Applied Logic Corp., In re, 671

• Decision Date: 27 April 1978
• Docket Number: No. 671,D,671
• Citation: 576 F.2d 952
• Parties: In re APPLIED LOGIC CORPORATION, Bankrupt. NEW JERSEY NATIONAL BANK, Plaintiff-Appellant, v. Daniel GUTTERMAN, as Trustee of Applied Logic Corporation, Bankrupt, Defendant-Appellee. ocket 77-5034.
• Court: U.S. Court of Appeals — Second Circuit

Page 952

576 F.2d 952

In re APPLIED LOGIC CORPORATION, Bankrupt.

NEW JERSEY NATIONAL BANK, Plaintiff-Appellant, v. Daniel GUTTERMAN, as Trustee of Applied Logic Corporation, Bankrupt, Defendant-Appellee.

No. 671, Docket 77-5034.

United States Court of Appeals, Second Circuit.

Argued Feb. 23, 1978.

Decided April 27, 1978.

Michael S. Landes, New York City, (Hahn, Hessen, Margolis & Ryan and Gilbert Backenroth, New York City, of counsel), for plaintiff-appellant.

Mark D. LeBow, New York City (Coudert Brothers and Victor C. Murphy, New York City, of counsel), for defendant-appellee.

Before FRIENDLY, MULLIGAN and MESKILL, Circuit Judges.

FRIENDLY, Circuit Judge:

This appeal from an order of Judge Goettel in the District Court for the Southern District of New York affirming an order of Bankruptcy Judge Babitt raises questions of some difficulty concerning a bank's rights to exercise a set-off of an unsecured debt owed it by the bankrupt against deposits and certificates of deposit held by the

bank. The Bankruptcy Judge and the district court decided adversely to the bank. Although the case is close, we are constrained to reverse.

THE FACTS

The bankrupt, Applied Logic Corporation, (ALC) is a New Jersey corporation in the computer time sharing business whose headquarters were in Princeton, N. J. In 1967 it opened a demand checking account ("the account") with appellant New Jersey National Bank (NJNB) and was given a $100,000 line of credit. ALC incurred indebtedness to NJNB in much larger amounts and became indebted to other banks. By September, 1970, its bank debt had risen to $1,300,000, held as follows:

                New Jersey National Bank  $  650,000
                First National Bank of
                  Princeton                  300,000
                Chase Manhattan Bank         250,000
                First National City Bank     100,000
                                          ----------
                                          $1,300,000
                

In addition ALC had entered into various equipment leases under which it was in arrears in an amount exceeding $2,000,000 and owed Digital Equipment Corp. (DEC) over $1,000,000 for purchases of equipment.

Discussions between ALC, the banks, five lessors, and DEC resulted in an agreement dated September 2, 1970. Summarily stated, this provided as follows: The five lessors granted a moratorium on all rental payments until August 1, 1971; the deferred payments were to be paid in 26 equal monthly installments beginning on that date except that if ALC's cash flow would not permit, the beginning date for the deferred payments could be postponed to August 1, 1972. The banks also agreed to forbear demand for payment of principal until August 1, 1971. The bank indebtedness was to be converted into two notes "payable at the New Jersey National Bank" one in the amount of $300,000, "which shall be held by New Jersey National Bank on behalf of First National Bank of Princeton", and the other in the amount of $1,000,000, "which shall be held by New Jersey National Bank on behalf of the other Banks." ¹ Payment of interest on the $300,000 but not on the $1,000,000 note was deferred until August 1, 1971. ALC was to "conduct all banking of its funds at and through New Jersey National Bank until both notes are paid." Special arrangements, unnecessary here to detail, were made between ALC and DEC. NJNB extended to ALC an irrevocable line of credit in the amount of $750,000 until August 1, 1971. None of this was to be drawn down unless ALC raised $300,000 through the sale of convertible notes. The banks other than First National Bank of Princeton were to participate ratably in this line of credit. All loans taken by ALC pursuant to the new line of credit were to be secured in a manner detailed in the agreement and interest was to be paid monthly.

The 1970 agreement also provided for a committee of five members, one member for each of four lessors and NJNB, which was to monitor ALC's business. Any member of the Committee could cause the agreement to be terminated if for monthly periods ending on June 30, 1971, ALC's cash expenditures exceeded cash receipts by more than specified amounts, or operating revenues fell below specified amounts, or in certain other events. Any three members of the Committee could terminate the agreement if more rigorous terms were not met.

