Matter of Powe

• Decision Date: 01 June 1987
• Docket Number: Bankruptcy No. 82-436,Adv. No. 86-281.
• Citation: 75 BR 387
• Parties: In the Matter of Edward Eugene POWE, Debtor. O.H. WRIGHT, Freddie T. Wright, Bartow Motor Parts, Inc., Plaintiffs, v. The UNITED STATES of America, Defendant.
• Court: U.S. Bankruptcy Court — Middle District of Florida

75 B.R. 387 (1987)

In the Matter of Edward Eugene POWE, Debtor.

O.H. WRIGHT, Freddie T. Wright, Bartow Motor Parts, Inc., Plaintiffs, v. The UNITED STATES of America, Defendant.

Bankruptcy No. 82-436, Adv. No. 86-281.

United States Bankruptcy Court, M.D. Florida, Tampa Division.

June 1, 1987.

Robert H. Buesing, Tampa, Fla., for plaintiffs.

Virginia Covington, Asst. U.S. Atty., Tampa, Fla., Edwin Meese, Dept. of Justice, Tax Div., George T. Rita, Tax Div., Dept. of Justice, Washington, D.C., for U.S.

FINDINGS OF FACT, CONCLUSION OF LAW AND MEMORANDUM OPINION

ALEXANDER L. PASKAY, Chief Judge.

AT TIMES controversies arise which at first blush appear not to present any particular problems and seem to be susceptible to an easy resolution, yet on closer analysis turn out to be extremely bothersome because the resolution of the controversy if based only on the cold letter of the controlling law produces a patently unfair and unjust result. As it is not uncommon in these type of situations, the relevant facts appear to be without dispute and are as follows:

Edward Eugene Powe (Debtor) at the time relevant was engaged in the automotive parts business. As a result of an ongoing fraudulent scheme the Debtor defrauded O.H. Wright, Freddie T. Wright, Bartow Motor Parts, Inc. (Plaintiffs), the Plaintiffs who instituted this adversary proceeding, and several other parties not involved in this adversary proceeding. After the discovery of the fraudulent conduct of the Debtor, he was indicted, tried and found guilty and was sentenced to 8 years of imprisonment and placed on probation for 15 years.

On March 10, 1982, the Debtor while in prison filed his voluntary Petition for Relief under Chapter 7 of the Bankruptcy Code. In due course the Plaintiffs filed an adversary proceeding and sought and obtained by default a final judgment in the amount of $1,094,034.40 and a declaration of non-dischargeability of the liability represented by the judgment. The initial notice scheduling the Meeting of Creditors indicated that since the case appeared to be a no-asset case, creditors need not file proofs of claim. However, subsequently the Trustee was able to recover some assets; therefore, the creditors were notified of the deadline to file proofs of claim.

On July 7, 1984, the Internal Revenue Service (IRS) filed a proof of claim for priority taxes in the sum of $567,287.64. This proof of claim was amended on October 1, 1985, to reflect a total of $298,243.13. Part of this claim is based upon an audit deficiency in income tax for the taxable year 1981 in the sum of $188,557.47 plus fraud penalties of $108,992.53 for failure to file tax returns for that year. The Plaintiffs, unsecured creditors, filed an objection to the IRS proof of claim which was overruled by Order of this Court on March 26, 1986, without prejudice to their right to file an adversary proceeding seeking subordination of the claim of the IRS to their claims.

Following this Order the Plaintiffs filed their adversary proceeding, and in the Complaint they contend in Count I that the claim of the IRS shall be subordinated to their claims pursuant to § 510(c) of the Bankruptcy Code; in Count II the claim of the Plaintiffs is based on the proposition that the taxes claimed for the year 1981 are, in fact, fines and penalties and not compensation for a pecuniary loss of the Government, therefore, pursuant to § 726(a), the Court shall not authorize payment on this claim unless all unsecured claims are satisfied in full. The last claim of these Plaintiffs set forth in Count III is based on the proposition that the funds currently in the hands of the Trustee shall be impressed by a constructive trust in favor of the Plaintiffs and satisfied in full before any payment can be made to the IRS.

The final report of the Trustee indicates gross receipts of $65,411.19. In light of the fact that the monies available for distribution are far short to pay any dividends to general unsecured creditors unless they prevail on the theories advanced by them in their Complaint, particularly their claim of subordination, this should be the first issue to be considered. This is so because the tax claim of the IRS would be paid pursuant to the priority provision of § 507(a)(7) of the Bankruptcy Code, and if that occurs, that will leave no funds whatsoever to pay dividends to the general unsecured creditors.

The concept of equitable subordination is long recognized in the American Jurisprudence. Even though the Act of 1898 did not have a specific provision dealing with subordination of claims, courts never hesitated to order subordination in order to achieve a fair and just result. Pepper v. Litton, 308 U.S. 295, 60 S.Ct. 238, 84 L.Ed. 281 (1939). Section 510(c) of the Bankruptcy Code expressly deals with this subject and provides that:

§ 510(c) Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may —

(1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed interest to all or part of another allowed interest.

