U.S. Financial Inc., In re

• Decision Date: 24 November 1980
• Docket Number: No. 17007,79-3684,Nos. 78-2802,s. 78-2802,17007
• Citation: 648 F.2d 515
• Parties: , Bankr. L. Rep. P 67,741 In re U. S. FINANCIAL INCORPORATED, a Delaware Corp. & affiliates, Robert D. KELCE, Plaintiff-Appellant, v. U. S. FINANCIAL INCORPORATED, a Delaware corporation, and affiliates, and Swan Constructors, Inc., a California Corporation, Defendant-Appellee. Bankruptcy
• Court: U.S. Court of Appeals — Ninth Circuit

Page 515

648 F.2d 515

7 Bankr.Ct.Dec. 166, Bankr. L. Rep. P 67,741

In re U. S. FINANCIAL INCORPORATED, a Delaware Corp. & affiliates,

Robert D. KELCE, Plaintiff-Appellant, v. U. S. FINANCIAL INCORPORATED, a Delaware corporation, and affiliates, and Swan Constructors, Inc., a

California Corporation, Defendant-Appellee.

Nos. 78-2802, 79-3684.

Bankruptcy No. 17007.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted July 1, 1980.

Decided Oct. 2, 1980.

Rehearing Denied Nov. 24, 1980.

Jeffrey L. Beattie, Denver, Colo., William G. Wilson, Beverly Hills, Cal., for plaintiff-appellant, Robert D. Kelce.

William D Scheid, Denver, Colo., argued, Jason Barton Lumish, Beverly Hills, Cal., on brief, for defendant-appellee, Swan Const.

Appeal from the United States District Court for the Southern District of California.

Before SKOPIL and FERGUSON, Circuit Judges, and LYDICK, ^* District judge.

FERGUSON, Circuit Judge.

Claimant Robert Kelce appeals from the entry of judgments on the pleadings against him in two proceedings under Chapter X of the Bankruptcy Act, ¹ consolidated on appeal. We affirm both judgments.

I. BACKGROUND

As of December, 1968, Kelce owned a condominium project and an adjacent apartment building in La Jolla, California. That month, Kelce entered into an agreement with the debtor, U. S. Financial Inc. ² ("USF") whereby USF obtained an option to purchase Kelce's La Jolla properties for $5 million. The option agreement specified that USF would pay $1 million down and would sign a $4 million promissory note payable in five equal annual installments and secured by a deed of trust on the property. Subsequently, USF declined to purchase the property in accordance with the terms set out in the option agreement. Instead, USF offered to purchase the property for $1 million down, $3 million Series A redeemable preferred stock (300,000 shares at $10 per share par value) and $1 million in Series B convertible preferred stock (100,000 shares at $10 per share par value). USF provided Kelce with materially false, misleading and fraudulent ³ financial statements for the three years ending December 31, 1968, and Kelce relied on those financial statements in accepting USF's proposal.

Prior to USF's collapse, Kelce converted his Series B stock for approximately $1.5 million, thereby realizing a $500,000 profit. Redemptions of Kelce's Series A preferred stock were made in 1970, 1971 and 1972. No redemptions were made after 1972, and Kelce still owns 120,000 shares of Series A stock.

In 1973, USF filed a petition for arrangement under Chapter XI of the Bankruptcy Act (11 U.S.C.A. § 701 et seq.). At the time of filing, USF still owned four condominium units and the apartment building. The history and collapse of USF is described by Judge Anderson in In Re U. S. Financial Securities Litigation, 609 F.2d 411 (9th Cir. 1979).

II. RESCISSION AND RECLAMATION

On August 29, 1975, Kelce filed a complaint for rescission and reclamation of the property still owned by USF. He also sought reclamation of the proceeds of any sale of that property subsequent to the filing of USF's Chapter XI petition.

In Late 1975, the Chapter XI proceedings were converted into Chapter X proceedings. Herbert Solomon was appointed and qualified to act as reorganization trustee, and he subsequently filed a motion for judgment on the pleadings or for summary judgment dismissing Kelce's claim. The bankruptcy court sustained the trustee's motion for judgment on the pleadings, holding that although Kelce was entitled to partial rescission and reclamation under California law, the absolute priority rule barred any recovery by Kelce. The district court affirmed, and this appeal followed.

A. Title

Kelce contends that the courts below erred in holding that his state law right of rescission is superceded by Chapter X of the Bankruptcy Act. He argues that property is not "property of the debtor" ⁴ and therefore does not pass into the bankrupt estate if the debtor held voidable rather than nondefeasible title to the property at the time of filing.

