UNITED STATES BANKRUPTCY COURTSOUTHERN DISTRICT OF NEW YORK

Hearing Date: Expedited Hearing Requested

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In re : :

SPONGETECH DELIVERY SYSTEMS, INC., ::

Debtor. ::

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Chapter 11

Case No. 10-13647(SMB)

MOTION OF THE UNITED STATES TRUSTEE FOR ORDER DIRECTING THEAPPOINTMENT OF A CHAPTER 11 TRUSTEE OR, IN THE ALTERNATIVE,CONVERTING THE CASE TO CHAPTER 7 OF THE BANKRUPTCY CODE

TO THE HONORABLE STUART M. BERNSTEIN,UNITED STATES BANKRUPTCY JUDGE:

Tracy Hope Davis, the Acting United States Trustee for Region 2 (the “United States

Trustee”), hereby respectfully files this Motion for an Order Directing the Appointment of a Chapter

11 Trustee or, in the Alternative, Converting the Case to Chapter 7 (the “Trustee Motion”). In

support of her motion and this memorandum, the United States Trustee respectfully alleges as

follows:

PRELIMINARY STATEMENT

There are numerous reasons why the appointment of a trustee is required under the standards

set forth in section 1104(a) (1) and (2) of the Bankruptcy Code. Not only is there cause—including

compelling evidence of fraud, dishonesty, and gross mismanagement of the affairs of Spongetech

Delivery Systems, Inc. (the "Debtor") by current management, but appointment of a Chapter 11

trustee is in the interests of creditors, equity security holders, and other interests of this estate. The

cause here includes, among others:

(1) allegations of securities fraud and obstruction of justice, resulting in the recent arrestof current management and a civil enforcement action by the Securities and ExchangeCommission (the “SEC”);

(2) allegations raised at a hearing before the Bankruptcy Court in the Southern District ofGeorgia regarding a very recent diversion of at least $700,000 in cash for the personalbenefit of the Debtor’s current management from the Debtor’s wholly-ownedsubsidiary, Dicon (which is itself in Chapter 11 in Georgia with an appointed trustee);and

(3) the apparent forgery of an attorney’s signature on the Debtor’s bankruptcy petition bysomeone affiliated with current management.

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Specifically, in May 2010, the United States of America filed a criminal complaint in the

United States District Court for the Eastern District of New York charging the Debtor's Chief

Operating Officer (who is also the Debtor's Chief Financial Officer, and Chief Accounting Officer)

and President (who is also the Chief Executive Officer) with conspiracy to commit securities fraud

and obstruction of justice. On the same date, the SEC filed a complaint, also in the United States

District Court Eastern District of New York, against the Debtor, these two officers of the Debtor,

and several others (collectively referred to as the "Defendants"). That complaint contains very

specific and serious allegations based on the SEC's finding that the Defendants were involved in a

massive "pump and dump" scheme dating back to 2007. According to the SEC, as part of this

scheme, the Defendants allegedly deceived the Debtor's investors through false statements about

“non-existent Spongetech customers, bogus sales orders, and phony revenue.” Defendants then

“dumped” the fraudulently inflated shares by “illegally selling them to the public through affiliated

entities in unregistered transactions.” One of the Defendants, Metter, has allegedly resigned his

position as an officer of the Debtor, but current management remains largely intact. Although the

SEC has moved for the appointment of a receiver with the support of some equity holders, its motion

has not been granted as of this date, and the suspect management remains in control of the debtor-in-

possession.

The misconduct did not conclude with the arrests. Rather, the Debtor’s Petition apparently

bears the forged signature of purported counsel to the Debtor. Soon after the Petition was filed, the

attorney whose name and address appears on the Petition wrote the Court that he did not represent

the Debtor and did not sign the Petition. These acts by the Debtor are further evidence that current

management cannot be relied upon by creditors to fulfill the fiduciary responsibilities of a debtor-in-

possession and that the immediate appointment of a Chapter 11 trustee is needed.

Not only is there substantial cause here, but the appointment of a trustee would also be in the

interests of creditors and equity holders of this estate. Given the pending criminal action by the

United States and the civil action by the SEC, coupled with a pending class action lawsuit against

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the Debtor and current and former officers alleging violations of federal securities laws, current

management has lost the confidence of its investors and creditors. Indeed, it is difficult to imagine

how the Debtor will be able to operate with its current management being the subject of criminal and

civil fraud actions. Certainly, for investors and creditors seeking transparency and financial

accountability of this Debtor, it is in the interests of creditors and seemingly defrauded equity

holders for an independent fiduciary to be appointed as soon as possible. For these reasons, the

United States Trustee urges the Court to grant the instant motion and to direct the United States

Trustee to appoint a chapter 11 trustee in accordance with sections 1104(a). In the alternative, if the

Court declines to do so, this case should be converted to a chapter 7 case or dismissed..

FACTS

A. General Background on Debtor and Filing of Bankruptcy Proceeding

1. On July 9, 2010 (the “Petition Date”), the Debtor filed a voluntary petition (the

“Petition”) for relief under Chapter 11 of the Bankruptcy Code. See Declaration of Elisabetta

Gasparini in Support of Motion for an Order Directing the Appointment of a Chapter 11 Trustee or,

in the Alternative, Conversion of the Case to Chapter 7 (the “Gasparini Declaration”) at Exs. 1 and

2. To date, the Debtor has continued to operate its business and manage its property as a debtor-in-

possession in accordance with sections 1107 and 1108 of the Bankruptcy Code.