According to the legislative history of this Section, the Section was intended to codify prior case law and was not intended to limit the court's power in any way. H.R.Rep. No. 595, 95th Cong. First Sess. 359 (1977) U.S.Code Cong. & Admin.News, pp. 5787, 6315. Congress specifically left it to the courts to develop general principles which might be considered to be germane to the question of subordination. 124 Cong.Rec.H. 11095 (daily ed. September 28, 1978) (statement of Representative Edwards).

In re Branding Iron Steak House, 536 F.2d 299, 302 (9th Cir.1976) it was stated: "We acknowledge that a claim may be subordinated even in the absence of fraud or mismanagement (citations omitted). Nevertheless, a Bankruptcy Court is a court of equity, and subordination requires some showing of suspicious, inequitable conduct. . . ." See also Central States Corp. v. Luther, 215 F.2d 38, 46 (10th Cir.1954), cert. denied, 348 U.S. 951, 75 S.Ct. 438, 99 L.Ed. 743 (1955) (subordination is within the court's powers where "it is necessary to prevent the consummation of conduct which is inequitable . . ."); McDonnell v. Sampsell, 193 F.2d 954, 956 (9th Cir.1952) (quoting In re Bowman Hardware & Electric Co., 67 F.2d 792, 794 (7th Cir.1933) (for a court to order subordination of a claim, "it must appear that the claimant has been guilty of some act involving moral turpitude or some breach of duty or some misrepresentation whereby other creditors were deceived to their damage"); In re Kansas City Journal-Post Co., 144 F.2d 791, 800 (8th Cir.1944) ("the power of subordination necessarily must be measuredly and not blankly exercised. . . . It should not operate to take away anything punitively to which one creditor is justly entitled . . . and bestow it upon others, who in the relative situation have no fair right to it"); In re Calpa Products Co., 249 F.Supp. 71, 73 (E.D.Pa.) aff'd mem. 354 F.2d 1002 (3rd Cir.1965), cert. denied, 383 U.S. 947, 86 S.Ct. 1204, 16 L.Ed.2d 209, reh'g denied, 384 U.S. 934, 86 S.Ct. 1444, 16 L.Ed.2d 535 (1966) (subordination on equitable grounds requires "that the claimant be guilty of at least some inequitable conduct"); In re Loewer's Gambrinus Brewery Co., 74 F.Supp. 909, 913-914 (S.D.N.Y.1947), aff'd, 167 F.2d 318 (2nd Cir.1948), ("the essence of the test is whether or not under all the circumstances the transaction carries the ear marks of an arms length bargain. If it does not, equity will set it aside").

The leading case of Pepper v. Litton, supra, held that "in the exercise of its equitable jurisdiction, the bankruptcy court has the power to sift the circumstances surrounding any claim to see that injustice or unfairness is not done in administration of the bankrupt estate." See also, Central States Corp. v. Luther, 215 F.2d 38, 46 (10th Cir.1954), cert. denied 348 U.S. 951, 75 S.Ct. 438, 99 L.Ed. 743 (1955) (subordination is within the court's powers where "it is necessary to prevent the consummation of conduct which is inequitable . . ."); Columbia Gas and Electric Corp. v. United States, 153 F.2d 101 (6th Cir.1946) (bankruptcy court may exercise its powers of subordination where the "conduct of the claimant in acquiring or asserting his claim is contrary to established equitable principles").

Courts traditionally held, as appears from the cases dealing with this question Pepper v. Litton, supra; Taylor v. Standard Gas and Electric Co., 306 U.S. 307, 59 S.Ct. 543, 83 L.Ed. 669 (1939), that absent some showing of fraud or inequitable conduct on the part of the claimant injurious to other creditors, no equitable ground exists for subordination of a claim. In In re Columbia Ribbon Co., 117 F.2d 999, 1002 (3d Cir.1941) (referring to Pepper v. Litton, supra) the court stated:

"That case holds that a court of bankruptcy under its equitable powers may disallow or subordinate a particular claim in bankruptcy which, because of the fraudulent nature of the claim or the bad faith or improper conduct of the claimant, ought not in equity and good conscience to be allowed or paid on a parity with other claims. It does not hold that the court may set up a subclassification of claims within a class given equal priority by the Bankruptcy Act and fix an order of priority for the subclasses according to its theory of equity.

It is noteworthy, however, that the power of the bankruptcy court to impose a result different from that prescribed by the statute and circumvent the statutory scheme of distribution is not unlimited as noted in the case of In re Ahlswede, 516 F.2d 784 (9th Cir.) cert. denied, 423 U.S. 913, 96 S.Ct. 218, 46 L.Ed.2d 142 (1975). It is always important to keep in mind that the bankruptcy judge never had and does not have now an unrestricted power to contravene the statutory or common law, just because he is of the opinion that the fairer result may be...