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In re Physiotherapy Holdings, Inc.

United States District Court, D. Delaware

December 21, 2017

WATER STREET HEALTHCARE PARTNERS L.P., et al., Defendants. PAH LITIGATION TRUST, Plaintiff, Misc. No. 16-201-LPS



         Having reviewed the papers submitted in connection with Defendants' motion for leave to appeal (D.I. 1, 18) (the "Motion for Leave") the Bankruptcy Court's Memorandum Opinion and Order[1] (the "Interlocutory Order"), which granted in part and denied in part Defendants' motion to dismiss (Adv. D.I. 106)[2] the above-captioned adversary proceeding, and Plaintiffs opposition thereto (D.I. 13); and having reviewed the papers submitted in connection with Defendants' petition for certification of direct appeal to the United States Court of Appeals for the Third Circuit (D.I. 4, 18) (the "Petition") and the opposition thereto (D.I. 14); and having reviewed the notices of subsequent authority (D.I. 16, 20);

         IT IS ORDERED that the Motion for Leave and Petition (D.I. 1, 4) are DENIED for the reasons that follow:

         1. Introduction.

         Defendants seek leave to appeal the Interlocutory Order which granted in part and denied in part their motion to dismiss an adversary proceeding initiated by the PAH Litigation Trust (the "Trust" or "Trustee"), as the authorized representative of the Debtor's estate. The Trustee's complaint asserted eight fraudulent transfer claims against numerous defendants including Water Street Healthcare Partners, L.P. ("Water Street") and Wind Point Partners IV, L.P. ("Wind Point") (collectively, the "Defendants" or the "Controlling Shareholders") and certain subsequent transferees. The complaint seeks to recover $248.6 million in payments made to the Controlling Shareholders and other selling shareholders (the "Selling Shareholders") in exchange for their equity in Physiotherapy Holdings, Inc. ("Physiotherapy" or the "Debtor"). Trustee alleges that in order to finance the sale of Physiotherapy, the buyer's ("Court Square" or the "Purchaser") merger subsidiary issued $210 million in senior secured notes (the "Secured Notes"). Pursuant to the terms of the transaction, the Debtor assumed the Secured Notes and certain other liabilities. Physiotherapy issued the Secured Notes pursuant to an offering memorandum (the "OM"), which the Trustee alleges fraudulently overstated the Debtor's revenue stream and its overall firm value. According to the complaint, the Purchaser ultimately acquired an insolvent company, and the Secured Noteholders received debt instruments worth far less than their face value. The Trustee alleges that this sequence of events led to the Debtor's chapter 11 petition and seeks to claw back certain payments made to the Selling Shareholders under both state and federal fraudulent transfer law.

         2. Background.

         The Interlocutory Order sets forth the relevant background, including allegations contained in the complaint:

