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Client Alert: Bankruptcy Meets State Court: Lessons from a $4M Escrow Dispute

Explore how a $4M dispute sheds light on bankruptcy vs. state court powers. Strategic lessons for investors, companies, and counsel.

When bankruptcy courts and state courts vie for authority in complex financial disputes, the outcome can reshape recoveries for creditors, investors, and businesses. This tension was front and center in Silverman v. Rosenberg, et al.(Adv. Pro. No. 24-03734, Bankr. S.D.N.Y.), where a former Chapter 11 trustee’s bid to seize $4.4 million in escrow funds collided with a state court litigation. For private equity firms, hedge funds, and corporate leaders, this case offers insights into navigating these jurisdictional clashes and their impact on bankruptcy investments.

Lessons for Investors and Businesses

Silverman v. Rosenberg and its counterparts offer practical takeaways:

1. Evaluate State Law Disputes: Investors should assess LLC claims before buying bankruptcy assets or claims, as disputes like this may enhance LLC member’s claims, and reduce recoveries in the bankruptcy case.
2. Strengthen LLC Agreements: Clear distribution and fiduciary duty clauses bolster defenses and protect minority stakeholders.
3. Use State Courts Strategically: Proactive litigation in alternative jurisdictions and/or venues can become a powerful shield in bankruptcy cases.
4. Partner with Dual-Jurisdiction Legal Experts: Navigating state and federal courts simultaneously demands specialized expertise. Missteps can cost millions. 

Understanding Turnover Actions in Bankruptcy

Section 542(a) of the Bankruptcy Code governs turnover of property of the debtor’s bankruptcy estate. However, when ownership of property is contested, the road to recovery becomes complicated. With bankruptcy filings rising—over 40,000 cases in 2024,[1] per American Bankruptcy Institute—these conflicts are increasingly common. For investors eyeing distressed assets or claims, understanding these dynamics is critical to assessing value.

The Legal Landscape: Bankruptcy vs. State Court

Bankruptcy courts aim to consolidate asset recovery, but state courts often hold jurisdiction over property disputes, especially those involving LLCs. Under 28 U.S.C. § 1334(c), bankruptcy courts may abstain from ruling on matters arising under or arising in or related to a bankruptcy case when the claims are created by state law and a more efficient resolution is possible in state court. This is especially true for claims involving:
 

• Equitable accounting
• LLC distributions
• Fiduciary duty violations

New York Limited Liability Company Law (NY LLC Law) Sections 506 and 704 empower LLC members to seek equitable accounting for improper actions, giving state courts a pivotal role. These rules matter for private equity and hedge funds asserting claims or other interests in bankruptcy, as state law disputes can diminish recoveries before any funds are recovered or disbursed.

Case Background: A $4M Escrow Fund in Dispute

In Silverman v. Rosenberg, the former Chapter 11 trustee of Alrose Allegria LLC, sought 75% of a $4.4 million escrow fund from the 2022 sale of an Astoria property owned by Alrose Dagny LLC. The bankruptcy estate’s interest in those funds, which were being held under a New York Supreme Court order (Hart v. Rosenberg, Index No. 652740/2022), were tied to a $9.2 million bankruptcy settlement with Allen Rosenberg, who owned 75% of Dagny. One of the Defendants, the 25% owner of Alrose Dagny, alleged in state court that Rosenberg breached fiduciary duties by diverting income and taking unauthorized mortgages, denying her distributions.

The trustee's turnover action affected the Defendant’s interest in the escrow. The Defendant contended that the claims were premature due to a dispute over the funds, based on her state court claims for equitable accounting under NY LLC Law and the LLC's Operating Agreement. She sought dismissal or abstention, pointing out the advanced stage of the state court action and the necessity to resolve the state law claims first. The Defendant also stated that the dispute involves only non-debtor parties and argued that there is no bankruptcy jurisdiction, including “core” bankruptcy jurisdiction, merely because an action is initiated by a post-confirmation trustee. Furthermore, she noted that allowing these claims to proceed in bankruptcy court could lead to conflicting rulings and might undermine the state court’s authority over what are primarily state law issues.

Unlike those cases where the resolution of a state law dispute may be a prerequisite to confirm a Chapter 11 plan, or where no other assets are available to satisfy creditors’ claims, in Alrose, the plan was confirmed some time ago, and other assets were approved for sale to satisfy the trustee’s claims against Rosenberg under their $9.2 million bankruptcy settlement.

What Set This Case Apart

Here, the Defendant leveraged her advanced state court claim and provisions of New York’s LLC law to argue for abstention. The bankruptcy court recognized the validity of her state-law claims, pausing the turnover proceedings pending resolution of the bona fide dispute in state court over the escrowed funds.

This case shows that well-documented LLC agreements, timely asserting claims in state court, and timely objecting to bankruptcy court jurisdiction can prevent a trustee or liquidating trust from recovering property they may not be entitled to.
 
Conclusion: Navigating the Crossroads of Jurisdiction

As bankruptcy-state court conflicts grow, cases like Silverman v. Rosenberg underscore the need for strategic navigation. For investors, these disputes shape the value of distressed assets and claims; for businesses, they test the strength of legal defenses. To explore how Whiteford can support your bankruptcy or LLC disputes, contact our team or visit our Business Solutions, Restructuring & Financial Litigation pages.