Opinion
No. 97-83543, Adv. No. 99-8168, No. 97-83541, Adv. No. 99-8169.
September 10, 2001
O P I N I O N BACKGROUND
These adversary proceedings have been consolidated for purposes of trial. A default judgment was entered against DWE, Inc., leaving KEVIN J. DAVLIN as the only defendant.
FACTS
KEVIN J. DAVLIN (DAVLIN), one of the DEFENDANTS, met Joseph and Suzanne Hobbick (HOBBICKS) in 1986 when they owned and operated a nightclub in Springfield known as "Chantilly Lace." In 1988, the HOBBICKS moved to Peoria and opened and operated a "Chantilly Lace" there. In 1991, DAVLIN purchased the "Chantilly Lace" in Springfield from the HOBBICKS. At that time, DAVLIN formed IBAR, Inc., a corporation which holds the rights to the trade name or assumed business name "Chantilly Lace." DAVLIN is the sole shareholder of IBAR, Inc.
In the fall of 1991, the HOBBICKS moved to Rock Island to construct another bar. By late 1991, the HOBBICKS had run out of money and approached DAVLIN for financial assistance. DAVLIN agreed to loan the HOBBICKS $160,000.00. The HOBBICKS and DAVLIN formed a corporation, AFI, Inc., to operate the nightclub. DAVLIN owned fifty percent of the shares and the HOBBICKS owned the remaining fifty percent. AFI, Inc., owned the personal property and the HOBBICKS owned the real estate.
Shortly after the nightclub opened in early April, 1992, DAVLIN wanted out. In December of 1992, the DEBTORS and DAVLIN entered into a buy-out agreement whereby the HOBBICKS purchased DAVLIN'S fifty percent of the shares of AFI, Inc. for $500.00. The shares owned by DAVLIN were to be held in escrow, as security, until all payments were made. As part of the buy-out agreement, the HOBBICKS and AFI, Inc. agreed to pay an existing demand debt of AFI, Inc. to DAVLIN in the amount of $160,012.30. In addition, AFI, Inc. and the HOBBICKS executed a full and final release, settling any claims DAVLIN may have for injuries, losses and damages against the HOBBICKS individually and AFI, Inc., upon payment of the sum of $203,438.11, for statements made about DAVLIN by the HOBBICKS from February 14, 1992 to April 10, 1992. The $160,012.30 demand note executed as a part of the transaction was immediately cancelled and replaced by a promissory note in the amount of $363,950.41, executed by the HOBBICKS and AFI, Inc., which called for a payment of $13,950.41 to be made on or before December 28, 1992, with the balance of $350,000.00 to be paid in monthly installments of minimum payments of $10,000.00. The note provided that it was secured by all of the stock and assets in AFI, Inc. According to the testimony at trial, if the DEBTORS defaulted, DAVLIN was entitled to purchase the DEBTORS' shares for a nominal sum.
All of the documents executed in connection with the buy-out were backdated to April 10, 1992, the first day of operations.
On August 31, 1994, by amendment to the Articles of Incorporation of AFI, Inc., the corporation's name was changed to AFI of Illinois, Inc (AFI). From 1992 through 1996, the Rock Island nightclub, while successful, had difficulty paying its bills and no payments other than the initial payment of $13,950.41, were made to DAVLIN. DAVLIN pressed the HOBBICKS for payment, and became actively involved in seeking a refinancing or a purchaser for the nightclub.
In 1996, the HOBBICKS entered into negotiations with Chantilly Time, Inc. (Chantilly Time), to purchase the assets and real property of "Chantilly Lace." Because the purchasers wanted to continue to use the name "Chantilly Lace," DAVLIN became actively involved in the negotiations, basically controlling the deal. An Asset Purchase Agreement and Articles of Agreement for Warranty Deed ("purchase agreement")was entered into on November 27, 1996, by the HOBBICKS and AFI, as Sellers, and Chantilly Time, as Purchaser. DAVLIN, while not named as a seller, was also a party to the purchase agreement. Pursuant to the purchase agreement, Chantilly Time agreed to pay $490,306.52 for the assets and the real estate. The payments under the purchase agreement were to be made as follows: (A) fifty thousand dollars at closing; (B) twenty-five thousand dollars on or before February 4, 1997; (C) twenty-five thousand dollars on or before May 4, 1997; (D) $36,306.52 paid directly by Purchaser to the City of Rock Island according to the terms of the note between the Sellers and the City; (E) the balance of $354,000.00, plus interest of $5,900.00, to be paid in one hundred twenty (120) monthly installment payments, with a portion of the payment, in the amount of the Sellers' obligation, to be made directly to First of America Bank (FOA) as mortgagee and the balance of the payment to be made to DAVLIN. As part of the purchase agreement, IBAR, Inc. executed a license agreement granting Chantilly Time a license to use the name "Chantilly Lace" for a fee of $10.00.
