209 F.3d 252 (3rd Cir. 2000), 98-2164, Folger Adam Security v. Dematteis Macgregor

Docket Nº:98-2164, 98-2165, 99-1107, 99-1108
Citation:209 F.3d 252
Party Name:FOLGER ADAM SECURITY, INC. v. DEMATTEIS/MACGREGOR, JV; INSURANCE COMPANY OF NORTH AMERICA; FIDELITY & DEPOSIT COMPANY OF MARYLAND; SWISS REINSURANCE AMERICA CORPORATION, formerly know as North American Reinsurance Corporation DeMatteis/MacGregor, JV; Insurance Company of North America; Fidelity & Deposit Company of Maryland; Swiss Reinsurance Ameri
Case Date:March 20, 2000
Court:United States Courts of Appeals, Court of Appeals for the Third Circuit

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209 F.3d 252 (3rd Cir. 2000)




DeMatteis/MacGregor, JV; Insurance Company of North America; Fidelity & Deposit Company of Maryland; Swiss Reinsurance America Corporation, Appellants

Nos. 98-2164, 98-2165, 99-1107, 99-1108

United States Court of Appeals, Third Circuit

March 20, 2000

Argued: October 1, 1999

Appeal from the United States District Court for the Eastern District of Pennsylvania (D.C. Civ. Nos. 96-04072, 96-cv-04073) District Judge: Honorable Charles R. Weiner

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Counsel for Appellee: B. Christopher Lee, Esquire (Argued) Jacoby, Donner & Jacoby 1515 Market Street Suite 2000 Philadelphia, PA 19102

Counsel for Appellants: Carl A. Solano, Esquire (Argued) Philip G. Kircher, Esquire Jacqulynn M. Broughton, Esquire Schnader, Harrison, Segal & Lewis 1600 Market Street Suite 3600 Philadelphia, PA 19103

Before: MANSMANN, McKEE and STAPLETON, Circuit Judges.


MANSMANN, Circuit Judge.

In this appeal, we are asked to decide whether the affirmative defenses of setoff, recoupment, and other contract defenses, which arose as a consequence of alleged defaults under certain contracts with the debtors, constitute an "interest" under section 363(f) of the Bankruptcy Code such that a sale of the debtors' assets in a consolidated Bankruptcy Court auction free and clear, extinguished such affirmative defenses and effectively transformed such contract rights into unimpeachable

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accounts receivable in the hands of the purchaser. Further, this appeal raises a question as to whether the creditor whose affirmative defenses were extinguished by the Bankruptcy sale received constitutionally adequate notice such that failure to object would result in a waiver of its affirmative defenses and its deemed consent to the transformation of the debtors' contract claims into unimpeachable accounts receivable.

We find that the affirmative defenses do not constitute an "interest" for purposes of section 363(f) and, therefore, were not extinguished by the Bankruptcy sale. A setoff right, however, may only be asserted to the extent the creditor can prove it actually took the setoff prior to the bankruptcy filing. Moreover, we find that the notice of the section 363 sale given by the debtors failed to give the creditor notice that it would lose its defenses and, therefore, was constitutionally inadequate. Accordingly, we will reverse the judgment of the District Court and remand for further proceedings consistent with this opinion.


For the most part, the parties do not dispute the facts. Folger Adam Security, Inc. ("Folger") instituted the underlying declaratory judgment action against DeMatteis/MacGregor Joint Venture ("DeMatteis"), along with three sureties, Insurance Company of North America, Fidelity & Deposit Company of Maryland, and Swiss Reinsurance America Corporation, seeking $370,446.67 in unpaid "accounts receivable" relating to equipment sold to DeMatteis for a construction project. Folger acquired substantially all of the assets of three bankrupt companies through a bankruptcy auction "free and clear" of all claims and other interests.1 The facts leading up to this litigation are set forth below.

The alleged debts that are the basis of Folger's claim against DeMatteis arose from a construction project at the Curran Fromhold Prison in Northeast Philadelphia (the "Northeast Project"). DeMatteis sells and installs security systems for use within prisons. In October 1993, Perini/TriState, the general contractor on the Northeast Project, hired DeMatteis as a subcontractor to supply security equipment for the project. Prior to contracting with DeMatteis, Perini/TriState executed a labor and materialman's bond on the Northeast Project, with Fidelity & Deposit Company of Maryland and Swiss Reinsurance America Corporation (then known as the North American Reinsurance Company) acting as sureties. Insurance Company of North America issued a similar subcontractor's bond in favor of DeMatteis.

