Saugus General Hosp., Inc., In re, 82-1420

Citation698 F.2d 42
Decision Date20 January 1983
Docket NumberNo. 82-1420,82-1420
Parties7 Collier Bankr.Cas.2d 1276 In re SAUGUS GENERAL HOSPITAL, INC., Debtor. Philip L. SISK, Receiver of Saugus General Hospital, Plaintiff, Appellee, v. SAUGUS BANK AND TRUST COMPANY, Defendant, Appellant.
CourtUnited States Courts of Appeals. United States Court of Appeals (1st Circuit)

James R. DeGiacomo, Boston, Mass., with whom Susan J. Baronoff, and Roche, Carens & DeGiacomo, Boston, Mass., were on brief, for Saugus Bank and Trust Co.

Anthony M. Feeherry, Boston, Mass., with whom Jon D. Schneider, Marjorie R. Corman, and Goodwin, Procter & Hoar, Boston, Mass., were on brief, for Philip L. Sisk.

Before BROWN, * Senior Circuit Judge, BOWNES and BREYER, Circuit Judges.

BREYER, Circuit Judge.

This bankruptcy appeal requires us to determine the setoff rights of a secured creditor under Massachusetts law. The creditor-appellant, Saugus Bank and Trust Co. ("the Bank"), set off about $83,000 contained in a general account and a payroll account of the debtor, Saugus General Hospital ("the Hospital"), against a $134,000 Hospital debt that was secured by a mortgage on the Hospital facility itself. The Hospital's receiver, Philip Sisk, contested the setoff and sued to recover the deposits. In our view, Massachusetts law allowed the Bank to set off funds from the Hospital's general account, to the extent that the Bank reasonably believed that the security it held was inadequate to pay the outstanding Hospital debt. We remand this case to the bankruptcy court for application of this principle to the facts.

I

In early 1967, the Bank loaned the Hospital $200,000, to be repaid over fifteen years at 6 percent interest. The loan was secured by a first mortgage on real property, namely the 110-bed facility and adjacent land in Saugus. The Hospital, in and out of default over the years, stopped paying the Bank entirely after September 1977. On July 20, 1978, the Bank informed the Hospital that it would foreclose on the mortgage. On August 19, 1978, the Hospital's directors voted to close the facility and dissolve the corporation. Nine days later, on August 28, the Bank took the steps at issue here.

On August 28, the Hospital owed the bank $134,775.77 on its mortgage loan. On the same day, the Hospital had on deposit with the Bank the following amounts in three separate accounts: $63,261.40 in a general account; $20,006.68 in a payroll account; and $388.84 in a tax account. The Bank simply debited the three accounts for the amounts they contained and credited its own treasurer's account with the total sum, namely $83,656.92. There is testimony it did this because it believed that the Hospital could not pay what it owed and that the foreclosure would not bring in enough money to cover the debt. Immediately after it learned what the Bank had done, the Hospital wrote a check for about $31,000 to transfer money out of its general account, but the Bank refused to honor the check.

Three days later an involuntary bankruptcy petition was filed against the Hospital. The Hospital stopped operating altogether on September 6. The sale of its property was not completed, however, for another sixteen months. By that time, enough taxes (and possibly other priority expenses) had accrued so that the Bank received only $6,500 from its first mortgage foreclosure sale. In the meantime, the receiver had begun an action in the bankruptcy court to recover from the Bank the money that the Hospital had had on deposit.

The bankruptcy court held for the receiver as to the funds in the payroll account. It concluded that the Bank could not set off such "special purpose" funds. It held against the receiver, however, as to the funds in the general account. It reasoned that, under Massachusetts law, a bank can set off funds only if it has good reason to believe that its security is inadequate, but that here the Bank had such reasons. The court did not ask the further question whether the Bank had set off more money than was necessary to make up for the security's inadequacy. The court thought that Massachusetts law did not require this inquiry and that a bank whose security was inadequate in any amount could set off the full amount of a debtor's deposits (up to the amount of the debt). Finally, because the receiver waived all claims to the $388 in the tax account, the court did not consider the propriety of that setoff.

The receiver appealed to the district court, where he won a larger recovery. The district court held that the Bank, as a secured creditor, could set off nothing unless it had an objective basis for believing that the security was inadequate. The court stated that the Bank should have had the security, the Hospital's property, appraised before setting off any Hospital funds. And, since the Bank had not conducted such an appraisal, the court found for the receiver and disallowed the entire setoff. The Bank appeals.

