debtor’s inventory as of January 28, 1990, was comprised of a substantial amount of stale or seasonal goods that were saleable only at greatly reduced prices, if at all. He opined that the debt- or’s inventory as of January 28, 1990, was worth only 50 percent of the amount stated

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on the debtor’s balance sheet on that date. Haas formulated this opinion using extensive information from the debtor’s books and records from the months of January and February 1990. Haas testified at trial that this opinion was “absolute.” The court credits this opinion.

Haas also opined that the debtor’s inventory on July 30, 1989 — an earlier date — was worth 70 percent of the amount stated on the debtor’s balance sheet on that date. Haas testified further that it was appropriate to use the same valuation for the May 28, 1989, inventory because the debtor’s sales figures between May 28, 1989, and July 30, 1989, suggested that its inventory mixture did not change between those dates. Accordingly, Haas opined that the debtor’s inventory on May 28, 1989, was also worth 70 percent of the amount stated on the debtor’s balance sheet of the same date.

Haas acknowledged at trial that his opinion as to the worth of the debtor’s inventory in May and July 1989 was only a “ballpark figure” because he did not have access to all the information needed to reach a firm valuation.

43

The court credits Haas’ testimony with respect to his observation that he did not see an appreciable difference between the value of the debtor’s inventory between May and July 1989. The court does not, however, credit Haas’ opinion as to a valuation of 70 percent of the stated worth of the debtor’s inventory in May and July 1989. Instead, the court credits McCarthy’s opinion that a retailer coming out of a successful reorganization is left with a substantial amount of residual inventory that cannot be sold at a normal margin. McCarthy testified that this occurs because the debtor expedites sales and tries to turn over its inventory more rapidly during a reorganization than during normal operations.

For reasons that will be more fully explicated in Section IV.G.4. of this opinion, the court concludes that the debtor’s inventory from May 23, 1989, and at all times thereafter was inventory that in substantial part was not susceptible to sale at a normal mark up. Accordingly, the court concludes that the debtor’s inventory at all times after the confirmation of Toy King I was overstated on its balance sheets by 50 percent.

44

Haas also testified as to the value of the debtor’s fixed assets. Haas opined that, at all times between the confirmation of Toy King I and the filing of Toy King II, the debtor’s furniture, fixtures, and equipment had a value that did not exceed $52,000. He further opined that the debtor’s permanent assets, including leasehold improvements and point of sale equipment, and this $52,000 of furniture, fixtures, and equipment, had a value that did not exceed $130,000 at any time during this period.

45

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The court credits this opinion for the purpose of determining the debtor’s financial condition.

4.

Toy King is insolvent.

Based upon the credited testimony of these experts, the court is required to adjust the balance sheets presented by the debtor. Where the evidence permits, the court has made adjustments to the debt- or’s balance sheets in accordance with this expert testimony. As shown in the notes, the court adopts these adjusted balance sheets as illustrative of the debtor’s true financial condition.

46

These balance sheets

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do not reflect “purchase” or “fresh start” accounting.

47

The court notes, however,

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that use of this accounting convention would reflect an even graver financial posture for the debtor dating from the confirmation of Toy King I on May 23, 1989, through the filing of Toy King II on February 12,1990.

Adjusting the May 28, 1989, balance sheet in accordance with these findings, the court determines that the debtor showed a negative net worth of at least $450,036.41 at the time of confirmation. The debtor plainly was insolvent then. As these figures clearly illustrate, the little cash remaining on the Liberty line of credit was inadequate for the debtor’s needs.

5.

Inventory reports.

Haas also testified that the debtor prepared inventory reports that valued its inventory by pricing it at its retail price, rather than the lowest sale price or cost. This retail price was calculated by multiplying cost by an anticipated gross margin of 41.8 percent, or approximately 174 percent of the initial cost of goods. The margin used exceeded even the most favorable projections used by the debtor and was unrealistic, especially given the fact that 30 to 34 percent of the debtor’s inventory was comprised of stale or obsolete merchandise. In addition, the debtor included defective, return, and “field destroy” merchandise in its inventory counts, thereby further inflating the value of the inventory. Haas opined that the debtor’s use of this methodology in valuing its inventory was “unusual.”

The debtor’s use of a retail valuation methodology, particularly with this 41.8 percent margin, substantially inflated the calculated value of its inventory in its reports. The debtor sent these inventory reports to Liberty each month with its balance sheets. The debtor also sent these reports to McCarthy. It is unclear from the evidence whether the trade creditors received these inventory reports.

48

G.

OTHER POST-CONFIRMATION DEVELOPMENTS.

1.

The Liberty line of credit is exhausted.

Although it appeared that the debtor had navigated the shoals of bankruptcy, the future was not clear sailing, and the debtor was ill-equipped to handle the approaching storms. The debtor was in the down cycle for sales and was also attempting to open new stores in Mississippi, Pennsylvania, and Maryland. It had very little capital to sustain its operations. At the same time, it needed inventory to stock its stores for the coming Christmas season.

By mid-July, TKA had drawn most of the money remaining on the $500,000 line of credit.

49

All of the monies in turn were

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made available to the debtor and in most cases, the debtor executed unsecured notes in favor of TKA. The interest rate on the TK notes was in all eases at least one percent more than TKA was obligated to pay to Liberty.

50

All of these notes were demand notes.

Despite its rapidly dwindling cash, the debtor continued to make interest payments to TKA, including the additional interest upcharge of one percent, on every penny it received from the parent’s borrowing from Liberty and C & S. The debt- or also paid TKA guaranty fees tied to the parent’s C & S line of credit indebtedness.

In addition, Morrow and Angle received salaries that exceeded the salaries paid during the pendency of Toy King I. Both Morrow and Angle worked part-time for the debtor, and each received an annual salary of $75,000 following the confirmation of Toy King I.

51

The debtor also paid fees to AMI for management services. There is no evidence in the record as to the specific services that AMI provided to the debtor or the amount of fees it received for those services. AMI, TKA, and M & D each had its office at the debtor’s business premises. The evidence, however, does not show how the premises were divided or who paid the operating costs for those premises.

2.

The C & S line is drawn again.

As the Liberty line of credit was exhausted, the debtor began to look for a new source of capital. The debtor approached Liberty for an additional loan as early as June 27, 1989. Liberty, however, declined. Nevertheless, Liberty did consent to waive the prohibition contained in the commitment letter and its loan documents against further borrowing and sent a letter to that effect to TKA.

Accordingly, between August 7, 1989, and September 8, 1989, TKA drew on the C & S line in the amount of $250,000 and in turn made the money available to the debtor to pay its ordinary operating expenses.

52

The debtor executed unsecured demand notes in favor of TKA at a rate of interest, to be paid monthly, that was at least one percent more than the interest paid by TKA to C

&

S.

53

As stated earlier,

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TKA s promissory note to C & S required interest payments to be made quarterly and the principal to be paid on December 30,1989.

In addition, TKA charged the debtor “guaranty fees” ostensibly tied to the C & S line of credit. These fees were essentially funneled through TKA, the actual obligor on the C & S line of credit, and distributed equally to the individual guarantors on the C & S line of credit, Morrow, Angle, and Woodward.

54

There was no writing between the debtor and TKA with respect to these “guaranty fees.”

Initially, the “guaranty fees” were one percent, but beginning in September all “guaranty fees” were increased to two percent. The “guaranty fees” were tied to specific notes executed by the debtor, and accordingly the debtor paid “guaranty fees” even during months in which TKA owed no money to C & S and the actual guarantors were m no danger of being called upon to perform on their guaranties.

55

The defendants put forward no credible explanation for why the debtor, neither obligor nor guarantor of the C & S obligation, paid these fees to the parent company, TKA, the actual obligor on the note. The court credits the testimony and opinion of Iman, plaintiffs banking expert, that these “guaranty fees” were excessive and unreasonable.

3.

Toy King makes plan payments to creditors.

During this time, the debtor also began making payments to creditors from the $1 million Liberty letter of credit pursuant to its confirmed plan. These payments were effected by sending a list of the payees and amounts to Liberty who in turn made the payments and debited the letter of credit.

56

The debtor did not execute any note to

*65

memorialize an indebtedness owed by Toy King to TKA on the $1 million letter of credit. Notwithstanding this lack of documentation, the debtor made regular interest payments to TKA that it credited in service of the $1 million letter of credit obligation. The interest rate that the debt- or paid to TKA was at least one percent more than the rate that TKA paid Liberty.

