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Jeffrey K. Garfinkle, Cal. Bar No. 153496 Joseph M. Welch, Cal. Bar No. 259308 BUCHALTER NEMER, PC 18400 Von Karman Avenue, Suite 800 Irvine, California 92612-0514 Telephone: (949) 760-1121 Facsimile: (949) 720-0182 Email: jgarfinkle@buchalter.com jwelch@buchalter.com Proposed Counsel to the Official Committee of Unsecured Creditors UNITED STATES BANKRUPTCY COURT CENTRAL DISTRICT OF CALIFORNIA SANTA ANA DIVISION In re: WESTCLIFF MEDICAL LABORATORIES, INC., Debtor. Lead Case No.: 8:10-bk-16743-TA Jointly Administered with Case No. 8:10-bk-16746-TA OBJECTION TO DEBTORS EMERGENCY MOTION TO APPROVE STIPULATION AND SETTLEMENT AGREEMENT AMENDING APRIL 30, 2010 LETTER AGREEMENT BETWEEN SPECIALTY LABORATORIES, INC. AND WESTCLIFF MEDICAL LABORATORIES, INC. Date: June 3, 2010 Time: 2:00 p.m. Place: Courtroom 5B 411 West Fourth Street Santa Ana, CA 92701

BIOLABS, INC., 17 18 19 20 21 22 23 24 25 26 27 28
B UCHALTER N EMER
A PROFESSIONAL CORPORATION

Debtor.

Affects Both Debtors Affects WESTCLIFF MEDICAL LABORATORIES, INC. only Affects BIOLABS, INC. only

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The Official Committee of Unsecured Creditors (Committee), by and through its proposed counsel, hereby objects to Debtors Emergency Motion to Approve Stipulation and Settlement Agreement Amending April 30, 2010 Letter Agreement between Specialty Laboratories, Inc. (Specialty Labs) and Westcliff Medical Laboratories, Inc. (together with Biolabs, Inc., the Debtors), filed on May 25, 2010 [Docket No. 46] (Motion), as follows:

I.

INTRODUCTION The proposed Stipulation and Settlement Agreement between Specialty Labs and the

Debtors (Settlement) is the end product of extortionary efforts by one of the Debtors key vendors during the earliest stages of these cases. Threatening the Debtors with draconian price increases and the removal of Specialty Labs on-site employees, which in turn would have jeopardized the Debtors pending sale, Specialty Labs was able to force the Debtors to agree to the following: (1) granting Specialty Labs administrative expense priority based on arbitrary list prices; (2) relinquishing substantial preference exposure (which may comprise a large portion of Debtors unencumbered assets); (3) assuming a one page letter agreement, that effectively extended by 45 days, from May 1, 2010 through June 14, 2010, the Laboratory Services Agreement dated March 19, 2009. Under this purported assumption, the Debtors are forced to pay Specialty Labs a $150,000 cure payment, with Specialty Labs retaining its $1.3 million unsecured claim under that same contract. This entire settlement is a transparent effort by one unsecured creditor to give itself preferred treatment in these cases. That is highly improper and should not be countenanced by this Court. As discussed in detail below, the Settlement must be denied for many reasons, including: (1) the Settlement is not entitled to the discretion typically afforded motions to compromise on fully developed facts; (2) Specialty Labs arbitrary list prices are unenforceable and do not give rise to a valid administrative expense claim; and (3) pursuant to 11 U.S.C. 503(c)(3), the BN 6313036v1 1
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expenses owed to Specialty Labs by the Settlement shall neither be allowed, nor paid - [as] outside the ordinary course of business and not justified by the facts and circumstances of the case.

II.

FACTUAL SUMMARY

A.

Debtors Active Sales Efforts

According to Debtors Motion, the Debtors have been engaged in an active sale process since early 2009. (Motion at p. 10, lines 23-24). After months of negotiations and substantial due diligence, the Debtors entered into an Asset Purchase Agreement (APA) to sell substantially all of the Debtors assets to a wholly owned subsidiary of Laboratory Corporation of America (Purchaser) for a purchase price of $57.5 million, subject to certain adjustments and overbid. (Motion at p. 11). It is important to note that Specialty Labs and its parent corporation, Quest Laboratories (Quest), were fully aware of the Debtors efforts to sell itself, and the likelihood that such a sale would be through a bankruptcy process and to a competitor of Specialty Labs and Quest. In fact, the April 30, 2010 Letter provides that upon any announcement of a sale to a competitor, Specialty Labs could, at its sole discretion, increase pricing to list price. Pursuant to Section 3.1 of the APA, the purchase price being paid by the Purchaser will be adjusted downward if there is a meaningful reduction in the Debtors post-petition business volume pending the closing of the sale. Moreover, should that reduction reach the level of a Material Adverse Change, Purchaser has the ability [to] walk away from this transaction completely. (Motion at pp. 11-12). Debtors characterize the risks to their estates of failing to promptly close the sale as severe and express no doubt that if they fail to consummate the sale to Purchaser, the Debtors will either be forced to sell their business for substantially less money than Purchaser has offered, or worse, shut down their business and liquidate. (Motion at p. 12).

