Costello v. Fazio

Citation256 F.2d 903
Decision Date28 May 1958
Docket NumberNo. 15587.,15587.
PartiesJohn COSTELLO, Trustee in Bankruptcy of Leonard Plumbing and Heating Supply, Inc., Bankrupt, Appellant, v. J. A. FAZIO and Lawrence C. Ambrose, Appellees.
CourtUnited States Courts of Appeals. United States Court of Appeals (9th Circuit)

COPYRIGHT MATERIAL OMITTED

Francis P. Walsh, Henry Gross, James M. Conners, Stuart R. Dole, San Francisco, Cal., for appellant.

Shapro & Rothschild, San Francisco, Cal., for appellees.

Before HEALY, FEE and HAMLEY, Circuit Judges.

HAMLEY, Circuit Judge.

Creditors' claims against the bankrupt estate of Leonard Plumbing and Heating Supply, Inc., were filed by J. A. Fazio and Lawrence C. Ambrose. The trustee in bankruptcy objected to these claims, and moved for an order subordinating them to the claims of general unsecured creditors. The referee in bankruptcy denied the motion, and his action was sustained by the district court. The trustee appeals.

The following facts are not in dispute: A partnership known as "Leonard Plumbing and Heating Supply Co." was organized in October, 1948. The three partners, Fazio, Ambrose, and B. T. Leonard, made initial capital contributions to the business aggregating $44,806.40. The capital contributions of the three partners, as they were recorded on the company books in September 1952, totaled $51,620.78, distributed as follows: Fazio, $43,169.61; Ambrose, $6,451.17; and Leonard, $2,000.

In the fall of that year, it was decided to incorporate the business. In contemplation of this step, Fazio and Ambrose, on September 15, 1952, withdrew all but $2,000 apiece of their capital contributions to the business. This was accomplished by the issuance to them, on that date, of partnership promissory notes in the sum of $41,169.61 and $4,451.17, respectively. These were demand notes, no interest being specified. The capital contribution to the partnership business then stood at $6,000 — $2,000 for each partner.

The closing balance sheet of the partnership showed current assets to be $160,791.87, and current liabilities at $162,162.22. There were also fixed assets in the sum of $6,482.90, and other assets in the sum of $887.45. The partnership had cash on hand in the sum of $66.66, and an overdraft at the bank in the amount of $3,422.78.

Of the current assets, $41,357.76, representing "Accounts receivable — Trade," was assigned to American Trust Co., to secure $50,000 of its $59,000 in notes payable. Both before and after the incorporation, the business had a $75,000 line of credit with American Trust Co., secured by accounts receivable and the personal guaranty of the three partners and stockholders, and their marital communities.

The net sales of the partnership during its last year of operations were $389,543.72, as compared to net sales of $665,747.55 in the preceding year. A net loss of $22,521.34 was experienced during this last year, as compared to a net profit of $40,935.12 in the year ending September 30, 1951.

Based on the reduced capitalization of the partnership, the corporation was capitalized for six hundred shares of no par value common stock valued at ten dollars per share. Two hundred shares were issued to each of the three partners in consideration of the transfer to the corporation of their interests in the partnership. Fazio became president, and Ambrose, secretary-treasurer of the new corporation. Both were directors. The corporation assumed all liabilities of the partnership, including the notes to Fazio and Ambrose.

In June 1954, after suffering continued losses, the corporation made an assignment to the San Francisco Board of Trade for the benefit of creditors. On October 8, 1954, it filed a voluntary petition in bankruptcy. At this time, the corporation was not indebted to any creditors whose obligations were incurred by the pre-existing partnership, saving the promissory notes issued to Fazio and Ambrose.

Fazio filed a claim against the estate in the sum of $34,147.55, based on the promissory note given to him when the capital of the partnership was reduced. Ambrose filed a similar claim in the sum of $7,871.17. The discrepancy between these amounts and the amounts of the promissory notes is due to certain set-offs and transfers not here in issue.