57

Virtually the first dividend paid under the plan was to M & D in the amount of $138,500 in partial payment of its right to payment under the original First Union claims. (The total amount of that right to payment was $415,382.62, representing 17.5 percent of the face amount of First Union’s original claims.)

58

The payment to M & D, in turn, was distributed to Morrow, Angle, and Woodward as princi

*66

pal, interest, and “profit” and, as a practical matter, reimbursed Morrow and Angle for their purchase of the First Union claims in addition to their equity contribution in the debtor.

59

From this time forward, Morrow and Angle’s financial risk on account of the debtor was therefore limited to their personal guaranties.

4.

Trade credit is king.

Although the debtor continued to operate, it was beset with problems. It could not open its new stores as scheduled.

60

Much of its inventory was stale and inadequately advertised. Inventory shrinkage exceeded industry norms. Most importantly, the debtor’s actual sales were below projections, and the gross margin realized by the debtor was not even close to the anticipated 40 percent.

61

At the same time, the debtor had a continuing need for inventory. Trade credit was therefore the linchpin of the debtor’s post-confirmation operations. After Toy King I was confirmed, each toy manufacturer made an independent credit decision about the debtor, based upon the debtor’s current financial status. Many, if not all, of these creditors received a copy of the finalized Touche Ross pro forma. They also received periodic copies of the debtor’s internal balance sheets. Each creditor placed primary rebanee on the financial reports of the debtor in deter

*67

mining whether and how much credit to advance the debtor. In addition, each creditor relied on informal reports of the debtor’s financial situation provided periodically by Morrow, Angle, and King.

Joseph Stewart, Director of Credit and Collections for Hasbro Industries, Thomas R. Mauntel, Director of Credit Administration for Kenner Products, and James E. Brown, Credit Manager for Fisher Price, Inc., all testified at trial on the above points. Each also testified that, based upon the information provided by the debt- or, he believed that the debtor had substantial equity following the confirmation of Toy King I.

62

Each witness testified that he would not have extended credit to the debtor, after the confirmation of Toy King I, absent the equity cushion as shown in the debtor’s balance sheets and the Touche Ross pro forma. The court credits this testimony.

Following confirmation, toy manufacturers were initially cautious in extending credit to the debtor. Lines of credit were lower than requested, terms were less generous, and the debtor was encouraged to buy on anticipation.

63

The debtor began placing its orders for the Christmas season beginning in late July. Most of its Christmas inventory needed to be ordered during August for shipment during September and October.

64

Consequently, it was essential that the debtor increase its lines of credit with the toy manufacturers to accommodate its greater inventory needs.

Morrow, Angle, and King sent optimistic letters to the toy manufacturers to induce them to increase the debtor’s credit lines. In these letters, they stated that the debt- or was exceeding projections and performing well. Angle and King reinforced that message in personal phone calls placed to credit managers.

The gist of these communications was that expenses were below budget and sales were holding steady or higher than projected, thereby allowing the debtor to show a smaller loss than anticipated for the summer months.

65

There was no mention of the fact that the cost of goods used to generate budgeted sales exceeded projections. In addition, Morrow based his calculations of actual versus projected performance using the financial information contained in the debtor’s balance sheets, and therefore understated the expenses. Also, none of these communications gave any indication that the debtor was suffering from an extreme shortage of cash. Accordingly, all of these communications were misleading with respect to the financial condition of the debtor at the time they were made.

66

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These communications were further buttressed by the debtor’s balance sheets reflecting a positive net equity. As stated earlier, each of these balance sheets utilized “quasi-reorganization” accounting, omitted liabilities, and most importantly, showed $1 million of the Liberty loan as paid-in capital or equity.

Many of the toy manufacturers responded favorably to the debtor’s requests for credit line increases, although the total credit was still inadequate to meet the debtor’s needs. Nintendo was a notable exception.

5.

The Nintendo loan.

Nintendo products were an integral component of the debtor’s business plan. At that time, Nintendo was the leading manufacturer of electronic games and game cartridges and enjoyed a substantial percentage of the market share for such products.

67

Electronic games and game cartridges were very popular and thus sold quickly and with little advertising. Because Nintendo did not produce enough product to satisfy demand, its product could be marked up by the seller more than other kinds of inventory, thereby enhancing the gross margin.

While formulating projections in connection with the confirmation of Toy King I, the debtor projected that 26 percent of its sales would be from Nintendo products. Toy King was unable, however, to negotiate credit terms with Nintendo following confirmation due to the debtor’s negative history with Nintendo. Accordingly, all orders placed with Nintendo were on a “cash in advance” basis. In view of Toy King’s severely limited cash position, this represented a significant problem.

68

At the same time, the debtor was forced to purchase a substantial percentage of its general inventory from toy wholesalers, rather than toy manufacturers, with a concomitant increase in the cost of goods. This was due to the debtor’s inability to obtain adequate credit from toy manufacturers. The debtor filled in with closeout inventory.

69

Because this kind of inventory was relatively inexpensive, the markup at sale was greater resulting in a higher gross margin. Unfortunately, closeout goods, by their very nature unpopular with the public, also had the potential to depress the gross margin if they could not be sold.

Notwithstanding its limited cash reserves and its anticipated increase in operating costs, the debtor continued faithfully to make its payments of interest to TKA, including the interest upcharge of one percent. The debtor also paid the “guaranty fees” to TKA without fail.

70

The debtor’s cash flow problem became acute. The C

&

S line of credit had an available balance of $210,000 at this time. The line was inadequate, however, to address fully the debtor’s cash flow problems. In addition, Morrow and Angle were keenly aware of their personal exposure on that line and sought to limit that exposure as much as possible.

TKA turned instead to Liberty and, on August 10,1989, requested additional cred

*69

it, the stated purpose of which was to purchase Nintendo products. On August 30, 1989, Horne prepared a three page memorandum to the Liberty loan committee recommending extension of a new $600,000 short-term line of credit to benefit the debtor. The senior loan committee considered the loan request on August 31, 1989. The committee deferred its decision pending further investigation.

Even though Liberty had not yet approved the loan request, TKA executed a promissory note on September 12, 1989. That note granted Liberty a security interest in the same collateral that secured the original Liberty loan, including the debt- or’s inventory. The note contemplated monthly interest payments with the principal being retired by TKA on December 31, 1989. Morrow and Angle signed the note as officers of TKA.

The debtor was not a signatory on that note. The defendants testified that the note was executed on this date as an accommodation to Liberty because Morrow and Angle were frequently out of town. The court finds this testimony incredible in view of subsequent events.

On September 13,1989, Liberty received a request from TKA to draw $100,000 from the $500,000 line of credit. The request exceeded the amount available on the line of credit.

71

Liberty made funds available to TKA, notwithstanding the unavailability of funds on the line of credit, and charged it against the $1 million portion of the Liberty loan. TKA, in turn, made those funds available to the debtor. In effect, therefore, the debtor utilized these monies for operating funds with Liberty’s full knowledge and consent. Although the $1 million letter of credit had expired by its own terms two days earlier, the loan documents nevertheless limited the $1 million portion of the loan for the sole use of making payments to creditors under the confirmed plan.

There were a number of meetings between Horne and the senior loan committee to discuss the Nintendo loan request, and the committee sought additional information. Horne ultimately prepared a credit approval/credit memorandum on September 27, 1989, in furtherance of the Nintendo loan request. In that memorandum, Horne wrote that the Nintendo loan would be secured by the same collateral that secured the Liberty loan except that all guarantors would unconditionally guaranty the Nintendo loan and there would be a $350,000 letter of credit to secure advances in excess of $350,000. Horne also recommended that the loan be effected through a letter of credit made payable to Nintendo.

The senior loan committee met on September 27, 1989, to consider the Nintendo loan. At that meeting, the senior loan committee approved the Nintendo loan on the terms submitted by Horne with two exceptions. First, the senior loan committee did not require that the loan be disbursed through a letter of credit to Nintendo.

72

Second, the senior loan committee did not require all guarantors to guaranty unconditionally the Nintendo loan. Instead, the senior loan committee required unconditional guaranties from Woodward and Hunsaker II. The Nintendo loan approval on these terms was memorialized in the senior loan committee’s minutes.