2. The Debtor, a Delaware publicly-held corporation, manufactures, markets, and

distributes cleaning products, including car sponges, pet sponges, bowl cleaners, and child bath

sponges with licensed characters such as SpongeBob, Pink Panther, and Dora the Explorer. See

Gasparini Declaration at Ex. 7 at p. 2 (Defendant Spongetech Delivery Systems, Inc.’s Opposition to

Plaintiff Securities and Exchange Commission’s Motion for Preliminary Injunction, Asset Freeze,

and Other Relief filed in Civil Action No. 10-CV-2031 in United States District Court Eastern

District of New York) (“Opposition to Motion for Preliminary Injunction and Asset Freeze”); see

1 The Debtor is delinquent in its SEC filings. While it is required to file quarterlyand annual reports, it has not filed any such reports since April 20, 2009. Form 10-K was theDebtor’s last 10-K form filed with the SEC.

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also Debtor Form 10-KSB for fiscal year ended May 31, 2008 dated August 29, 2008) (“Form 10-

K”).1

3. RM Enterprises International, Inc. (“RM Enterprises”) is the majority shareholder of

the Debtor. See Form 10-K at p. 22; see also Gasparini Declaration at Ex. 5, ¶ 18 (Complaint

captioned Securities and Exchange Commission v. Spongetech Delivery Systems, et al., CV 10-2031

(E.D.N.Y.)) (the “SEC Complaint”). RM Enterprises is controlled by Michael E. Metter (“Metter”)

and Steven Y. Moskowitz (“Moskowitz”), who are also the sole officers of the company. See SEC

Complaint at ¶18.

4. Moskowitz is also the Debtor’s Chief Operating Officer, Chief Financial Officer,

Chief Accounting Officer, and Secretary and serves as a member of the Debtor’s Board of Directors.

See SEC Complaint at ¶ 19.

5. Metter was the Debtor’s President and Chief Executive Officer until June 8, 2010,

when he resigned. See Gasparini Decl. at Ex. 9 at p. 2 (Plaintiff Securities and Exchange

Commission’s Memorandum of Law in Support of Motion to Appoint a Receiver filed in Civil

Action No. 10-CV-2031 in United States District Court Eastern District of New York) (“Receiver

Motion”); see also Gasparini Decl. at Ex. 8, ¶4 (Declaration of Jesse Z. Weiss in Opposition to

Motion for Preliminary Injunction and Asset Freeze).

6. The Debtor is also the sole member of Dicon Technologies, LLC (“Dicon”), which

manufactures and sells products such as eye make-up applicators, foundation wedges, powder puffs,

and footwear insoles. See Opposition to Motion for Preliminary Injunction and Asset Freeze at p. 2.

The Debtor purchased Dicon on or about July 9, 2009. See Gasparini Declaration at Ex. 15, ¶6

(Emergency Motion of Petitioning Creditors for Order Appointing Chapter 11 Trustee filed in

bankruptcy case of In re Dicon Technologies, LLC, Case No. 10-41274(LWD) (S.D.Ga.)) (“Dicon

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Motion for Appointment of Trustee”). As set forth below, Dicon is the Debtor in a Chapter 11

bankruptcy proceeding in the Southern District of Georgia.

7. On October 5, 2009, the SEC temporarily suspended trading on the Debtor’s shares

after questions arose regarding the accuracy of assertions in press releases to investors and in

periodic reports filed with the SEC concerning, among other things: (1) the amount of sales and

customer orders the Debtor received; (2) the Debtor’s investment agreements; and (3) the Debtor’s

revenues as reported in its financial statements. See Gasparini Declaration at Ex. 6 at p. 14 (SEC’s

Memorandum of Law in Support of Motion for Preliminary Injunction, Asset Freeze, and Other

Relief filed in Civil Action No. 10-CV-2031 in United States District Court Eastern District of New

York) (“Motion for Preliminary Injunction and Asset Freeze”).

8. On October 9, 2009, a class action lawsuit captioned Quang Le, Individually and on

Behalf of All Others Similarly Situated v. Spongetech Delivery Systems, Inc., et al., Civil Case No.

09-8616 was filed (the “Class Action”). See Gasparini Declaration at Ex. 23. The Class Action,

which names as defendants the Debtor, Metter, and Moskowitz as defendants, among others, seeks

to recover damages caused by the defendants’ violations of the federal securities laws. Id.

9. On the Petition Date, the Debtor filed a bare-bones petition for Chapter 11

bankruptcy relief (the “Petition”). See Gasparini Declaration at Ex. 2. The Petition was not

accompanied by (a) the Debtor’s affidavit pursuant to Local Bankruptcy Rule 1007-2, (b) a mailing

matrix and a list of creditors holding the 20 largest unsecured claims, (c) a corporate ownership

statement, (d) the corporate resolutions reflecting the Debtor’s board of directors’ consent to the

bankruptcy filing, or (e) an application to retain bankruptcy counsel. See id. at Ex.2.

10. The Petition was signed by Ira Minkoff (“Minkoff”), under the title of Vice President,

and also bore what appeared to be the signature of Edward Neiger, Esq. (“Neiger”), identified as the

Debtor’s attorney. Id. at Ex.1.

11. Immediately after the Petition was filed, Neiger filed a letter with the Court indicating

that neither he nor his firm represents the Debtor in this case and that, while the firm had been

2 Neiger was listed as “of counsel” in the Debtor’s Emergency Motion for (I)Reconsideration of the Order Appointing A Chapter 11 Trustee and Scheduling a HearingThereon and (II) An Immediate Stay of the Order Appointing A Chapter 11 Trustee and Requestfor Expedited Hearing filed in the bankruptcy case of In re Dicon Technologies, LLC, Case No.10-41274(LWD) (S.D.Ga.). See infra at ¶26.

3 The three other defendants are George Speranza, a self-employed consultantassociated with the Debtor who operated the internet stock hype site “nohypenobull.com”; JoelPensley, an attorney licensed to practice in New York, who was the Debtor’s corporate counselfrom 1999 to approximately 2005; and Jack Halperin, an attorney also licensed to practice law inNew York, who was retained by the Debtor from approximately June 12, 2009 throughSeptember 29, 2009 to perform corporate services for the Debtor. Pensley and Halperinprovided opinion letters relating to transactions involving the Debtor’s shares. See SECComplaint.

