Teltronics, Ltd., In re

• Decision Date: 02 June 1981
• Docket Number: No. 80-1434,No. 76,76,80-1434
• Parties: , Bankr. L. Rep. P 68,266 In re TELTRONICS, LTD., an Illinois Corporation, Bankrupt. Glenn R. HEYMAN, Receiver in Bankruptcy of Teltronics, Ltd., an Illinois Corporation, Plaintiff-Appellant, v. George W. KEMP, Jr., Receiver in the Circuit Court of Cook County, CaseCH 7741, Defendant-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1236

649 F.2d 1236

7 Bankr.Ct.Dec. 1172, Bankr. L. Rep. P 68,266

In re TELTRONICS, LTD., an Illinois Corporation, Bankrupt.

Glenn R. HEYMAN, Receiver in Bankruptcy of Teltronics, Ltd., an Illinois Corporation, Plaintiff-Appellant, v. George W. KEMP, Jr., Receiver in the Circuit Court of Cook

County, Case No. 76 CH 7741, Defendant-Appellee.

No. 80-1434.

United States Court of Appeals, Seventh Circuit.

Argued Sept. 25, 1980.

Decided June 2, 1981.

John H. Redfield, Chicago, Ill., for plaintiff-appellant.

James P. Connelly, Chicago, Ill., for defendant-appellee.

Before SPRECHER and BAUER, Circuit Judges, and CAMPBELL, Senior District Judge. ^*

BAUER, Circuit Judge.

Drawn for battle, a state court receiver and a bankruptcy trustee challenge each other's power over funds of the bankrupt, Teltronics, Ltd. The issue here is whether money held by a state court receiver under the Illinois Consumer Fraud and Deceptive Business Practices Act, Ill.Rev.Stat. ch. 1211/2, § 261 et seq., is property of the bankrupt's estate and thus subject to surrender to the bankruptcy trustee. The district court held that the money was not the "property" of the bankrupt under the Bankruptcy Act, 11 U.S.C. § 11(a)(21) ¹, because it was acquired by fraud. We affirm.

I

Dennis Roberts, doing business as Teltronics, Ltd., defrauded thousands of consumers when they responded to magazine advertisements offering digital watches. The watches were never delivered. Roberts collected about $1,700,000 in prepaid orders and absconded with $1,300,000, still not recovered. He was later found guilty of fifty counts of mail fraud. ² 18 U.S.C. § 1341.

On December 26, 1976, the Illinois Attorney General filed an action in the Circuit Court of Cook County under the Illinois Consumer Fraud and Deceptive Business Practices Act ("Consumer Fraud Act"), Ill.Rev.Stat. ch. 1211/2, § 261 et seq., against Dennis Roberts, Teltronics, and other defendants.

Section 267 of the Act authorized the Attorney General to seek an injunction in state court to restrain violations of the Act. Id. at § 267. Section 267 also permits the court to appoint a receiver. Id. Circuit Court Judge O'Brien entered a preliminary injunction, freezing about $836,000 held in Teltronic's checking accounts. On January 13, 1977, he appointed defendant-appellee George Kemp as receiver and placed the funds in his possession.

On January 24, 1977, certain business creditors of Roberts d/b/a Teltronics filed a petition for involuntary bankruptcy, asserting claims of approximately $15,000. Bankruptcy Judge James appointed plaintiff-appellant Glenn Heyman as receiver in bankruptcy on December 5, 1977. On December 20, 1977, Teltronics was adjudicated a bankrupt.

On January 20, 1978, the bankruptcy receiver filed a complaint against the state court receiver, seeking turnover of all assets, books, and records of the bankrupt. On June 26, 1979, Judge James entered a judgment in favor of the bankruptcy receiver and ordered the state court receiver to turn over the funds, books, and records. The district court reversed on review, and the bankruptcy trustee appeals.

II

A

The Bankruptcy Act authorizes the bankruptcy court to order a person in possession of property of the bankrupt to turn that property over to the trustee. In particular, section 2(a)(21) of the Act gives the bankruptcy court jurisdiction to:

(r)equire receivers appointed in proceedings not under this title to deliver the property in their possession or under their control to the receiver or trustee appointed under this title

11 U.S.C. § 11(a)(21). That power, however, is limited, by definition, to property that is part of the bankrupt's estate. As noted by the district court, it is settled that property obtained by fraud of the bankrupt is not part of the bankrupt's estate. Nicklaus v. Bank of Russellville, 336 F.2d 144, 146 (8th Cir. 1964); In re Paragon Securities Co., 589 F.2d 1240, 1242 (3d Cir. 1978); 4A Collier, Bankruptcy P 70.41 at 484 (14th ed. 1978) (hereinafter "Collier"). Roberts' conviction of mail fraud collaterally estops Teltronics from contesting that fraud occurred here; in any event, appellant does not seriously question the finding of fraud. Parklane Hosiery Co., Inc. v. Shore, 439 U.S. 322, 331, 37 S.Ct. 506, 61 L.Ed. 1148 (1979); Hart Steel Co. v. Railroad Supply Co., 244 U.S. 294, 37 S.Ct. 506, 61 L.Ed. 525 (1917). This appeal, then, appears quickly resolved: since the property is not part of the bankrupt's estate, the bankruptcy trustee has no power over it.

