Matter of Keystone General, Inc., Bankruptcy No. 1-89-0238

• Decision Date: 12 December 1991
• Docket Number: Bankruptcy No. 1-89-0238
• Citation: 135 BR 275
• Parties: In the Matter of KEYSTONE GENERAL, INC., Debtor. ASSOCIATED INDUSTRIES, Plaintiff, v. KEYSTONE GENERAL, INC., et al., Defendants.
• Court: U.S. Bankruptcy Court — Southern District of Ohio

135 B.R. 275 (1991)

In the Matter of KEYSTONE GENERAL, INC., Debtor ASSOCIATED INDUSTRIES, Plaintiff, v. KEYSTONE GENERAL, INC., et al., Defendants.

Bankruptcy No. 1-89-0238, Adv. No. 1-89-0238.

United States Bankruptcy Court, S.D. of Ohio.

December 12, 1991.

Edmund Adams, Vincent Mauer, Frost & Jacobs, Cincinnati, Ohio, for plaintiff.

Randy Slovin, Nicholas Pantel, Richard Boydston, Timothy Hurley, Taft, Stettinius & Hollister, Cincinnati, Ohio, for defendants.

FINDINGS OF FACT, OPINION AND CONCLUSIONS OF LAW

J. VINCENT AUG, Jr., Bankruptcy Judge.

Two good men, Semler and Lee

Made a Deal that could not be

Reserving title on delivery

They ran afoul of the UCC

And so Star Bank over its opponents

Holds secure the "Kentucky Components."

The rather complex facts underlying this commercial transaction belie the two relatively simple issues before the Court. The first issue is whether the transferor of inventory made an effective reservation of title under the Uniform Commercial Code so as to defeat the rights of the transferee's secured lender. The second issue is whether the interstate transfer of inventory back to the transferor defeated the rights of the transferee's secured lender.

FINDINGS OF FACT

Keystone General, Inc. ("Debtor") was in the business of manufacturing various radios for military and commercial use. In May, 1986, the Debtor refinanced its existing long-term bank debt with a $5,000,000 revolving credit loan from Star Bank, N.A. Cincinnati ("Star Bank"). Pursuant to the loan documents, including a security agreement, the Debtor granted Star Bank a security interest in substantially all of the Debtor's personal property, including the Debtor's inventory. Inventory is defined in the security agreement as follows:

Inventory which means goods, merchandise and other personal property, now owned or hereafter acquired by the Borrower (the Debtor), which are held for sale or lease or are furnished or to be furnished under a contract of service or are raw materials, work in process or materials used or consumed or to be used or consumed in the Borrower\'s (the Debtor\'s) business, and whether in Borrower\'s (the Debtor\'s) possession or in the custody or possession of a third party for the account of Borrower (the Debtor) or the Bank (Star Bank), and all accessions, proceeds and products thereof.

Star Bank perfected its security interest in the Debtor's property, including the inventory, by filing the appropriate financing statements with the Recorder of Hamilton County and the Ohio Secretary of State.

In 1987, certain radio components were offered for sale by E-Systems, a Florida company, which components the Debtor wished to purchase. The then president of the Debtor, Robert Lee ("Lee"), contacted Arnold A. Semler ("Semler"), president of Associated Industries, a division of Arnold A. Semler, Inc., ("Associated") and requested that Associated assist the Debtor in the purchase of the components. The Debtor was not in a position to buy the components directly from E-Systems because of its financial condition and because of "bad blood" between Lee and the principals of E-Systems. Essentially, Associated was to be the front man for the Debtor. Associated would buy the components from E-Systems and then turn around and sell the components to the Debtor. The Debtor planned to use most, if not all, of the components in the manufacture of radios which it hoped to sell to the U.S. government, pursuant to government contracts.

Associated agreed to purchase the components and on September 21, 1987, issued a purchase order to E-Systems thereby obligating Associated to pay E-Systems the amount of $2,700,000. In turn, the Debtor agreed to pay $3,500,000 to Associated for the components, creating an anticipated profit of $800,000 for Associated. At trial, testimony was elicited from both Lee and Semler that the $3,500,000 purchase price was a "good deal" and a "real bargain". Evidence at trial showed several internal documents prepared by Associated identifying a $3,500,000 balance due from the Debtor to Associated by virtue of this transaction.

