Opinion
No. 84-C-43-C.
September 17, 1984.
Standard of Review — District Courts — Appeals — Constitutionality
The congressional intent in enacting the new 28 U.S.C. § 157 and 158, which are included in the new Chapter 6 of the Bankruptcy Reform Act, is that appeals to district courts from bankruptcy courts in matters involving core proceedings should be reviwed under the clearly erroneous standard. Readoption of this standard does not affect substantive rights of parties, but rather only establishes the procedural framework for appeals; hence it may be applied here, a case pending upon passage of the Bankruptcy Amendments and Federal Judgeship Act of 1984, of which Sections 157 and 158 are a part. Any conflict between Rule 8013, which provides for the clearly erroneous standard on appeal of a bankruptcy case, and the constitutional rule laid down in Northern Pipeline Construction Company v. Marathon Pipe Line Co., CCH Bankruptcy Dec. at ¶ 68,698, is rendered moot by the new legislation. As for the constitutionality of new Sections 157 and 158 themselves, this new legislation passes the constitutional muster of the Northern Pipeline decision. As part of the 1984 Amendments, they place greater restriction on bankruptcy judges, leave the real judicial power with the district courts, and allow use of the clearly erroneous standard in proceedings involving core matters of the bankruptcy power. See 28 U.S.C. § 157 at ¶ 4030, 28 U.S.C. § 158 at ¶ 4035, and Rule 8013 at ¶ 12,413.
Equitable Subordination — Standard of Proof — Non-Insider — Measure of Damages
To establish a claim of equitable subordination against a non-insider, a creditor must show gross misconduct, that is, misrepresentation whereby other creditors were deceived to their damage. The proper assessment of damages permits subordination only to the extent necessary to offset the harm suffered by the creditors. See Sec. 510(c) at ¶ 9043.
[Excerpted Opinion of the Court]
This case involves an application by plaintiffs for equitable subordination under 11 U.S.C. § 510(c) of the claim of defendant Production Credit Association of River Falls, Wisconsin. Plaintiffs claim that defendant's alleged control over the debtors' beef cattle business and misrepresentations to plaintiffs about the degree of support defendant would provide to the debtors entitle plaintiffs to have defendant's claim subordinated to theirs. Defendant appeals the bankruptcy judge's finding that defendant engaged in inequitable conduct which resulted in injury to the plaintiffs and his order that defendant's claim is subordinated to those of the plaintiffs. . . .OPINION
Equitable subordination under 11 U.S.C. § 510(c) is an exception to the usual principles of equality of distribution and preference for secured creditors. 11 U.S.C. § 510(c) gives bankruptcy courts broad equitable powers to adjust the status of claims on equitable grounds. However, both prior to and after the adoption of 11 U.S.C. § 510(c), equitable subordination has required that at a minimum the party whose claim is to be subordinated must have engaged in some type of inequitable conduct, and that the misconduct must have resulted in injury to other creditors or an unfair advantage to the claimant. Matter of Mobile Steel Co., 563 F.2d 692, 678-700 (5th Cir. 1977); Matter of Multiponics, 622 F.2d 709 (5th Cir. 1980). Defendant contends that the bankruptcy judge misapplied the law in concluding that that standard had been satisfied. Before I can reach the merits of that contention, I must deal with issues raised by defendant concerning the appropriate standard of review and the validity of the factual findings made by the bankruptcy judge.
Initially, defendant challenges the applicability of the clearly erroneous standard of review reinstated by Bankruptcy Rule 8013. Defendant argues that application of the clearly erroneous standard to its appeal would conflict with the rationale of Northern Pipeline Construction Co. v. Marathon Pipeline Co., 458 U.S. 50 (1982) and that in promulgating Bankruptcy Rule 8013, the Court exceeded the authority granted to it under 28 U.S.C. § 2075. Defendant argues that the district court should continue to follow the de novo review procedure mandated by the Emergency Rule enacted in this district after the Northern Pipeline decision. See Moody v. Martin, 27 B.R. 991 (W.D. Wis. 1983).
