In re Montgomery
| Decision Date | 08 February 1991 |
| Docket Number | Bankruptcy No. 388-03712,Adv. No. 389-0119. |
| Parties | In re N. Eddie MONTGOMERY and Southland Escrow Services, Inc., Consolidated Debtors. John C. McLEMORE, Trustee, Plaintiff, v. THIRD NATIONAL BANK IN NASHVILLE, Defendant. |
| Court | United States Bankruptcy Courts. Sixth Circuit. U.S. Bankruptcy Court — Middle District of Tennessee |
Edwin M. Walker, Robert Garfinkle, McMackin, Garfinkle, McLemore & Walker, Nashville, Tenn., for trustee.
Bradley MacLean, Katherine S. Allen, Farris, Warfield & Kanaday, Nashville, Tenn., for Third Nat. Bank.
The issue is whether Third National Bank received a preference when it was extracted from the debtors' check kiting scheme during the 90 days before this involuntary bankruptcy. Third National Bank received an avoidable preference. The following are findings of fact and conclusions of law. Bankr.R. 7052.
Eddie Montgomery was a lawyer. Through his company, Southland Escrow Services, Inc., Montgomery conducted thousands of real estate closings in Middle Tennessee.
In July of 1987, Montgomery met with officers of Third National Bank ("TNB") to discuss banking problems in his real estate closing business. Montgomery was a customer of another bank. He complained to TNB of cash flow problems resulting in overdrafts in his accounts and large "overdraft charges."
A young Third National Bank officer working his first account development and two more senior bank officers studied bank statements from Montgomery's other bank and visited Montgomery's offices to analyze the real estate closing operation. They presented a detailed written proposal to solve Montgomery's banking problems: a "cash management system" not unlike the arrangement discussed by the Sixth Circuit in First Fed. of Michigan v. Barrow, 878 F.2d 912 (6th Cir.1989). The proposal included three new bank accounts, a "lock box," a $500,000 line of credit and a data terminal. Montgomery accepted the proposal.
A Main Funding Account was established at TNB in Nashville to concentrate all incoming funds from real estate closings. Checks were to be deposited to the Main Funding Account by delivery to a "lock box" at the Third National Operations Center in Nashville. Using TNB's "in-house concentration system," funds would be taken from the Main Funding Account once a day to cover disbursement checks presented that day. The balance remaining in the Main Funding Account would be automatically invested each day to earn interest for Montgomery.
Montgomery was to write checks on two disbursement accounts: a Controlled Disbursement Account ("CDA") and a Zero Balance Account ("ZBA"). The CDA was established at an affiliate bank in Oak Ridge, Tennessee. TNB explained that locating the CDA at its affiliate would gain "days of float" for Montgomery because checks clear the affiliate bank only once in the morning of each business day.
A second disbursement account, the ZBA, was established at Third National Bank in Nashville. The ZBA account was supposed to be similar to the CDA in that "at the end of the day, the bank will make a bookkeeping transfer of funds from the Main Funding Account to cover the checks that have cleared." Unlike the CDA, the ZBA would clear checks throughout the day. It was recommended that the ZBA be used for "local checks."
The "brain" of the system was INTERLINK, a "modular automated cash management system." From a computer in his office, Montgomery could use INTERLINK to determine the ledger and collected balances, the amount of "float" and "detailed credit and debit information on all . . . accounts." As TNB explained, "with this balance information the capability to maximize the utilization of your cash balances is possible."
By implementing the cash management system, TNB estimated Montgomery would realize $42,246 in annual investment income.
As a condition of the cash management system, Third National Bank required a $500,000 line of credit secured by land owned by Montgomery. The loan documents state the line of credit was created "for the sole purpose of covering overdrafts which occur in borrowers' trust accounts . . . caused by delays in collecting checks deposited by borrower. . . ." It is stipulated that "advances under the line of credit were extended for the purpose of covering ledger overdrafts that occurred in the Funding Account."
The cash management system designed by TNB never worked as described in its sales proposal. Southland never made significant use of the CDA at TNB's affiliate; rather, disbursement checks were written on the ZBA account in Nashville. Deposits of incoming checks from real estate closings were accomplished by delivery to branch offices of Third National Bank in Nashville rather than through the "lock box."