The Debtor is a leading provider of outpatient physical therapy services throughout the United States. Compl. ¶ 3.[3]Defendants Water Street and Wind Point are private equity funds whose portfolio companies consist of businesses in the healthcare sector. Compl. ¶2. As of 2012, the Debtor operated approximately 650 clinics in 33 different states and derived the majority of its revenue from outpatient rehabilitation services. Def.'s Br. 14.[4] In 2007, Defendant Water Street acquired Physiotherapy for roughly $150 million. Id. Shortly after the transaction closed, Water Street entered into an agreement (the "2007 Merger") to merge the Debtor with Benchmark Medical, Inc. ("Benchmark"), an "outpatient physical therapy chain that Wind Point had previously acquired." Id. Following the 2007 Merger, Water Street owned 45% of the common stock of the surviving entity while Wind Point held a 35% ownership stake. Id. Throughout the next five years, the Controlling Shareholders gradually increased their ownership to approximately 90% of the Debtor's common shares. Compl. ¶ 14, 16. The Trustee alleges that during this time, Water Street and Wind Point engaged in various forms of accounting fraud in order to overstate Physiotherapy's financial health and reap a substantial profit from the sale of their shares. Id.
The alleged fraud began as a result of the 2007 Merger as the Debtor was faced with numerous operational challenges arising from the Controlling Shareholders' efforts to integrate the accounting systems of Benchmark and Physiotherapy. Compl. ¶ 3. According to the Trustee, "[t]here were delays in implementing a new single accounting system to replace the various legacy systems; there were problems keeping up with cash collections; and there were almost no internal financial reporting controls." Id. The Complaint further alleges that the Debtor began to overstate its EBITDA, net revenue, and accounts receivable in 2010 in order to conceal these problems. Compl. ¶ 4.
By 2009, Physiotherapy's financial condition had deteriorated significantly. Compl. 136. In response, the Controlling Shareholders allegedly began to implement new strategies in order to sell [Physiotherapy] ¶ 2011 or 2012 and maximize the potential sales consideration. Compl. ¶ 37. One particular strategy was to abandon the "look back method" of revenue recognition and adopt the more controversial "rate bridge method." Compl. 139.. Physiotherapy's board was, according to the Trustee, aware of and sanctioned the use of the rate bridge method. Compl. ¶ 43. According to the Complaint, the rate bridge method estimates revenue by calculating "a 'net rate per visit' based on the prior month's net rate per visit - which was, at the time, based on an estimate - and adjusted upward or downward based on supposed increases and/or decreases to the published rates and assumptions about the amount Physiotherapy could charge per visit or per 'unit.'" Compl. ¶ 40. Unlike the look back method, the rate bridge method is not based on actual historical collections and may be subject to manipulation. Compl. ¶ 41-42. [Allegedly, ] within six months of switching to the rate bridge method, the Debtor's management became aware that [Physiotherapy's] net revenue had been overstated. Compl. ¶ 44. Nonetheless, it continued to apply this revenue recognition methodology.
The marketing process formally began in October 2011 when the Controlling Shareholders solicited bids from more than 100 potential buyers. Compl. ¶ 45. ... As participants dropped out of the auction process, Water Street and Wind Point allegedly pressured the Debtor's senior management into "manipulating] Physiotherapy's net revenue and patient visit counts so that Physiotherapy could be marketed as a company that was able to grow its net revenue per visit year over year." Compl. ¶ 47. The Complaint specifically details six forms of alleged accounting fraud that enabled the Defendants to inflate Physiotherapy's earnings. Compl. ¶¶ 48-54.
The Trustee also quotes numerous emails from the Debtor's billing and collections vendor indicating that the Debtor was instructing them to falsify its financial statements. Compl. ¶ 55. During this time, the Debtor began to develop substantial cash shortfalls as a result of these procedures. Compl. ¶¶ 61-70. The Complaint alleges that this growing discrepancy between revenue and cash collections was a result of Physiotherapy's switch to the rate bridge method. Compl. ¶ 72.
According to the Trustee, the Board of Directors was aware that the Debtor's use of the rate bridge method had led to inflated revenue. Compl. ¶¶ 59-61. Additionally, the Board was presented with tangible evidence that Physiotherapy was experiencing significant cash collection shortfalls. Compl. ¶¶ 61-63. ... The Trustee further alleges that various third parties presented the Board with tangible evidence that Physiotherapy had been overstating its revenue. Compl. ¶ 74.
Throughout this time, the Debtor had been engaged in an extensive marketing process. Court Square, a private equity firm, emerged as the winning bidder with a cash offer of $510 million. Def.'s Br. 20. The deal was structured as a reverse-triangular merger, and Court Square created a subsidiary to merge into Physiotherapy with Physiotherapy as the surviving entity. The subsidiary financed the transaction by issuing: "(i) a $ 100 million term loan (the "Term Loan"), which was part of a larger credit facility; (ii) $210 million in Secured Notes underwritten by Jefferies and RBC (the "Secured Notes"); (iii) a management equity rollover; and (iv) a minority investment by a third-party." Def.'s Br. 23. According to the Trustee, these Secured Notes were marketed with an OM that falsely represented Physiotherapy's pretax net income and unadjusted EBITDA. Compl. ¶ 82. The least 936% and unadjusted EBITDA by 109% for fiscal year 2011. Compl. ¶¶ 83-84. Under the terms of the deal, the new Physiotherapy assumed this debt, and Water Street and Wind Point received $248.6 million in exchange for their shares. Compl. ¶ 88. Allegedly, the Controlling Shareholders profited handsomely from the fraud while [Physiotherapy] was left insolvent. Compl. ¶ 89. "The sum of all of the foregoing was that Physiotherapy incurred a massive amount of new debt-predicated on false fmancials-the proceeds of which were transferred out to Physiotherapy's former owners without receiving anything of value in return." Id.
Shortly after the transaction closed, [Physiotherapy's] new owner retained Deloitte to investigate a gap in accounts receivable and cash collections from the previous years. Deloitte determined that the Debtor's net income had been overstated for the years 2010 and 2012.

