Ahlswede, In re, 73-2506

• Decision Date: 29 April 1975
• Docket Number: No. 73-2506,73-2506
• Parties: In the Matter of Arthur Clarke AHLSWEDE and Dorothy Ahlswede, Bankrupts. Richard W. STEBBINS, Trustee, Appellant, v. CROCKER CITIZENS NATIONAL BANK, Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 784

516 F.2d 784

In the Matter of Arthur Clarke AHLSWEDE and Dorothy Ahlswede, Bankrupts Richard W. STEBBINS, Trustee, Appellant, v. CROCKER CITIZENS NATIONAL BANK, Appellee.

No. 73-2506.

United States Court of Appeals Ninth Circuit.

April 29, 1975.

Bruce D. Roberts (argued), Reno, Nev., for appellant.

Richard R. Clements (argued), Los Angeles, Cal., for appellee.

OPINION

Before CHAMBERS, KOELSCH and KILKENNY, Circuit Judges.

KOELSCH, Circuit Judge:

This case presents a unique question regarding the extent of a bankruptcy court's equitable power to subordinate a creditor's claim against the bankruptcy estate.

Bankrupt is one of four beneficiaries of a so-called "spend-thrift" trust created inter vivos by his father. The trust instrument provides that "(t)he interests of all beneficiaries other than the Trustor in principal or income shall not be subject to claims of their creditors or others nor to legal process and may not be voluntary (sic ) or involuntary (sic ) alienated or encumbered." The trust situs is California; California law enforces such trust provisions. See Kelly v. Kelly, 11 Cal.2d 356, 79 P.2d 1059 (1938); Cal.Civ.Code § 867. But see Cal.Civ.Code § 859; II Scott on Trusts § 152.1, at 1143 and n.21 (3d ed. 1967); Comment, Trusts: Spendthrift Trusts in California: Civil Code Sections 859 and 867: Planning and Construction of Spendthrift Provisions, 40 Cal.L.Rev. 441, 442 (1952). The effect of the trust provision is that upon the bankruptcy of the beneficiary his equitable interest in the income and principal of the trust estate, being non-assignable and immune from judicial process under California law, does not pass to the trustee of the bankruptcy estate, under Section 70(a)(5) of the Bankruptcy Act, 11 U.S.C. § 110(a)(5), and title remains in the trustee of the spendthrift trust. ¹ See 4A Collier on Bankruptcy P 70.26, at 364-71 (rev.ed.1971); Restatement of Trusts 2d §§ 149, 152 (1959); Danning v. Lederer, 232 F.2d 610 (7th Cir. 1956); Scott, supra, § 152.2, at 1150-51.

The claimant in this bankruptcy proceeding is the Crocker National Bank (Bank), the trustee of the bankrupt's spendthrift trust, claiming on behalf of the trust. The Bank's claim derives from a number of promissory notes, held as assets of the trust, evidencing loans made to the bankrupt at various times either by his father or the Bank, and now due the trust.

The trust instrument sets up a plan for equal periodic distributions of the income and principal of the trust to the four beneficiaries. It also provides that if a beneficiary is indebted to the trust when a distribution is scheduled, his distributive portion must first be used to offset his indebtedness. All of the bankrupt's shares of trust income and principal have heretofore been applied to discharge his obligations to the trust, and several distributions remain to be made.

However, in this proceeding the Bank seeks to have the remaining indebtedness immediately discharged (insofar as possible) by allowing the trust to share in the bankruptcy estate on a parity with the general creditors. The ultimate effect of such a recovery by the Bank for the trust will be, of course, that the bankrupt's obligations to the trust will be diminished by reducing the shares going to general creditors, and the share of the trust which the bankrupt will ultimately receive will increase.

The trustee in bankruptcy objected to the claim, but the referee allowed it as provable, apparently concluding that the notes reflected bona fide debts rather than anticipatory distributions of the bankrupt's share of the trust estate. ² However, the referee subordinated the Bank's claim to those of the other creditors. The referee justified his exercise of his general equitable powers on the rationale that it was unfair that the spendthrift trust should insulate the bankrupt's beneficial interest in the trust from the general creditors but that the trust should share with the creditors in the bankrupt's other assets, thereafter distributing assets in an equivalent amount to the bankrupt free of the creditor's claims. ³

On review, the district court reversed, holding that under the circumstances the Bankruptcy Act permits the Bank to share equally with the other unsecured general creditors, and that the referee lacked cognizable equitable grounds for subordinating the claim. We agree.