After these arguments were made, Congress enacted the Bankruptcy Amendments and Federal Judgeship Act of 1984, Public Law 93-353. Section 104(a) of the Act amends Title 28 of the United States Code by adding a new chapter 6, including provisions dealing with bankruptcy procedures and appeals. 28 U.S.C. § 157 now enumerates a number of "core proceedings" and provides for de novo review only for proceedings which are not "core proceedings." 28 U.S.C. § 157(c)(1). 28 U.S.C. § 158 also provides that appeals from decisions of bankruptcy judges "shall be taken in the same manner as appeals in civil proceedings generally are taken to the courts of appeals from the district courts. . . ." 28 U.S.C. § 158(c). Since Rule 52(a), Federal Rules of Civil Procedure, applies the clearly erroneous standard to appeals taken from district courts to courts of appeals, the clear implication of both § 158(c) and the special de novo review procedure of § 157(c)(1) is that Cngress intended that the clearly erroneous standard apply in appeals from decisions of bankruptcy judges in "core" proceedings.
The instant equitable subordination action is clearly a "core" proceeding as defined by the Act. In it, the general creditors seek the court-ordered subordination of the claim of a secured creditor. It thus falls within 28 U.S.C. § 157(b)(2)(0), which includes among "core" proceedings "other proceedings affecting the liquidation of the assets of the estate or the adjustment of the debtor-creditor or the equity security holder relationship, except personal injury tort or wrongful death claims."
This court must apply the Act although it was passed while the instant proceedings were pending. Section 122(a) of the Act states that except as otherwise provided Title I of the Act "shall take effect on the date of the enactment of this Act." Section 122(b) makes an exception for two sections not relevant herein which are not to apply to pending cases. Thus, it was clearly Congress' intent that the other provisions of Title I apply to pending cases. Moreover, it is a settled principle that "a court is to apply the law in effect at the time it renders its decisions, unless doing so would result in manifest injustice or there is statutory direction or legislative history to the contrary." Bradley v. School Board of Richmond, 416 U.S. 696, 711 (1974). In supporting the readoption of the clearly erroneous standard, the Act does not affect substantive rights of the parties, but simply establishes the procedural framework for appeals. It does not affect existing rights of the parties or cause "manifest injustice." Bradley, 416 U.S. at 716-21; Central Freight Lines, Inc. v. United States, 669 F.2d 1063, 1069-70 (5th Cir. 1982); United States v. Blue Sea Line, 553 F.2d 445, 448-49 (5th Cir. 1977). Accordingly, any question of the validity of the adoption of Bankruptcy Rule 8013 is rendered moot by the passage of the Act.
The only remaining question is whether it was constitutional under Northern Pipeline for Congress to provide for review under the clearly erroneous standard.
As appellants point out, the use of the clearly erroneous standard was one of the aspects of the Bankruptcy Act of 1978 that led the Supreme Court to conclude that the bankruptcy courts esablished by the 1978 Act were not valid adjuncts to the Article III district courts. Northern Pipeline, 458 U.S. at 84-86 (1982). However, the plurality did not hold that the clearly erroneous standard could never be used. It mentioned use of the clearly erroneous standard as one of a number of factors which convinced it that virtually all of the "essential attributes of the judicial power of the United States" had been vested in the supposedly adjunct bankruptcy court. Id. at 84-85. As this court noted in Moody v. Martin, 27 B.R., at 1000:
In setting forth the characteristics differentiating the bankruptcy courts from properly structured adjuncts to Article III courts, the plurality opinion suggests strongly that, with the exceptions of jurisdiction over "related" matters and the total grant of bankruptcy jurisdiction to the bankruptcy courts, no one of these differentiating characteristics taken alone would suffice to render a delegation scheme unconstitutional.
The Bankruptcy Amendments, while reinstating the clearly erroneous standard, place considerably greater limits on the jurisdiction of the bankruptcy courts than did the Bankruptcy Act of 1978. The Amendments limit jurisdiction over related cases by requiring abstention in some circumstances, 28 U.S.C. § 1334(c)(2); give all jurisdiction over related personal injury and wrongful death claims to the district court in which the claim arose, 28 U.S.C. § 157(b)(5); and place the entire jurisdiction in the district courts, while permitting the district courts to refer to bankruptcy judges any or all cases under Title 11 or proceedings arising under or related to Title 11, 28 U.S.C. § 157(a), but also to withdraw in whole or in part any case or proceeding so referred, either on their own motion or for good cause shown. 28 U.S.C. § 157(d).