The payment of $25,000.00, with accrued interest of $758.22, due on February 4, 1997, was made by Chantilly Time directly to DAVLIN, in the amount of $18,493.39, after certain offsets were made for expenses incurred by Chantilly Time, which were liabilities of the Sellers. The payment of $25,000.00, with accrued interest of $1,319.18, due on May 4, 1997, was also made directly to DAVLIN, in the amount of $19,069.18, with Chantilly Time keeping a hold back of $7,250.00, to cover any remaining obligations of the Sellers. At some point in time after the closing of the purchase agreement, Chantilly Time changed its name to Ranrod, Inc.
Both the HOBBICKS and AFI filed Chapter 7 petitions on September 24, 1997. Charles Covey was appointed the Chapter 7 Trustee (TRUSTEE) in both bankruptcy cases. The Purchaser continued to make the monthly payments called for by the purchase agreement, part to FOA and part to DAVLIN. On July 31, 1999, Ranrod, Inc., entered into an asset purchase agreement with DWE, Inc. (DWE), and Ranrod, Inc., with the consent of DAVLIN, assigned its interest in the purchase agreement to DWE.
At some point, however, the payments were made directly to the TRUSTEE.
The TRUSTEE was not a party to this agreement and did not participate in the negotiations.
At no time, during the period from January 1, 1992 through December 31, 1999, did DAVLIN'S corporation, IBAR, Inc., ever receive any income or money from AFI, Inc., the DEBTORS, Chantilly Time, Ranrod, Inc., DWE, and/or any other entity relating in any way to the operation of the nightclub.
This fact was stipulated to by the parties. The following facts were also part of the stipulation:
1. Accordingly, during said years, IBAR, Inc. reported no income on its federal or state income tax returns relating in any way to operation of the nightclub or relating to the use of the name "Chantilly Lace" by said nightclub; and
2. No portion of the payments received by DAVLIN from Chantilly Time, Ranrod, Inc., and/or DWE, pursuant to the purchase agreement were reported as income by DAVLIN on his federal or state income tax returns for any year. Said payments were applied to reduce the principal amount of indebtedness owed to DAVLIN by the DEBTORS.
The TRUSTEE filed these adversary proceedings, each complaint containing eight counts identical in every aspect, seeking to recover from DAVLIN the sum of $38,565.44, representing the amount he received during the period between 90 days and one year of the filing of the bankruptcy. The TRUSTEE also seeks to recover from DAVLIN the sum of $4,992.33, representing the amount he received during the 90-day period immediately preceding the filing of the bankruptcy. Since the filing of the bankruptcy, DAVLIN has received $25,620.48, and the TRUSTEE seeks to recover this amount under § 549(a) as a post-petition transfer. The TRUSTEE also seeks a determination that the amounts he has received under the purchase agreement from DWE since the filing of the bankruptcy petitions are property of the bankruptcy estates of AFI and the HOBBICKS, as well as a determination that the remaining amounts due under the purchase agreement by DWE should be made to him. DWE failed to answer the complaints and a default judgment was entered against it. A trial was held on January 9, 2001, and the matter was taken under advisement. The parties have submitted written briefs.
DISCUSSION
A. The Preference Claims.
Section 547(b) of the Bankruptcy Code sets forth five elements which must be met in order for a trustee to avoid certain transfers made before the filing of the bankruptcy. A transfer is preferential if it is (1) to a creditor, (2) on account of a pre-existing debt, (3) made while the debtor is insolvent, (4) made on or within 90 days before the date of filing the petition, or made between 90 days and one year before the date of filing the petition if the creditor was an insider who had reasonable cause to believe the debtor was insolvent, and which (5) enables the creditor to receive more than he would receive if the estate were liquidated under Chapter 7. 11 U.S.C. § 547(b).