Physiotherapy, 2016 WL 3611831, at *2-*4.

         In December 2012, eight months after the transaction closed, Court Square and the Defendants entered into an agreement containing a general release of claims ("Release"). The agreement containing the Release resolved certain "post-closing disputes" relating to the transaction. (See D.I. 1 at 16) On April 2, 2013, Physiotherapy defaulted on the Senior Notes, and, on November 12, 2013 (the "Petition Date"), it filed for relief under chapter 11 of the Bankruptcy Code. Pursuant to the confirmed Plan, the Trust was created and authorized to pursue causes of action belonging to the estate. (See B.D.I. 197-1 at 27-28) Additionally, the Secured Noteholders assigned their individual claims to the Trustee; as a result, the Trust had standing to assert claims in the capacity of both an estate representative and an assignee. See Physiotherapy, 2016 WL 3611831, at *4.

         On September 1, 2015, the Trustee filed the eight-count complaint which asserted various claims for actual and constructive fraudulent transfer under the Bankruptcy Code and Pennsylvania law. Count I of the complaint seeks avoidance and recovery of actual fraudulent transfers to Defendants, as initial transferees, pursuant to section 548(a)(1)(A)[5] of the Bankruptcy Code. Count II similarly seeks avoidance and recovery of constructive fraudulent transfers to initial transferees pursuant to section 548(a)(1)(B)[6] of the Bankruptcy Code. Count III seeks avoidance and recovery of transfers to subsequent transferees under the foregoing sections of the Bankruptcy Code. Count IV seeks avoidance and recovery of actual fraudulent transfers from initial transferees under Pennsylvania's version of the Uniform Fraudulent Transfer Act, 12 Pa.C.S.A. § 5104(a)(1), and pursuant to section 544(b)[7] of the Bankruptcy Code. Count V similarly seeks avoidance and recovery of constructive fraudulent transfers to initial transferees pursuant to section 544(b) of the Bankruptcy Code and 12 Pa.C.S.A. §§ 5104(a)(2) and 5105. Count VI seeks avoidance and recovery of transfers to subsequent transferees under Pennsylvania law. Because the Secured Noteholders assigned their individual claims to the Trustee, Count VII is asserted by the Trustee as a direct assignee of unsecured creditors (and not as an estate representative) and asserts direct claims under Pennsylvania law, 12 Pa.C.S.A. § 5104(a)(2), for avoidance and recovery of constructive fraudulent transfers to initial transferees. Finally, Count VIII seeks avoidance and recovery of transfers made to subsequent transferees under 12 Pa.C.S.A. §§ 5104(a)(2) and 5105.

         In response to the complaint, Defendants moved to dismiss on several grounds, including: (1) all of the transfers are immune from avoidance pursuant to the Bankruptcy Code's safe harbor provision, 11 U.S.C. § 546(e), [8] which prohibits a trustee or estate representative from avoiding transactions involving the purchase and sale of securities, and, according to Defendants, prohibits creditors from pursuing recovery under state fraudulent transfer laws as well; (2) the claims against Defendants are barred by the Release; and (3) the Secured Noteholders ratified the transaction and are thus barred from seeking its avoidance. (See Adv. D.I. 107)