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engaged to provide bankruptcy and restructuring advise to the Debtor,2 it has not agreed to represent

the Debtor. See Gasparini Declaration at Ex. 3. Neiger also indicated that he did not sign the

Petition. Id.

12. On July 15, 2010, the Debtor filed an application seeking authority to pay the firm of

Kera & Graubard a post-petition retainer in the amount of $50,000 in order to retain their services as

bankruptcy counsel in this case (the “Retention Application”). See ECF Doc. 4. The Retention

Application is signed by Moskowitz in his capacity as the Debtor’s Chief Financial Officer. Id. at

¶1. In the Retention Application, Moskowitz states that while Neiger was retained on or about June

18, 2010, with respect to the Debtor’s bankruptcy filing, differences arose between the Debtor and

Neiger. Id. at ¶7. As a result of this disagreement, Neiger concluded that it could not file the

Petition on behalf of the Debtor. Id.

B. SEC Complaint

13. On May 5, 2010, the SEC filed the SEC Complaint against the Debtor, RM

Enterprises, Moskowitz, Metter, and three other Defendants.3 See Gasparini Declaration at Ex. 5.

The SEC Complaint charges the Defendants with, among other things, fraud in violation of Section

17(a) of the Securities Act of 1933 and Section 10(b) and Rule 10b-5 of the Securities Exchange Act

of 1934, and with violations of Section 5 of the Securities Act, as well as other violations. See SEC

Complaint at pp. 42-45. In addition, the SEC Complaint seeks civil penalties under Section 20(d) of

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the Securities Act and Section 21(d)(3) of the Exchange Act and the disgorgement from the Debtors

of any ill-gotten gains. Id.

14. The SEC Complaint alleges that the Defendants perpetrated an elaborate scheme in

which the Defendants artificially “pumped” the value of the Debtor’s shares by illegally increasing

demand for, and thus the price of the Debtor’s stock, and then “dumped” the shares into the public

market in unregistered transactions. Id.

15. Among other things, the SEC Complaint avers that the Debtor, Metter, and

Moskowitz made fraudulent statements to mislead investors into believing that the Debtor was a

thriving company with extensive demand for its products. See SEC Complaint at ¶30. For

example, the Complaint states that the Defendants repeatedly and fraudulently exaggerated the

demand for pre-soaped sponges by announcing in press releases and public filings that the Debtor

had received tens of millions of dollars in orders for the Debtor’s products from customers that did

not even exist. See id. at ¶3; see also Gasparini Declaration at Ex. 24 (New York Post article by

Kaja Whitehouse dated September 25, 2009, “SpongeTech client records spring leak”).

16. Moreover, the SEC Complaint further alleges that the Defendants used false and

baseless attorney opinion letters rendered by Pensely and Halperin to distribute shares of Spongetech

to the public. See SEC Complaint at ¶7.

17. On May 14, 2010, the SEC filed the Motion for Preliminary Injunction and Asset

Freeze requesting that, as a result of the allegations in the SEC Complaint, in particular, with respect

to the alleged fraudulent scheme that the Defendants perpetrated, the Court preliminarily enjoin the

Defendants from violating the federal securities law. See Gasparini Declaration at Ex. 6. The

Motion for Preliminary Injunction and Asset Freeze also sought to freeze the assets of the Debtor,

RM Enterprises, Metter, and Moskowitz. Id.

18. On June 16, 2010, the Debtor filed the Opposition to Motion for Preliminary

Injunction and Asset Freeze. See Gasparini Declaration at Ex. 7.

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19. On June 18, 2010, the SEC filed the Receiver Motion, seeking the appointment of a

receiver of the Debtor and its affiliated entities. See Gasparini Declaration at Ex. 9. More

specifically, the SEC requested that the Court select and appoint an appropriate receiver or, in the

alternative, appoint S. Gregory Hays, Managing Principal of Hays Financial Consulting Inc., as the

receiver. See Receiver Motion at p.5. The Receiver Motion is still pending before the District Court

for the Eastern District of New York. See Gasparini Declaration at Ex. 4 (Docket for action

captioned Securities and Exchange Commission v. Spongetech Delivery Systems, et al., CV 10-2031

(E.D.N.Y.)).

C. Criminal Charges Against Moskowitz and Metter

20. On May 5, 2010, the same date that the SEC Complaint was filed, the United States

Attorney’s Office for the Eastern District of New York filed a criminal complaint (the “Criminal

Complaint”) against Metter and Moskowitz, charging them with conspiracy to commit securities

fraud and obstruction of justice. See Gasparini Declaration at Ex. 11 (Complaint and Affidavit in

Support of Affidavit of Arrest Warrants); see also id. at Ex. 12 (Press Release by United States

Attorney’s Office for the Eastern District of New York dated May 5, 2010).

21. Metter and Moskowitz were arrested on May 5, 2010 and were subsequently released

on bond. See Motion for Appointment of Trustee at ¶18. As set forth above, see infra at ¶5, Metter

resigned as the Debtor’s CEO on or about June 8, 2010. As set forth in the Opposition to the Motion

for Preliminary Injunction and Asset Freeze, the Debtor stated that Moskowitz intends to resign as

soon as an interim CEO is on board. See Opposition to the Motion for Preliminary Injunction at p.

4, fn.3. Upon information and belief, however, no such interim CEO was ever appointed to replace

Moskowitz and to manage the Debtor’s business. See infra at ¶30.