With the exception of DAVLIN'S status as an insider which will be addressed later in the Opinion, the last three of those elements are not at issue. First, in the Amended Pretrial Statements filed in each adversary, DAVLIN concedes that the HOBBICKS and AFI were insolvent during the one year period before filing for bankruptcy relief. 11 U.S.C. § 547(b)(3). Second, the amount and timing of the payments in question are admitted. DAVLIN was paid $4,992.33 within 90 days of bankruptcy and an additional $38,673.58 between 90 days and one year before bankruptcy. 11 U.S.C. § 547(b)(4). Third, since creditors will not be paid in full in either bankruptcy case, the pre-petition payments in question enabled DAVLIN to receive more than he would if the payments had not been made and he received payment of his debt as an unsecured creditor in these Chapter 7 cases. 11 U.S.C. § 547(b)(5).
This element is not contested by DAVLIN, and unless the assets are sufficient to provide a 100% distribution to creditors in a Chapter 7 case, any unsecured creditor who receives a payment in the preference period has received more than it would receive in a liquidation.
The first two elements of Section 547(b) are not conceded by DAVLIN and are intertwined with the introductory clause of subsection (b). Section 547(b) provides, in material part:
(b) Except as provided in subsection (c) of this section, the trustee may avoid any transfer of an interest of the debtor in property —
(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt owed by the debtor before such transfer was made . . . .
DAVLIN denies that the pre-petition payments are funds that constitute "an interest of the debtor in property." On the one hand, he claims that he received an absolute assignment of the DEBTORS' rights to a portion of the Purchaser's payments under the purchase agreement, and that the right to the payments became his sole property when the agreement was executed so that the payments he received are not property of the DEBTORS. Alternatively, he claims that the payments were consideration for the license to the Purchaser for use of the name "Chantilly Lace" and, as such, were separate from and independent of the purchase agreement. It follows, argues DAVLIN, that the payments were made to him (or IBAR, Inc.) as a licensor and were neither "to or for the benefit of a creditor" nor "for or on account of an antecedent debt owed by the debtor before such transfer was made."
In addition to those three disputed elements of a preference and the dispute as to whether DAVLIN was an "insider", DAVLIN has also raised the common law affirmative defense known as the "earmarking doctrine." While there is some overlap between the earmarking doctrine analysis and the analysis of the elements of a preference, because the earmarking doctrine is asserted defensively, it will be addressed separately. The Court will first address the "absolute assignment"argument, then the "payment for use of name" argument, and finally the earmarking doctrine.
1. There was no absolute assignment.
DAVLIN argues that the payments he received under the purchase agreement are not transfers of an interest of the DEBTORS because the DEBTORS previously divested themselves of their right to receive the payments when the purchase agreement was executed. The purchase agreement provides at paragraph 1.2.2 that:
The portion of the monthly payments relating to the debt owed by Seller to First of America Bank shall be paid directly by Purchaser to First of America Bank, with the balance of the monthly payment being paid by Purchaser to Kevin J. Davlin.
When a debtor makes an absolute assignment to a creditor, of money that the debtor is entitled to receive from a third party, the transfer is complete when the assignment is executed rather than when the money is disbursed to the creditor. In re Gibraltar Resources, Inc., 202 B.R. 586, 588 (N.D. Tex. 1996). An assignment that is in the nature of a security interest, however, is not absolute or complete when executed and the assignor retains an interest in the subsequent payments. In re Navigation Technology Corp., 880 F.2d 1491 (1st Cir. 1989).
In determining whether a transfer is an absolute assignment or a form of security, the court must examine the intent of the parties. This intent is to be discerned from the contents of the documents at issue, the testimony of the contracting parties, the circumstances surrounding the transaction, as well as the parties' conduct, practices, objectives, business activities and relationships. U.S. v. Poling, 73 F. Supp.2d 882, 893 (S.D. Ohio 1999). Factors that indicate a transfer is merely for security include:
1) the payments received are applied to reduce the outstanding balance; and
2) the assignee retains a right to a deficiency on the debt if the assigned funds are insufficient.
Id. at 893-94.
The following facts indicate that the language contained in paragraph 1.2.2 of the purchase agreement directing the Purchaser to pay the balance of each monthly payment to DAVLIN was not intended to be an absolute assignment but was intended to serve as a security mechanism:
1) The contract provision does not contain the usual words indicating an absolute assignment such as "sell", "transfer", "convey" or "assign."
2) There is no document or contract provision indicating that DAVLIN accepted the transfer of the Purchaser's payments in full satisfaction of the note. DAVLIN did not cancel the note or sign a release of the debt.
3) DAVLIN applied the payments he received from the Purchaser to reduce the debt and did not consider the debt to be paid in full upon execution of the purchase agreement.
4) There is no evidence that the HOBBICKS considered the Note to DAVLIN to have been paid in full by virtue of the payment direction in paragraph 1.2.2.
