563 F.2d 692 (5th Cir. 1977), 75-4195, Matter of Mobile Steel Co.

Docket Nº:75-4195.
Citation:563 F.2d 692
Party Name:In the Matter of MOBILE STEEL COMPANY, Debtor. Elaine E. BENJAMIN et al., Appellants, v. Lester Y. DIAMOND, as Trustee in Bankruptcy for Mobile Steel, Inc., Appellee.
Case Date:November 21, 1977
Court:United States Courts of Appeals, Court of Appeals for the Fifth Circuit
 
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563 F.2d 692 (5th Cir. 1977)

In the Matter of MOBILE STEEL COMPANY, Debtor.

Elaine E. BENJAMIN et al., Appellants,

v.

Lester Y. DIAMOND, as Trustee in Bankruptcy for Mobile

Steel, Inc., Appellee.

No. 75-4195.

United States Court of Appeals, Fifth Circuit

November 21, 1977

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I. David Cherniak, J. Don Foster, Mobile, Ala., for appellants.

Herbert P. Feibelman, Jr., Mobile, Ala., for appellee.

Appeal from the United States District Court for the Southern District of Alabama.

Before GODBOLD and CLARK, Circuit Judges, and HOFFMAN, [*] District Judge:

CLARK, Circuit Judge:

The appellants are organizers, officers, and directors of the bankrupt, the Mobile Steel Company, Inc. (Mobile Steel), members of their immediate families, and a corporation which one of them controls. They attack the district court's affirmance of the bankruptcy judge's decision to subordinate some of their claims against the bankrupt estate to those asserted by other unsecured creditors, and to disallow some that were not subordinated. The principal question presented is whether the claimants violated the "rules of fair play and good conscience" 1 in their dealings with the corporation and its creditors, and in their management of corporate affairs. We hold that they did not.

I. FACTUAL AND PROCEDURAL BACKGROUND

  1. The Proceedings Below

    The claims at issue in this case 2 were filed during proceedings conducted under Chapter XI of the Bankruptcy Act, 11 U.S.C.A. §§ 701 et seq. (1970), and challenged by the trustee, Lester Y. Diamond. For the purpose of analysis the claims may be divided into two groups. The first group, Claim Nos. 17-19, 26, and 27, consists of claims based upon the debentures issued to all but one of the appellants by Mobile Steel's predecessor, the E.B.F. Company, Inc. (E.B.F.), on the day after its incorporation. The second group, Claim Nos. 20, 23 and 24, is comprised of claims arising from promissory notes given to three of the appellants by Mobile Steel in exchange for some commercial property located in Savannah, Georgia. The bankruptcy judge disallowed the first group of claims on the ground that the consideration which the appellants had given in exchange for the debentures was a contribution to capital rather than a loan. 3

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    He subordinated Claim Nos. 20 and 24 of the second group to the claims asserted by other unsecured creditors because he concluded that the appellants had failed to demonstrate that they had properly performed their fiduciary duties and acted in good faith toward Mobile Steel and its creditors in arranging for Mobile Steel to purchase the Georgia property from a partnership which they controlled at a time when Mobile Steel was in precarious financial condition. The district court affirmed the bankruptcy judge's decision without opinion. This appeal followed.

  2. The Origin of the Mobile Steel Company and the Issuance of the Corporate Debentures

    On February 18, 1965, Harvey L. Benjamin (Benjamin), Ernest H. Woods (Woods), 4 and Frank A. Plummer (Plummer), formed E.B.F. Its authorized capital consisted of 37,500 shares of $10 par value common stock ($375,000.00) and 1,250 shares of $100 par value preferred stock ($125,000). Initial subscriptions for 12,500 shares of common stock ($125,000.00) and all 1,250 shares of the preferred ($125,000.00) produced a paid in capital of $250,000.00.

    E.B.F.'s officers and directors included Benjamin (Director, President, and Treasurer), Ernest Woods (Director and Chairman of the Board), Plummer (Director), and William Woods (Secretary). They owned E.B.F.'s capital stock in the following proportions: Benjamin (20%), Benjamin's wife Elaine (20%), Woods (0.62%), Woods' son William (17.2%), the Lynspen Company (17.2%), 5 and Plummer (24.98%). The Board of Directors authorized E.B.F. to purchase the assets of the Mobile Steel Company, Inc. (old Mobile Steel), except for the cash surrender value of life insurance policies on two principal officers, and to assume most of its liabilities. For the stated purpose of improving "the cash position of the corporation" and "thus . . . its credit rating," the Board also approved a proposal that E.B.F. issue 100 debentures, each with a face value of $2,500.00 ($250,000), bearing 6% interest payable bi-annually, and maturing ten years from March 1, 1965. As soon as this resolution was passed Benjamin, Woods, and Plummer offered to "loan and advance" E.B.F. $250,000.00 in exchange for the debentures. The Board voted to accept their offer, and the debentures were issued to them and their designees. 6