Thus, there were significant differences between the Nintendo loan and the Liberty loan. First, the Nintendo loan was short-term and required payment of the entire balance within three months. Second, the loan contained no provisions for

*70

further extensions or repayment of principal. Third, the loan was to be secured with an additional letter of credit in the amount of $350,000. Finally, the loan was to be unconditionally guarantied by two additional guarantors, Woodward and Hunsaker II.

The loan as ultimately structured was not in accord with the terms approved by the senior loan committee, except that it did not permit further extensions or advances and was to be repaid on December 31, 1989. After the approval of the Nintendo loan, TKA informed Liberty that the individual guarantors were unwilling to provide a letter of credit to secure the loan.

73

Although Liberty prepared and sent for execution the paperwork that would have expanded the guaranties, none of the paperwork that would have effected those changes was ever signed. Instead, the debtor, Morrow, Angle, Hunsaker II, Hunsaker III, and Ranney signed amendments that simply carried over their guaranties from the Liberty loan. Woodward did not sign an amended guaranty.

Liberty charged a loan fee of .005 percent of the total indebtedness, or $3,500. It is unclear from the record whether this fee was ever paid or, if so, who paid it.

On September 30, 1989, Liberty posted and established a note with a maximum availability of $700,000 effective September 12, 1989, and maturing on December 31, 1989. Also on that date, Liberty posted the $100,000 line of credit “overdraw” advances of September 13 to the Nintendo loan effective September 13, 1989. At the same time, Liberty debited the debtor’s letter of credit for the charge posted on September 13,1989.

Iman, the plaintiffs banking expert, testified that Liberty’s actions in advancing funds prior to the receipt of signed loan documents and on terms different and materially less advantageous than those that the senior loan committee approved were imprudent. The court credits this testimony.

The Nintendo loan was fully drawn down by October 17, 1989. TKA disbursed the monies to Toy King as they were drawn.

74

Toy King in turn executed unsecured notes in favor of TICA. The interest rate on the Toy King notes exceeded the interest rate charged to TKA by Liberty by at least one percent.

75

All of the notes were demand notes.

Notably, Toy King used less than a quarter of the monies obtained through the Nintendo loan to purchase Nintendo

*71

products.

76

The rest of the monies were used to pay ordinary operating expenses.

H.

THE FINAL CHAPTER.

1.

Christmas is no help.

As the debtor moved into the 1989 Christmas season, the debtor’s financial situation worsened dramatically. November’s actual sales were much lower than projected by the debtor.

77

Because this was the debtor’s peak sales season, the disparity between projected gross margin and actual gross margin, attributable in part to higher acquisition costs and poor product, was more marked.

78

In short, all of the previous bad business decisions and siphoning of cash by management, in the guise of interest upcharges and guaranty fees,

79

was coming home to roost with a vengeance.

During the 1989 Christmas season, all toy retailers experienced slow sales, and most discounted their sale prices early in the season. The debtor was reluctant to do this for fear that it would further reduce its gross margin. The debtor did not discount until right before Christmas and consequently had little opportunity to boost its sales.

This delay in discounting, coupled with poor inventory mix, inadequate capital, and the continuous bleeding of the debtor’s scant cash, sounded the death knell for the debtor.

80

It became clear to Morrow, Angle, and King that the debtor was going to post a substantial loss for the year and would not be able to meet its deferred obligations to its trade creditors. The debtor’s days as an independent operating entity were clearly numbered. At the same time, the due dates for payment to trade creditors for the debtor’s inventory were fast approaching.

81

As important to Morrow and Angle, the due dates for payment of principal by TKA on the C & S and the Liberty Nintendo obligations were imminent.

Morrow wrote a letter to Liberty dated October 17, 1989, and advised the bank that the debtor was experiencing a downturn in sales. Horne met with Morrow and Angle on November 17, 1989, and learned that a loss was projected for the year and that TKA did not believe that it would be able to make any principal prepayments on the $1.5 million loan.

As shown in the notes, the debtor’s liabilities exceeded its assets throughout this period as they had from the date of eonfir-

*72

mation.

82

By October 29, 1989, the debt- or’s liabilities exceeded its assets by at

*75

least $1,860,956.05.

83

The November 26, 1989, balance sheet posted the $1 million

*76

letter of credit as a liability rather than as preferred stock for the first time. By this time, the debtor’s trade creditors had shipped to the debtor all of its inventory for the Christmas selling season. The debtor’s liabilities continued to exceed its assets throughout the Christmas season.

84

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Morrow testified that he knew in December that the debtor would be unable to pay all of its debts as they came due. On December 14, 1989, Morrow began advertising the availability of the debtor for sale or merger in the

Wall Street Journal.

On December 18, 1989, Morrow wrote a letter to Liberty stating that the debtor was now projecting a “sizable” loss and was beginning a deep discount program. In addition, Morrow advised the bank that he had put the company up for sale or merger.

2. Preparing for the inevitable.

As the end drew inevitably nearer, the debtor began making payments of principal to TKA on its demand notes for the stated purpose of enabling TICA to pay down its secured debt on the underlying transactions.

85

The debtor made all of these payments by check drawn on the debtor’s operating account and signed by both Morrow and King. There is no evidence in the record that TKA made formal demand on the debtor for these payments of principal.

The debtor also paid to M & D the remaining amount due on the First Union claims in contravention of the subordination agreement and without the written consent of Liberty.

86

The debtor made this payment by check drawn on the debt- or’s operating account and signed by Morrow.

87

King questioned the propriety of this payment.

88

Morrow and Woodward ultimately received substantially all of the proceeds of this payment.

89

The debtor

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paid the dividend claim of at least one other Toy King I unsecured creditor during this same period.

90

By this time, the debtor had paid at lest $1,270,256.39 in Toy King I dividends.

91

The debtor did not prepare a balance sheet for December, even though Morrow had advertised the company for sale or merger. Although the debtor prepared its balance sheets on an inconsistent and irregular schedule dating from the confirmation of Toy King I, this was the first time that the debtor failed to prepare any balance sheet.

92

Angle divested himself of his interest in TKA and all related companies, including M & D, by selling his shares to Morrow on or about December 23, 1989.

93

At the same time, he resigned his position as an officer and director of the debtor, TKA, and M

&

D. Angle remained personally liable on TKA’s obligations to Liberty and C&S.

In January, Liberty filed Uniform Commercial Code financing statements in all states with Toy King stores except Mississippi.

94

All of these financing statements for the first time specifically included proceeds and products in the description of collateral.

On January 22, 1990, Liberty sent' formal notice to TKA that it was closing the open-ended provision in the Liberty loan note. That provision allowed TKA to make additional draws against the line of credit equivalent to the amount of principal repayments, provided that TKA was not in default of its obligations. The letter simply recognized the financial realties facing both TKA and the debtor, even though TKA was not in default and $500,000 was technically available on the line.

3.

VMI makes an offer.

There were several responses to the

Wall Street Journal

advertisement, among them a response by Wisconsin Toy, Inc. (later known as Value Merchants, Inc., or “VMI”). In mid-January, VMI made an offer to buy the debtor for $1.5 million. Under the terms of the offer, shareholders were to receive stock in VMI with an approximate value of $50,000 while general unsecured creditors were to receive payment of 24 percent of their debts. The offer was effective only until February 8, 1990, and contained numerous contingencies. One of these contingencies was the entry of a final decree in Toy King I.

The trade creditors were dissatisfied with the terms of the proposed merger agreement, principally because it contained an equity distribution in favor of the individual defendants. The creditors felt that any equity distribution to the debtor’s

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principals was unwarranted and unconscionable under the circumstances.

Most of the trade creditors had been creditors of Toy King I. Although these creditors did receive from the debtor payment in satisfaction of their Toy King I claims, that payment represented only 17.5 percent of each creditor’s total claim in that case. The merger agreement contemplated payment to unsecured creditors that was only marginally better than the Toy King I dividend, making many of the unsecured creditors two time losers.

At the same time, some of the facts relating to the debtor’s actual financial situation were coming to light. Consequently, unsecured creditors were beginning to learn about the debtor’s early payment of principal to TKA, payment of subordinated debt to M & D, and the true nature of the debtor’s financial arrangements with TKA.

In addition, the trade creditors correctly believed that it was unlikely that the proposed merger could be consummated because of the many contingencies. Both YMI and the debtor lacked the ability to satisfy all of the contingencies. For example, neither VMI nor the debtor had the means to effect the court’s entry of a final decree in Toy King I. Indeed, the court itself had no ability to enter a final decree because there was an appeal pending of the bankruptcy court’s order awarding attorney’s fees. The court could not enter a final decree until that appeal was determined.