In asking that these claims be subordinated to the claims of general unsecured creditors, the trustee averred that the amounts in question represent a portion of the capital investment in the partnership. It was alleged that the transfer of this sum from the partnership capital account to an account entitled "Loans from Copartners," effectuated a scheme and plan to place copartners in the same class as unsecured creditors. The trustee further alleged, with respect to each claimant:

"* * * If said claimant is permitted to share in the assets of said bankrupt now in the hands of the trustee, in the same parity with general unsecured creditors, he will receive a portion of the capital invested which should be used to satisfy the claims of creditors before any capital investment can be returned to the owners and stockholders of said bankrupt."

A hearing was held before the referee in bankruptcy. In addition to eliciting the above recounted facts, three expert witnesses called by the trustee, and one expert witness called by the claimants, expressed opinions on various phases of the transaction.

Clifford V. Heimbucher, a certified public accountant and management consultant, called by the trustee, expressed the view that, at the time of incorporation, capitalization was inadequate. He further stated that, in incorporating a business already in existence, where the approximate amount of permanent capital needed has been established by experience, normal procedure called for continuing such capital in the form of common or preferred stock.

Stating that only additional capital needed temporarily is normally set up as loans, Heimbucher testified that "* * * the amount of capital employed in the business was at all times substantially more than the $6,000 employed in the opening of the corporation." He also expressed the opinion that, at the time of incorporation, there was "very little hope of financial success in view of the fact that for the year immediately preceding the opening of the corporation, losses were running a little less than $2,000 a month. * * *"

William B. Logan, a business analyst and consultant called by the trustee, expressed the view that $6,000 was inadequate capitalization for this company.1 John S. Curran, a business analyst, also called by the trustee, expressed the view that the corporation needed at least as much capital as the partnership required prior to the reduction of capital.

Robert H. Laborde, Jr., a certified public accountant, had handled the accounting problems of the partnership and corporation. He was called by the trustee as an adverse witness, pursuant to § 21, sub. j of the Bankruptcy Act, 11 U.S.C.A. § 44, sub. j. Laborde readily conceded that the transaction whereby Fazio and Ambrose obtained promissory notes from the partnership was for the purpose of transferring a capital account into a loan or debt account. He stated that this was done in contemplation of the formation of the corporation, and with knowledge that the partnership was losing money.

The prime reason for incorporating the business, according to Laborde, was to protect the personal interest of Fazio, who had made the greatest capital contribution to the business. In this connection, it was pointed out that the "liabilities on the business as a partnership were pretty heavy." There was apparently also a tax angle. Laborde testified that it was contemplated that the notes would be paid out of the profits of the business. He agreed that, if promissory notes had not been issued, the profits would have been distributed only as dividends, and that as such they would have been taxable.

Claimants, in their brief, say that Laborde "testified that in his opinion the bankrupt corporation was adequately capitalized at the inception of its corporate existence for several reasons. * * *" We find no support in the record for this statement, and claimants have cited none.2

Laborde did express the opinion that the corporation had adequate working capital at the time of incorporation. This was disputed by Heimbucher and Curran. They called attention to the fact that the corporate books showed that current liabilities exceeded current assets at that time, and that there was thus a minus working capital on the opening day of business of the corporation.3

In any event, when we speak of inadequacy of capital in regard to whether loans to shareholders shall be subordinated to claims of general creditors, we are not referring to working capital. We are referring to the amount of the investment of the shareholders in the corporation. This capital is usually referred to as legal capital, or stated capital in reference to restrictions on the declaration of dividends to stockholders.4 As before stated, Laborde expressed no opinion as to the adequacy of proprietary capital put at the risk of the business. On the other hand, the corporate accounts and the undisputed testimony of three accounting experts demonstrate that stated capital was wholly inadequate.

On the evidence produced at this hearing, as summarized above, the referee found that the paid-in stated capital of the corporation at the time of its incorporation was adequate for the continued operation of the business. He found that while Fazio and Ambrose controlled and dominated the corporation and its affairs they did not mismanage the business. He further found that claimants did not practice any fraud or deception, and did not act for their own personal or private benefit and to the detriment of the corporation or its stockholders and creditors. The referee also found that the transaction which had been described was not a part of any scheme or plan to place the claimants in the same class as unsecured creditors of...

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