    A few days after its incorporation E.B.F. purchased old Mobile Steel for approximately.$1.2 million. It combined a bank loan of $650,000, secured by a mortgage on the real property transferred, all $250,000 of its paid in capital, and the $250,000 obtained from the issuance of the debentures to finance the acquisition. On February

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    23, E.B.F. changed its corporate name to "Mobile Steel Company, Inc.," and the bankrupt was born. Because the purchase of the assets of old Mobile Steel had consumed all of the new company's cash, it borrowed $822,893.52 from James Talcot, Inc., to serve as operating capital, pledging its trade accounts receivable and inventories as collateral.

    Within two years of its date of incorporation Mobile Steel acquired two subsidiaries that were destined to play an important role in the course of events we must explore. The first is the McGowin-Lyons Hardware & Supply Company, Inc. (McGowin-Lyons), which Mobile Steel purchased on October 29, 1965. The significance of the McGowin-Lyons acquisition is twofold. First, McGowin-Lyons later bought $185,000 worth of the Mobile Steel debentures from the appellants. When the subsidiary was dissolved on April 6, 1968, the bankrupt's obligation to repay these bonds was extinguished. The remaining $65,000 worth of debentures are still outstanding and constitute the basis of Claim Nos. 17-19, 26, and 27. Second, on December 8, 1966, McGowin-Lyons received $400,000.00 from the sale of property under threat of imminent condemnation. The opportunity afforded by Section 1033 of the Internal Revenue Code of 1954, 26 U.S.C.A. § 1033 (1967) to avoid recognition of the $378,750.00 capital gain resulting from the transaction through a reinvestment in similar property which had been preserved until December 31, 1969 by extensions, passed to Mobile Steel upon McGowin-Lyons' dissolution. The existence of this potential tax benefit forms a part of the context of the bankrupt's subsequent decision to purchase the Georgia property.

    Mobile Steel acquired a second subsidiary, the Jones & Armstrong Steel Company, Inc. (Jones & Armstrong), on November 9, 1966. Jones & Armstrong is important primarily because of its involvement in the transfers of the Georgia property.

  3. Mobile Steel's Purchase and Resale of the Georgia Property

    About 1967, 7 Benjamin, Tumlin & Woods, a partnership comprised of Benjamin, Woods, and Dwight-Tumlin, purchased some commercial property (including land, improvements, machinery, and equipment) located in Savannah, Georgia, at a bankruptcy sale. Although the partnership had originally offered the Trustee $250,000, and the realty and improvements alone had recently been appraised at $210,700.00, the price it paid was $200,000.00. 8 In order to finance its purchase, the partnership borrowed $200,000 from the Citizens & Southern National Bank, giving in exchange a note secured by a first mortgage on the property. The partnership then leased the property to Jones & Armstrong, which had agreed to guarantee payment of the partnership's note.

    Shortly after McGowin-Lyons had realized the $378,750.00 capital gain, Mobile Steel began to search for a suitable piece of similar property in which it could reinvest the proceeds of the sale, thereby deferring recognition of the capital gain. Although it succeeded in finding four such parcels, their aggregate purchase price amounted to only $23,655.00, obviously far less than what was needed. Negotiations for the purchase of other larger pieces of property fell through because Mobile Steel was unable to obtain the necessary financing. As the deadline for reinvestment, December 31, 1969, drew near, the partnership agreed to sell the

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    Georgia property to the bankrupt. Mobile Steel's Board of Directors authorized the purchase on December 19, 1969. The terms of the transaction were as follows. The total purchase price was $236,364.83. Of this $210,700.00 was allocated to the real estate. In payment of this amount Mobile Steel assumed the partnership's undischarged indebtedness to the bank of $123,342.16 and gave the partnership two promissory notes, secured by a second mortgage on the land, totalling $87,357.84 which were to mature in ten years and bear annual interest of 6%. The remaining $25,664.83 of the purchase price was allocated to the machinery and equipment located on the property. In order to cover this amount, Mobile Steel gave the partnership a third ten-year promissory note, secured by a second mortgage on the machinery and equipment, also bearing interest at the rate of 6% annually. The partnership did not request a downpayment, and no cash changed hands. Benjamin testified that this was because "we (the partnership) felt that Mobile Steel did not have or could not take that money out of their operating assets at that time."

    Shortly after the purchase was consummated, Mobile Steel entered into negotiations with the Ingalls Iron Works Company (Ingalls) in an attempt to arrange for the sale of Jones & Armstrong to Ingalls. The talks culminated in Ingalls agreement to purchase Jones & Armstrong, and the necessary documents were...

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