I.

THE TOY KING II CASE.

1.

The trade creditors file an involuntary Chapter 7 petition.

The relationship between the unsecured creditors and the principals of the debtor became very hostile at this point. When it became apparent that an accord could not be reached, several toy manufacturers filed an involuntary Chapter 7 against the debtor on February 12, 1990, commencing this case — Toy King II.

Even though the debtor operated continuously at a loss during the almost nine month period between the confirmation of Toy King I and the filing of Toy King II, TKA and M & D profited handsomely from their relationship with the debtor. The debtor paid TKA

95

$13,342.60 in interest upcharges and $20,283.22 in guaranty fees during that time. Morrow and Angle, of course, received the lion’s share of these profits by virtue of their ownership interests in TKA. In addition, the debtor paid generous salaries to both. Finally, both received a handsome profit on their acquisition of the First Union claims in Toy King I through M

&

D. After the debtor completed all payments on those claims, M & D received $314,506.17 more than it paid for the claims. This represented a “profit” of more than 250 percent, most of which ended up in Morrow’s pocket.

96

The debtor terminated King’s employment on January 31, 1990. King resigned as director on February 13, 1990. He subsequently filed a proof of claim (Claim No. 21) on April 24, 1990, for monies owed on his employment contract in the amount of $77,591.89, $2,000 of which he claimed as priority and $75,591.89 of which he claimed as unsecured.

At the time the creditors filed the involuntary petition initiating this case, the debtor’s liabilities exceeded its assets.

97

Both the debtor’s tax return for 1989 and its balance sheets for January 28, 1990, corroborate the debtor’s financial condition. The debtor’s 1989 tax return reflects

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net income as a negative $2,673,287 before taking the net operating loss deduction and a negative $5,085,341 after posting the net operating loss deduction. As shown in the notes, the January 28, 1990, balance sheet reflects that, at a minimuni, the debtor’s liabilities exceeded its assets by at least $1,675,317.83.

98

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2.

Closing the Toy King I case.

The Toy King I case continued to be active long after the filing of Toy King II. The Toy King I debtor filed an application for final decree on January 25, 1990 (Main Case Document No. 428 in Toy King I). The court could not enter the decree, however, because there were matters pending in the case, including objections to claims and a pending appeal of one of the court’s orders approving attorney’s fees.

The debtor filed a motion for special consideration of application for final decree (Main Case Document No. 480 in Toy King I) on January 31, 1990, in a final bid to consummate the VMI sale before the offer lapsed. The court denied that motion (Main Case Document No. 449 in Toy King I) on June 28, 1990, however, because of the pending matters.

The clerk docketed a notice of the district court’s transmittal of the appeal to the court of appeals on August 28, 1990 (Main Case Document No. 450 in Toy King I). The court of appeals dismissed the appeal on January 30, 1991, and the clerk docketed a notice of entry of the dismissal of the appeal on February 6, 1991 (Main Case Document No. 450A in Toy King I). Subsequently, the debtor filed a renewed motion for final decree (Main Case Document No. 451 in Toy King I), and the court entered a final decree (Main Case Document No. 452 in Toy King I) on June 1, 1992.

3.

Toy King II becomes a Chapter 11 case.

After several of the debtor’s unsecured creditors filed the involuntary petition under Chapter 7 on behalf of the debtor (Case No. 90-528), the debtor filed a motion to dismiss the case and a motion to convert the case to one under Chapter 11. The petitioners and the debtor ultimately stipulated to the entry of an order for relief and to the conversion of the case to Chapter 11. The court conducted an evi-dentiary hearing of the joint motion for order of relief and the motion to convert on April 10, 1990. On April 13, 1990, the court entered an order for relief, effective April 10, 1990, and converted the case to a case under Chapter 11 (Main Case Document No. 52).

The debtor filed its statement of financial affairs and schedules (Main Case Document No. 43) on April 11, 1990. It listed secured debt in the amount of $932,818.97, priority unsecured debt in the amount of $177,295.67, and unsecured debt in the amount of $2,372,118.59.

99

The same counsel who represented the debtor in the Toy King I case represented the debtor in the Toy King II case. On April 30, 1990, the debtor filed a motion to approve Morrow’s salary of $90,000 per year (Main Case Document No. 78A). Several of the debtor’s unsecured creditors filed an objection to the motion.

The debtor also immediately filed a motion to approve a sale to VMI of substantially all of the debtor’s assets (Main Case Document No. 56A). The proposed sale contemplated that VMI would pay $1.5 million for these assets. The terms of the sale required VMI to pay $1.2 million for the debtor’s inventory, $299,000 for the debtor’s fixed assets, $500 to assume eight leases, and $500 for the right to purchase goods from Nintendo. The purchase price for the debtor’s inventory was subject to adjustment for diminution.

The United States trustee appointed an unsecured creditors committee on May 29, 1990. Many of the creditors on that committee had previously been members of the unsecured creditors committee during the pendency of Toy King I.

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Although the debtor continued its operations while the motion to sell was pending, it immediately began to close its stores and consolidate its inventory. To further this effort, the debtor filed a number of motions to reject leases.

The court conducted a hearing on the motion to sell the debtor’s assets on May 1, 1990. The court heard certain objections and resolved all issues, orally approving the sale on terms substantially the same as those proposed. The court entered its findings of facts and conclusions of law and an order approving the sale on May 11, 1990 (Main Case Documents Nos. 102 and 103). That order required the sale to be concluded no later than noon on May 15, 1990. By this date, the debtor had effectively ceased all operations.

The parties appeared in court on May 15, 1990, and announced that they were unable to consummate the sale on the terms and by the deadline set forth in the court’s order. VMI offered at that hearing to purchase the debtor’s inventory and fixed assets and to assume three leases for the reduced price of $1,050,000. VMI reduced its offer largely because the debtor’s inventory had diminished. On May 17, 1990, the court entered an order approving the sale on the terms announced at the May 15, 1990, hearing (Main Case Document No. 119).

VMI and the debtor completed the sale, and the parties filed a closing statement (Main Case Document No. 169) on June 25, 1990. The debtor received all the proceeds of the sale. Comparing the original VMI offer with the reduced offer ultimately consummated, and considering the fact that VMI reduced its offer because of the diminution in the debtor’s inventory, the court concludes that $750,000 of the sale proceeds represented the debtor’s inventory, $299,000 represented the debtor’s fixed assets, and the remaining $1,000 represented the lease assignments and purchase rights.

The defendants have suggested at various times throughout this proceeding that, through their actions, the petitioning creditors or the official committee of unsecured creditors interfered with the consummation of the original VMI sale and/or delayed the consummation of the second VMI offer. They have further suggested that these actions caused a diminution of the amount ultimately realized by the debtor from its sale of assets to VMI. These assertions are wholly without merit. The actions of the petitioning creditors and the official committee of unsecured creditors in advancing their interests were not wrongful in any respect. Moreover, nothing these creditors did delayed the sale to any material degree. The fact is that the sale occurred as quickly as the bankruptcy process would permit.

The court conducted a contested hearing on June 26, 1990, of the debtor’s motion to pay compensation to Morrow. The court subsequently entered an order authorizing the debtor to pay Morrow compensation in the reduced amount of $5,000 per month, or $60,000 per year, only from April 10, 1990, to May 18, 1990. (Main Case Document No. 192) The court further directed Morrow to return to the debtor any compensation that the debtor paid him prior to the entry of the order in excess of the allowed amount.

Morrow was entitled to compensation under that order in the amount of $6,333.33.

100

The debtor’s financial reports, filed under penalty of perjury, reflect that Morrow received $20,769.24 in compensation between the dates of April 10, 1990, and June 30, 1990.

101

The debt- or’s July financial report, reflecting the debtor’s business from July 1, 1990, through July 31, 1990, shows a repayment by Morrow pursuant to court order in the

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amount of $12,014.62. The court concludes, therefore, that Morrow received and continues to hold $2,421.29 in compensation more than the amount to which he was entitled.

102

Liberty filed a motion for payment of its secured claim (Main Case Document No. 217) on August 15, 1990. The unsecured creditors committee and several unsecured creditors vehemently opposed the motion. The court denied the motion for payment after a hearing.

The court approved the debtor’s disclosure statement on November 1, 1990. The court conducted a confirmation hearing on January 29, 1991, and entered a confirmation order on February 12, 1991, exactly one year after the petitioning creditors filed the involuntary petition.

