In re Ludwig Honold Mfg. Co.

• Decision Date: 22 November 1983
• Docket Number: Bankruptcy No. 81-04610G,Adv. No. 83-1742G.
• Citation: 33 BR 724
• Parties: In re LUDWIG HONOLD MANUFACTURING COMPANY, Debtor. The COMMITTEE OF CREDITORS OF LUDWIG HONOLD MANUFACTURING COMPANY, INC., and Fred Zimmerman, Trustee, Plaintiffs, v. CENTRAL PENN NATIONAL BANK, Defendant.
• Court: U.S. Bankruptcy Court — Eastern District of Pennsylvania

33 B.R. 724 (1983)

In re LUDWIG HONOLD MANUFACTURING COMPANY, Debtor The COMMITTEE OF CREDITORS OF LUDWIG HONOLD MANUFACTURING COMPANY, INC., and Fred Zimmerman, Trustee, Plaintiffs, v. CENTRAL PENN NATIONAL BANK, Defendant.

Bankruptcy No. 81-04610G, Adv. No. 83-1742G.

United States Bankruptcy Court, E.D. Pennsylvania.

October 13, 1983.

Reconsideration Denied November 22, 1983.

Nancy V. Alquist, Douglas J. Smillie, Clark, Ladner, Fortenbaugh & Young, Philadelphia, Pa., for plaintiff, The Committee of Creditors of Ludwig Honold Mfg. Co., Inc.

Melvin Lashner, Daniel Bernstein, Melvin Lashner & Associates, Philadelphia, Pa., for plaintiff Fred Zimmerman, trustee.

John J. Lamb, Philadelphia, Pa., for debtor, Ludwig Honold Mfg. Co., Inc.

James M. Matour, Paul Patterson, Robert A. Kargen, White & Williams, Philadelphia, Pa., for defendant, Central Penn National Bank.

OPINION

EMIL F. GOLDHABER, Bankruptcy Judge:

The issue at bench is whether under the doctrine of marshalling of assets we should order a creditor who holds a security interest in the debtor's property as well as the property of the debtor's sureties, to foreclose its security interest in the sureties' property prior to recourse against the debtor's property. The issue is presented to the court through the defendant's motion to dismiss the complaint for failure to state a cause of action. For the reasons stated herein we will deny the motion.

The facts of this case are as follows:¹ An involuntary petition for relief under chapter 11 of the Bankruptcy Code was filed against Ludwig Honold Manufacturing Company, Inc. ("the debtor"), on November 9, 1981. Shortly thereafter an order for relief was entered and a trustee was appointed. Prior to the filing of the reorganization petition Central Penn National Bank ("Central Penn") loaned the debtor a substantial amount of money in exchange for a security interest in the debtor's goods. To assure repayment of the debt Central Penn obtained guarantees from three entities which guarantees are secured by collateral. The loan documents state that in the event of default on the loan Central Penn has the discretion to seek recourse against the property of either the sureties² or the debtor. During the pendency of this reorganization the trustee liquidated virtually all of the debtor's property which was secured by Central Penn's security interest and has distributed the proceeds to this creditor. The trustee and the committee of unsecured creditors³ hereafter commenced this action to compel marshalling.

The parties have not pointed to any federal rule of decision governing this matter, and thus our decision must be based upon existing state law or, in the absence of such law, upon our determination of how the state courts would resolve the matter if presented with it. 28 U.S.C. § 1652.⁴ The governing rule of law in Pennsylvania on the equitable doctrine of marshalling is summarized as follows:

When a creditor has a lien on two funds in the hands of the same debtor and another creditor has a lien on only one of them, the first may be compelled in equity to levy his debt out of the fund to which the other cannot resort.

Schwarz's Estate, 290 Pa. 420, 422, 139 A. 131, 132 (1927); Ramsey's Appeal, 2 Watts 228, 232 (1834); Lloyd v. Galbraith, 32 Pa. 103, 108 (1858).