B.

Specialty Labs Pre-Petition Agreements with the Debtors

Beginning May 1, 2007, the Debtors and Specialty Labs operated according to an initial laboratory services agreement wherein Specialty Labs agreed, among other things, to provide BN 6313036v1 2
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(1) laboratory testing services to the Debtors, and (2) third-party billing services to some of the Debtors clients, by which Specialty Labs would invoice insurance companies and third-party payors and collect from such parties for [the Debtors]. (Motion at p. 2). The initial agreement was ultimately evidenced by a three page Laboratory Services Agreement dated March 19, 2009, with a May 1, 2007 effective date. (Motion, Exhibit 2). The initial term of that agreement was three years While the Laboratory Services Agreement provides for a one year renewal option, it is unclear from the Motion whether the Debtors exercised that option. Instead, on April 30, 2010, the Debtors and Specialty Labs entered into a letter agreement dated April 30, 2010 (Letter Agreement), which effectively extended the March 19, 2009 Laboratory Services Agreement by another 45 days. Although the Letter Agreement allowed Specialty Labs to increase its fees to a list price, it did not specify or explain this amount. (Motion at p. 14). On May 19, 2010, the same day as the Debtors filed bankruptcy and following announcement of the intended sale to Specialty Labs/Quests competitor, Specialty Labs advised the Debtors that Specialty [Labs] was exercising its right to increase its pricing to list price and began removing its employees from the Debtors locations. (Motion at pp. 14-15). Specialty Labs is described as a critical reference laboratory for [the Debtors]. (Motion at p. 12). In fact, [i]f [the Debtors] cannot send out testing to Specialty [Labs] so that [the Debtors] can provide ongoing quality services to its customers, [the Debtors have] no doubt that [they] would immediately start to lose customers. (Motion at pp. 12-13). This, in turn, could jeopardize the Debtors sale and force liquidation.

C.

Specialty Labs Post-Petition Extortionary Tactics

Debtors filed voluntary chapter 11 bankruptcy petitions on May 19, 2010 (Petition Date). Notwithstanding Debtors bankruptcies, Specialty Labs threatened, and in fact began, to remove all outside employees at Debtors locations and jeopardize Debtors extremely timesensitive sale and the volume based sales price. Because of these tactics, within the first days of these cases, Debtors were forced to capitulate to Specialty Labs and its outrageous demands.
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Settlement, by Friday, May 28, 2010; (2) pay a $175,000 cure amount to Specialty Labs within two (2) business days thereafter, (3) utilize a minimum of $125,000 in weekly services from Specialty Labs and pay for those services on a weekly basis, and (4) release all avoidance actions they may have against Specialty Labs under Chapter 5 of the Bankruptcy Code. (Motion at p. 4). In exchange, Specialty Labs simply agreed to (a) continue to provide nearly all services under the Letter Agreement to the Debtors through the earlier of the closing of the sale or the end of the term (June 14, 2010) and (2) limit its increase in billing rates to three times the rates provided for under the Agreement. (Motion at pp. 4-5). The Debtors have determined payments to Specialty Labs during the 90 day preference period total $1,138,075 with a potential claim against Specialty Labs to avoid and recover, at most, approximately $529,000. (Motion at p. 16). Furthermore, the APA lists Specialty Labs contract as one that may be assumed by the Purchaser within 180 days after the sale. (See APA at Schedule 2.4(a)-2). Although the Debtors (a) admit the potential claims only recently came to [their] attention and (b) [they do] not have a firm belief at this time as to which party would prevail in litigation concerning the issues related to performance under the Letter Agreement, the Debtors propose the Settlement as reasonable, fair and equitable. (Motion at pp. 20-21). While the Committee appreciates the Debtors difficult position, caused entirely by Specialty Labs outrageous tactics, the Committee is duty bound to oppose this settlement. As the Courts tentative ruling on the Motion aptly notes, Specialty Labs potential preference liability may be one of the few unencumbered assets in this case, and so, effectively, the unsecureds [may be] paying for this settlement. The Committee joins the Court in questioning [w]hat is in this [Settlement] for the unsecureds? The Committee does not see the need to deal with Specialty Labs on any special terms and is willing to litigate Specialty Labs putative claims based upon unenforceable post-petition price increases. For the reasons discussed in greater detail below, the Motion must be denied.

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III.

LEGAL ANALYSIS

A.

The Settlement Is Not Entitled To Discretion Based On The Facts Presented

The Committee notes the Debtors bring the Motion on extremely limited notice. Further, Debtors schedules and statement of financial affairs have not yet been filed and there is scant evidence before the Court as to whether the Settlement is reasonable or proper. As the Courts tentative ruling suggests, the costs of Settlement may ultimately be born by unsecured creditors who are left questioning what the Settlement does for them and whether this Settlement is truly in the best interests of the Debtors estates. Although the Settlement is premised on saving an estimated $1.6 million in billings between the Petition Date and June 14, 2010, the Committee strongly doubts Specialty Labs is entitled to this otherwise factually and legally unsubstantiated claim. If anything, as discussed below, Specialty Labs may only claim an administrative expense claim for the reasonable value of its services to the Debtors as supported by the facts and circumstances of the case. Furthermore, the Debtors business judgment is undermined by the APA, which suggests Specialty Labs agreement (giving rise to a very substantial administrative expense claim in the Debtors estate) may have no prospective value beyond the sale.