The writings constituting the agreement between the Debtor and Associated for the purchase of the components were a Master Governing Invoice dated November 6, 1987, and the Debtor's Purchase Orders to Associated Nos. 17289 and 17290. The purchase price of $3,500,000 was reflected in the Master Governing Invoice as being payable in four installments. Notwithstanding the clear terms of the Master Governing Invoice, Semler and Lee had an oral understanding that Associated would be paid through progress payments that the Debtor would receive from the government. A progress payment is the receipt of money from the government prior to the completion of the goods being produced for the government. Under its contracts with the government, Debtor was entitled to receive progress payments if it had incurred the cost of obtaining the property and if it had title to the property. When the Debtor requested a progress payment, it had to certify to the government that it had unencumbered title to the property.

Semler and Lee had an understanding that title to the components would pass from Associated to the Debtor only after Associated received full payment for the components. This understanding was reflected in the Master Governing Invoice which contained the following provisions:

1. All material shipped by Associated Industries covered by these purchase orders are to be kept at the Debtor\'s segregated from other material.

2. Associated Industries is to maintain title to this material until such time as the corresponding invoice is paid, upon which time the title will transfer to the Debtor.

On direct examination, Lee testified that title did not pass to the Debtor until the Debtor received progress payments which would then be paid to Associated. On cross-examination, however, Lee testified that title passed when the Debtor submitted progress payment requests to the government.

The components purchased by Associated were shipped in four lots directly to the Debtor from E-Systems in Florida. Due to the large size of the shipment, the components were initially received at a separate warehouse in Hamilton County leased by the Debtor for purposes of receiving this shipment. Eventually, all components were transferred to the Debtor's main facility for the lengthy and painstaking process of inspection. While Associated attempted to show at trial that these components were segregated from the other inventory of the Debtor as required by the Master Governing Invoice, testimony of the Debtor's employee who was responsible for the incoming inspection of these components refuted this allegation. Accordingly, we find there were no special instructions given with respect to the treatment of these components and that the components were neither segregated nor separately identified from other inventory of the Debtor.

Sometime after the purchase of the components, the Debtor realized that it could only assign approximately $1,600,000 of the components to government contracts rather than the anticipated $2,700,000 amount. On or about January 20, 1988, a portion of the components ("Kentucky Components") were transferred from the Debtor's facility in Ohio to a warehouse in Kentucky leased by Associated. Semler testified that he had Associated take back the Kentucky Components because of the Debtor's shaky financial position. In exchange for the transfer of the Kentucky Components, Associated issued to the Debtor a credit memorandum dated January 20, 1988 in the amount of $1,909,952, thereby deducting the value of these components from the $3,500,000 Master Governing Invoice. Star Bank was not aware of the transfer of inventory from the Debtor to Associated. Neither the Debtor nor Associated sought Star Bank's prior or subsequent consent to such transfer. Thomas Huenefeld, the bank officer primarily responsible for the loan, testified that he learned of this transfer sometime in 1988, "well after" the fact.

Subsequently, the Debtor determined that it could utilize a portion of the Kentucky Components on government contracts. The Debtor therefore requested that Associated transfer $450,640.95 worth of the components back to the Debtor. Associated complied with this request in February, 1988. As a result of this transaction the value of the remaining Kentucky Components, based on the Master Governing Invoice price, was $1,459,311.05. Star Bank offered expert testimony that the value of these Kentucky Components was actually $2,840,000. In August, 1989, Associated placed a value of $100,000 on the Kentucky Components in its annual financial statement. In November, 1989, Associated agreed to sell the Kentucky Components to Electronic Microsystems, Inc. for $250,000.

The unpaid balance on the Master Governing Invoice is $1,022,391.69.

The Debtor filed its bankruptcy petition on November 15, 1989. In its schedules the Debtor listed the claim of Star Bank at $4,850,000, with the secured portion of the claim being $500,000. In its trial brief, Associated withdrew any claim that it had a security interest, perfected or unperfected, in any property of the Debtor.

Associated initiated this adversary action against the Debtor, Star Bank and the Department of the Army raising several claims, most of which were resolved immediately prior to trial. The remaining claims heard at trial were as follows: The claim of Associated against Star Bank as to the validity and perfection of the security interest of Star Bank in the Kentucky Components; the claim of Star Bank against Associated for money damages for conversion of the Kentucky Components.

CONCLUSIONS OF LAW

I. Transfer of Inventory From Associated to the Debtor.

In May, 1986, Star Bank obtained a valid and perfected security interest in the Debtor's inventory as defined in the security agreement, which included after-acquired inventory. We...