Pearson Bros. Co., In re

• Decision Date: 11 April 1986
• Docket Number: No. 85-1623,85-1623
• Citation: 787 F.2d 1157
• Parties: Bankr. L. Rep. P 71,072 In re The PEARSON BROS. COMPANY, an Illinois corporation, Debtor-in-Possession under Chapter 11 of the Bankruptcy Code, Appeal of The PEARSON BROS. COMPANY.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1157

787 F.2d 1157

Bankr. L. Rep. P 71,072

In re The PEARSON BROS. COMPANY, an Illinois corporation Debtor-in-Possession under Chapter 11 of the Bankruptcy Code Appeal of The PEARSON BROS. COMPANY.

No. 85-1623.

United States Court of Appeals Seventh Circuit.

Argued Nov. 8, 1985.

Decided April 4, 1986.

As Amended April 11, 1986.

Richard J. Sankovitz, Jenner & Block, Chicago, Ill., for debtor-appellant.

David B. Radley, Baymiller, Christison & Radley, Peoria, Ill., for appellee.

Before COFFEY, EASTERBROOK and RIPPLE, Circuit Judges.

COFFEY, Circuit Judge.

The Pearson Bros. Company appeals the decision of the district court reversing the bankruptcy court's entry of judgment in its favor in a suit to recover the setoff of $182,209.23 from its checking account with the First National Bank in Galva. We reverse the decision of the district court and remand with instructions to the district court to enforce the judgment of the bankruptcy court.

I.

The Pearson Bros. Company ("Pearson"), a manufacturer of equipment for the livestock industry, such as liquid manure spreaders and hog crates, is located in Galva, Illinois. In November, 1979, Pearson entered into negotiations with the Bettendorf Bank and Trust Company, ("Bettendorf"), for financing of the completion of its plant expansion and for a line of credit. In August of 1981, Pearson and Bettendorf agreed upon a four and one-half million dollar loan, 90 percent of which was guaranteed by the Farmers Home Administration ("FmHA"). Both the Loan and Security Agreement between Pearson and Bettendorf, as well as the FmHA Loan Guarantee, permitted Bettendorf to enter into a "loan participation agreement." ¹ The Loan and Security Agreement signed by Pearson and Bettendorf provided for "participation by a financial institution acceptable to [Bettendorf] and [Pearson] in one-half ( 1/2) of the ten percent (10%) unguaranteed portion of the loan." The FmHA guarantee specified:

"The Lender may retain or sell the unguaranteed portion of the loan only through participation. Participation, as used in this instrument means the sale of an interest in the loan wherein the Lender retains the note, collateral securing the note, and all responsibility for loan servicing and liquidation."

Shortly after the loan to Pearson was closed, Bettendorf sold a $190,000.00 participation interest in the unguaranteed part of the loan to the First National Bank in Galva ("Galva") and retained the remaining $260,000.00 unguaranteed portion of the loan. ² Under the loan participation agreement, Bettendorf was responsible for servicing and collecting the loan, with both parties bearing a proportionate share of the collection expenses. No officer of the First National Bank in Galva signed any of the loan documents, nor did the bank's name appear on any of the loan documents entered into between Bettendorf, Pearson or the FmHA.

Approximately one year after the loan was closed, Pearson began experiencing financial difficulty and negotiated with Bettendorf to temporarily reduce the interest rate of the loan from 18 percent to 6 percent. Bettendorf, in turn, renegotiated its participation agreement with Galva to reflect the lower interest rate. Although the interest on the note had been successfully renegotiated, Pearson continued to experience financial difficulty and, beginning in August of 1983, failed to make four monthly scheduled payments.

On November 21, 1983, Galva wrote Bettendorf a letter pointing out that Pearson's loan was four months overdue and inquiring into the status of the loan. On that date, the unpaid amount due Galva was $182,209.23 and the balance in Pearson's checking account with Galva was approximately $236,000.00. The signature card and account agreement signed by Pearson and Galva provided in pertinent part:

"AGREEMENT CONCERNING SETOFF RIGHTS OF FINANCIAL INSTITUTIONS

Each depositor, individually and jointly, hereby acknowledges that this financial institution has the right to charge or setoff against any deposit of the depositor with this financial institution any debts or obligations owing by the depositor to this financial institution whether direct or indirect, secured or unsecured, absolute or contingent, joint or several, due or to become due, whether as maker, endorser, guarantor, or otherwise, now existing or hereafter contracted or acquired by this financial institution and wherever payable, and the interest thereon and expense, if any, which may be incurred by this financial institution in connection therewith, and this agreement shall be construed to be the consent of the depositor to make such a charge or set-off against his/her/their account(s) if consent be required by any present or future statute or law."