D. The Dicon Bankruptcy Proceeding

22. On June 17, 2010, an involuntary Chapter 11 bankruptcy petition was filed by three

creditors on behalf of Dicon in the Bankruptcy Court for the Southern District of Georgia (the

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“Dicon Bankruptcy Proceeding”). See Gasparini Declaration at Exs. 13 and 14. The Dicon

Bankruptcy Proceeding is captioned In re Dicon Technologies, LLC, Case No. 10-41275(LWD)

(Bankr. S.D. Ga.).

23. On June 18, 2010, the three petitioning creditors filed the Dicon Motion for

Appointment of Trustee. Id. at Ex. 15. In the Dicon Motion for Appointment of Trustee, the

petitioning creditors argued, among other things, that as soon as Spongetech’s alleged fraud was

discovered, the same principles, Metter and Moskowitz, reacted by siphoning hundreds of dollars in

cash from Dicon. These actions made it impossible for Dicon to meet its obligations to its creditors

and jeopardize Dicon’s ability to continue to operate and retain its customers. Id. at p. 2. The Dicon

Motion for Appointment of Trustee also alleged that over a period of several months in 2010,

commencing before and continuing after issuance of the civil and criminal charges, Moskowitz and

the Debtor caused approximately $700,000 to be transferred from Dicon for the benefit of persons

and entities affiliated with Moskowitz and Metter to persons to whom Dicon owed no legitimate

debts.

24. At a hearing on June 24, 2010, the Court heard testimony from the Controller and

Plan Manager of Dicon about alleged siphoning of money away from Dicon by its sole member –

the Debtor. See Gasparini Declaration at Ex. 19 at ¶ 3 (Emergency Motion of the United States

Trustee to Release Stay of Order Directing the Appointment of a Chapter 11 Trustee and Request for

Expedited Hearing) (“UST Release Motion”).

25. On June 24, 2010, based upon the record at the hearing, the Court entered an order

directing the United States Trustee to appoint a Chapter 11 trustee. See Gasparini Declaration at Ex.

16 (Order Granting Motion to Appoint Trustee).

26. On June 28, 2010, Dicon and the Debtor filed an Emergency Motion for (I)

Reconsideration of the Order Appointing A Chapter 11 Trustee and Scheduling a Hearing Thereon

and (II) An Immediate Stay of the Order Appointing A Chapter 11 Trustee and Request for

Expedited Hearing (the “Motion to Reconsider”). See Gasparini Declaration at Ex. 17.

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27. On June 29, 2010, a telephonic hearing was held on the Motion to Reconsider.

Attorneys for Dicon and the Debtor indicated that the Debtor would file bankruptcy in New York

within three days and it would simultaneously file a motion to transfer the venue of the Dicon

Bankruptcy Proceeding to New York. See UST Release Motion at ¶6.

28. Dicon agreed to withdraw any opposition to the involuntary bankruptcy filed by

Dicon’s creditors and an Order for Relief was entered on June 29, 2010. See id. at ¶7.

29. On June 29, 2010, in order to consider the issues raised in the Motion to Reconsider,

the Court also entered an Order Staying the Trustee Appointment Order until further order of the

Court (the “Order Staying Order Granting Motion to Appoint Trustee”). See Gasparini Declaration

at Ex. 18.

30. As indicated in the UST Release Motion filed in the Dicon Bankruptcy Proceeding,

upon information and belief, the Debtor had discussions with an independent financial advisor about

becoming a restructuring officer/advisor to both the Debtor and Dicon. See UST Release Motion at

¶9. No formal agreement was signed and no retainer was paid, but the discussions reached a level

where the independent financial advisor began working towards a turnaround of Dicon. See id. at

¶10.

31. Apparently, the Debtor failed to pay the retainer of the independent financial advisor,

who subsequently withdrew his engagement proposal. See id. at ¶11.

32. On July 9, 2010, the Court entered an Order in the Dicon bankruptcy proceeding

vacating the Order Staying Order Granting Motion to Appoint Trustee. See Gasparini Decl. at Ex.

20. On the same date, Lloyd T. Whitaker was appointed as the Chapter 11 Trustee in the Dicon

Bankruptcy Proceeding. See Gasparini Decl. at Ex. 21.

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DISCUSSION

A. The Appointment of a Chapter 11 Trustee is Required

The Chapter 11 Code is designed to allow a debtor-in-possession to retain management and

control of the debtor’s business operations. See Eurospark Indus., 424 B.R. 621, 627 (Bankr. E.D.

N.Y. 2010). It is well recognized, however, that a debtor-in-possession owes fiduciary duties to the

bankruptcy estate and must, among other things, “protect and . . . conserve property in [its]

possession for the benefit of creditors” and “refrain [] from acting in a manner which could damage

the estate, or hinder a successful reorganization of the business.” In re Ionosphere Clubs, Inc., 113

B.R. 164, 169 (Bankr. S.D.N.Y. 1990) (quoting In re Sharon Steel Corp., 86 B.R. 455, 457 (Bankr.

W.D. Pa. 1988)). “The willingness of Congress to leave a debtor-in-possession is premised on an

expectation that current management can be depended upon to carry out the fiduciary

responsibilities of a trustee.” In re V. Savino Oil & Heating Co., Inc., 99 B.R. 518, 526 (Bankr.

E.D. N.Y. 1989). If a debtor-in-possession defaults in that respect then the debtor may be

dispossessed of its officer and alternative management may be appointed in the form of a Chapter 11

trustee. See Schuster v. Dragone, 266 B.R. 268, 271 (D. Conn. 2001).

The Bankruptcy Code sets forth two separate standards for the Court’s determination of the

necessity of appointing a trustee: Section 1104(a)(1) and (a)(2). The sections provide, in pertinent

part:

(a) At any time after the commencement of a case but before confirmationof a plan, on request of a party in interest or the United States Trustee, and afternotice and a hearing, the Court shall order the appointment of a trustee –

(1) for cause, including fraud, dishonesty, incompetence, orgross mismanagement of affairs of the debtor by currentmanagement, either before or after the commencement ofthe case, or similar cause, but not including the number ofholders of securities of the debtor or the amount of theassets or liabilities of the debtor;

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(2) if such appointment is in the interest of creditors, anyequity security holders, and other interests of the estate,without regard to the number of holders of securities of thedebtor or the amount of assets or liabilities of the debtor.