Under the terms of the confirmed plan, the debtor was to pay Liberty’s secured claim. The plan further provided that unsecured creditors would be paid any funds remaining up to the full amount of their claims. The debtor ultimately paid Liberty on its secured claim in the amount of $1,049,008.33 on August 2, 1991. This payment was comprised of $900,000 in principal and $149,008.33 in interest.

103

There were no remaining funds, and, therefore, the debtor made no distribution to priority or unsecured creditors. There are pending in this case allowed priority claims in the approximate amount of $273,973.39 and allowed general unsecured claims in the approximate amount of $2,889,908.52.

104

The court authorized the unsecured creditors committee to pursue any and all of the debtor’s claims for the benefit of the priority and unsecured creditors. Liberty was to retain all collateral pledged by the individual guarantors pending the court’s determination of the adversary proceeding, if filed. The committee then filed this adversary proceeding by the deadline fixed by the court to do so.

V.

CONSIDERATION OF INDIVIDUAL CLAIMS AND MORE SPECIFIC FACTS.

A.

INTRODUCTION.

The complaint in this adversary proceeding contained claims stated in 16 sepa

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rate counts. In addition, the committee objected to the claim of Liberty, and the court consolidated that contested matter with this adversary proceeding. Later, the parties filed several stipulations of fact and law (Document Nos. 31, 43, 87A, 104) that restated, recharacterized, modified, and expanded the claims somewhat. The court dismissed both Liberty’s and the individual defendants’ counterclaims for the reasons stated orally and recorded in open court at the final pretrial conference (Document No. 59). As made clear in the final order on pretrial conference, the claims and defenses that the court tried are those described in the pretrial stipulation (Document No. 43, 87A and 104).

105

Before discussing each of the claims, however, the court will initially address threshold or preliminary legal issues that affect the consideration of several claims. These issues involve the legal effect of the confirmation order in Toy King I as it relates to the claims made in this proceeding and the defendants’ assertion that the Liberty loan should be recharacterized as a loan made to the debtor rather than to TKA.

B.

THRESHOLD LEGAL ISSUES.

1.

What is the effect of the commitment letter as included in the order of confirmation in Toy King I?

Initially, the parties dispute the effect of the confirmation order in Toy King I as it relates to the obligations of Liberty and the borrowers and guarantors under the commitment letter. Liberty says that the commitment letter was nothing but a private contract under which it agreed to lend money. Once it lent the money, the terms of the loan documents themselves establish all rights and obligations of the parties, and the commitment letter itself loses any independent significance.

The plaintiff, on the other hand, says that the commitment letter became a specific order of the court that Liberty and the others were bound to follow. In that sense, Liberty was bound to perform and to require performance by the debtor and the other defendants under the terms of the commitment letter. To the extent the loan actually made differed from the terms of the commitment letter, the plaintiff contends the differing aspects were not authorized and can be avoided. To the extent the parties did not comply with the terms of the commitment letter and creditors were damaged thereby, the plaintiff contends the breaches are actionable.

The confirmation order in Toy King I confirmed the plan and authorized the debtor to execute and deliver to Liberty all necessary documents in connection with the debtor’s guaranty in accordance with the terms of the commitment letter attached to the order and incorporated in it by reference. Thus, the terms of the commitment letter became an integral part of the plan as confirmed, indistinguishable in any respect from any of the plan’s other terms. The loan terms described in the commitment letter were the only terms that were permitted or authorized by the court. Terms or provisions that were materially different from the loan described in the commitment letter would and will constitute a breach of the plan as confirmed by the court to the extent any such breach can be attributed to a person or entity bound by the confirmed plan.

The parties had ten days to take an appeal from the confirmation order pursuant to Part VII of the Federal Rules of Bankruptcy Procedure or to seek to alter or amend the confirmation order pursuant to F.R.B.P. 9023 and F.R.Civ.P. 59. No party took any such action. Accordingly, the confirmation order became final.

Section 1141(a) of the Bankruptcy Code provides that “the provisions of a confirmed plan bind the debtor, ... any entity acquiring property under the plan, and any creditor, [and] equity security holder.... ”

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Obviously, therefore, all defendants were bound by the terms of the commitment letter as an order of the court and as part of the confirmed plan. TKA and King were equity security holders of the debtor. TKA, Morrow, Angle, Woodward, Hunsaker II, Hunsaker III, and Ranney all acquired property under the plan. M

&

D was a creditor of the debtor.

Liberty was to acquire property under the plan. It was to receive a security interest in the debtor’s inventory. It was also to receive the debtor’s guaranty of TKA’s obligation to repay the loan. It is true that Liberty was not to receive these interests in the debtor’s property until the loan closed. The loan as described in the commitment letter, however, was an integral part of the debtor’s confirmed plan, specifically approved and authorized by the court and without which the plan would not have been feasible and therefore not confirmed. Thus, it is clear that Liberty was an “entity acquiring property under the plan.”

Liberty was also bound to the terms of the confirmation order, as an order of the court and as an integral portion of the debtor’s confirmed plan, because Liberty voluntarily appeared and agreed to be so bound. Indeed, it was Liberty that requested that the commitment letter be made part of the confirmation order.

Section 1142 of the Bankruptcy Code provides that:

(a) Notwithstanding any otherwise applicable nonbankruptcy law, rule, or regulation relating to financial condition, the debtor and any entity organized or to be organized for the purpose of carrying out the plan shall carry out the plan and shall comply with any orders of the court.

(b) The court may direct the debtor and any other necessary party to execute and deliver or to join in the execution or delivery of any instrument required to effect a transfer of property dealt with by a confirmed plan, and to perform any other act, including the satisfaction of any lien, that is necessary for the consummation of the plan.

In this case, Liberty came to the bankruptcy court and proposed making the loan described in the commitment letter as the means of permitting the confirmation of the debtor’s plan. Liberty is clearly an “other necessary party” within the meaning of Section 1142(b). Liberty was bound under the terms of the confirmed plan to make the loan described in the commitment letter — not a loan the terms of which varied in material respect from the loan described in the commitment letter.

In

Paul v. Monts,

906 F.2d 1468, 1472 (10th Cir.1990), the court dealt with the effect of a confirmed plan on a third party who proposed to take specified action under the plan but who did not perform. The plan as confirmed contained alternative means to consummate the plan, one of which anticipated that the third party would provide new capital to the reorganized debtor. The third party was not a signatory on any documents and had not specifically consented to be bound. The court held that, under these circumstances, the Bankruptcy Code did not bind the nonperforming third party but that such a party could agree to be bound.

Id.

The court stated that “[a] fair reading of section 1141(a) provides that [the noncreditor] was not bound by the plan under section 1141(a) and would not be bound until it acquired property thereunder or

unless it agreed to be bound.” Id.

(Emphasis added). The court further suggested that, where the party to be charged enters into a preconfirmation written agreement with the debtor that is incorporated into the confirmed plan, the noncreditor party is bound

(citing Kal-O-Mine Industries, Inc. v. Camp (In re Lumpkin Sand & Gravel, Inc.),

104 B.R. 529, 536 (Bankr.M.D.Ga.1989), aff'

d,

111 B.R. 370 (M.D.Ga.1990)).

Id.

Finally, the court suggested that, although the noncreditor was not bound by the confirmed plan under the

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Bankruptcy Code, ordinary contract principles nevertheless applied.

Id.

In this case, Liberty was not merely an alternative party to the plan. Instead, it represented the only means by which the plan was to be consummated. To this end, Liberty was a signatory to the commitment letter that was incorporated into the order of confirmation. Indeed, the court incorporated the commitment letter into the confirmation order at the request of Liberty. Liberty made that request specifically to bind the debtor to the conditions and terms outlined in the commitment letter. But for Liberty’s action in requesting approval of the making of the loan described in the commitment letter, the court would not have been able to confirm the plan. These circumstances can be construed in only one way — that Liberty consented to be bound by the terms of the confirmed plan just as the other parties described in Section 1141(a) would be bound.

Having so consented, Liberty was also contractually bound.

See In re Page,

118 B.R. 456, 460 (Bankr.N.D.Tex.1990) [“In essence, the plan becomes a binding contract between the debtor and the creditors and controls their rights and obligations.”];

United States v. Shepherd Oil, Inc. (In re Shepherd Oil, Inc.),

118 B.R. 741, 751 (Bankr.D.Ariz.1990) [“Certainly a plan of reorganization is a binding contract.”].

For these reasons, therefore, each and every defendant was bound by the terms of the commitment letter.

