In re Daugherty Coal Co., Inc.
| Decision Date | 31 August 1992 |
| Docket Number | Civ. A. No. 92-0037-E. |
| Citation | 144 BR 320 |
| Parties | In re DAUGHERTY COAL COMPANY, INC. Thomas H. FLUHARTY, as Trustee of the Bankruptcy Estate of Daugherty Coal Company, Inc., Plaintiff, v. WOOD PRODUCTS, INC., Defendant. |
| Court | U.S. District Court — Northern District of West Virginia |
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Evans L. King, Jr., Thomas Fluharty, Clarksburg, W.Va., for plaintiff.
Leo Wm. Dunn, Jr., Greenbelt, Md., Shelia Kae Williams, Kingwood, W.Va., for defendant.
On August 1, 1991 the Bankruptcy Court for the Northern District of West Virginia held an adversarial hearing following which secured liens of Defendant Wood Products, Inc. ("Appellant"), as well as a secured lien of Royal Tippling, in the property of Debtor Daugherty Coal Company ("Appellee") were equitably subordinated pursuant to 11 U.S.C. § 510(c) (1988). Appellant filed a timely notice of appeal, in which Royal Tippling did not apparently join, and the parties have designated the record for review. This Court has examined the record on appeal, including the transcript of the August 1, 1991 hearing, the relevant exhibits, and the parties' briefs, and is of the opinion that this appeal is ready for disposition by the Court.
Pursuant to Bankruptcy Rule 8013, "findings of fact, whether based on oral or documentary evidence, shall not be set aside unless clearly erroneous, and due regard shall be given to the opportunity of the bankruptcy court to judge the credibility of the witnesses." Special deference is due determinations of fact based solely on oral testimony, which depend largely upon the credibility of the witnesses. See Brady v. Thurston Motor Lines, 726 F.2d 136, 144 (4th Cir.), cert. denied, 469 U.S. 827, 105 S.Ct. 110, 83 L.Ed.2d 53 (1984) (citing 9 Wright & Miller, Federal Practice and Procedure § 2586 at 737 (1971)); Bonds v. Mortensen and Lange, 717 F.2d 123, 125 (4th Cir.1983). To overturn a finding of fact, this Court must have "a firm and definite conviction that a mistake has been committed. . . ." Id. Questions of law are reviewed de novo. E.g. In re Gustafson, 111 B.R. 282 (Bankr. 9th Cir.1990).
The facts applicable to this appeal may be briefly summarized as follows. Appellee is a closely-held corporation whose stock is owned in equal shares by Max Messenger, Elmer C. Grimm, Jr., and Howard Parsons. Messenger was the President of Appellee during all periods relevant to this dispute. Grimm was Secretary/Treasurer until August 1985, after which he was no longer employed by Appellee. Parsons was Vice President until September 1987, when he terminated his employment. All continued to be the sole stockholders in Appellee. Beginning in 1985, Appellee suffered severe economic hardship during which time it lost a great deal of money. By 1989, Appellee conducted very little business, and creditors filed an involuntary petition against Appellee on May 8, 1990.
Appellant is also a closely-held corporation, whose stock is owned entirely by Max Messenger, his wife, and his two sons. Messenger was the primary shareholder, sole active employee, and (apparently) officer, of Appellant.
Appellant began loaning substantial amounts of money to Appellee in August 1986. Unsecured promissory notes evidenced these debts. On April 30, 1987 Appellee granted Appellant a security interest in real property owned by Appellee in exchange for a demand note and deed of trust in the amount of $198,200.00. The Bankruptcy Court found that, at this time, Appellee owed Appellant approximately $237,565.00. Appellee auctioned a large amount of its equipment the following month.
Appellant subsequently advanced more funds to Appellee, including $60,000.00 on January 11, 1988. This debt was secured by a security interest in a piece of heavy equipment. This equipment had previously been pledged as security for a bank loan. Royal Tippling, Inc., a closely-held corporation owned by Messenger and his two sons, supposedly took possession of the equipment in June 1988 in exchange for forgiveness of a substantial debt owed it by Appellee and assumption of the bank debt. However, no bill of sale was prepared, and Appellee continued to exercise apparent ownership and control of the equipment.
The final transaction material to this dispute was consummated on June 9, 1988 when Appellee granted Appellant a security interest in all real property owned by Appellee in exchange for a promissory note in the amount of $724,882.42. This note included the prior amount advanced on April 30, 1987, which had not yet been paid to Appellee.