B.

Specialty Labs Is Limited to the Reasonable Value of Services, Not Arbitrary List Prices

Section 503(b)(1) allows an administrative expense claim for the actual, necessary costs and expenses for preserving the estate. Section 503(b) priorities are narrowly construed to maximize the value of the estate for all creditors. See In re Colortex Indust., Inc. 19 F.3d 1371, 1377 (11th Cir. 1994); In re Hemingway Transport, Inc., 954 F.2d 1 (1st Cir. 1992). An administrative claim is limited to the reasonable value of that performance and not necessarily the price specified in the contract. See, e.g. In re Dant & Russell, Inc., 853 F.2d 700, 707 (9th Cir. 1988) (administrative claim cannot exceed the reasonable rental value); Mason v. Official Comm. Of Unsecured Creditors (In re FBI Distrib. Corp.), 330 F.3d, 36, 42-43 (1st Cir. 2003); NLRB v. Bildisco & Bildisco, 465 U.S. 513, 531-532 (1984). Further, a bankruptcy court may consider the fair market value of the goods leased under a contract to determine the
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amount owed. (See In re Pilgrims Pride Corp., 431 B.R. 231 (Bankr. N.D. Tex. 2009), citing In re ICS Cybernetics, Inc., 111 B.R. 32, 41 (Bankr. N.D.N.Y 1989).) Specialty Labs claim for an administrative expense claim of at least three times what it charged just three weeks ago is dubious at best. Likewise, increasing the Debtors weekly charge from $87,000 (a portion of which includes payment on the amounts previously owed to Specialty Labs) to $125,000a 43% increaseis equally objectionable.1 Section 503(b) priorities, which benefit all creditors, undermine Specialty Labs extortionary efforts against the bankruptcy estate. Specialty Labs is not entitled to an administrative expense claim in the Debtors estate based on its unilateral and arbitrary list price as there is simply no evidence suggesting the list price represents the fair value of Specialty Labs services. Although some of Specialty Labs claims may be entitled to administrative expense priority based on the reasonable or fair market value of Specialty Labs services (for which Specialty Labs currently is receiving weekly payments of $125,000), the Settlement before the Court is simply too premature to be approved.2

C.

The Settlement Agreement Violates Section 503(c)(3)s Limits On Administrative Expense Claims

Section 503(c) provides, there shall neither be allowed, nor paid (3) other transfers or obligations that are outside of the ordinary course of business and not justified by the facts and 18 circumstances of the case, including transfers made to, or obligations incurred for the benefit of, 19 officers, managers, or consultants hired after the date of the filing of the petition. Collier 20 explains, 21 22 23 24 25 26 27 28
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the reference in section 503(c)(3) to officers, managers, or consultants hired after the date of the petition is largely surplusage. The rules of construction in section 103(c) indicate that the term including is not a limitation. Accordingly, section 503(c)(3) is not
These kind of post-petition unilateral pricing increases by a pre-petition credit may violate the automatic stay. Following this hearing, the Committee intends to explore this issue in more depth. The Committee has not yet done a full accounting and, as such, the Debtors may have disgorgement claims against Specialty Labs for the weekly payments of $125,000, or a portion thereof. The Committee notes that prior to the Petition Date, under the Letter Agreement, the Debtors were paying Specialty Labs $87,500 per week to reimburse Specialty [Labs] past due and current amounts for Laboratory Testing Services performed . . . both prior to and after the Effective Date of the Letter Agreement.
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limited to such persons and is a general restriction on postpetition transactions. Collier on Bankruptcy, 16 ed. rev. at 503.17[4]; emphasis added. Here, the Settlement is both (a) outside the ordinary course of business for the Debtors and (b) is not justified by the facts and circumstances of the case. As a result, the restrictions on allowance of administrative claims apply. Although many of the foregoing issues regarding the Letter Agreement, administrative expense priority and avoidance action will likely be decided at a later point, the Committee highlights these provisions to show that Settlement is not procedurally proper, factually warranted or substantively reasonable. The Committee is prepared to participate in a full evidentiary hearing, adequately noticed to all parties, whereby Specialty Labs aggressive and hurried post-petition tactics, demands and fees are carefully scrutinized by the Committee and the Court alike. At such an evidentiary hearing, the Court will have a full opportunity to review Specialty Labs pricing structures in an open forum and determine whether the post-petition charges which it now seeks to impose upon the Debtors and their estates are entitled to administrative priority.

IV.

CONCLUSION Based on the foregoing, the Committee respectfully requests the Motion be denied in all

respects and for such other and further relief and the Court deems just and proper.

Dated: June 3, 2010

BUCHALTER NEMER

By: /s/ Jeffrey K. Garfinkle Jeffrey K. Garfinkle Proposed Counsel to Official Committee of Unsecured Creditors

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