Central Penn asserts several points in resisting the complaint for marshalling. First, it points out, the debtor holds only one fund; the other funds being in the hands of the sureties. Second, marshalling cannot be invoked in favor of unsecured creditors. Third, the balance of equities weighs against marshalling. The trustee has responded to these assertions in turn. Firstly, he argues that the guarantors' security is deemed a contribution to the capital of the corporation, and thus equity should view the debtor as holding two funds. Secondly, the Bankruptcy Code gives the trustee the status of a secured creditor pursuant to 11 U.S.C. § 544 and consequently the party invoking marshalling is, in fact, a secured creditor. And thirdly, the equities weigh in favor of marshalling. Central Penn also contends that the trustee has waived marshalling by failing to seek it timely since virtually all of the debtor's collateral has been liquidated with distribution of the proceeds going to Central Penn. Although both parties have referred to numerous cases, for some inexplicable reasons they have failed to cite the line of Pennsylvania authorities that deny a creditor's request for marshalling between the collateral of a debtor and his surety. Squarely on point is Schwarz's Estate, 290 Pa. 420, 139 A. 131 (1927), in which five individuals held equal shares in a decedent's estate. Joseph, one of the shareholders, was indebted to the Northern Trust and Savings Company ("Northern"). Joseph and three other shareholders granted a security interest in their shares to Northern to assure payment of Joseph's debt. Subsequent to this the Dauphin Deposit Trust Company ("Dauphin") obtained a lien on Joseph's share. Under the doctrine of marshalling, the lower court directed Northern to seek payment of its debt from the three surety shareholders before proceeding against Joseph's share. Dauphin was directed to seek payment of its debt from the remainder of Joseph's share only after the satisfaction of Northern's claim. Under this scheme the three surety shareholders would have been left with nothing, while Dauphin would have received partial payment from Joseph's share. Had marshalling not been applied, Northern's claim would have exhausted Joseph's share, but only part of each of the shares of the three sureties, while Dauphin would have received nothing. The Pennsylvania Supreme Court reversed the lower court and held that marshalling was not applicable. The court stated as follows:

While it is true under certain circumstances that a creditor who has a lien on two funds must give way as to one of them to another creditor who has a lien on only one of them, the two funds must be in the hands of the same debtor. Here the debtor was Joseph and he did not have two funds in his hands, he had only one,—his own interest in his mother\'s estate. . . . Here the creditor is Northern. Its primary debtor is Joseph. It has two funds upon which it can call, that belonging to Joseph and that belonging to Schwarz who is a surety shareholder. As in Neff v. Miller, 8 Pa. 347, the creditor has a joint and several encumbrance against the estates to two distinct debtors. "It is ...... the case of two funds belonging to the different debtors, and not an instance of a double fund belonging to a common debtor. Under such circumstances, a court of equity will not, in general, compel the joint creditor to resort to one of his debtors for payment, so as to leave the estate of the other debtor for the payment of his separate and several debt, for, as between the two debtors, this might be inequitable; and the equity subsisting between them ought not to be sacrificed merely to promote the interest of the separate creditor,\' which is what would happen in the instant case if we followed the lower court.

290 Pa. at 425-26, 139 A. at 133 (emphasis in original).

This same principle is expressed in Miller Lumber & Coal Co. v. Berkheimer, 342 Pa. 329, 20 A.2d 772 (1941). In this case a wife acting as a surety mortgaged her property in favor of one of her husband's secured creditors. Another creditor who had a lien solely upon the husband's collateral sought to compel the first creditor to proceed against the wife's property before seeking recourse to the husband's property. In noting that marshalling was not applicable to the case, the Pennsylvania Supreme Court stated as follows:

The rule of marshalling does not prevail except where both funds are in the hands of a common debtor of both creditors or unless the fund taken is one which in equity is primarily liable. . . .

Each debt was in fact the debt of the husband alone and the wife has a right to insist that the husband\'s land be sold first in satisfaction of what was in reality his debt. She has the rights of a surety. Fulmer v. Stewart, 207 Pa. 70, 71, 56 A. 1135. The rule of marshalling is never enforced where it will unjustly prejudice the rights of third parties.

342 Pa. at 331-32, 20 A.2d at 773.

This same factual situation was found in the related cases of Fulmer v. Stewart, 207 Pa. 70, 56 A. 1135 (1903) and Stewart v. Stewart, 207 Pa. 59, 56 A. 323 (1903). In nothing that a wife stood in no different stead as a surety than a friend acting as such, the Pennsylvania Supreme Court refused the request for marshalling.

The case law cited⁵ above indicates that in Pennsylvania marshalling generally cannot be ordered merely upon averment that the creditor seeking marshalling has a lien on only the debtor's property, and that a surety has pledged collateral to assure payment of the principal's debt. Pennsylvania's rule comports with the generally accepted application of the doctrine of marshalling in this country. In reaching the same result on this issue that we have, the court in a neighboring jurisdiction stated that "this rule is in accord with virtually every court in the United States which has specifically addressed the issue." Central Trust Co., N.A. v. Burchett (In Re Willson Dairy Co.), 30 B.R. 67, 71 (Bkrtcy.S.D.Ohio, 1981).⁶

The trustee has cited several cases that seem contrary to the general rule of disallowing marshalling...