Appellee's trustee in bankruptcy moved to have the April 30, 1987 and June 9, 1988 security interests subordinated pursuant to § 510(c)1 of the Bankruptcy Code. The Bankruptcy Court subordinated the liens and transferred them to Appellee's estate, finding that Appellant had used its insider position to loan money to Appellee while gaining an unfairly advantageous position relative to other creditors. The parties do not contest the facts set forth above. Instead, Appellant raises the following contentions on appeal: 1) The Bankruptcy Court applied the incorrect legal standard regarding the showing necessary to subordinate these transactions; 2) The Bankruptcy Court clearly erred by subordinating the April 30, 1987 transaction; and 3) The Bankruptcy Court clearly erred by subordinating the entire June 8, 1988 transaction.
The Bankruptcy Court properly determined the three-factor test for the subordination determination: 1) The claimant must have engaged in inequitable conduct; 2) The claimant must have unfairly profited from the action, or must have placed other creditors at a disadvantage; and 3) Subordination must be consistent with the principles contained in the Bankruptcy Code. E.g. Matter of Fabricators, Inc., 926 F.2d 1458, 1464-65 (5th Cir.1991); In re Mobile Steel, 563 F.2d 692, 700 (5th Cir.1977). The trustee/debtor must prove sufficient facts to invalidate the creditor's proof of claims, and the creditor must then come forward with sufficient evidence to demonstrate the good faith and fairness of its actions. Id. at 701. The Bankruptcy Court must make specific findings regarding the three factors above. Fabricators, 926 F.2d at 1465 (citing In re Missionary Baptist Foundation of America, Inc., 712 F.2d 206, 212 (5th Cir.1983)).
The proof required by the above test varies according to the status of the creditor, and this is the legal point contested in the present appeal. Appellant contends that heightened scrutiny of the fairness of the transactions is required only when the claimant is a fiduciary of the debtor, and that Appellant was not a fiduciary of Appellee. The Bankruptcy Court held that heightened scrutiny under the first prong of the three-factor test is proper when the claimant is either a fiduciary or an insider of the debtor. The distinction is important. If heightened scrutiny applies, the trustee/debtor must only prove unfairness in the transaction; otherwise, subordination is proper only in cases of fraud, spoliation or overreaching. In re N & D Properties, Inc., 799 F.2d 726, 731 (11th Cir.1986); Fabricators, 926 F.2d at 1465; In re Missionary Baptist Foundation of America, Inc., 818 F.2d 1135, 1144 n. 8 (5th Cir.1987) ("Missionary Baptist II").
Upon review of the applicable case law, none of which was decided by the United States Court of Appeals for the Fourth Circuit, this Court is absolutely satisfied that insider status, by itself, demands closer scrutiny regarding the fairness of these transactions. Appellant premises its contention that only fiduciaries warrant stricter scrutiny primarily upon a distinction drawn in the Missionary Baptist II decision between fiduciaries and insiders. Id. at 1144, 1144 n. 8. This Court reads this passage as standing for the proposition that fiduciaries are subject to even stricter scrutiny than are insiders, not that insiders are not subject to close study regarding their transactions with debtors.
More important than this Court's interpretation of the passage from Missionary Baptist II, the court which authored the passage has clearly rejected Appellant's argument. Relying on the language upon which Appellant's argument is premised, the Fifth Circuit held:
A claim arising from the dealings between a debtor and an insider is to be rigorously scrutinized by the courts. . . . If the claimant is not an insider, then evidence of more egregious conduct such as fraud, spoliation or overreaching is necessary. . . . Accordingly, whether a claimant is an insider of the debtor can be fundamentally important in an equitable subordination case in that it effects sic the standard of scrutiny a court will apply. Appellant argues that Missionary Baptist II stands for the proposition that strict scrutiny is apposite only to fiduciaries. To the contrary, Missionary Baptist II merely states that a finding of inequitable conduct may be different, depending on whether the claimant is an insider or a fiduciary. . . .
Fabricators, 926 F.2d at 1465 (citations omitted). The court relied heavily on the N & D Properties decision, where it was stated, N & D Properties, 799 F.2d at 731 (In re Multiponics, 622 F.2d 709, 714 (5th Cir.1980)) (emphasis added). "If the claimant is not an insider or fiduciary, however, the trustee must prove more egregious conduct. . . ." Id. (citations omitted) (emphasis added).
Examining de novo the Bankruptcy Court's legal conclusion regarding the standards applicable to the present dispute, this court holds that the lower court properly determined the legal standard. Appellant admits, as it must, that it was an insider of Appellee. Reviewing the Bankruptcy Court's determination that Appellant was an "insider" for clear error, se...
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