11 U.S.C. §1104(a). Moreover, section 1104(e) of the Bankruptcy Code provides:

(e) The United States Trustee shall move for the appointment of atrustee under subsection (a) if there are reasonable grounds tosuspect that current members of the governing body of thedebtor, the debtor’s chief executive or chief financial officer, ormembers of the governing body who selected the debtor’s chiefexecutive or chief financial officer, participated in actual fraud,dishonesty, or criminal conduct in the management of the debtoror the debtor’s public financial reporting.

11 U.S.C. §1104(e). The United States Trustee “must seek an order requiring appointment of a

chapter 11 trustee whenever the ‘reasonable grounds to suspect’ standard is met.” In re The 1031

Tax Group, LLC, 374 B.R. 78, 87 (Bankr. S.D.N.Y. 2007) (quoting section 1104(e)). The

“statutory requirement that the U.S. Trustee bring such a motion [under Section 1104(e)] does not

alter the standard for deciding whether to grant the motion. Rather, §1104(a)(1) & (2), and the

cases interpreting these subsections, continue to control whether a trustee should be appointed.”

Id. at 87.

In the Second Circuit, a party moving for the appointment of a trustee must demonstrate

the existence of one of the factors mentioned in Section 1104(a)(1) by clear and convincing

evidence standard. In re Bayou Group, LLC, 564 F.3d 541, 546 (2d Cir. 2009); see also In re

Euro-American Lodging Corp., 365 B.R. 421, 426 (Bankr. S.D.N.Y. 2007). Once that burden is

met, however, appointment of a trustee becomes mandatory. See 11 U.S.C. § 1104(a) (providing

that court “shall order” appointment of trustee where cause exists); In re V. Savino Oil & Heating

Co., Inc., 99 B.R. 518, 525 (Bankr. E.D. N.Y. 1989) (holding that where a court finds cause under

section 1104, “there is no discretion; an independent trustee must be appointed”).

4 In The 1031 Tax Group, the Court initially denied the United States Trustee’s motionto appoint a Chapter 11 trustee under Bankruptcy Code sections 1104(a)(1) and (a)(2) on August13, 2007. See id. The United States Trustee filed a subsequent trustee motion under section1104(a)(2), which was granted on October 23, 2007. The 1031 Tax Group, Case No. 07-11448(MG), Amended Memorandum Opinion and Order, ECF Docket No. 812 (Not for Publication).

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In this case, there are three separate grounds for the appointment of a trustee under section

1104(a)(1): (a) the prepetition fraud and wrongdoing of the Debtor and its management, as set

forth in the SEC Complaint and the Criminal Complaint; (b) the improper diversion of assets by

Debtor’s management in connection with the Dicon bankruptcy case; and (c) the Debtor’s filing of

a bankruptcy petition under a falsified signature of counsel

(i) Cause Is Established Under 11 U.S.C. § 1104(a)(1)

In the instant case, there is cause for the Court to appoint a Chapter 11 trustee under

subsection (a)(1) of section 1104 of the Bankruptcy Code. “The sole question presented in a

Section 1104(a)(1) motion is whether the acts or omissions of current management, whether

committed before or after filing the Chapter 11 petition, supply the ‘cause’, as defined, to trigger

the appointment of a trustee.” See In re V. Savino Oil & Heating Co., Inc., 99 B.R. at 526; see

also In re 1031 Tax Group, LLC, 374 B.R. at 86 (“A court may consider both the pre- and

postpetition misconduct of the current management when making the determination that ‘cause’

exists for the appointment of a trustee.”). A finding of “cause” mandates the appointment of a

trustee. Sharon Steel, 871 F.2d at 1226 (“[11 U.S.C. § 1104](a)(1) requires the bankruptcy court,

[ ] to appoint a trustee when the movant has proved ‘cause,’ which the statute defines to include

incompetence and gross mismanagement.”); Oklahoma Refining Co. v. Blaik (In re Oklahoma

Refining Co.), 838 F.2d 1122, 1136 (10th Cir. 1988); In re 1031 Tax Group, LLC, 374 B.R. at 86;4

In re V. Savino Oil & Heating Co., Inc., 99 B.R. at 525; In re Bonded Mailings, Inc., 20 B.R. 781,

786 (Bankr. E.D.N.Y. 1982).

The list of wrongs constituting “cause” warranting the appointment of a trustee is non-

exclusive, and “[f]actors relevant to the appointment of a trustee under § 1104(a)(1) include:

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conflicts of interest, including inappropriate relations between corporate parents and the

subsidiaries; misuse of assets and funds; inadequate record keeping and reporting; various

instances of conduct found to establish fraud or dishonesty; and lack of credibility and creditor

confidence.” In re Altman, 230 B.R. 6, 16 (Bankr. D. Conn. 1999), aff’d in part, vacated in part,

254 B.R. 509 (D. Conn. 2000). The “court need not find any of the enumerated wrongs to find

cause for appointing a trustee.” In re Oklahoma Refining Co., 838 F.2d at 1136.