(emphasis added). On November 25, 1983, Galva debited Pearson's checking account in the amount of $182,209.23, the amount due Galva under the participation agreement.

Three days later, on November 28, 1983, Pearson filed a voluntary petition for reorganization under Chapter 11 of the Bankruptcy Code and on December 23, 1983, filed a complaint against Galva in the bankruptcy court to recover the amount of the setoff. The bankruptcy court conducted a hearing and all parties agreed that because no officer of the Galva Bank signed the loan participation agreement and the Bank's name did not appear on the document, that there was no "direct obligation" between Pearson and Galva as that term was used on the signature card and account agreement governing Pearson's checking account with Galva. Jeffrey Hatch, the vice president and cashier of Galva, testified that a participation agreement was an indirect obligation or debt:

"Q: Well, can you tell us, drawn on that same [banking] expertise, what the term 'indirect obligation' or debt means?

A: Indirect would be--it wouldn't require a direct obligation. That any funds owed could be, you know, by guarantee, participation.

Q: Okay. Now, which category would a participation fall in?

A: I would consider that to be indirect."

Elaine Bartholme, the vice president of Bettendorf, also testified as to the meanings of direct and indirect obligations:

"Q: Ms. Bartholme, with regard to the characterization of an obligation as direct or indirect, can you explain to the Court what you understand those terms to mean?

A: Under normal banking terms, a direct obligation is a promissory note from a debtor directly to a financial institution; for example, Pearson Bros. Company owes money directly to the First National Bank in Galva. An indirect obligation, again under normal banking vernacular, is the debtor owes money to a vendor who sells the note to a financial institution. So, for example, Pearson Bros. Company would purchase a vehicle from Lindquist Ford, the indebtedness would be funded by Lindquist Ford to Pearson. And then Lindquist Ford would sell that to the First National Bank in Galva, usually 100 percent.

And then the debtor, Pearson, would pay funds directly to the First National Bank in Galva, who has purchased 100 percent of that indirect obligation. Indirect obligations are often looked at as dealer paper.

Q: In a participation, how is that looked on in the bank's books?

A: A participation is viewed as an investment in an obligation, of which the debtor may or may not be aware of the fact that there is an investment in their obligation. For example, in the case of Pearson Bros. Company, they owe the money to the Bettendorf Bank, and First National Bank in Galva, purchases or participates, invests in, that obligation owed on the Bettendorf Bank.

Pearson Bros. Company may or may not be aware that the First National Bank in Galva is participating. Pearson Bros. Company does not pay the Galva Bank directly for their loan."

The bankruptcy judge, in rendering his judgment in Pearson's favor, stated as a finding of fact that a loan participation is not an indirect obligation.

"The contract on Galva Bank's signature cards purported to give the bank the right to offset 'indirect' obligations; the court finds that a loan participation is not an indirect obligation of the borrower (such as the purchase of 'dealer paper' from a merchant who sells goods to a debtor and then assigns a conditional sales contract to the banks) but is, rather an investment."

Galva appealed the bankruptcy court's decision to the district court. Because the parties agreed and consented in advance to having the bankruptcy court issue findings of fact and conclusions of law and judgment subject to review under only 28 U.S.C. Sec. 158(c), the appeal to the district court was, "taken in the same manner as appeals in civil proceedings generally are taken to the court of appeals...." The parties filed briefs and the district court reversed the decision of the bankruptcy judge, reasoning that under 11 U.S.C. Sec. 553(a), Galva's setoff rights were governed by Illinois law. Pearson filed a motion to reconsider, arguing that Illinois law requires that for the bank to have setoff rights, there must be a mutuality of obligations between the bank and its depositor. Galva responded that the real issue was not whether Pearson's debt to Galva was "mutual," but rather whether the debt was an indirect obligation as that term was used in the account agreement. The district court agreed with Galva's characterization of the issue and entered judgment for Galva holding:

"In its ruling, the Bankruptcy Court held that a loan participation is not an indirect obligation...