5) The balance due from the Purchaser is listed as an asset on AFI'S Schedule B.
6) AFI disclosed the direct payments from the Purchaser to DAVLIN as pre-petition transfers from AFI to DAVLIN.
7) Joseph Hobbick testified that he considered that the payments to DAVLIN were being made by AFI.
8) The contract language directing the Purchaser to pay DAVLIN the balance of each monthly payment is contained in the same paragraph with and follows immediately the direction to pay FOA a portion of the monthly payment. DAVLIN does not claim that FOA accepted the "assignment" of a portion of the Purchaser's payments in full satisfaction of its claim against the DEBTORS. DAVLIN'S position would require the Court to render opposite interpretations to nearly identical contract language.
After considering all of the evidence, this Court concludes that paragraph 1.2.2 of the purchase agreement was not intended to embody an absolute assignment to DAVLIN of a portion of the Purchaser's payments. The Court concludes that the provision was intended by DAVLIN and the DEBTORS to operate as a mechanism to assure DAVLIN that he would receive the balance of each payment without concern that the DEBTORS would use the funds for other purposes. Therefore, the payments paid to DAVLIN by the Purchaser under the purchase agreement are transfers of property of the DEBTORS.
2. The payments to DAVLIN were part of the asset sale price.
DAVLIN'S argument that the payments he received were not "on account of an antecedent debt" is two-pronged. On the one hand, he claims that the payments he received from the Purchaser were traceable to an increase in the purchase price solely attributable to his negotiating efforts. On the other hand, he claims that the payments directed to him were in consideration for use of the name "Chantilly Lace." Even if the first prong is true, it is no defense to a preference claim to say that the recipient of the transfers negotiated a better deal for the sale of the assets than the DEBTORS may have been able to obtain on their own. The purchase agreement expressly provides that the total purchase price of $490,306.52 was payment for the DEBTORS' assets. What influence, if any, DAVLIN may have had on that figure is academic. To the extent that DAVLIN seeks a kind of equitable setoff against his preference liability in recognition of his negotiating efforts, there is simply no basis in the Bankruptcy Code for his position. See, In re Mowry, 263 B.R. 499 (Bankr.W.D.Pa. 2001).
See discussion infra pp. 15-17.
DAVLIN'S second argument that the payments made directly to him by the Purchaser were in reality present consideration for use of the name "Chantilly Lace," is contradicted by the documentary evidence. The terms of the purchase agreement make it clear that the Purchaser's rights in and payment for the trade name were separate and independent from the purchase of the assets. The trade name license is addressed at paragraph 1.4 of the purchase agreement, as follows:
1.4 License for Use of Trade Name "Chantilly Lace." The obligation of Purchaser to acquire the Assets under this Agreement is subject to Purchaser receiving the right to use the trade name "Chantilly Lace" in the form of a License Agreement executed by IBAR, Inc., an Illinois corporation, the current holder of trade name, under terms acceptable to the Purchaser. The license to use the trade name "Chantilly Lace" shall terminate in the event of the Purchaser's default under the terms of this Agreement. The Purchaser's breach or default under the License Agreement which results in the termination of the license shall not invalidate Purchaser's obligations under this Asset Purchase Agreement.
According to DAVLIN'S own testimony, the rights to the name were at all times held by IBAR, Inc., not by DAVLIN personally. A separate license agreement was executed with the consideration being separate and distinct from the purchase price under the purchase agreement. The payments made to DAVLIN under the purchase agreement were part of the total purchase price for the assets and were payable to DAVLIN, individually, as a creditor of the Sellers. In addition, DAVLIN stipulated that IBAR, Inc. received no income or money from the Purchaser's use of the name and reported no income derived from Purchaser's use of the name. DAVLIN further stipulated that all payments he received were credited by him to the indebtedness owed by AFI and the HOBBICKS. DAVLIN'S position would require the Court to disregard the purchase agreement, the license agreement, and DAVLIN'S own stipulation. This, the Court will not do.
The Seventh Circuit recently addressed a similar situation where a creditor of the debtor and recipient of an alleged preference argued that the payments it received under the debtor's asset purchase agreement represented independent consideration and were neither an interest of the debtor in property, nor for or on account of an antecedent debt. Warsco v. Preferred Technical Group, 258 F.3d 557 (7th Cir. 2001). As an initial matter, the Seventh Circuit recognized that indirect transfers made by third parties to a creditor on behalf of the debtor may be avoidable preferences. Noting that the focus is on whether the transfer diminished the debtor's estate, the court stated:
When a third party pays a creditor of the debtor after having purchased the debtor's assets, the fundamental question in determining whether that payment was property of the debtor is whether the funds used to make the payment were part of the purchase price for the assets.