It is clear, however that the trustee did acquire title to the property at issue here. Section 186 of the Bankruptcy Act, 11 U.S.C.A. § 586, provides that a Chapter X trustee acquires the same title as a trustee in ordinary bankruptcy receives pursuant to § 70a, ⁵ 11 U.S.C.A. § 110(a). Contrary to Kelce's assertions, a trustee in ordinary bankruptcy does take title to property to which the debtor held voidable title, but he takes that title subject to the defrauded party's claim for rescission and reclamation. See 4A Collier on Bankruptcy P 70.41 at 483 (14th ed. 1979). "(T)he trustee in bankruptcy takes title to the bankrupt's property subject to the retroactive divestment effected by such a rescission." (emphasis supplied). A Chapter X trustee, therefore, does take title to property which is subject to a state law for rescission. There is, however, a critical distinction between Chapter X and Chapter XI proceedings which may affect the ultimate disposition of property taken subject to a rescission claim. That distinction is the necessary application of the absolute priority rule in Chapter X proceedings. See Protective Committee v. Anderson, 390 U.S. 414, 441, 88 S.Ct. 1157, 1171, 20 L.Ed.2d 1 (1968); In Re Equity Funding of America Securities Litigation, 603 F.2d 1353, 1356 n. 4 (9th Cir. 1979).

Kelce cites several cases in support of his claim for rescission and reclamation. As the district court noted, however, none of these cases addressed the interaction between the absolute priority rule and the common law right of rescission in Chapter X proceedings. As such, none is controlling here.

In Pearlman v. Reliance Insurance Co., 371 U.S. 132, 83 S.Ct. 232, 9 L.Ed.2d 190 (1962), the Supreme Court held that the debtor's surety was entitled to recover funds specifically set aside to secure the surety's obligation. The debtor had no colorable ownership claim to the funds in question, thus the trustee never obtained title at all. Moreover, Pearlman involved an ordinary bankruptcy, and thus the Court was not presented with an opportunity to discuss the absolute priority rule, or a shareholder's right to rescission and reclamation in the context of a Chapter X reorganization. In fact, the case has only once been applied in a Chapter X case, In re Bruce Construction Corp., 217 F.Supp. 926 (S.D.Fla.1963). Bruce, like Pearlman, involved a surety, and, as in Pearlman, the Bruce debtor had no colorable claim to title over the fund.

Similarly, none of the Ninth Circuit cases cited by Kelce involved Chapter X proceedings and they therefore do not discuss the absolute priority rule. In Matter of Paderewski, 564 F.2d 1353 (9th Cir. 1977), a trustee in ordinary bankruptcy claimed title to a one-half interest in a community property residence. An interlocutory divorce decree, which had not been appealed and which therefore had become final, had not awarded each party a one-half interest in the residence. Since the bankrupt did not have a one-half interest, the trustee did not receive a one-half interest. Again, this was not a Chapter X case. Moreover, the bankrupt clearly did not have title to one-half of the property in issue, and neither, therefore, did the trustee. In contrast, USF did not have title to the property in issue here, however defective, and the trustee was vested with that title.

In re Forester, 529 F.2d 310 (9th Cir. 1976), involved the subrogation of a second lien holder's claims to collateral to those of a first lien holder. This court made clear that the trustee in ordinary bankruptcy is vested with the bankrupt's title at the moment of bankruptcy. Id. at 316. Our holding is not inconsistent with that maxim.

In re Telemart Enterprises, Inc., 425 F.2d 761 (9th Cir. 1975), cert. denied, Holzman v. Alfred M. Lewis, Inc., 424 U.S. 969, 96 S.Ct. 1466, 47 L.Ed.2d 736 (1976), concerned reclamation under the Uniform Commercial Code by a seller of goods to a bankrupt purchaser. While we held that a seller could reclaim goods when a bankrupt received voidable title, we were not faced with a Chapter X reorganization and thus did not have to resolve the absolute priority issue. As discussed below, that rule changes the focus of our inquiry and mandates that we refuse to permit Kelce to reclaim the property and proceeds at issue.

B. The Absolute Priority Rule

The Supreme Court has long recognized that a reorganization plan cannot be "fair and equitable," as it must be before it can be approved ⁶ or confirmed, ⁷ if it fails to comply with the absolute priority rule. Case v. Los Angeles Lumber Products Co., 308 U.S. 106, 115-19, 60 S.Ct. 1, 7-9, 84 L.Ed. 110 (1939); Protective Committee v. Anderson, supra, 390 U.S. at 441, 88 S.Ct. at 1171. This rule requires that

(b)eginning with the topmost class of claims against the debtor, each class in descending rank must receive full and complete compensation for the rights surrendered before the next class below may properly participate.

6A Collier on Bankruptcy, P 11.06 at 210-11 (14th ed. 1979) (citations omitted).

We cannot square the absolute priority rule with Kelce's claim for rescission and reclamation. Were we to allow his claim, we would be permitting Kelce to transform his claim as a defrauded shareholder into a secured claim, in derogation of the rights of senior classes and in violation of the absolute priority rule.

The absolute priority rule is designed to vindicate the reasonable expectations formed by claimants when their investments or loans were made. Matter of Stirling Homex Corp., 579 F.2d 206, 214 (2d Cir. 1978), cert. denied, Jezarian v. Raichle, 439 U.S. 1074, 99 S.Ct. 847, 59 L.Ed.2d 40 (1979); Slain & Kripke, The Interface Between Securities Regulation and Bankruptcy Allocating the Risk of Illegal Securities Issuance Between Security Holders and the Issuer's Creditors, 48 N.Y.U.L.Rev. 261, 286-87 (1973) ("Slain & Kripke");...