Appellant, however, launches several attacks on the state court receiver's powers. Appellant asserts that Roberts' fraud also vitiates the state receiver's right to the property, since he represents the bankrupt. He then argues, citing Thompson v. Magnolia Petroleum Co., 309 U.S. 478, 481, 60 S.Ct. 628, 629, 84 L.Ed. 876 (1940), that only the Bankruptcy Court has jurisdiction to adjudicate any controversy over the money.

Appellant's assault founders on its first step. In contrast to the Bankruptcy Act, a receiver under the Illinois Consumer Fraud Act is expressly empowered to administer funds obtained by fraud. Section 268 gives the receiver power to "sue for, collect, receive and take into his possession" property "derived by means of any practice declared to be illegal and prohibited by this Act." Ill.Rev.Stat. ch. 1211/2, § 268. Illegal practices under the Act include frauds sufficient to give rise to a common law right to rescission of contract. Id. at § 262; cf. Beard v. Gress, 90 Ill.App.3d 622, 46 Ill.Dec. 8, 413 N.E.2d 448 (1980). The state court receiver thus has powers over different funds than the bankruptcy receiver does.

The rule that property obtained by fraud is not part of the bankrupt's estate represents the policy that property should remain in the hands of its rightful owners, no matter how legitimate the claims of creditors. In re Paragon Securities Co., 589 F.2d at 1242. The Illinois Consumer Fraud Act furthers this end by establishing a receiver to manage the claims of the defrauded rightful owners. It can hardly be said that the receiver is powerless to give the consumers their money back because of the very fraud which took it from them. The bankruptcy rule simply does not apply to a receivership under the Consumer Fraud Act.

Thompson v. Magnolia Petroleum Co., if it applies at all here, militates in favor of our decision. While holding that the Bankruptcy Court may determine disputes over property in the bankrupt's estate, Thompson also held that the court's jurisdiction should not be exercised when the dispute concerns purely local questions. 309 U.S. at 483-84. Section 268 of the Consumer Fraud Act has not yet been interpreted by the Illinois courts. If the trustee wishes to contest the receiver's power under that section, he should do so in the state courts. ³

B

Retreating from a frontal attack on the state court receiver's powers, appellant next attempts to ambush Nicklaus v. Bank of Russellville, 336 F.2d 144 (8th Cir. 1964), the leading case establishing that the bankrupt's estate does not include property obtained by fraud. The bankrupt in Nicklaus had swindled some bonds from the Bank of Russellville. By the time of bankruptcy, however, the bank had gotten the bonds back. The bank answered, in response to the bankruptcy trustee's turnover suit, that it possessed the very bonds the bankrupt had swindled. Id. at 146. Here the property cannot be so easily identified. Since Roberts deposited the money in several bank accounts over a period of time, a customer can only roughly identify which money is his or hers. According to appellant, these circumstances violate the tracing rule of Cunningham v. Brown, 265 U.S. 1, 44 S.Ct. 424, 68 L.Ed. 873 (1924); see 4A Collier P 70.41 at 498.

Cunningham held that a rescission for fraud creates a resulting trust in favor of the defrauded person. However, to recover the trust funds, the defrauded person must be able to trace his money to where the cestui que trustent applied it, the Court held. 265 U.S. at 11, 44 S.Ct. at 426.

The Court further held that tracing money to a fund "wholly made up of the fruits of the frauds perpetrated against a myriad of victims" was insufficient. Id. at 13, 44 S.Ct. at 427. According to the Court, a victim had to follow his actual deposits into and out of a bank account. Id. at 11, 44 S.Ct. at 426. If the victim was unable to so identify his funds, he had to participate as a general creditor in the bankrupt's estate. These stringent requirements have defeated the claims of consumers suing as a class to rescind contracts for fraud. See e. g., In re Kennedy & Cohen, Inc., 612 F.2d 963 (5th Cir.), cert. denied, -- U.S. --, 101 S.Ct. 103, 66 L.Ed.2d 38 (1980); In re Faber's, Inc., 360 F.Supp. 946, 948 (D.Conn.1973).

Even Cunningham, however, recognized that the tracing rule could be avoided if abandoning the rule resulted in equal treatment of the defrauded customers. 265 U.S. at 13, 44 S.Ct. at 427. Cunningham considered applying an exception that

where a fund was composed partly of a defrauded claimant's money and partly of that of the wrongdoer, it would be presumed that in the fluctuations of the fund it was the wrongdoer's purpose to draw out the money he could legally and honestly use rather than that of the claimant, and that the claimant might identify what remained as his res and assert his right to it by way of an equitable lien on the whole fund, or a proper pro rata share of it.

265 U.S. at 12, 44 S.Ct. at 426. ⁴ The Court refused to apply the exception because, under the circumstances, it would violate the policy of equality. Some investors learned of the scheme prior to bankruptcy, rescinded their contracts, and received full refunds from Charles Ponzi, the bankrupt. ⁵ The available funds were depleted before all the investors were satisfied. Id. at 7-9, 44 S.Ct. at 425. Since all the funds were obtained by fraud, to allow some...