If so, the payment may be avoided as a preference since "the debtor effectively transferred to the creditor its right to receive a portion of the sale price equal to the amount of the debt."
By contrast, the Court distinguished those asset purchase scenarios where the funds paid by the purchaser to the creditor were clearly consideration for future services provided by the creditor so that the transferred funds were not part of the asset purchase price and would not have otherwise been paid to the debtor. See, In re Sneakers Sports Grill, Inc., 228 B.R. 795 (Bankr.M.D.Fla. 1999). Under those circumstances, the transfer does not diminish the debtor's estate and is not an avoidable preference.
The facts in the case at bar lead this Court to conclude that the payments DAVLIN received from Chantilly Time and DWE were part of the purchase price for the DEBTORS' assets, caused a corresponding diminution to the DEBTORS' estates and are preferential transfers. Specifically, the Court finds that DAVLIN was a creditor of the HOBBICKS and AFI since 1992, when the HOBBICKS and AFI bought out his ownership interest. "Creditor" includes a person "that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor." 11 U.S.C. § 101(10)(A). "Claim" means "right to payment." 11 U.S.C. § 101(5)(A). Although DAVLIN was initially a shareholder of AFI, the HOBBICKS bought out his interest as of April 10, 1992. In conjunction with the buy-out, the HOBBICKS and AFI became obligated on a note to DAVLIN for $160,012.30 evidencing DAVLIN'S prior loan of $160,000.00. The note was cancelled and replaced by an installment note in the amount of $363,950.41, apparently in consideration for DAVLIN'S release of certain claims against the HOBBICKS. Consequently, DAVLIN held a claim against the DEBTORS that arose before the Orders for Relief, that remains unpaid, and DAVLIN was therefore a creditor of the HOBBICKS and AFI at the time of the bankruptcy filings and for more than one year prior thereto. This finding is consistent with DAVLIN'S own characterization of himself in the purchase agreement that expressly identifies DAVLIN as a "creditor" of AFI and the HOBBICKS.
Based on the evidence in the record, the Court finds that the payments received by DAVLIN were part of the purchase price for the sale of the DEBTORS' assets and, as such, were "an interest of the debtor in property" for purposes of Section 547(b). The Court further finds that the payments were "to or for the benefit of a creditor" for purposes of Section 547(b)(1) and were "for or on account of the antecedent debt" owed by the DEBTORS to DAVLIN before the transfers were made for purposes of Section 547(b)(2). Given this determination, Counts V, VI, VII and VIII of the Complaints, alleged in the alternative and premised upon an absolute assignment to DAVLIN, will be DISMISSED.
3. The Earmarking Doctrine is inapplicable.
DAVLIN raises the earmarking doctrine as an affirmative defense, asserting that the DEBTORS had no interest in the payments he received from Chantilly Time, or from DWE. The TRUSTEE contends that the earmarking doctrine, requiring a loan or other extension of credit by a third party to the debtor for the purpose of satisfying the claim of a specific creditor, has no application to these proceedings.
DAVLIN correctly contends that the TRUSTEE, as an element of his proof, must establish that the transfer he seeks to recover was "an interest of debtor in property" within the meaning of Section 547(b). Though not defined in the Bankruptcy Code, this prefatory element has been interpreted as including that property which would have been property of the estate if it had not been transferred prepetition. Matter of Merchants, Inc. Grain By and Through Mahern, 93 F.3d 1347 (7th Cir. 1996). The judicially created earmarking doctrine is one facet of this statutory requirement. However, since it is not provided for in Section 547 and undermines the goals of the preference recovery statute, the earmarking doctrine is narrowly applied. In re Moses, 256 B.R. 641 (10th Cir. BAP 2000).
The earmarking doctrine typically applies when a third party makes a loan to the debtor with the specific purpose of enabling the debtor to satisfy an existing debt of a particular creditor, thus involving the substitution of a new creditor for the old creditor. In re Interior Wood Products Co., 986 F.2d 228 (8th Cir. 1993). The elements for application of the doctrine are stated to be (1) an agreement between the new lender and the debtor that new funds will be used to pay a specified antecedent debt; (2) actual performance of the terms of the agreement; and (3) no diminution of the debtor's estate as a result of the allegedly preferential transfer. In re Libby Intern., Inc., 247 B.R. 463 (8th Cir.BAP 2000). It is essential that the debtor lack control over the disposition of the funds. In re Crystal Medical Products, Inc., 240 B.R. 290 (Bankr.N.D.Ill. 1999).