After contracting with Perini/TriState to supply the security equipment, DeMatteis sought and received proposals from the William Bayley Company ("Bayley") and the Folger Adam Company ("FAC") (collectively the "Companies" or "Debtors") to supply security hardware and furniture for the Northeast Project. In response to the proposals, DeMatteis sent letters to Bayley and FAC informing them that it intended to issue a purchase order for the equipment. On January 12, 1994, DeMatteis issued a purchase order to FAC for security equipment in the amount of $801,500.2 DeMatteis also issued a purchase order to Bayley on January 13, 1994, in the amount of $315,900.

Pursuant to the purchase orders, Bayley and FAC began supplying materials and equipment to DeMatteis for the Northeast Project sometime after April 20, 1994. They continued to supply materials and equipment until June 6, 1995 in the case of

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Bayley, and until December 20, 1995 in the case of FAC. After supplying all the materials, Bayley and FAC claimed that DeMatteis still owed them $310,648 and 59,798.67, respectively. DeMatteis refused to pay the balances due, however, claiming that the Companies had breached their contractual obligations. Specifically, DeMatteis claimed that materials and equipment furnished by Bayley and FAC were defective, requiring repurchase of missing components and the performance of remedial work. DeMatteis also claimed that materials were delivered late, causing disruption to the project's schedules and a need for "work-arounds."

Bayley and FAC advised DeMatteis that they would try to cure their defective performances. Shortly thereafter, on February 8, 1996, the Companies filed separate petitions for reorganization relief under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware. On that same date, Bayley and FAC filed a motion, pursuant to sections 363 and 365 of the Bankruptcy Code, for approval of the sale of substantially all of their assets to Folger which had been newly formed and whose management was comprised of many of the principals from Bayley and FAC. The Notice of Auction and Final Hearing on Motion to Approve the Sale of Substantially All of the Debtors' Assets and Assumption and Assignment of Certain Contracts Pursuant to 11 U.S.C. SS 363 and 365 and Providing for Final Distribution of Proceeds of Sale (the "Notice of Auction"), indicated that the sale was to be "free and clear" of all claims and other "interests" that could be asserted against the Debtors. The Notice of Auction further stated that a list of the Debtors' contracts that were being assumed by and assigned to Folger in the sale pursuant to section 365 of the Bankruptcy Code would be provided on or before February 18, 1996. Although the Debtors' contracts with DeMatteis were specifically excluded from this list, DeMatteis only became aware that Folger was not assuming these contracts some time after the March 7, 1996 bankruptcy auction.3

DeMatteis maintains that although it was listed on an affidavit of service, it did not receive the Notice of Auction from either of the Debtors. In support of this statement, DeMatteis provided the affidavit of M. MacGregor, Project Director for DeMatteis/MacGregor Security Constructors. In his affidavit, MacGregor stated that the official Notice of Auction was never received but, on February 15, 1996, an incomplete copy of the notice was received by fax from another party. He further stated that he did not understand the Debtors' accounts receivable to include monies claimed by the Debtors but denied by DeMatteis because of nonperformance of contracts. Because it believed that the disputed amounts were not included among the assets being sold at the bankruptcy auction, DeMatteis did not file an objection to the sale.

At the March 7, 1996 auction, Folger was the sole bidder and, therefore, successfully acquired substantially all of the assets of the Debtors. The Bankruptcy

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Court approved this sale on March 8, 1996.4

Between March 20 and 22, 1996, DeMatteis completed four proofs of claim which it filed in the Chapter 11 bankruptcy cases, one each with respect to the two projects which form the basis for the claims in this consolidated appeal, and the two others relating to cases pending in other courts. In the proofs of claim, DeMatteis asserted claims for replacement costs, late/incomplete delivery costs, quality problems, third party claims, productivity loss, extended overhead, loss of cash flow and interest paid, warranty costs, and additional bond premium associated with each project. On August 21, 1996, the Debtors filed an objection to the proofs of claim filed by DeMatteis, claiming that the March 8, 1996 order approving the sale and asset purchase agreement transferred the Debtors' accounts receivables from DeMatteis to Folger "free and clear" of all rights of setoff, recoupment, counterclaim and other defenses and claims of DeMatteis (the "Omnibus Motion"). DeMatteis contested this assertion, disagreeing with the Debtors' re-characterization of the executory contracts (which were specifically excluded from the sale) as "accounts receivable." Nonetheless, the Bankruptcy Court entered an order on October 10, 1996, disallowing and expunging the proofs of claim objected to in the Omnibus Motion.5

In the meantime, on May 31, 1996, Folger instituted two lawsuits against DeMatteis in the United States District Court for the Eastern District of Pennsylvania asserting breach of contract. In Civil Action No. 96-4072...

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