Finally, the Amendments limit application of the clearly erroneous standard to a list of enumerated "core" proceedings. 28 U.S.C. § 157. With regard to non-core proceedings, the de novo standard of review will apply. 28 U.S.C. § 157(c)(1). This limitation on the application of the clearly erroneous standard is important, since both the plurality and concurring opinions in Northern Pipeline indicated a primary concern with the extension of the bankruptcy courts' jurisdiction to traditional common law matters outside the "core" of the federal bankruptcy power. Northern Pipeline, supra, 458 U.S. at 71; 458 U.S. at 90-91, (Rehnquist, J., concurring). Significantly, the only case after Northern Pipeline which held the application of the clearly erroneous standard unconstitutional, 1616 Reminc Ltd. Partnership v. Atchison Keller Co., 704 F.2d 1313 (4th Cir. 1983), did so in the non-core context of a breach of contract counterclaim and limited its holding to such traditional common law actions.
The limited application of the clearly erroneous standard to "core" proceedings does not violate either the holding or the rationale of Northern Pipeline. The Amendments reserve to the district court "most, if not all, of `the essential attributes of the judicial power,'" Northern Pipeline, supra, 458 U.S. at 87, and limit application of the clearly erroneous standard to proceedings within the core of the federal bankruptcy power. Accordingly, I conclude that the proper standard or review is the clearly erroneous standard adopted in Bankruptcy Rule 8013 and approved implicitly in the Bankruptcy Amendments of 1984.. . .
Appellants' challenge to the validity of the adoption of Bankruptcy Rule 8013 would fail even if the Bankruptcy Amendments had not been adopted. Reinstatement of the clearly erroneous standard did not by itself impermissibly extend jurisdiction or affect the substantive rights of the parties. At least as applied to proceedings within the core area of federal bankruptcy power, application of the clearly erroneous standard has been routinely upheld. In re Morrissey, 717 F.2d 100, 104 (3d Cir. 1983); Matter of Missionary Baptist Foundation, 712 F.2d 206 (5th Cir. 1983). But see 1616 Reminc Ltd. Partnership v. Atchinson Keller Co., 704 F.2d 1313 (4th Cir. 1983) (clearly erroneous standard unconstitutional when applied to traditional common law action).
I come at last to the substantive issue in this case: whether the bankruptcy court's findings of fact supported its ultimate conclusion that appellees are entitled to equitable subordination.
The basic test for equitable subordination of claims was set forth as follows in Matter of Mobile Steel Co., 563 F.2d at 700:
(i) The claimant must have engaged in some type of inequitable conduct.
(ii) The misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant.
(iii) Equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Act.
(Citations omitted). Plaintiffs argue that the Mobile Steel standard is not a test, but rather "criteria" or a "guideline" for use in making an ad hoc equitable determination. However, whatever label is placed on the Mobile Steel standard, it is clear that there must be a showing of some type of inequitable conduct in order to justify an exception to the general principle of equality of claims.
On the other hand, defendant claims that in the instant case, more than the Mobile Steel standard must be shown. It argues that it had neither an insider's fiduciary duty to the Osbornes' business. Consequently, it argues, citing Matter of Teltronics Services, Inc., 29 B.R. 139, 169 (Bkrtcy. E.D.N.Y. 1983) and Matter of W.T. Grant Co., 4 B.R. 53, 75 (Bkrtcy. S.D.N.Y. 1980), that the burden of proof must remain on plaintiffs rather than shifting to the defendant as it would in a case involving an inisider creditor, and plaintiffs must show egregious misconduct rather than simply inequitable conduct.