The trustee quite properly concedes that, despite the fact that the trust's claim against the bankrupt is to some extent ⁴ secured by his distributive share of the trust, the Bank's claim was properly filed as an unsecured claim. The Bankruptcy Act defines a secured creditor as one "who has security for his debt upon the property of the bankrupt of a nature to be assignable under this title" (11 U.S.C. § 1(28) ). The bankrupt's interest in the trust is not assignable and not part of the bankruptcy estate; consequently the trust's claim is not secured within the meaning of the Act, and the Bank may file its claim as unsecured. Ivanhoe Bldg. Assn. v. Orr,295 U.S. 243, 55 S.Ct. 685, 79 L.Ed. 1419 (1935).

The remaining question therefore is whether the referee could subordinate the Bank's claim (undoubtedly thereby defeating it).

Subordination is an equitable power. We recognize the principle that a bankruptcy court is a court of equity, charged to apply equitable principles to reach equitable results when administering the Bankruptcy Act. In doing so, the bankruptcy "chancellor" may disregard form for substance and alter the result which would obtain under a formal application of general legal principles, in order to do equity. Pepper v. Litton, 308 U.S. 295, 60 S.Ct. 238, 84 L.Ed. 281 (1939).

Nevertheless, the bankruptcy court's power to impose a result different from that prescribed by the statutory distribution scheme is not unlimited. The standard is that "(a claim's) disallowance or subordination may be necessitated by certain cardinal principles of equit(able) jurisprudence." Pepper v. Litton, supra, at 306, 60 S.Ct. at 245. In defining the nebulous "cardinal principles of equitable jurisprudence," it is important to keep in mind that the chancellor never did, and does not now, exercise unrestricted power to contradict statutory or common law when he feels a fairer result may be obtained by application of a different rule. Courts of equity have long applied standards of conscience to conduct on an individual basis to prevent formally proper but unconscionable applications of legal rules; they have not engaged in the practice of making abstract legislative judgments about the fairness of a result contemplated by the legislature's statutory scheme if it has otherwise been followed in good faith and without overreaching. See Colonial Trust Co. v. Goggin, 230 F.2d 634, 636-37 (9th Cir. 1955). As Maitland put it:

"(W)e ought to think of equity as supplementary law, a sort of appendix added on to our code, or a sort of gloss written round our code, an appendix, a gloss, which used to be administered by courts specially designed for that purpose, but which is now administered by the High Court of Justice as part of the code. The language which equity held to law, if we may personify the two, was not 'No, that is not so, you make a mistake, your rule is an absurd, an obsolete one'; but 'Yes, of course that is so, but it is not the whole truth.' "

Maitland, Equity; A Course of Lectures 18 (1936). Here, the referee in effect said, "No, the distribution scheme provided by the Act is a mistake, the rules of spendthrift trusts and the definition of a secured creditor are absurd and obsolete," and reached a different result.

Whatever the validity of the referee's judgment on the merits of the statutes, a trio of Supreme Court cases dealing with subordination in a closely analogous situation makes clear that he was without power to impose it. In the three mentioned cases the Court indicated that before a bankruptcy court may disallow or subordinate a claim, some basis must exist of the sort traditionally cognizable by equity as justifying its intervention, such as fraud, breach of fiduciary duties, mismanagement, overreaching; in fact, any breach of the multitude of "rules of fair play and good conscience" (Pepper v. Litton, supra, 308 U.S. at 310, 60 S.Ct. at 247) traditionally enforced by a court of equity will suffice. A supposed inequity resulting when an innocent party in good faith asserts a legally valid claim will not. Comstock v. Group of Institutional Investors, 335 U.S. 211, 68 S.Ct. 1454, 92 L.Ed. 911 (1948).

In the first two cases of the trilogy, Taylor v. Standard Gas & Electric Co., 306 U.S. 307, 59 S.Ct. 543, 83 L.Ed. 669 (1939) (The Deep Rock Case), and Pepper v. Litton, supra, the Court subordinated...