Fabricators, Inc., Matter of

• Citation: 926 F.2d 1458
• Decision Date: 27 March 1991
• Docket Number: No. 90-1019,90-1019
• Parties: 24 Collier Bankr.Cas.2d 1489, 21 Bankr.Ct.Dec. 809, Bankr. L. Rep. P 73,875 In the Matter of FABRICATORS, INC., Debtor. FABRICATORS, INC., Appellee, Cross-Appellant, v. TECHNICAL FABRICATORS, INC., Appellant, Cross-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (5th Circuit)

Page 1458

926 F.2d 1458

24 Collier Bankr.Cas.2d 1489, 21 Bankr.Ct.Dec. 809,

Bankr. L. Rep. P 73,875

In the Matter of FABRICATORS, INC., Debtor.

FABRICATORS, INC., Appellee, Cross-Appellant, v. TECHNICAL FABRICATORS, INC., Appellant, Cross-Appellee.

No. 90-1019.

United States Court of Appeals,

Fifth Circuit.

March 27, 1991.

Irvin Grodsky, Grodsky & Mitchell, Mobile, Ala., for appellee cross-appellant.

Hugh D. Keating, Gulfport, Miss., Richard Scruggs, Pascagoula, Miss., for appellee cross-appellant.

Appeals from the United States District Court for the Southern District of Mississippi.

Before THORNBERRY, JOHNSON and DAVIS, Circuit Judges.

JOHNSON, Circuit Judge:

Technical Fabricators, Inc. ("TFI") appeals a decision of the district court affirming the ruling of the bankruptcy court to equitably subordinate TFI's secured and administrative claims and to transfer TFI's liens to the estate of Fabricators, Inc. ("Fabricators") pursuant to 11 U.S.C. Sec. 510(c). In a cross appeal, Fabricators, through its bankruptcy trustee, alleges error in the subordination of TFI's claims to a level equal to and not below that of general unsecured creditors. For the reasons set forth below, this Court affirms.

I. FACTS AND PROCEDURAL HISTORY

TFI ¹ and Fabricators both were corporations engaged in the steel fabrication business. TFI's sole stockholder, as well as its chief executive officer, president and director, was Marcus Wayne Williams ("Williams"). As of January 1985, Fabricators' stock was owned in equal percentages by four persons. ² Prior to the events giving rise to this case, TFI and Fabricators had no business connection with each other.

In late 1984, Fabricators' president, James C. Avinger ("Avinger"), discussed with Williams the possibility of a merger, joint venture or outright sale of Fabricators to TFI because Fabricators was having difficulty with performing and completing its fabrication contracts. Fabricators' difficulties were due to a cash flow problem, inefficient management capability, and insufficient physical capacity and equipment in its two plants. Soon after the initial discussion, the stockholders of Fabricators and Williams began to negotiate in earnest. Fabricators' stockholders told Williams that the corporate accounting records had not been posted currently, but when posted the accounting records would show Fabricators with a positive net worth and a net profit from operations for the months of December 1984 and January 1985. The stockholders also advised Williams that Fabricators' current financial statements were not available because of computer problems.

Williams and Fabricators' stockholders executed a written stock exchange agreement on February 2, 1985, contemplating that TFI would obtain all of Fabricators' stock, while Fabricators' stockholders would receive twenty-five percent of TFI's stock. This agreement contained an escape clause allowing TFI to rescind prior to closing ³ unless TFI was satisfied with Fabricators' financial status. Incident to the stock exchange agreement, TFI agreed to loan Fabricators up to $500,000. On February 4, 1985, Fabricators executed a security agreement in order to secure any amounts TFI would loan to Fabricators, giving TFI a security interest in Fabricators' machinery, equipment, accounts receivable and contracts in progress. Thereafter, TFI made six advances to Fabricators totaling $369,000, as evidenced by certain promissory notes. ⁴

After further discussion, the parties renegotiated the stock exchange agreement. In a signed agreement on February 10, 1985, Williams agreed to eliminate TFI's escape right and set a new closing date. ⁵ Contemporaneously, Williams was formally elected Executive Vice President of Fabricators. Beginning on February 13, 1985, the same employees managed the business affairs of TFI and Fabricators jointly and Fabricators' contracts were completed using TFI's plant.

Following Williams' takeover, Fabricators' poor financial condition continued and Williams was forced to confront Fabricators' problems. In compiling financial information to apply for an asset-based loan from an institutional lender, Williams learned of an ongoing tax audit targeted at Fabricators. Williams then discovered that the institutional lender would not furnish an asset-based loan to Fabricators. On March 7, 1985, Fabricators' auditors provided Williams with preliminary drafts of their audit reports which reflected a loss of $1,200,000 through November 1984 and a loss of $169,000 for the months of December 1984 and January 1985. These revelations resulted in a meeting on March 9, 1985, attended by Williams, Fabricators' former stockholders and one of Fabricators' auditors. At this March 9 meeting, Williams expressed his intention not to consummate the stock purchase. However, for the next two weeks, Williams continued to manage Fabricators' business while Fabricators continued to use TFI's facilities. Finally, on March 24, 1985, the parties signed a release agreement to cancel the stock exchange and provide for the repayment of the amounts already advanced by TFI. While Williams did not formally resign as an officer of Fabricators, Williams no longer exercised any significant management responsibilities.

