In re Garden Manor Associates

• Decision Date: 25 February 1987
• Docket Number: 1-82-01413.,Bankruptcy No. 1-82-01412
• Court: United States Bankruptcy Courts. Ninth Circuit. U.S. Bankruptcy Court — Northern District of California
• Parties: In re GARDEN MANOR ASSOCIATES, a California Limited Partnership, Debtor. In re FAIRWOOD MANOR ASSOCIATES, a California Limited Partnership, Debtor.

70 B.R. 477 (1987)

In re GARDEN MANOR ASSOCIATES, a California Limited Partnership, Debtor.

In re FAIRWOOD MANOR ASSOCIATES, a California Limited Partnership, Debtor.

Bankruptcy Nos. 1-82-01412, 1-82-01413.

United States Bankruptcy Court, N.D. California.

February 25, 1987.

Jeff Berger, Richard W. Williams, Leonard J. Martinet, Paul E. Rabin, San Francisco, Cal., for debtors.

Joseph P. Russoniello, U.S. Atty. for N.D. Cal., Judith A. Whetsinte, Chief, Civ. Div. by Patrick J. Simonelli, Sp. Asst. U.S. Atty., c/o U.S. Dept. of Housing and Urban Development, Region IX, San Francisco, Cal., for U.S.

FINDINGS AND CONCLUSIONS IN AUGMENTATION OF ORDER ON MOTION

CONLEY S. BROWN, Bankruptcy Judge.

The United States having filed a request for Findings and Conclusions in relation to the Court's rulings of November 21, 1985 and entered November 25, 1985, the Court hereby augments its rulings by setting forth its Findings and Conclusions that led to said Orders.

The United States on behalf of the Secretary of Housing and Urban Development (HUD), has requested that this Court compel the debtors (collectively, for the sake of convenience, "Manor Partners")¹ to restore improperly diverted funds to the debtor's estates which Manor Partners paid, pre-petition and post-petition, as legal fees.

Manor Partners are the owners of rental housing projects for the elderly in Garden Manor and Orange Grove, California and are operating the projects as debtor in possession under 11 U.S.C. § 1101.² HUD is the holder of a First Deed of Trust (also referred to as mortgage) on the apartments. Manor Partners are in default and owe HUD as of November 1, 1985, in excess of $2,000,000.

During the period starting in January, 1982 and ending October 15, 1982 Manor Partners paid Attorney Sherman A. Silverman, $2,659 for legal services to defend HUD foreclosure initiatives; from September 21, 1982 through October 20, 1982, Manor Partners paid the law firm of Murphy, Weir & Butler, $2,402 for similar services. On October 1, 1982, it paid Attorney Ronald L. Fenolio, $10,400, retainers for services to be incurred with these Chapter 11 Petitions.

In 1976 Manor Partners borrowed in excess of $4,000,000 from the Bankers Mortgage Company of California for the construction of these apartments. HUD insured the mortgage loans to facilitate financing of these rental housing units for the elderly or handicapped as authorized by Congress under Section 231 of the National Housing Act (NHA), as amended, (12 U.S.C. § 1715v). Section 231 was designed to assist in relieving the shortage of housing for the elderly or handicapped by providing reasonable rentals to its tenants. The general and limited partners of these projects as owner-mortgagors agreed to be bound by a HUD security instrument known as the "Regulatory Agreement"³ that included, inter alia, a restriction on their right to disburse funds from the income of the mortgaged property. The Regulatory Agreements were incorporated into the mortgage under paragraph 3 of the mortgage. The mortgage and Regulatory Agreements were all recorded in the official records of Orange County, California.

In 1979, after Manor Partners had defaulted on these loans, HUD paid the original lender in excess of $4,000,000 from the Government insurance fund; the lender assigned its interest in the mortgage notes and other documents to the Secretary of HUD.

After several unsuccessful attempts by Manor Partners to remedy the default under proposed workout agreements, HUD initiated foreclosures. Minutes before the scheduled sale set for 10 a.m., November 3, 1982 Manor Partners filed its Chapter 11 Petitions.

There is no dispute regarding the amount or purpose of the disbursements the United States seeks to have returned to the project operating accounts. As noted, Manor Partners paid attorney Sherman A. Silverman $2,659.00 and the law firm of Murphy, Weir & Butler $2,402.00 for legal services to defend HUD foreclosures. It paid Ronald L. Fenolio $10,400.00 to file Chapter 11 petitions. It is undisputed that these funds were paid out of rental income in the project operating accounts. This court believes that its inquiry is limited to determining if Manor Partners should have paid these lawyers with project income.