This case is replete with specific allegations strongly suggesting gross mismanagement,

dishonesty, and fraud by current management. According to the SEC Complaint and the Criminal

Complaint, inter alia, prior to the Petition Date the Debtor’s management allegedly engaged in a

massive and prolonged fraudulent scheme that spanned over a period of three years which only

came to an end when Moskowitz and Metter were arrested last month. The alleged scheme

revolved around, among other things, the fabrication by the Debtor’s management of sales to

fictitious customers to mask the Debtor’s revenues and make-believe in the eyes of shareholders

that the company was in a much better financial position than it realistically was. See infra at

¶¶15-17. Testimony presented in the Dicon Bankruptcy Proceeding indicated that, even after their

arrest, Moskowitz and Metter continued to engage in fraudulent activities by diverting funds from

the Debtors’s main asset – Dicon – for the benefit of persons and entities affiliated with them. See

infra at ¶23. This allegation, in itself, if true, would constitute a breach of the Debtor’s

management’s fiduciary duties owed to its creditors as Dicon’s value would have significantly

diminished as a result of the siphoning of funds.

Although naked allegations of misconduct, standing alone, are an insufficient basis for the

appointment of a trustee, it is not necessary for this Court to conduct a mini-trial of each of the

factual allegations of the SEC Complaint and the Criminal Complaint. Rather, appointment of a

trustee is mandated if this Court determines that the allegations of those complaints have a

“substantial basis in the facts.” In re American Resources, Ltd., 54 B.R. 245, 247 (Bankr. D.

Hawaii 1985); see also Tradex Corp. v. Morse, 339 B.R. 823 (D. Mass. 2006) (finding, in case

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decided under preponderance of the evidence standard, that bankruptcy court properly ordered

appointment of trustee based on credible, though disputed, allegations against debtor that were the

subject of a grand jury proceeding).

What is even more telling is the fact that the Bankruptcy Judge in the Dicon Bankruptcy

Proceeding found that “cause” indeed existed based on these facts to appoint a Chapter 11 trustee

in the Dicon Bankruptcy Proceeding. While Moskowitz and Metter’s alleged mismanagement and

fraudulent scheme has severely directly damaged the Debtor’s business and the interest of its

shareholders, the alleged siphoning of funds from Dicon to entities affiliated with Moskowitz and

Metter has also damaged Dicon – the wholly-owned subsidiary of the Debtor – thus also, if true,

has indirectly caused harm to the Debtor’s shareholders.

The United States Trustee acknowledges that at least one of the main perpetrators of the

fraudulent scheme – Metter – resigned as the Company’s officer and director effective June 8,

2010; see infra at ¶5, however, “[c]orrective measures that are too few too late cannot defeat a

change in command.” Sharon Steel Corp., 871 F.2d 1217. In this case, upon information and

belief and despite false promises that an independent financial advisor would be hired, see infra at

¶30, Moskowitz is still at the Debtor’s reins.

Notably, the Debtor has itself admitted in papers filed in response to the motions the SEC

brought in the SEC action that given the current state of affairs, it would be useful to replace

current management. See Opposition to Motion for Preliminary Injunction and Asset Freeze at p.

7 (“Spongetech is endeavoring to find a new operating executive to guide it going forward. It has

submitted proposed individuals to the SEC for review.”); see also Opposition to Receiver Motion

at p. 2 (“Spongetech recognizes that, given the current state of affairs, it may be useful to bring in

a third party to exercise some form of oversight or operational authority over the Company’s

affairs.”).

Moreover, the alleged fraudulent actions that caused the Debtor’s demise have not ceased.

As current as the Petition Date, it appears that a representative of the Debtor, possibly Minkoff

16

who signed the Petition on behalf of the Debtor, may have forged Niger’s signature in an attempt

to comply with the requirement that a corporation be represented by counsel. See infra at ¶¶10-

11. Although the United States Trustee has no information on who Minkoff is, his exact title with

the Debtor, and his tenure with the company, what is clear is that, consistent with the Debtor’s

management modus operandi, Minkoff declared under penalty of perjury that the information on

the Petition was true and correct, when in reality someone may have forged Niger’s signature.

Minkoff himself has admitted that Neiger had ultimately concluded it would not file the Petition

on behalf of the Debtor. See Retention Application at ¶3.

Accordingly, the United States Trustee submits that sufficient cause exists for the

appointment of a Chapter 11 trustee in this case pursuant to 11 U.S.C. §1104(a)(1).

(ii) Cause Is Established Under 11 U.S.C. § 1104(a)(2)

Similarly, even if the Court finds that the United States Trustee has failed to demonstrate

cause for the appointment of a trustee under subsection (a)(1) of section 1104, a Chapter 11

Trustee would be in the best interests of creditors. See 11 U.S.C. § 1104(a)(2).

Section 1104(a)(2) of the Bankruptcy Code allows appointment of a trustee even when no

“cause” exists. See Sharon Steel, 871 F.2d at 1226 (describing the standard as “flexible”); In re

Ionosphere Clubs, Inc., 113 B.R. 164, 168 (Bankr. S.D.N.Y. 1990). Under section 1104(a)(2), the

Court may appoint a trustee, in its discretion, to address the “interests of the creditors, [ ] and other

interests of the estate.” 11 U.S.C. § 1104(a)(2). See, e.g., Sharon Steel, 871 F.2d at 1226.

Under section 1104(a)(2), courts “eschew rigid absolutes and look to the practical realities

and necessities.” See In re Taub, 427 B.R. 208, 227 (Bankr. E.D. N.Y. 2010) (quoting In re

Adelphia Communication Corp., 336 B.R. 610, 658 (Bankr. S.D.N.Y. 2006)); In re Euro-

American Lodging Corp., 365 B.R. 421, 427 (Bankr. S.D.N.Y. 2007). As the court noted in

Schuster v. Dragone, 266 B.R. 268 (D. Conn. 2001):

“In determining whether the appointment of a trustee is in the best interests ofcreditors, a bankruptcy court must necessarily resort to its broad equity powers.” Inequity, “courts eschew rigid absolutes and look to the practical realities and

17

necessities inescapably involved in reconciling competing interests . . . . Moreover,equitable remedies are a special blend of what is necessary, what is fair, and whatis workable.”

Id. at p. 272-73 (quotations omitted).

