N & D Properties, Inc., In re, 85-8890

• Citation: 799 F.2d 726
• Decision Date: 19 September 1986
• Docket Number: No. 85-8890,85-8890
• Parties: 15 Collier Bankr.Cas.2d 726, 15 Bankr.Ct.Dec. 254 In re N & D PROPERTIES, INC., Debtor. Julia Schou ESTES, Plaintiff-Appellee, v. N & D PROPERTIES, INC., Sofa Galleries on Paces, Defendants, David W. Cranshaw, Trustee for N & D Properties, Inc., Appellant.
• Court: United States Courts of Appeals. United States Court of Appeals (11th Circuit)

Page 726

799 F.2d 726

15 Collier Bankr.Cas.2d 726, 15 Bankr.Ct.Dec. 254

In re N & D PROPERTIES, INC., Debtor.

Julia Schou ESTES, Plaintiff-Appellee, v. N & D PROPERTIES, INC., Sofa Galleries on Paces, Defendants, David W. Cranshaw, Trustee for N & D Properties, Inc., Appellant.

No. 85-8890.

United States Court of Appeals,

Eleventh Circuit.

Sept. 19, 1986.

Robert A. Bartlett, Steven K. Bender, Peter J. Quist, Atlanta, Ga., for appellant.

Nolan B. Harmon, Karsten Bicknese, Tyrone M. Bridges, Atlanta, Ga., for plaintiff-appellee.

Appeal from the United States District Court for the Northern District of Georgia.

Before RONEY, Chief Judge, CLARK, Circuit Judge, and GIBSON ^*, Senior Circuit Judge.

CLARK, Circuit Judge:

Appellant David Cranshaw, bankruptcy trustee for debtor N & D Properties, Inc. brings this appeal from the district court's denial of subordination or invalidation of appellee Julia Estes' secured claims against the estate of the debtor. Mrs. Estes, a minority shareholder of the debtor corporation, had filed a claim against the estate for loans to the debtor in the amount of $320,000. The bankruptcy court found verifiable loans in the amount of only $192,858 and deemed $60,000 of that sum to be a capital contribution. The remaining $132,858 was then subordinated to unsecured creditor's claims on grounds of appellee's unequitable conduct toward the debtor. The bankruptcy court refused to invalidate the claim as a fraudulent conveyance or a disguised capital contribution. Appellee sought review of the order to subordinate her claims in the district court. The district court overturned the bankruptcy court's conclusions regarding inequitable conduct and let the adjusted claim of $132,858 stand as a secured claim prior to those of unsecured creditors. Denial of invalidation on alternative grounds was affirmed. The trustee now appeals from the district court order, alleging error in the denial of subordination and invalidation. We reverse in part and affirm in part.

I. FACTS

Appellee Julia Estes is a Marietta, Georgia housewife. Some years ago, she inherited several hundred thousand dollars. In February, 1980, her accountant and tax advisor, James Dowis, asked her to help him start a retail furniture business under the name N & D Properties, Inc. Estes lent N & D $40,000, with interest to be paid as a percentage of sales, and principal to be repaid "when the store got on its feet." ¹ Eight months later, appellee pledged bonds worth $100,000 to enable N & D, the debtor, to borrow money from First National Bank of Gwinnett ("FNBG"). In return, Estes received 450 shares, or 47.4 percent, of N & D. N & D then loaned appellee $25,000 of the bank loan proceeds. Appellee used the money to construct a swimming pool at her home, and repaid the loan a year later. In April, 1981, appellee pledged on behalf of N & D some American Brands Corporation stock to First National Bank of Cobb ("FNBC"). FNBC secured its loans to N & D not only with appellee's stock collateral, but also with a security interest in the debtor's inventory.

Over the course of the next two years, the debtor borrowed approximately $389,588 against appellee's stock collateral. ² Appellee was personally obligated on most of the debtor's borrowings from FNBC. In addition to pledging valuable assets in support of bank loans, appellee from time to time also made numerous small loans to the debtor.