2.

Is the debtor the obligor or a guarantor on the Liberty loan?

The way in which the court construes the Liberty transaction — whether with the debtor as guarantor or the debtor as principal obligor — is important because of its significant ramifications affecting other issues in this proceeding. These ramifications include:

• Whether TKA or Liberty is the initial transferee of recoverable preferences;

• Whether transfers made by the debtor were to insiders or non-insiders;

• Wdiether the transferee recovered more in payment of its loan than it would in a hypothetical Chapter 7 liquidation of the debtor;

• Whether the payments were made by the debtor in the ordinary course of the debtor’s and TKA’s business or the debt- or’s and Liberty’s business;

• Whether the debtor or its principals made the payments with the intent to hinder, delay, and defraud creditors;

• Whether the debtor received equivalent value for its payments;

• Which defendants are the immediate or mediate transferees and thus eligible to use the good faith defense to preference and fraudulent transfer claims;

• The scope of the principals’ fiduciary duties;

• Whether the debtor has available the defenses of a surety; and

• Whether the debtor has rights of contribution or subrogation against the other guarantors/defendants and Liberty.

The plaintiff takes the position that the written loan documents evidence the true and accurate position of the parties with respect to their rights and obligations under the Liberty loan. Under both the commitment letter and the loan documents, of course, Liberty made the loan to TKA as obligor. The debtor guarantied this obligation.

The plaintiff also asserts that TKA made or intended to make some or all of the proceeds of the Liberty loan available to the debtor as a capital contribution, consistent with the terms of the commitment letter. It points to the inclusion of preferred stock in the Touche Ross pro forma and the debtor’s listing of $1 million of these proceeds as shareholder’s equity on all of its balance sheets generated between May 28, 1989, through October 29, 1989.

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The defendants argue, however, that the court should construe the transaction differently. The defendants say the court should determine that the debtor was, in actual fact, the principal on the Liberty loan rather than the guarantor. This construction, the defendants assert, is consistent with the actual substance of the transaction as contemplated and transacted between the parties.

The defendants point out that all parties understood from the outset that the Liberty loan was for the ultimate benefit of the debtor. In addition, the parties understood that the ultimate payment of the loan would be effected through the sale of the debtor’s inventory in the ordinary course of its business.

The defendants assert that this understanding was consistent with the financial realities of the debtor and TKA. The debt- or was the operating entity and generated revenues through the sale of its inventory. TKA, in contrast, was nothing but a shell company, with its only asset being its stock in the debtor and receivables owed to it by the debtor. Accordingly, TKA, on its own, was financially incapable of servicing the loan without the debtor’s revenues. The defendants argue, therefore, that Toy King was intended to be the — “true”—obligor on the loan.

The defendants claim that Liberty wanted to denominate TKA as the borrower to avoid the appearance of making a loan to a company in bankruptcy. The defendants say denominating TKA as borrower was nothing more than a technical formality or a semantic exercise for appearances only.

The gist of the defendant’s argument seems to be as follows: the debtor was the one who needed the money, the debtor received the money, and the debtor was the one who repaid the money. Because the debtor was the only one with the resources to repay the loan, the transaction was never and could never have been more than a simple loan to the debtor, notwithstanding any writings to the contrary.

The most notable aspect of the transaction consistent with the defendants’ argument is the execution of notes and the monthly payment of interest by the debtor. The defendants argue that these loan characteristics of the Liberty loan are more reasonable than the capital contribution aspects. The defendants point to the clear benefit inuring to the debtor and the inability of the parent to service the underlying loan absent these periodic payments.

The difficulty with this argument is that the notes that the debtor executed were not notes to Liberty but were instead notes to TKA. The interest that the debtor paid was not interest paid to Liberty but was instead interest paid to TKA. These notes were entirely and legally independent of the Liberty loan promissory note. The debtor did not give any notes or pay any interest directly to Liberty.

Moreover, the record overwhelmingly supports the fact that TKA intended to use at least some of the Liberty loan to make a capital contribution rather than a loan to the debtor. The commitment letter, prepared by sophisticated and competent counsel, clearly states that the proceeds could be used solely for payment of Toy King I dividends and capital contributions to the debtor. Similarly, the accountant from Touche Ross testified that it was his understanding, gained from information provided by Morrow, that at least some of the Liberty loan proceeds would be applied as a capital contribution to the debt- or. This understanding is consistent with the written evidence. The pro forma referred to preferred stock — plainly a capital contribution — and the debtor’s own balance sheets for many months posted some of the monies received from the proceeds of the Liberty loan as preferred stock.

106

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In addition, the record contains no evidence that the debtor was unable to obtain financing on its own behalf,

107

other than the self-serving testimony of the individual defendants. To the contrary, the evidence supports the fact that Liberty was willing to denominate Toy King as borrower but did not do so at the request of the debtor’s principals. Although Liberty received a tangential benefit in acceding to this request, it was the debtor who received the most benefit. As Morrow testified, designating TKA as borrower, rather than the debtor, afforded the debtor substantial tax advantages.

The most important advantage, however, was the “capital contribution” characterization of some of the borrowing. This characterization enhanced the debtor’s stated net worth. Had the Liberty loan been posted on the debtor’s balance sheets as a liability, the debtor’s net worth would have been reduced by that amount.

Finally, as will be discussed at greater length in Section V.D.2.a.iii. and V.D.3. below, this characterization was a material factor in the toy manufacturers’ decisions to extend credit to the debtor after confirmation. Thus, the debtor was a direct recipient of the benefits of structuring the transaction with the debtor as guarantor and TKA as obligor.

Recognizing the debtor as guarantor rather than obligor is more than mere “form” or an exercise in semantics. The defendants’ argument invites circuity — if the parent company was “nominal” to the loan to the point that it should be excised from the transaction, why was it needed in the first place? If it was necessary to structure the transaction in that way, then TKA could not have been a nominal party.

A finding that the debtor is obligor on the Liberty loan would materially affect the disposition of this proceeding and the potential liability of each party, as noted earlier. It would be inequitable to permit the parties to reap the benefits of the transaction as they structured it, with TKA as obligor and the debtor as guarantor, and then avoid the consequences by having the court ignore their chosen structure and recharacterize the transaction well after the fact. Recharacterizing the transaction as the defendants urge would turn equity on its head, contrary to principles of reorganization. “It is the duty of the court, especially a court of equity, to adjust the rights of the parties so far as possible so that the ultimate loss shall accord with the equitable position of the parties.”

Whitlock v. Max Goodman & Sons Realty, Inc. (In re Goodman Industries, Inc.),

21 B.R. 512, 520 (Bankr.D.Mass.1982)

(quoting

10

Williston on Contracts

§ 1264 at 842 (3d ed.1967)). “That is especially true when the party now complaining that the court should consider the realities and not the form were instrumental in creating the very form of which they now complain.”

Id.

It is true, as the defendants argue, that there is some evidence in the record supporting the proposition that all parties to this proceeding intended that the debtor was the “real” or “true” borrower. It is also true, however, that there is equally compelling evidence that supports the position that the parties intended TKA to be the borrower while the debtor served as guarantor. In the face of this conflicting evidence, the court is persuaded that the terms of the commitment letter and loan documents themselves establish the roles each of the parties were and are to play in accordance with the intent and desires of the parties.

More importantly, this was the role mandated by the terms of the confirmed plan as evidenced by the Toy King I confirmation order. Were those roles to be

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reversed by the parties, the parties would be in material breach and in violation of the confirmed plan. That breach would be no less material or severe if ordered by the court in this proceeding at the urging of the defendants.

Accordingly, the court finds that TKA is the obligor for the Liberty loan and the debtor is an unlimited guarantor.

C.

PREFERENCE CLAIMS.

1.

Introduction.

The unsecured creditors committee seeks to set aside as preferences, pursuant to the provisions of Sections 547 and 550 of the Bankruptcy Code, payments that the debtor made to TKA. The payments that the committee attacks are payments of interest and principal on the Liberty loan, the C & S line of credit, and the Nintendo loan. Also included are guaranty fees paid by the debtor to TKA in connection with the C

&

S line of credit.