Accordingly, the standard for appointment of a Chapter 11 trustee under section 1104(a)(2)

is flexible. See 124 Cong.Rec. H11,102 (daily ed. Sept. 28, 1978); S17,419 (daily ed. October 6,

1978). The House Report summarizes the reasons for Congress' adoption of a flexible standard

for the appointment of trustees. The House Report, in part, reads as follows:

The twin goals of the standard for the appointment of a trustee should be protectionof the public interest and the interests of creditors, as contemplated in currentchapter X and facilitation of a reorganization that will benefit both the creditors andthe debtors, as contemplated in current chapter XI. Balancing the goals is adifficult process, and requires consideration of many factors.

H.R. Rep. No. 595, 95th Cong., 1st Sess. 232 (1977), U.S. Code Cong. & Admin. News 1978, p.

6192.

Among the factors considered by the courts in assessing motions brought under this

section include: (1) the trustworthiness of the debtor, (2) the debtor’s past and present

performance and prospects for rehabilitation, (3) the confidence – or lack thereof – of the business

community and of creditors in present management, and (4) the benefits derived from the

appointment of a trustee, balanced against the cost of the appointment. Euro-American, 365 B.R.

at 427.

Here, the factors exist for the appointment of a Chapter 11 trustee under section

1104(a)(2). The Debtor’s principals lack credibility in light of the pending SEC and Criminal

Complaints. As set forth above, allegations made in the complaints indicate that Debtor’s

management have been the masterminds behind a convoluted scheme that involves, among other

things, false SEC filings and fraudulent press releases. The Debtor’s management has been, and

continues to be, unstable. Moskowitz, as the primary alleged perpetrator of the fraud, is now

solely running the company but, as the allegations against him and others reflect, his credibility is

in question. The apparent forgery of an attorney’s signature on the Petition is further indication

18

that dishonesty and gross mismanagement of the company is continuing and that an independent

trustee is necessary to ensure that the Debtor’s business operations are being conducted in

accordance with appropriate business standards and, most importantly, in accordance with the

fiduciary duties owed the creditor body.

Second, in this case the appointment of a trustee is in the best interest of creditors because

there is a substantial adversity of interest that exists. In fact, it appears that the Debtor lacks an

independent management structure to analyze and pursue claims against its principals for the

benefit of creditors. See e.g., In re Ridgemour Meyer Properties, LLC, 413 B.R. 101, 113 (Bankr.

S.D.N.Y. 2008) (“An independent trustee should be appointed under §1104(a)(2) when they suffer

from material conflicts of interest, and cannot be counted on to conduct independent investigations

of questionable transactions in which they were involved.”).

Third, given the negative press and charges that have been brought against the Debtor and

its management, any investor should be reluctant to trust the “fox watching the henhouse.” As set

forth in the Receiver Motion, subsequent to the filing of the SEC Complaint, “several Spongetech

investors have expressed concern to the SEC about Spongetech’s assets and management.” See

Receiver Motion at p. 4. Moreover, the Class Action is further evidence that as early as October

2009, soon after the SEC suspended trading in the Debtor’s stock, several investors lost

confidence in the Debtor and its management and commenced a lawsuit. See infra at ¶8.

Lastly, with respect to the benefits of a Chapter 11 trustee balanced against the cost of

appointment, redressing the concern that the Debtor be managed by an untainted fiduciary

outweighs the cost of appointment of a Chapter 11 trustee. Where, as here, the continuation of

current management could result in further siphoning of funds or continued fraudulent actions that

would further harm the creditors’ interests and reduce any possible recovery by the victims of the

fraudulent scheme the appointment of a trustee is the only cure..

B. In the Alternative, Cause Exists to Convert the Case to One Under Chapter 7 Or toDismiss It

5 Notably, section 1104(a)(3) of the Bankruptcy Code also provides that the courtshall order the appointment of a Chapter 11 trustee “if grounds exist to convert or dismiss thecase under section 1112, but the court determines that the appointment of a trustee or anexaminer is in the best interests of creditors and the estate.” 11 U.S.C. §1104(a)(3).

19

Grounds also exist to convert this case or, alternatively, to dismiss it under 11 U.S.C.

§1112(b)(4). Section 1112(b) of the Bankruptcy Code governs the conversion or dismissal of a

Chapter 11 case and grants bankruptcy courts the power to promptly administer chapter 11 cases

on their docket. See In re Squires Motel, LLC, 416 B.R. 45 (Bankr. N.D.N.Y. 2009); In re

Strawbridge, 2010 WL 779267, at *1 (Bankr. S.D.N.Y. March 5, 2010). It provides that, on

request of a party in interest, and after notice and a hearing, “the court shall convert a case under

[Chapter 11] to a case under chapter 7 or dismiss [it], whichever is in the best interest of creditors

and the estate, if the movant establishes cause.” 11 U.S.C. §1112(b)(1) (emphasis added); see also

In re Scott Cable Communications, Inc., 407 B.R. 8, 15 (Bankr. D. Conn. 2009) (“Once cause for

relief is shown, the Court has broad discretion to either convert or dismiss the Chapter 11 case.”).5

While the term “cause” is not defined by the statute, section 1112(b)(4) of the Bankruptcy

Code provides some examples which are meant to be non-exclusive, and any one of which may

constitute “cause” for either the conversion of a Chapter 11 case to a Chapter 7 case or the

dismissal of a Chapter 11 case in its entirety. See In re Ameribuild Const. Management, Inc., 399

B.R. 129, 132 (Bankr. S.D.N.Y. 2009). While the burden of showing cause rests with the moving

party, In re Loco Realty Corp., 2009 WL 2883050, at *2 (Bankr. S.D.N.Y. June 25, 2009), that

burden can be met either by demonstrating the existence of one or more of the statutory grounds

enumerated in 11 U.S.C. §1112(b) or by showing other cause. See 11 U.S.C. §1112(b)(4); In re

TCR of Denver, LLC, 338 B.R. 494, 500 (Bankr. D. Colo. 2006) (noting that “the Court may

dismiss a Chapter 11 case for reasons other than those specified in section 1112(b) as long as

those reasons satisfy ‘cause’”); In re State St. Assocs., L.P., 348 B.R. 627, 638 (Bankr. N.D.N.Y.