Contending that the earmarking doctrine applies to the payments he received from Chantilly Time and DWE, DAVLIN asserts that the purchase agreement and the license agreement entered into between Chantilly Time and the DEBTORS providing that "new funds" will be used to pay the debt owed him by the DEBTORS satisfies the first element and that performance of that agreement by Chantilly Time meets the second requirement of the earmarking doctrine. Again asserting that the purchase agreement would not have been entered into by Chantilly Time unless it also received the right to use the name "Chantilly Lace," and also that the higher purchase price was the result of his negotiations with the Purchaser's attorney, DAVLIN argues that there has been no diminution of the DEBTORS' estates because AFI and the HOBBICKS owned only the land, buildings and fixtures and not the right to use the name "Chantilly Lace."
Relying on In re Phelps Technologies, Inc., 245 B.R. 858 (Bankr.W.D.Mo. 2000), the TRUSTEE contends that the earmarking doctrine does not apply because Chantilly Time was not a "new lender" but a purchaser of the DEBTORS' assets. In that case, involving payments made at the debtor's direction by a purchaser of its components inventory directly to one of the debtor's suppliers, the court held that the earmarking doctrine did not apply, determining that there was no advance of any new credit to the debtor, and thus no substitution of one creditor for another. Rather, the court found that the debtor's estate was diminished by the amount paid directly to the debtor's supplier, an unsecured creditor, by the purchaser of the inventory components, notwithstanding the circuitous route of the payment.
The TRUSTEE also relies on In re Interior Wood Products Co., 986 F.2d 228 (8th Cir. 1993), a case involving an agreement by the purchaser of the debtor's assets to pay an unsecured debt on behalf of the debtor. Rejecting the unsecured creditor's argument that the requirements of the earmarking doctrine were satisfied by the agreement between the purchaser and the debtor which provided that the purchaser's funds would pay the debt of a designated creditor, performance of that agreement according to its terms, and no resulting diminution of the debtor's estate, the court held that the transfer resulted in a voidable preference, stating:
The purchase price was clearly set by the [asset purchase agreement.] The intent of the parties is not a factor to consider when determining if the payment constituted a voidable preference. Although the earmarking doctrine is widely accepted as a valid defense against a voidable preference claim, it is not applicable to the facts of the present case because [the purchaser] did not make a loan to [the debtor] so that [the debtor] could pay the [unsecured creditor]; rather, [the purchaser] paid [the unsecured creditor] on behalf of [the debtor.] [The debtor] was under no obligation to repay [the purchaser]; therefore, this transaction did not substitute a new creditor for an old creditor, which is a key factor characteristic of the earmarking doctrine.
Though not cited by the TRUSTEE, the court in In re S.E.L. Maduro (Florida), Inc., 205 B.R. 987 (Bankr.S.D.Fla. 1997), following the court's decision in Interior Wood, rejected a similar contention to that made here by DAVLIN, that the transfers by the purchaser of the debtor's assets to certain unsecured creditors were not preferential because the purchaser's ability to designate the unsecured creditors to be paid as part of the purchase transaction was a condition of the purchase and resulted in a higher price for the debtor's assets, explaining:
Carving out exceptions by requiring a factual inquiry into who designated the creditors and what effect designations may have had on the purchase price would be inconsistent with preference policy and create an intolerably high risk of collusion. Any time an insolvent company wanted to pay preferred creditors from the proceeds of a sale of assets, it could "cleanse" the funds by having the proceeds paid to an escrow agent who is instructed to disburse to the preferred creditors.
The Court rejects this approach in favor of a bright line rule. Preference liability will be strictly imposed on creditors who receive preferential treatment as part of a purchase transaction where it is clear that the money they are receiving is money that was part of the purchase price.
205 B.R. at 992-93. This Court agrees with that reasoning and likewise rejects DAVLIN'S argument.
The elements of the earmarking doctrine are not supported by the evidence. The Purchaser is not a "new lender" who is making a loan to the DEBTORS for the purpose of paying a specified antecedent debt, the payment of which would result in the mere substitution of the Purchaser as a creditor of the DEBTORS in place of DAVLIN, with no resulting diminution to the DEBTORS' estates. The Purchaser did not make a new "loan" to the DEBTORS. Rather, the Purchaser became indebted to the DEBTORS and did not take the place of DAVLIN as a "creditor" of the DEBTORS. The evidence is also clear that it was not the Purchaser who insisted that DAVLIN be the recipient of a portion of each monthly payment, but DAVLIN himself. The Purchaser had to be cajoled by DAVLIN into including the "direct payment to DAVLIN" portion of paragraph 1.2.2 only after several drafts omitted it. The earmarking doctrine has no application to the facts in evidence.