         On June 20, 2016, the Bankruptcy Court entered the Interlocutory Order, granting the Motion to Dismiss in part and denying it in part. See Physiotherapy, 2016 WL 3611831, at *15. The Bankruptcy Court granted the motion to dismiss with respect to Counts II, IV, and V of the complaint, determining that section 546(e)'s safe harbor prohibited the Trustee's assertion of constructive transfer claims under section 548(a)(1)(B) and actual and constructive fraudulent transfer claims brought under section 544(b). See Id. In denying the motion to dismiss with respect to the fraudulent transfer claims brought directly under state law by the Trustee in the capacity of a creditor-assignee (Count VII), the Bankruptcy Court undertook a preemption analysis and rejected Defendants' argument that section 546(e) prohibits avoidance actions by creditors brought directly under state fraudulent transfer law. See Id. at * 10-* 15. The Bankruptcy Court determined that neither the text nor the purpose of section 546(e) was implicated by the constructive fraudulent transfers at issue and declined to find that the safe harbor preempted state fraudulent transfer laws in this case. Specifically, the Bankruptcy Court held that "a litigation trustee may assert state law fraudulent transfer claims in the capacity of a creditor-assignee when: (1) the transaction sought to be avoided poses no threat of 'ripple effects' in the relevant securities markets; (2) the transferees received payment for non-public securities, and (3) the transferees were corporate insiders that allegedly acted in bad faith. When these three factors are present, a finding of implied preemption is inappropriate." Id. at *10. The Bankruptcy Court also determined that a finding of estoppel by ratification was inappropriate at this juncture and declined to dismiss the complaint on this basis. See Id. at *12. The Bankruptcy Court further rejected Defendants' contention that the Trust's actual fraudulent transfer claim under section 548(A)(1)(a)[9] was barred by the Release executed by Physiotherapy before it filed its Chapter 11 petition and denied the motion to dismiss with respect to Count I. See Id. at *14. Finally, the Bankruptcy Court rejected several other arguments that Defendants do not argue warrant interlocutory review. See Id. at * 14-15.

         On July 18, 2016, Defendants filed their Motion for Leave to appeal the Interlocutory Order with respect to three issues. (D.I. 1) On August 1, 2016, Defendants also filed the Petition (D.I. 4) in this Court, despite the fact that Federal Rule of Bankruptcy Procedure 8006(b) required Defendants to file the Petition in the court where the matter was then pending, and this matter was pending in the Bankruptcy Court until August 15, 2016. (See D.I. 14 at 18) At the time of briefing on these requests, discovery was underway with respect to the Trust's two remaining claims, with document production scheduled to be completed by January 2017 and depositions scheduled to be completed in June 2017. (See D.I. 13 at 3; Adv. D.I. 284) A review of the adversary docket demonstrates that discovery is scheduled to conclude by May 22, 2018, with any case dispositive motions to be served no later than June 20, 2018. (See Adv. D.I. 676 (Second Amended Scheduling Order))[10]

         3. Applicable Standards.

         This Court has jurisdiction to hear appeals "with leave of the court, from interlocutory orders and decrees, of bankruptcy judges entered in cases and proceedings referred to the bankruptcy judges under section 157 of this title." 28 U.S.C. § 158(a)(3). Section 158(a) does not identify the standard district courts should use in deciding whether to grant such an interlocutory appeal. See Id. "Typically, however, district courts follow the standards set forth under 28 U.S.C. § 1292(b), which govern interlocutory appeals from a district court to a court of appeals." In re AE Liquidation, Inc., 451 B.R. 343, 346 (D. Del.2011).[11]

         Under the standards of section 1292(b), an interlocutory appeal is permitted only when the order at issue (1) involves a controlling question of law upon which there is (2) substantial ground for difference of opinion as to its correctness, and (3) if appealed immediately, may materially advance the ultimate termination of the litigation. See 28 U.S.C. § 1292(b); Katz v. Carte Blanche Corp., 496 F.2d 747, 754 (3d Cir. 1974). Entertaining review of an interlocutory order under § 1292(b) is appropriate only when the party seeking leave to appeal "establishes exceptional circumstances [to] justify a departure from the basic policy of postponing review until after the entry of final judgment." In re Del. and Hudson Ry. Co., 96 B.R. 469, 472-73 (D. Del. 1989), aff'd, 884 F.2d 1383 (3d Cir. 1989). In part, this stems from the fact that "[p]iecemeal litigation is generally disfavored by the Third Circuit." In re SemCrude, L.P., 2010 WL 4537921, at *2 (D. Del. Oct. 26, 2010) (citing In re White Beauty View, Inc., 841 F.2d 524, 526 (3d Cir. 1988)). Further, leave for interlocutory appeal may be denied for "entirely unrelated reasons such as the state of the appellate docket or the desire to have a full record before considering the disputed legal issue." Katz, 496 F.2d at 754.

         Pursuant to section 158(d)(2), certification for direct appeal to the circuit court is required if the Court, "acting on its own motion or the request of a party, " determines that:

(i) the judgment, order, or decree involves a question of law as to which there is no controlling decision of the court of appeals for the circuit or of the Supreme Court of the United States, or involves a matter of public importance;
(ii) the judgment, order, or decree involves a question of law requiring resolution of ...

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