From the debtor's inception, business affairs were directed by James Dowis rather than appellee. Dowis was the majority shareholder and president, as well as the bookkeeper and part-time store manager. Dowis' management of the debtor's affairs was inept. He failed to keep adequate records of sales and expenses, failed to maintain a trust account for consumer deposits, engaged in check kiting and used misleading and inaccurate financial statements to obtain financing from banks and trade creditors. Dowis also withdrew approximately $273,000 from the debtor for personal expenses, including the purchase of equipment for his soybean farm called "Teaselwood Farms." ³

Although appellee left management to Dowis and visited the debtor's store on only two or three occasions, she had several opportunities to learn of the debtor's financial problems. For example, appellee occasionally received the debtor's financial statements. Close inspection of these would have revealed that appellee's pledged collateral was erroneously listed as an asset of the corporation. This misrepresentation inflated the debtor's assets and thereby obscured the debtor's weak financial position. Appellee also could have learned about the debtor's problems by examining her own personal tax returns. During the years in which the debtor operated, Dowis prepared appellee's tax returns and included substantial tax deductions ⁴ based on the debtor's repeated losses. Although appellee signed the returns, she never questioned why the debtor continued to lose money nor did she connect the losses with the debtor's constant need for additional loans. The bankruptcy court attributed appellee's failure to discover the debtor's problems to appellee's lack of business education, experience and judgment.

Appellee was eventually alerted to the debtor's true financial condition in April 1983, when she learned that FNBC was considering calling its loan of $189,588. Appellee then met with Dowis and the debtor's staff to determine whether appellee should put more money into the business. One month later, the debtor's fortunes slipped again as its principal supplier stopped further shipment of furniture.

On June 23, FNBC called its loans and appellee retained a business consultant to investigate the debtor's situation in detail. Appellee's consultant learned about Dowis' mismanagement, including his failure to keep adequate records and to create a trust account for customer deposits. Despite this knowledge, appellee took no steps to close the store. The debtor continued to advertise and sell furniture, offering substantial discounts to customers who paid 50 to 100 percent of the purchase price in advance. The debtor promised delivery in six to eight weeks, even though its suppliers still refused to make further shipments. On July 18, appellee's consultant recommended that appellee make no further investment in the debtor. Appellee liquidated her stock collateral to pay FNBC and took an assignment of FNBC's security interest in the debtor's inventory.

Sometime thereafter, appellee decided that the debtor should file for protection under the bankruptcy laws. On July 22, appellee loaned the debtor $1,200 for filing fees and expenses, taking a second security interest in the debtor's remaining assets. On July 29, appellee became an officer of the debtor in order to file a valid bankruptcy petition. Three days later, the debtor filed for bankruptcy and appellee immediately resigned as secretary. On August 25, appellee filed her claim against the debtor's estate.

II. OPINIONS OF THE COURTS BELOW

As already noted, the bankruptcy court greatly reduced appellee's verified claim and then subordinated it to other claims against the estate. The court relied upon the fact that appellee had taken an assignment of FNBC's security interest on July 29, 1983, when she had full knowledge that appellee was insolvent. The court found this particularly egregious because appellee was already personally obligated to pay the debtor's loan from FNBC; she was not a disinterested volunteer. The assignment was obviously detrimental to other creditors, for it encumbered what few assets were available to the estate. For these reasons, the court also subordinated appellee's claim based on the $1,200 secured loan made to the debtor on the eve of bankruptcy.

The bankruptcy court refused to find, however, that all of appellee's loans and pledges on behalf of debtor should be considered capital contributions. It found no agreement to this effect between appellee and the majority shareholder, Dowis. The court likewise refused to find capital contributions based on the "Deep Rock" ⁵ or thin capitalization theory. In its opinion, the evidence justified only equitable subordination. The court also found no fraudulent conveyances or preferential transfers from debtor to appellee because the property allegedly conveyed had never been property of the debtor.

Later, the bankruptcy court clarified and amplified these legal conclusions in a second opinion. The court justified equitable subordination of appellee's first security interest from FNBC on several grounds in addition to appellee's pre-existing liability. First, appellee took a security interest, something she had never before done, only when the debtor was on the brink of collapse. Second, appellee's new secured position gave other creditors no notice that both the bank and a substantial shareholder were first in line. Third, appellee had displayed bad business judgment and unjustifiable ignorance about the debtor's poor prospects even though she had known for two years that debtor had initially defaulted on its principal loan. Fourth, appellee had failed to meet her burden of proof as to the good faith and fairness of her transactions with the debtor since the time she knew of its insolvency.

The district court adopted the bankruptcy court's findings of fact but disagreed with the legal conclusions in both opinions. The court reversed the equitable subordination because appellee was acting as a surety in paying off the debtor's loan. It is commonplace for a surety to assume the creditor's secured position by assignment. Furthermore, no notice problem resulted because appellee had no secret lien. She was merely standing in the shoes of FNBC of whom all creditors were aware. The district court then affirmed the decision not to consider all loans to be capital contributions. Any contrary finding would require more than the mere fact of the debtor's insolvency, it also would...