4. DAVLIN was an insider of AFI but not the HOBBICKS.
Count I of the TRUSTEE'S complaints is premised upon a determination that DAVLIN was an "insider" of the DEBTORS. The TRUSTEE may avoid transfers made between 90 days and one year of the filing of the bankruptcy if the creditor "at the time of such transfer was an insider." Section 547(b)(4)(B). Section 101(31) of the Bankruptcy Code gives separate definitions for "insider" depending upon the status of the debtor, as an individual, a corporation, or a partnership. "Insider" is defined to include:
(A) if the debtor is an individual —
(i) relative of the debtor or of a general partner of the debtor;
(ii) partnership in which the debtor is a general partner;
(iii) general partner of the debtor; or
(iv) corporation of which the debtor is a director, officer, or person in control;
(B) if the debtor is a corporation —
(i) director of the debtor;
(ii) officer of the debtor;
(iii) person in control of the debtor;
(iv) partnership in which the debtor is a general partner;
(v) general partner of the debtor; or
(vi) relative of a general partner, director, officer, or person in control of the debtor . . . .
11 U.S.C. § 101(31). By the rules of construction which govern the Bankruptcy Code, the statutory list is non-exclusive. The legislative history of Section 101(31) infers that an insider is a person or entity with "a sufficiently close relationship with the debtor that his conduct is made subject to closer scrutiny than those dealing at arm's length with the debtor." S.Rep. No. 95-989, 95th Cong.2d Admin.News 5787, 5810. Under that expanded interpretation, in addition to the entities set out, a creditor will also be determined to be an insider of the debtor if the creditor had sufficient influence or control over the debtor's operations. In re Armstrong, 231 B.R. 746 (Bankr.E.D.Ark. 1999). It is influence and control which stems from the parties' relationship, and not power emanating from any legal rights incident to the debtor/creditor relationship, which is determinative. In re Busconi, 177 B.R. 153 (Bankr. D.Mass. 1995). Friendship alone does not compel a finding of an insider relationship, but a de facto or de jure family relationship is required. In re Reinbold, 182 B.R. 244 (D.S.D. 1995). Nor is an attorney, simply by virtue of the normal attorney-client relationship, deemed an insider. In re Covenant Financial Group of America, Inc., 243 B.R. 450 (Bankr.N.D.Ala. 1999). Insider status is a question of fact, determined on a case by case basis through examination of the totality of circumstances. In re Murchison, 154 B.R. 909 (Bankr.N.D.Tex. 1993).
Section 102(3) of the Bankruptcy Code, which sets forth certain rules of construction, provides that "includes" is not limiting. 11 U.S.C. § 102(3).
The TRUSTEE relies upon the factors set forth by the court in In re Emerson, 235 B.R. 702 (Bankr.D.N.H. 1999), used to determine insider status:
1. Whether the loan made to the debtor was documented (e.g., promissory note, mortgage and specified repayments terms);
2. Whether the loans were made on an unsecured basis and without inquiring into the debtor's ability to repay the loans;
3. Whether the transferee knew that the debtor was insolvent at the time the debtor made the loans or recorded the security agreements;
4. Whether there were numerous loans between the parties;
5. Whether there were any strings attached as to how the debtor could use loan proceeds;
6. Whether the loans were commercially motivated;
7. Whether the transferee had an ability to control or influence the debtor;
8. Whether there was a personal, business, or professional relationship between the transferee and the debtor allowing the transferee to gain an advantage such as that attributable simply to affinity;
9. Whether the transferee had authority to make business decisions for the debtor;
10. Whether there is evidence of a desire to treat the transferee differently from all other general unsecured creditors;
11. Whether there was an agreement among the parties to share profits and losses from business transactions. (Citations omitted).