The debtor made these payments in two discreet time periods. First, the debtor made these kinds of payments in the 90-day period before the filing of the petition commencing the Toy King II case on February 12, 1990. Second, the debtor made these kinds of payments earlier, during the period commencing with the confirmation of the Toy King I case on May 23, 1989, and continuing through the date 91 days before the commencement of the Toy King II case.

In addition, the plaintiff attacks as preferences certain payments the debtor made to M

&

D. The plaintiff also seeks to set aside as preferences certain UCC-1 filings by Liberty purporting to perfect security interests and a security agreement allegedly made by the debtor in favor of Liberty after the loan purporting to be secured by the security agreement had closed.

Section 547(b) of the Bankruptcy Code permits the avoidance of:

... any transfer of an interest of the debtor in property—

(1) to or for the benefit of a creditor;

(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;

(3) made while the debtor was insolvent;

(4) made—

(A) on or within 90 days before the date of the filing of the petition; or

(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and

(5) that enables such creditor to receive more than such creditor would receive if—

(A) the case were a case under chapter 7 of this title;

(B) the transfer had not been made; and

(C) such creditor received payment of such debt to the extent provided by the provisions of this title.

“The bedrock philosophy of the Bankruptcy Code is an equality of a division of assets for all creditors of the debt- or.”

Jones v. J.E.G. Enterprises, Inc. (In re Greenbrook Carpet Co.),

22 B.R. 86, 89 (Bankr.N.D.Ga.1982). The plaintiff carries the burden of establishing by a preponderance of the evidence each of the elements constituting a preferential transfer.

Nordberg v. Arab Banking Corp. (In re Chase & Sanborn Corp.),

904 F.2d 588 , 595 n. 15 (11th Cir.1990);

Ruff v. Vurchio (In re Vurchio),

107 B.R. 363, 365 (Bankr.M.D.Fla.1989).

2.

Payments by the debtor to TKA made during the 90 days immediately before the filing of Toy King II.

a.

Introduction.

During the 90-day reach back period, the debtor paid TKA $2,906.26 in interest

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on the C & S line of credit, $40,492.62 in interest on the Liberty loan, and $12,157 in interest on the Nintendo loan. During the same period, the debtor also paid TKA $250,000 in principal on the C & S line of credit, $600,000 in principal on the Liberty loan, and $700,000 in principal on the Nintendo loan. The debtor also paid TKA a $5,000 guaranty fee in connection with the C & S line of credit during this period.

b.

Do the payments to TKA constitute transfers?

A “transfer” is broadly defined in Section 101(54) of the Bankruptcy Code. Under this definition, a transfer encompasses every means of disposing of or parting with property or an interest in property of the debtor. “The concept of property of the estate under Bankruptcy Code section 541(a) is expansive.”

United Agri Products v. Jonovich (In re Food & Fibre Protection, Ltd.),

168 B.R. 408, 417 (Bankr.D.Ariz.1994)

(citing Begier v. Internal Revenue Service,

496 U.S. 53, 58-59 , 110 S.Ct. 2258 , 110 L.Ed.2d 46 (1990)). In this case, the debtor wrote and delivered checks to TKA in payment of all its obligations. These checks were drawn on its regular operating account. The debtor’s operating account contained funds that were obtained through the sale of its inventory sold in the ordinary course. There can be no dispute, therefore, that the debtor’s payments to TKA were transfers within the meaning of Section 547(b).

c.

Was each transfer to or for the benefit of a creditor?

Section 101(10) of the Bankruptcy Code defines “creditor” as an “entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor.” Section 101(5) defines “claim” as a “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.”

TKA made monies available to the debt- or both directly and indirectly. TKA directly loaned to the debtor $500,000 of the Liberty loan, the C & S line of credit, and the Nintendo loan. The debtor executed notes that formalized its obligations to TKA for most, but not all, of these monies.

TKA also indirectly loaned to the debtor $1 million of the Liberty loan. Although Liberty funded the $1 million letter of credit by making payments to the debtor’s creditors as required by the confirmed plan, TKA was the obligor on the Liberty loan. TKA and the debtor did not execute a note to memorialize the debtor’s obligation to TKA for this $1 million portion of the Liberty loan. The, debtor, however, made monthly payments of interest to TKA on account of the $1 million letter of credit.

TKA and the debtor operated on the premise that all of the monies TKA made available to the debtor from the Liberty loan, the C & S line of credit, and the Nintendo loan created debts of the debtor in TKA’s favor. Although the plaintiff now attacks the payments of those debts, the defendants do not dispute that TKA was a creditor of the debtor at all times between the confirmation of Toy King I and the filing of Toy King II.

It is clear, therefore, that the debtor made transfers directly to TKA; TKA was the recipient of the funds paid; the transfers reduced the debtor’s unsecured obligations to TKA; and TKA received the direct benefit of these payments. Accordingly, TKA is a creditor of the debtor with respect to all transfers at issue here as required by Section 547(b)(1).

d.Were the transfers for or on account of an antecedent debt?

Section 101(12) of the Bankruptcy Code defines a “debt” as a “liability on a claim.” Section 101(5) defines a “claim” as a “right to payment....” “Although ‘antecedent debt’ is not defined by the Code, essentially a debt is ‘antecedent’ if it is

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incurred before the transfer.”

Tidwell v. AmSouth Bank, N.A. (In re Cavalier Homes of Georgia, Inc.),

102 B.R. 878, 885 (Bankr.M.D.Ga.1989)

(citing

4

Collier on Bankruptcy

¶ 547.05 (15th ed.1989)).

The debtor incurred the obligation to repay the principal debts at issue in this claim of preference at the time that it received the monies from TKA. This was true even when the debtor did not execute a note to evidence its obligation to TKA, as was the case with the $1 million letter of credit and a small portion of the $500,000 line of credit monies. Similarly, the debt- or incurred the obligation to pay the C & S guaranty fees at the time it received the proceeds from that line of credit. In every case, the obligation to repay principal or to pay guaranty fees was incurred before November 14, 1989 — the date 90 days before the filing of the Toy King II case. Accordingly, the payments of principal and guaranty fees on these obligations were payments “for or on account of’ antecedent debts.

The debtor also incurred the obligation to pay interest at the time it executed each note or otherwise incurred each obligation, notwithstanding the fact that the precise amount of the interest may then have been contingent until the due date of each interest payment.

CHG International, Inc. v. Barclays Bank (In re CHG International, Inc.),

897 F.2d 1479, 1486 (9th Cir.1990). The payment of interest was on account of, tied, and related to each of the underlying obligations that were plainly antecedent debts. This conclusion is consistent with Florida state law.

See Parker v. Brinson Construction Co.,

78 So.2d 873, 874 (Fla.1955) [interest is “generally considered to be a part of the principal debt itself’ because it is compensation paid by a borrower to a lender for the use of money].

108

Accordingly, all interest payments made during the 90 days before the filing of this bankruptcy case were payments made “for or on account of’ antecedent debts within the meaning of Section 547(b)(2).

e. Was

the debtor insolvent at the time of the transfers?

i.

Presumption of insolvency.

Under Section 547(f) of the Bankruptcy Code, the court presumes the debtor to be insolvent during the 90 days prior to the date of the filing of the bankruptcy petition. This presumption is not conclusive and may be rebutted by the defendants.

Pembroke Development Corp. v. Window (In re Pembroke Development Corp.),

122 B.R. 610, 611-12 (Bankr.S.D.Fla.1991). The plaintiff retains the burden of persuasion on the issue of insolvency, however, and must demonstrate the debtor’s insolvency by a preponderance of the evidence if the creditor defendant successfully rebuts the presumption.

Id.

In this case, the defendants presented evidentiary support of the debtor’s solvency in the form of the debtor’s financial balance sheets from the period of November 1989, through February 1990. These balance sheets reflected assets that exceeded liabilities for every month during that time. In addition, the defendants presented expert testimony in the person of Morrow, who is a certified public accountant in addition to being an officer and director of the debtor and a defendant personally. Morrow testified that, in his opinion, the debtor was solvent during the period between the confirmation of Toy King I and the filing of Toy King II irrespective of whether the debtor’s inventory was valued at cost or at market value. This evidence and testimony, while ultimately not credited by the court, is sufficient to rebut the presumption of insolven

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cy and require the plaintiff to put on its proof.

ii.

Liquidation valuation test.

Section 101(32)(A) of the Bankruptcy Code defines “insolvent” when referring to a corporation such as the debtor as “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation .In most circumstances, fair valuation is “an estimate of proceeds realizable within a reasonable time frame through either collection or sale at regular market value.”