Contrary to the Bank's proposal, the Third National Bank computer system was not able to "zero out" the ZBA account at the end of each business day. Instead, checks presented against the ZBA were recorded as an "overdraft" on the Bank's ledgers and this overdraft was carried on the Bank's books from the day of presentment to the next day. On the next day, a bank employee would internally debit the Main Funding Account in the amount necessary to "zero out" the negative balance showing in the ZBA from the day before. This process was described as "one day in arrears." Debiting the Funding Account to cover the "overdraft" in the ZBA account occurred without regard to whether there were funds in the Funding Account to cover the ZBA checks presented the day before. If the debit of the Funding Account exceeded its balance, an overdraft notice would be generated the following day — two days after presentment of the ZBA items that created the overdraft.
Though TNB predicted large collected balances would emerge in the Main Funding Account which would then earn substantial investment income, the opposite was true — there were never collected balances in the Funding Account and no investment income was earned. Incoming deposits to the Main Funding Account appear as ledger entries on the day received. These funds were immediately available to Montgomery, but deposits were considered "uncollected" for either zero, one or two days, depending on the "Availability Schedule" applicable at Third National Bank in Nashville through the Federal Reserve. Almost all deposits to the Funding Account occurred at a time of day and involved drawee banks for which the Availability Schedule required at least one day before the items were "collected funds." As a result, the daily use of the balances showing in the Funding Account was a use of uncollected funds which immediately triggered draws against the line of credit.
The cash management system began operating in late August, 1987. On August 31, 1987, $429,000 of the $500,000 line of credit was drawn to cover "overdrafts" on the Funding Account. By September 9, 1987, the entire $500,000 line had been consumed. After a brief reduction in the line of credit, the line was again fully extended on September 18, 1987. The line remained fully extended until it was converted to a term note on March 10, 1988. No principal reduction occurred on this debt until May of 1988.
After exhaustion of the line of credit, the cash management system did not collapse, but continued with a major difference. Instead of drawing against the line of credit, TNB charged Montgomery for the use of uncollected funds by calculating the "average (negative) collected balance" for the Funding Account. The Bank continued to debit the uncollected balance in the Funding Account to cover the "overdraft" showing in the ZBA account and for other purposes. This drafting of uncollected funds created continuous "ledger overdrafts" in the Funding Account that could not be covered by the line of credit so the Funding Account produced "large negative average collected balances." At the end of each month, Third National Bank charged Montgomery "analysis charges" calculated as 10.75 (sometimes 11.0 or 10.5) percent times the "average collected balance" in the Funding Account.
The "analysis charges" were not limited to the use of uncollected balances in the Funding Account. Because the ZBA account always showed a large "overdraft" — reflecting that the Bank was incapable of zeroing out the ZBA each day — Third National Bank applied the same 10.75 (11.0 or 10.5) percent "analysis charge" to the ZBA account. For example, in January of 1988, the average "overdraft" showing in the ZBA account was $1,599,969. The average collected balance for the Funding Account was (negative) $1,758,963. Third National added these two numbers together, then applied a 10.75% "analysis charge" against the total "average collected balance" of (negative) $3,358,933. This generated an analysis charge for January of $30,850. This amount was collected by debiting the Funding Account. Analysis charges for February, 1988, totalled $28,636; for March, $28,487; for April, $16,549. These analysis charges were in addition to the accrual of interest on the fully extended line of credit.
The Bank's cash management proposal does not mention "analysis charges." Bank officers knew Montgomery had experienced large "overdraft" charges at his previous bank, but "analysis charges" were "not expected" and thus not mentioned in the TNB sales proposal. Two different groups of bank officers were involved at TNB — one set designed and sold the cash management system; different officers were responsible for the line of credit. These separate bank officers professed not to meddle in the responsibilities of each other with the result that the officers for the cash management accounts claim not to have known that the line of credit was immediately and permanently consumed by the use of uncollected funds. Until January, 1988, no one at the Bank admits knowledge of the huge "analysis charges."
Notwithstanding the internal confusion, bank officers were concerned about Montgomery's relationship to the...
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