On May 25, 1971, ALC took down the last $100,000 of the line of credit provided by the 1970 agreement. ² Although, as stated, Chase Manhattan Bank and First National City Bank had agreed to participate in the loan, NJNB alone advanced the $100,000. In the demand note evidencing the loan, ALC pledged as security All unencumbered assets, including specifically: Fixtures and equipment as listed in Schedule A-B attached, all inventory and after acquired inventory, all accounts receivable now or arising hereafter, all notes receivable as listed on Exhibit # 1, attached.

The note was accompanied by a security agreement and a financing statement containing the same statement of collateral, the latter of which apparently were filed in accordance with § 9-401 of New Jersey's version of the Uniform Commercial Code. ³

As ALC's financial situation continued to deteriorate, it entered into a new agreement, dated September 15, 1971 with the parties to the 1970 agreement, and another creditor, Bryant Computer Products. The amended agreement required ALC to use its best efforts to raise a minimum of $500,000 in cash as working capital. Once ALC raised $300,000, the banks and the lessors would reduce their existing claims (other than the $100,000 secured loan by NJNB) by half in consideration of stock or non-interest bearing subordinated notes or both. ALC was to make monthly payments to a special account in NJNB in an amount determined by its cash flow; ⁴ such payments were to be applied to payment of ALC's debt in a manner described in the agreement. Nothing contained in the agreement was to affect any security interest held by any bank or lessor. ALC's board of directors was to be reconstituted so that persons designated by the lessors would constitute a majority; there was also to be one person designated by the banks. ALC was required to report an aging of its accounts receivable monthly to the banks. Any creditor could declare his debt to be immediately due and payable if ALC failed to meet specified cash flow goals, if it failed to raise the full $500,000 working capital required by the agreement or under other specified conditions.

Michael Lynch, executive vice-president of NJNB, became the banks' representative on ALC's board of directors. The special account called for by the 1971 agreement was never established. Instead the minutes of a directors' meeting held on August 29, 1972, recite:

The Board authorized payment of creditors directly instead of through a special account to expedite the receipts by individual parties.

The record suggests that the requisite amount of working capital was raised, though it is not clear whether the deadlines for this specified in the agreement were met. ⁵ Any such amounts as well as receipts in the ordinary course of business were paid into the general account which ALC had established in 1968. Mobach, the president of ALC, testified that payments were made from the general checking account in accordance with the formula in the 1971 agreement, though there was no documentary evidence corroborating this or showing the dates or amounts of any such payments. When monies accumulated in the account in excess of $100,000, NJNB, with ALC's approval, would invest these in its own certificates of deposit, of which it retained possession; the certificates would be "rolled over," again with ALC's assent, when they matured. ⁶ While NJNB did not insist on In June, 1974, about the time of discussions of ALC's likely inability to meet its obligations under the agreements, ALC endeavored to transfer a $100,000 certificate of deposit from the NJNB account to its account at the Princeton National Bank ⁸ for the purpose of meeting a payroll. In accordance with Lynch's instruction permission for this was refused. On July 3, 1974, NJNB notified ALC in writing that the latter was in default, which seems to be conceded, and that NJNB was accelerating ALC's debt to it, and Lynch resigned from ALC's board. Later NJNB told ALC that it intended to set off the balance in the account against its debt. At ALC's request NJNB agreed not to do this temporarily if ALC would maintain its existing balance. Thereafter NJNB examined each check to make certain that it was being used solely for operating purposes. On December 3, 9, and 31, 1974, NJNB applied certificates of deposit in the respective amounts of $100,739.58, $101,551.11 and $41,485.42 ⁹ against the balance of $325,000 due on its unsecured loan; in April, 1975 it applied funds in the account of $1,682.98 and a cashier's check in the amount of $830.62 representing interest on a CD against the loan balance. On April 1, 1976, NJNB set off an additional $26,095.76. ¹⁰

initialing checks since this might adversely affect ALC with customers, there were a few (apparently only two or three) occasions on which it inquired about a particularly large check. ⁷

Meanwhile, on March 27, 1975, ALC had filed a petition in the District Court for the Southern District of New York under Chapter XI of the Bankruptcy Act. Later, on August 10, 1976, it was adjudicated a bankrupt and Daniel A. Gutterman was appointed trustee. In the interval NJNB had filed a complaint, pursuant to Part VII of the Rules of Bankruptcy Procedure, before Bankruptcy Judge Herzog with respect to the $100,000 secured note. It alleged that $56,862.93 of the principal was due and unpaid ¹¹ and sought a declaration of the validity of its lien, a disposition of the collateral to satisfy its claim, and leave to file an unsecured claim for any balance. ALC filed an answer and counterclaim, which were later amended contending that the setoffs were not permitted by § 68 a of the Bankruptcy Act, constituted...