While equitable subordination of the claims of insiders or fiduciaries is more common, subordination of the claims of non-insiders has recently received considerable attention. See, e.g., Matter of Teltronics Services, Inc., 29 B.R. 139 (Bkrtcy. E.D.N.Y. 1983); In re T.E. Mercer Trucking Co., 16 B.R. 176 (Bkrtcy. N.D. Tex. 1981); In re Just For the Fun of It of Tennessee, Inc., 7 B.R. 166, 180-81 (Bkrtcy. E.D. Tenn. 1980); In re American Lumber Co., 5 B.R. 470 (D. Minn. 1980); Matter of W.T. Grant Co., 4 B.R. 53 (Bkrtcy. S.D.N.Y. 1980), aff'd 699 F.2d 599 (2d Cir. 1983). As the court stated in Teltronics Services, "The primary distinctions between subordinating the claims of insiders versus those of non-insiders lie in the severity of misconduct required to be shown, and the degree to which the court will scrutinize the claimant's actions toward the debtor or its creditors." Teltronics Services, supra at 169. Once an objectant in an insider case supports allegations of impropriety with a substantial factual showing, the burden shifts to the insider creditor to prove the good faith and inherent fairness of its actions. Matter of Mobile Steel Co., 563 F.2d 692, 701-02 (5th Cir. 1977). However, the burden remains on the objectant in cases involving non-insider creditors. Teltronics Services, supra at 169.
The degree of misconduct which the objectant must show in the case of a non-insider is more difficult to state. It has been variously described as "very substantial" misconduct involving "moral turpitude or some breach of duty or some misrepresentation whereby other creditors were deceived to their damage," W.T. Grant, 4 B.R. at 75, quoting In re Bowman Hardware Electric Co., 67 F.2d 792, 794 (7th Cir. 1933) (emphasis original) or as gross misconduct amounting to fraud, overreaching or spoliation, Teltronics Services, 29 B.R. at 169. However, the distinction between "inequitable conduct" and "gross misconduct" (possibly involving "moral turpitude") would seem to be a difficult one to draw in practice. There are few cases in which the gross misconduct standard has actually been applied. In Teltronics Services the court denied subordination after finding insufficient evidence of an alleged illicit takeover scheme and alleged effort to discourage other investors. Teltronics Services, 29 B.R. at 173-74. In contrast, in Just For the Fun of It the court subordinated the claim of a general contractor who filed an inaccurate notice of completion on which other creditors relied in extending additional credit to the debtor. Just For the Fun of It, 7 B.R. at 180-81. The key factor would appear to be misrepresentation on which other creditors relied to their detriment.
A further complicating factor is that creditors who are not insiders or fiduciaries will be treated like fiduciaries if they had and exerted sufficient control over the debtor, to the detriment of other creditors. Teltronics Services, 29 B.R. at 170-71; T.E. Mercer Trucking Co., 16 B.R. at 189-90; American Lumber, 5 B.R. at 478. The creditor must exercise virtually complete control to be treated as a fiduciary. Compare American Lumber, supra (control found where secured creditor took over receipt of debtor's accounts and payment of its creditors and terminated its employees) with Teltronics Services, supra, at 172 (no control despite restrictions on outside financing, monitoring finances of debtors and making recommendations on debtor's business decisions).
In the instant case, the bankruptcy judge made no finding that PCA had control over the Osbornes. However, he did find that PCA's relationship with the Osbornes "approach[ed] the status of a joint venture" and that the applicants "looked to PCA for payment of Osborne's accounts." Findings of fact 36 and 29. He also found that from August 1981 the PCA loan to the Osbornes was a "controlled" loan and that on at least one occasion PCA representatives gave the Osbornes directions on how to spend loan funds. Findings of fact 15 and 17. However, none of these findings support a conclusion that PCA exercised the type of control required by American Lumber and Teltronics Services. Undoubtedly as a result of PCA's security interest in most of the Osbornes' assets and the Osbornes' continuing need for funds, PCA had considerable power over the Osbornes. But the record contains no more than isolated examples of the exercise of that power. The facts in the record are much more analogous to those in Teltronics Services than to those in American Lumber. It is possible that at some point in November or December PCA did take control. However, the record is unclear, the bankruptcy judge made no such finding, and it does not appear that much if any of the allegedly inequitable conduct took place after PCA informed the applicants on November 6 that further payments to them would cease. Accordingly, the plaintiffs will be required to make a showing of gross misconduct. . . .