2006) (while the list of examples of “cause” has changed in the 2005 amendment, the fact that

they are illustrative, not exhaustive, has not).

20

Among other things, “cause” includes:

(B) gross mismanagement of the estate;

. . .

(F) unexcused failure to satisfy timely any filing or reporting requirement established

by this title or by any rule applicable to a case under this Chapter.

In this case, cause exists to convert the case under section 1112(b)(4)(F). Under the

Bankruptcy Code, Bankruptcy Rules, and Local Bankruptcy Rules, a Debtor has a duty to file

certain lists and schedules. More specifically, while the deadline to file schedules and statements

of financial affairs has yet to expire in this case, the Bankruptcy Code and Bankruptcy Rule

require that a Chapter 11 debtor file with its petition (a) a list containing the name and address of

each entity including or to be included on Schedules D, E, F, G, and H as prescribed by the

Official Form, (b) a corporate ownership statement, and (c) a list containing the name, address,

and claim of the creditors that hold the 20 largest unsecured claims, excluding insiders

(collectively with (a) and (b), the “Required Initial Information”). See 11 U.S.C. §521(a)(1)(A);

see also Bankruptcy Rule 1007(a)(1) and (d). Moreover, Local Bankruptcy Rule 1007-2 provides

that a debtor in a Chapter 11 shall file an affidavit setting forth various information set forth in the

rule and that such affidavit shall be filed with the petition.

Here, the Debtor has failed to file any of the Required Initial Information and has failed to

file the affidavit required by the Bankruptcy Rule. All that was filed was a bare-bones three page

Petition which bears the signatures of Niger, who apparently is not representing the Debtor and

indicated in a filing with the Court that he indeed did not sign the Petition, and Minkoff as the

Debtor’s representative. As a result of these deficiencies, the United States Trustee has been

unable to even solicit interest for the formation of a committee of general unsecured creditors.

Moreover, the Debtor’s failure to file a corporate resolution renders it impossible to determine

whether Minkoff even had proper authority to file the bankruptcy Petition on behalf of the Debtor.

See In re Carolina Park Assocs., LLC, 2010 WL 2557733, *4 (Bankr. D.S.C. June 17, 2010)

21

(citing Price v. Gurney, 324 U.S. 100, 106 (1945) (holding that “[a] bankruptcy petition by an

entity may only be filed under authority of those with the lawful power to so act” and dismissing

the case on the grounds that the filing was not properly authorized); In re Vitagliano, 303 B.R. 292

(Bankr. W.D.N.Y. 2003) (dismissing voluntary case which was not effectively commenced by the

filing of the petition by the debtor’s mother); In re Industrial Concerns, Inc., 289 B.R. 609 (Bankr.

W.D. Pa. 2003) (dismissing case on grounds of improper authority to file petition).

Accordingly, the Debtor’s failure to file the Required Initial Information and the Rule

1007-2 affidavit and a corporate resolution constitutes sufficient “cause” to convert this Chapter

11 case under 11 U.S.C. §1112(b)(4)(F), or, alternatively, to dismiss it. See In re Spencer C.

Young Invest., 2009 WL 901654, *4 (Bankr. M.D.N.C. Feb. 4, 2009) (“The Debtor has not filed

any schedules or affiliation statements, which constitutes cause for dismissal pursuant to 11

U.S.C. §1112(b)(4)(F).”).

Second, grounds exist for conversion under section 1112(b)(4)(B) as a result of the gross

management of the Debtor’s estate by current management. In order for mismanagement to be

“gross” it must be “glaringly noticeable usu[ally] because of inexcusable badness or

objectionableness.” See In re 210 W. Liberty Holdings, LLC, 2009 WL 1522047, *5 (Bankr.

N.D.W.Va. May 29, 2009). As set forth above, the Debtor’s “old management,” against whom the

SEC has brought a complaint for, among other things, perpetrating a scheme to portray the Debtor

as having higher revenues than it really had achieved, and against whom criminal charges are

presently pending, still has the reins to the Debtor’s business and operations. While the case was

only filed a week ago, the bad acts that have plagued the Debtors are as current as the Petition

Date, when a representative of the Debtor signed Niger’s name without his authority. See infra at

¶¶10-11. When there is blatant disregard for the fiduciary duties that a debtor-in-possession owes

to their creditors, as have been alleged in the SEC Complaint, Criminal Complaint, and Class

Action and as indicated as recent as the filing of the Petition Date, conversion of the case is

warranted. See In re Tucker, 411 B.R. 530, 533 n.6 (Bankr. S.D. Ga. 2009) (finding that cause to

22

dismiss the debtor’s Chapter 11 case existed where the debtor had reported that third parties had

been advancing money to pay for his expenses but no court approval was sought to authorize the

Debtor to borrow funds); In re 210 West Liberty Holdings, LLC, 2009 WL 1522047, *6 (same).

WHEREFORE, the United States Trustee respectfully requests that this Court enter an

order directing the appointment of a Chapter 11 trustee, or in the alternative, converting the case to

one under Chapter 7 or dismissing it, or grant such other relief as the Court deems just, fair, and

equitable.

Dated: New York, New York July 16, 2008

Respectfully submitted, TRACY HOPE DAVIS

ACTING UNITED STATES TRUSTEE By: /s/ Elisabetta G. Gasparini

Trial Attorney 33 Whitehall Street, 21st Floor

New York, New York 10004 Tel. (212) 510-0500

Fax (212) 668-2255