II

The threshold question is whether the Bank's setoff rights are to be determined by state or federal law. The parties and the courts below had proceeded on the assumption that Massachusetts law governs, but the Bank now raises the possibility that Sec. 68 of the former Bankruptcy Act imposes a federal standard. Assuming that the question may be presented for the first time on appeal, compare Dobb v. Baker, 505 F.2d 1041, 1044 (1st Cir.1974), with Johnston v. Holiday Inns, Inc., 595 F.2d 890, 894 (1st Cir.1979), we believe that the bankruptcy court and district court properly looked to the law of Massachusetts. We are aware of no case holding that federal rather than state law governs pre-petition setoffs. Cf. Studley v. Boylston Bank, 229 U.S. 523, 528-29, 33 S.Ct. 806, 808-09, 57 L.Ed. 1313 (1913) ("[T]here is nothing in Sec. 68a which prevents the parties from voluntarily doing, before the petition is filed, what the law itself requires to be done after proceedings in bankruptcy are instituted."). Even those cases that have held that federal standards govern post -petition setoffs under Sec. 68, moreover, have cast those standards " 'with an interested eye' toward the [forum state's] decisions." In re Goodson Steel Corp., 488 F.2d 776, 779 (5th Cir.1974) (quoting In re A.M. Townson & Co., 283 F.2d 449, 452 (3d Cir.1960)). Moreover, to refer to forum law, at least where that law is not hostile to the interests of federal bankruptcy policy, cf. United States v. Little Lake Misere Land Co., 412 U.S. 580, 93 S.Ct. 2389, 37 L.Ed.2d 187 (1973), is particularly appropriate where (as here) forum law restricts the setoff right, since Sec. 68 was not intended to expand pre-existing setoff rights but merely to preserve them in bankruptcy. See Studley v. Boylston Bank, 229 U.S. at 528, 33 S.Ct. at 808; Lehigh Valley Coal Sales Co. v. Maguire, 251 F. 581 (7th Cir.1918). It would be ironic were we to construe Sec. 68 to place the Bank in a better position by virtue of the Hospital's bankruptcy than it would have occupied had the Hospital defaulted on its loan but been able to stay out of bankruptcy court.

The Bank's setoff rights are governed by Massachusetts' basic common-law setoff doctrines. While the parties are free to modify these common-law setoff rules by contract, they have not done so here. Massachusetts occupies a minority position among American jurisdictions with regard to the setoff rights of secured creditors. In most jurisdictions, whether or not a creditor is secured, he can defend against a suit for money owed by asserting a setoff defense--that is, by showing that he set off a debt that he owed the plaintiff against a debt that the plaintiff owed him. See, e.g., Duncan v. Coahoma Bank, 397 So.2d 891 (Miss.1981); Allied Sheet Fabricators, Inc. v. Peoples Nat'l Bank of Washington, 10 Wash.App. 530, 518 P.2d 734, cert. denied, 419 U.S. 967, 95 S.Ct. 231, 42 L.Ed.2d 183 (1974). Thus, notwithstanding his status as a bankrupt, a depositor suing a bank for the return of his deposit ordinarily cannot recover if the bank has set off amounts due on any loan from the bank to the depositor, regardless of whether the bank has taken security for the loan. See Jensen v. State Bank of Allison, 518 F.2d 1 (8th Cir.1975) (applying Iowa law). In Massachusetts, however, a creditor loses his right to a setoff if the debt owed him is fully secured. See Prudential Realty Co. v. Commissioner of Banks, 241 Mass. 277, 135 N.E. 221 (1922); Furber v. Dane, 203 Mass. 108, 89 N.E. 227 (1909). We are asked here to decide: (1) whether a Massachusetts bank creditor can exercise a setoff right if it fears but cannot be certain that its security is inadequate; and (2) if so, whether it can set off the full amount of the deposit or only the amount by which the security is inadequate.

We believe that the answers to these questions flow readily from a consideration of the principles underlying Massachusetts setoff law. The right to set off debts owed to an insolvent party is derived not merely from principles of administrative convenience, but from principles of equity that would make it unfair for A to recover money from B when, because of A's insolvency, B could not recover an offsetting debt from A. From the beginning, Massachusetts courts insisted that a creditor show not merely "[t]he existence of cross demands," but "some peculiar equity which entitled him to be protected against his adversary's demand." Spaulding v. Bachus, 122 Mass. 553, 554 (1877). This insistence on confining setoffs to those cases in which equitable considerations support them plausibly accounts for Massachusetts' refusal to allow a creditor to set off a debt when the creditor is otherwise adequately secured. The very act of asserting a setoff by a creditor institution like a bank may severely injure the debtor by destroying his liquidity and throwing him into bankruptcy, while the need for a fully secured creditor to assert a setoff is minimal. This potential "inequity" in allowing a fully secured creditor to assert such a...

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