Fabricators filed its petition for relief under Chapter 11 of the Bankruptcy Code on April 9, 1985. TFI filed three proofs of claim and a request for administrative expenses from Fabricators. ⁶ As debtor-in-possession, Fabricators filed an adversary proceeding requesting the bankruptcy court to equitably subordinate TFI's claims against Fabricators and to transfer TFI's liens upon Fabricators' property to the estate pursuant to 11 U.S.C. Sec. 510(c). ⁷

After hearing testimony, the bankruptcy court made specific findings concerning Williams' knowledge of Fabricators' financial status in February. Williams knew that: (1) Fabricators' credit lines were "jammed," (2) Fabricators' bank credit was exhausted, (3) Fabricators was unable to meet its payroll or payroll tax obligations and (4) Fabricators would be unable to timely perform its contracts in progress because of the inadequacy of Fabricators' plants. The bankruptcy court emphasized the fact that Williams was not shown, and did not request, Fabricators' last federal income tax return. 109 B.R. 186. Fabricators' last income tax return, for the fiscal year ending November 30, 1983, reflected a loss of $612,000 and retained earnings of . The bankruptcy court found that TFI was an insider-fiduciary of Fabricators no later than February 2, 1985, when Williams assumed control and the two companies "effectively merged their affairs." Thus, the court undertook to rigorously scrutinize the dealings between TFI and Fabricators after that date, and found that TFI had engaged in the following inequitable conduct: (1) making loans to Fabricators on a secured basis at a time when Fabricators was undercapitalized and at a time when TFI's motivation in advancing the money was to acquire control of Fabricators in order to realize a projected $2,000,000 profit on contracts in progress; (2) causing creditors to extend new credit or to abstain from collection measures when TFI knew or should have known that Fabricators was in failing financial circumstances; (3) interfering with the completion of Fabricators' contract with Nicholson Engineering Systems to gain preferential payment and a release from TFI's liability to O'Neal Steel Corporation; (4) presenting a fraudulent resolution to open a new bank account, thus enabling Fabricators to deposit its receivables beyond the reach of a creditor; and (5) obtaining a lien upon Fabricators' assets to secure capital contributions, resulting in a shift of the risk of loss from TFI to the creditors of Fabricators.

Based on the inequitable conduct by TFI, the bankruptcy court subordinated TFI's secured claims and administrative claim to a position equal to and not below that of general unsecured creditors pursuant to 11 U.S.C. Sec. 510(c). The bankruptcy court also transferred TFI's liens to the estate as authorized by 11 U.S.C. Sec. 510(c)(2). The district court affirmed the bankruptcy court's decision in all respects, concluding that there had been sufficient findings to justify the subordination of TFI's claims under the three-pronged test enunciated in Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692 (5th Cir.1977). After the district court affirmed the bankruptcy court's order, TFI and Fabricators both timely appealed.

II. DISCUSSION

A. Standard of Review

Findings of fact made in a bankruptcy proceeding will not be set aside unless clearly erroneous. Wilson v. Huffman (In re Missionary Baptist Foundation of America, Inc.), 712 F.2d 206, 209 (5th Cir.1983) ("Missionary Baptist I" ). The clearly erroneous rule deserves strict application in this case where the district court has affirmed the bankruptcy court's findings. Id. Conclusions of law, on the other hand, are subject to plenary review on appeal. Id. Moreover, when a finding of fact is premised on an improper legal standard, that finding loses the insulation of the clearly erroneous rule. Id.

B. General Principles of Law

The bankruptcy court has long been recognized as a court of equity. See Local Loan Co. v. Hunt, 292 U.S. 234, 240, 54 S.Ct. 695, 697, 78 L.Ed. 1230 (1934). ⁸ Its equitable powers allow a bankruptcy court to produce fair and just results "to the end that fraud will not prevail, that substance will not give way to form, that technical considerations will not prevent substantial justice from being done." Pepper v. Litton, 308 U.S. 295, 305, 60 S.Ct. 238, 244, 84 L.Ed. 281 (1939). The judicially-created doctrine of equitable subordination developed as a policy against fraud and the breach of the duties imposed on a fiduciary of the bankrupt. See Id., 308 U.S. at 311, 60 S.Ct. at 247 (upholding use of equitable subordination as an equitable defense to the allowance of a claim in...