On this set of facts, it cannot be said that PCA's conduct in relation to the Bank was inequitable. The Bank was aware that it was taking a risk, and that it was doing so without as much as a firm oral commitment from PCA, let alone a written guarantee. Most important, there is no finding that PCA put any pressure on the Bank, or that PCA deceived the Bank or misrepresented the situation to the Bank. The facts that the Bank believed, assumed or hoped that PCA would "take care" of it if the Osbornes were unable to pay, and that PCA did not do so, do not in themselves establish inequitable conduct on the part of PCA.
With regard to Cenex, the factual findings supporting a conclusion that PCA engaged in inequitable conduct are even sparser than with regard to the Bank. . . .
Finally, I turn to PCA's conduct with regard to General. As with Cenex, PCA made several direct payments to General. (Finding of fact 14.) However, based on that fact alone General could not reasonably rely on PCA making such payments in the future. Thus, the direct payments did not make PCA's eventual refusal to pay inequitable. The only substantial basis for General's application for subordination is a series of conversations between General and PCA beginning in September 1981.
General initiated the meetings in early September out of concern regarding the Osbornes' account, which had gone unpaid for some time. (Finding of fact 20.) PCA and General did not discuss payment, however, but other matters such as the performance of the cattle and communication problems with the Osbornes. (Transcript at 80, 86.) The bankruptcy judge found that at a second meeting between PCA and General on October 19 General did raise the subject of payment and PCA responded that funds could be released once some cattle were sold. (Findings of fact 21 to 23.) Thereafter, General called PCA more than once and was told that payment would be forthcoming once some papers were signed. (Finding of fact 24.) However, apparently no payments were made until November 20, when PCA agreed to pay General $1,000 in response to a threat by General to stop delivery. (Finding of fact 27.)
These findings support a conclusion that PCA's conduct in regard to General was at least inequitable. PCA clearly was aware of General's concern about the size of the Osbornes' account. PCA responded with equivocation and outright misrepresentations concerning forthcoming payment. PCA continued to reassure General even in the weeks immediately preceding its decision to terminate its support for the Osbornes, a decision which it must have known made General's prospects for payment bleak to nonexistent. Moreover, this course of conduct was clearly deliberate, since the bankruptcy judge found on the basis of the testimony of PCA employees that PCA had anticipated a request for payment prior to the October 19 meeting and planned their less than forthright response. (Finding of fact 23; Transcript at 140, 146.)
Defendant's response is less than convincing. Defendant argues that the testimony supports a finding only that PCA told General that "funds would be released" when the Osbornes signed some papers, not the judge's actual finding that PCA told General "payment would be forthcoming." This argument is disingenuous. If indeed PCA told General that funds would be released but did not mean that the funds would be released to General, it was deliberately misleading General. Defendant argues also that part of the debt owed to General was the result of a dispute between General and the Osbornes. However, that argument does not negate a finding of inequitable conduct but merely suggests that not all of General's losses were attributable to PCA's inequitable conduct.
The question then is whether PCA's conduct with respect to General rose to a level of gross or egregious misconduct. Just For the Fun of It suggests that the standard is satisfied by "misrepresentation whereby other creditors were deceived to their damage." 7 B.R. at 181. I conclude that PCA's conduct toward General satisfied this standard. PCA repeatedly made misrepresentations to General concerning the prospects for payment. PCA obviously had both superior knowledge concerning the Osbornes' ability to pay and a superior position due to its security interests in virtually all of the Osbornes' assets. Moreover, it knew that General in particular would feel compelled to continue selling feed to preserve the cattle, although PCA was the only party likely to benefit. I conclude that PCA's misrepresentations led General on to continue delivering feed to the Osbornes despite their steadily growing account, and that misconduct on the part of PCA caused injury to General.
However, as appellant points out, a claim should be subordinated "only to the extent necessary to offset the harm which the bankrupt and its creditors suffered on account of the inequitable conduct." Mobile Steel, 563 F.2d at 701. Accordingly, PCA's claim should be subordinated to that of General only to the extent that General's claim resulted from PCA's misconduct. Since the bankruptcy judge made no findings on this issue I will remand to the bankruptcy court to determine the amount of General's claim to which PCA's claim should be subordinated. . . .