The notes, mortgages and Regulatory Agreements, copies are attached to the United State's memorandum as Exhibit B, make up the loan documents. In addition to the Regulatory Agreements HUD entered into two year Provisional Workout Arrangements⁴ (workout) with Manor Partners on June 1, 1983, in an attempt to remedy the default rather than move this Court to lift the automatic stay and exercise its right to foreclose, copies are attached to the United State's memorandum as Exhibit A.

The workouts did not modify or supersede the Regulatory Agreement. It was "provisional" and stated that under the arrangement HUD would "hold the mortgages in default" on a month to month basis. It explicitly stated that HUD would take no action on the existing monetary default "provided the owners made the minimum monthly payments and satisfactorily performed other requirements of the Arrangement."

Paragraph 6(b) of the Regulatory Agreement prohibits the owners of a project, without the prior written approval of the Secretary of HUD, from paying out any project income other than surplus cash, except for reasonable operating expenses and necessary repairs. Under paragraph 13(f), which defines surplus cash as cash remaining after payment of all sums and deposits due under the note and mortgage and all obligations of the project, it is impossible for the borrower to be in a surplus cash position while also in default under the note. Since Manor Partners had been in default since 1979, they have not been in a surplus cash position since that time.

Also, this Regulatory Agreement provides at paragraph 17 that Manor Partners did not assume personal liability for payments due under the note and mortgage but would remain liable for funds or property coming into their hands that they are not entitled to retain and for their own acts and deeds or acts and deeds of others that they have authorized in violation of the provisions of this agreement.

Also, paragraphs 6(e)(3) and 9(g) of the Regulatory Agreement impose a trust⁵ on the owners to hold all funds for the benefit of the project other than by distributions of surplus cash.

Therefore, the general and limited partners of Manor Partners are liable for these payments out of project income for the legal fees of Sherman A. Silverman, Murphy, Weir & Butler and Ronald Fenolio unless they can be classified as "reasonable operating expenses."

The Regulatory Agreement does not define "operating expenses". But in Thompson v. United States, 408 F.2d 1075 (8th Cir., 1969) the Court of Appeals observed at page 1080 that:

". . . it is a term which probably has no fixed, precise or inflexible meaning. Regard must be had to the context in which the term is used and to the nature of the business under consideration. In present context the Court is convinced the term must be construed with at least reasonable strictness and the concept of `operating expenses\' should be limited to expenses paid or incurred in connection with the actual operation of the project as a going concern. . . . "

Quoting from Chief Judge Henley of the District Court in United States v. Thompson, 272 F.Supp. 774 at 787 (E.D. Ark.1967).

Judge Henley acknowledged that attorney's fees under certain circumstances may be characterized as "operating expenses" of a rental housing project.

". . . . Such a project in the course of its day to day operations may require the services of counsel to collect rents, to evict tenants, or to prosecute and defend lawsuits growing out of the operation of the project . . ." United States v. Thompson, Supra, 272 F.Supp. at 789.

In Thompson the Court held that legal fees paid for the original acquisition of the project, settlement of lien claims and closing the construction loans were not reasonable operating expenses.

In United States v. Frank, 587 F.2d 924 (8th Cir.1978), the Court of Appeals in affirming the finding of the District Court held that legal fees that Frank authorized to be paid from the project operating account to challenge HUD's termination of forbearance agreements and to stop HUD's foreclosure of the mortgages were not reasonable operating expenses of the project. The Court observed at page 927:

"The District Court properly determined that these legal services were not incidental to the operation or maintenance of the project but were related to the personal investment interests of the mortgage partnerships. The regulatory agreements authorized disbursements for `reasonable operating expenses.\' A proper construction of this provision requires distinguishing expenses incurred primarily on behalf of the personal interests of the investors from those expenses related to the everyday operation of the enterprise. See Thompson v. United States, 408 F.2d 1075, 1079-80. (8th Cir. 1969).

The Court in In re Hil'Crest Apartments, 50 B.R. 610 (Bkrtcy., N.D.Ill.1985) on facts very similar to the case at bar, examined the question of whether a debtor bound by the Regulatory Agreement could pay its bankruptcy attorneys with project income. Like Manor Partners Hil'Crest was a partnership whose sole asset was an apartment complex insured by HUD under the National Housing Act. Hil'Crest had paid out of the project operating account attorneys' fees to defend a HUD foreclosure action and paid additional attorneys' fees to file a Chapter 11 bankruptcy. Both cases involved projects that had no surplus cash available because they were in default. The effect of both Chapter 11 filings was to forestall HUD foreclosures. Like Manor Partners HUD petitioned the Court to compel the partnerships to restore those funds to the project's operating account pursuant to the terms of the Regulatory...