Pembroke Development,

122 B.R. at 611

(citing Hill v. Southeast Bank, N.A. (In re Continental Country Club, Inc.),

108 B.R. 327, 331 (Bankr.M.D.Fla.1989)).

In circumstances where the debtor is on its “financial deathbed” and has no hope of continuing to operate as a going concern, liquidation value may represent a fair valuation of the financial condition of the debtor.

Schwinn Plan Committee v. AFS Cycle & Co. (In re Schwinn Bicycle Co.),

192 B.R. 477, 487 (Bankr.N.D.Ill.1996);

Miller & Rhoads, Inc. Secured Creditors’ Trust v. Robert Abbey, Inc. (In re Miller & Rhoads, Inc.),

146 B.R. 950, 956-57 (Bankr.E.D.Va.1992). This standard is especially applicable in circumstances such as those presented here where the debtor is liquidated shortly after the filing of the petition because otherwise the company’s true financial condition is “fictionalized.”

Miller & Rhoads,

146 B.R. at 956 .

In

Miller & Rhoads,

the debtor, M & R, was acquired in the late 1980’s in a leveraged buyout. The debtor incurred substantial debt in connection with the acquisition. After the buyout, the parent company made unsuccessful changes in the direction and focus of the debtor. As a consequence of these changes, the debt- or was at a competitive disadvantage and performed below industry averages. Price Waterhouse issued a going concern qualification with its audit of the 1988 fiscal year end financial statements. The retail economy declined and the debtor posted operating losses for almost every month after the leveraged buyout. Ultimately, the debtor was unable to pay its debts as they matured and filed for protection under Chapter 11. A Chapter 11 liquidating plan was confirmed less than a year after the case was filed. The debtor was unable to pay all claims in full upon liquidation.

In determining insolvency, the court found that the debtor “was not financially viable ... and was not salvageable.”

Id.

at 954 . It further found that “M & R’s chances of reorganizing were nonexistent unless it received a substantial infusion of new equity capital....”

Id.

In conclusion, the court stated that the “evidence of M

&

R’s extremely precarious financial position when it filed bankruptcy ... is overwhelming and in large part uncontroverted.”

Id.

In the Toy King case, the facts are much the same. Despite repeated borrowings, the debtor could not continue as a going concern without additional equity infusions because it was unable to generate sufficient sales to allow it to pay its operating costs in addition to its debt. This was apparent to all defendants at least as early as the November 17, 1989, meeting between Morrow, Angle, and Horne. From that point in time or soon afterwards, the focus of the debtor was on liquidation.

VMI was the only suitor that exhibited serious interest in “merging” with the debtor after it was offered in the

Wall Street Journal.

VMI was known in the industry as an “undertaker” with no interest in operating its acquisitions. VMI was interested only in acquiring the debtor’s inventory and leasehold interests at a substantially discounted price. VMI ultimately purchased the assets of Toy King after the filing of Toy King II for a price of $1,050,000, an amount that was not sufficient to pay the debtor’s unsecured creditors. Indeed, the debtor was unable to make any payment to unsecured creditors.

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This case is unlike

Brown v. Shell Canada, Ltd. (In re Tennessee Chemical Co.),

148 B.R. 468, 474 (Bankr.E.D.Tenn.1992). In that case, the court used “going concern” valuation even though the debtor had not made a profit in the last three years because, notwithstanding its protracted losses, it was sold as a going concern.

Id.

The court stated that the usual assumption is that “going concern value is greater than forced sale, liquidation or salvage value. Going concern value means that value is added to the property because it can be operated as a business.”

Id.

at 475 .

In contrast, Toy King was not sold as a “going concern.” VMI had no interest in operating Toy King stores but instead wanted to use the leaseholds to sell the debtor’s inventory together with its own at “rock bottom” prices.

Using a liquidation valuation approach, the court finds that the debtor was insolvent during the entire 90 day preference period, dating from November 14, 1989, through the filing of the involuntary petition on February 12, 1990. The debtor was in a liquidation posture for much of that time and was put in that posture through the direct actions of its principals who were actively seeking to sell the debt- or.

iii.

Going concern valuation test.

Even if the court were to use a “going concern” valuation as its measure for insolvency, the court would still find the debtor to be insolvent during this period. In determining going concern value, the court must “take into account all considerations that the parties might fairly bring forward and give substantial weight in their bargaining.”

National Rural Utilities Cooperative Finance Corp. v. Wabash Valley Power Association, Inc. (In re Wabash Valley Power Association, Inc.),

111 B.R. 752, 768 (S.D.Ind.1990). The court should consider both a willing buyer and a willing seller, evaluating the “assumptions and methods used by both sides.”

Id.

at 769 .

The balance sheet test is the simplest methodology to determine insolvency using a going concern valuation approach. This test compares “the fair value of the Debtor’s assets at the time of the transaction with the Debtor’s liabilities of the same date.”

Food & Fibre Protection,

168 B.R. at 417

(citing McWilliams v. Gordon (In re Camp Rockhill, Inc.),

12 B.R. 829, 833-34 (Bankr.E.D.Pa.1981)).

In this case, the court has found that the balance sheets of the debtor were not credible evidence of the debtor’s true financial condition. The court determined that the assets were overstated, the liabilities were understated, and some liabilities of the debtor were mischaracterized as shareholder’s equity. In addition, the balance sheets reflected the forgiveness of debt as shareholder’s equity in contravention of what is now generally accepted accounting practice. The debtor’s liabilities did not include all of the borrowings of the debtor. The liabilities also did not include lease rejection damages incurred as a consequence of closing stores after confirmation, nor did they include the actual costs of opening the six stores after confirmation. The persistent and unequivocal losses of the debtor were similarly understated.

Although the record does not contain sufficient evidence to correct the balance sheets with precision, the record does permit the court to make gross adjustments as are required by the expert testimony the court has credited, as the court has done in notes 46, 82, 83, 84, and 98.

See GHK Associates v. Mayer Group, Inc.,

224 Cal.App.3d 856 , 274 Cal.Rptr. 168, 178 (1990) [court has power to infer specific values for assets and/or damages, but inferences must be drawn from substantial evidence actually presented by the parties].

109

Based on the adjusted balance

*94

sheets, the court concludes that the debtor was insolvent from at least October 29, 1989, and at all times thereafter.

This conclusion is also supported by all the facts and circumstances of the debtor as established by the evidence.

See DuVoisin v. Anderson (In re Southern Industrial Banking Corp.),

71 B.R. 351, 369 (Bankr.E.D.Tenn.1987). By late October 1989, the debtor was in a downward spiral. By this time, most of the inventory needed for Christmas had been received. That inventory was insufficient in amount, contained many stale or unpopular products, and was obtained at a cost that almost guarantied inadequate sales margins. Despite its repeated borrowings from TKA, the debtor did not have sufficient capital to purchase quality inventory at a competitive cost.

Consequently, Toy King’s sales during November and December were substantially below projections and insufficient to compensate for the persistent and systemic losses of the debtor that occurred after the confirmation of Toy King I. As the deferred deadline for payment on its inventory approached, the debtor was completely and unquestionably incapable of meeting its obligations as they came due. “The point of peril is reached when the firm’s ability to continue as a going concern — a concern that can cover its costs— is in doubt because its expected costs are greater than its expected revenues.”

In re Taxman Clothing Co.,

905 F.2d 166, 169 (7th Cir.1990). “In legal and accounting terms, this means when its liabilities exceed its assets.”

Id.

The debtor’s schedules also support the court’s finding that the debtor was insolvent throughout the 90-day period before filing. Those schedules, executed under penalty of perjury by Morrow, reflect that liabilities of the debtor in the amount of $3,669,570 exceeded assets of $3,588,406. These schedules purport to represent the debtor’s financial condition at the time of the filing of the bankruptcy petition and reflect the debtor’s financial status following the months that traditionally are the most profitable in the industry.

The assets as stated in the schedules are in the exact amount of the assets as reflected in the debtor’s January 28, 1990, balance sheet. The liabilities, however, are greater, corroborating McCarthy’s opinion that the debtor understated its liabilities.

Moreover, the schedules overstate the actual value of the assets because the inventory value on the schedules is at “cost” at an amount that is twice the value of the inventory that the court has found as a matter of fact. These schedules, adjusted for the actual value of the invent

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