The TRUSTEE points to the fact that DAVLIN'S initial advances were not documented, were not clearly identified as capital or loans, were not secured, and were made to an admittedly financially strapped start-up business. Noting that the buy-out agreement was drafted by DAVLIN, the TRUSTEE contends that its provisions, in particular the right of DAVLIN to recover his shares upon default, evidence DAVLIN'S control over the HOBBICKS. The TRUSTEE argues that DAVLIN'S control is manifested by the HOBBICKS' execution of the new note for $363,950.41, immediately after the execution of the buy-out agreement and the execution and cancellation of the $160,000.00 note. The TRUSTEE stresses DAVLIN'S pivotal role in the sale of the nightclub to Chantilly Time and the undisputed testimony that without DAVLIN'S assent, the sale would not have taken place. Finally, the TRUSTEE calls attention to DAVLIN'S receipt of substantial portions of the two $25,000.00 down payments made by Chantilly Time under the purchase agreement, though the purchase agreement did not provide for DAVLIN to receive those sums. Characterizing AFI and the HOBBICKS as a functional unit, the TRUSTEE asserts that the finding of insider status as to one confers insider status as to the other, citing In re Baker Getty Financial Services, Inc., 88 B.R. 792 (Bankr.N.D.Ohio 1988).
DAVLIN argues that the evidence indicates that he did not exercise undue influence or control over the DEBTORS because:
1) He did not require the HOBBICKS to give him a mortgage on the business property or their residence.
2) When the note was signed, the HOBBICKS were represented by their corporate accountant, William Weinberg, who negotiated with DAVLIN.
3) The DEBTORS were represented by their own attorney, Linnea Thompson, during the negotiation of the purchase agreement.
4) He did not file a proof of claim in either bankruptcy case.
5) He did not know that AFI changed its corporate name.
The evidence supports the conclusion that DAVLIN was an "insider" of AFI. Prior to the 1992 agreement by the HOBBICKS to purchase DAVLIN'S shares, he was both a stockholder and officer of AFI. Thereafter, he continued to retain the ability to recover his shares, and purchase the HOBBICKS' shares for a nominal sum, upon a default. Where a right to repurchase stock is retained, a former shareholder does not cease to be an "insider," for preference purposes, when his stock is sold. In re Le Cafi Creme, Ltd., 244 B.R. 221, 232-33 (Bankr.S.D.N.Y. 2000). In addition, DAVLIN, who testified that he was uncertain about this point, may have continued his status as a corporate officer, even after the 1992 stock sale.
Whether or not he retained any formal status as an officer or director of AFI, it is clear that he retained substantial control and influence over corporate policy decisions. Because he "wanted out" in 1992 and wanted to cash out his financial interest in AFI, after the promised take-out loan from a bank failed to materialize, DAVLIN steered the corporation on a direct course to be sold. When a buyer was found, not only did DAVLIN, by his own admission, play a major role in negotiating the terms of the purchase agreement, he made sure that his interest was protected by the direct payment provision contained at paragraph 1.2.2. He made sure that the corporation's sale served to prefer him as a creditor.
When the original Purchaser wanted to convey its interest to a new buyer in 1998, DAVLIN again played a major role. He approved the transfer and made sure that the new buyer agreed to continue to pay a portion of the monthly payment direct to him. For these reasons, the Court finds that DAVLIN is an "insider" of AFI for preference purposes.
However, the evidence does not support a finding that there was such a close personal relationship between DAVLIN and the HOBBICKS that he can be considered an insider as to them individually. At the time DAVLIN made the advances to the HOBBICKS, the parties were mere acquaintances. DAVLIN made a few trips to Rock Island in order to check on the progress of the nightclub and was present for the opening event. It is clear that DAVLIN and the HOBBICKS had a falling out in 1992. DAVLIN testified that he no longer trusted them with respect to the operation of the nightclub. The personal conflict between DAVLIN and Joseph Hobbick was so severe that it led to the execution of a settlement agreement for claims DAVLIN allegedly had for conduct engaged in and statements made by the HOBBICKS between February 14, 1992 to April 10, 1992. After the execution of the buy-out agreement, DAVLIN'S contacts with the HOBBICKS were focused on collecting the note, and in that endeavor, trying to find a buyer for the business. Though DAVLIN may have made suggestions as to the management of the nightclub, they were characterized by Joseph Hobbick as just that. They may have operated like trusting business partners early on, but after the falling out and buy-out in 1992, their continued association was dominated by a mutual desire to see that DAVLIN'S financial interest in AFI was paid off.
Baker Getty, supra, relied upon by the TRUSTEE, is not determinative here. There, the court rejected the trustee's contention that, by reasons of the substantive consolidation of the debtors' cases, an insider of one debtor would necessarily be considered an insider of all the debtors. The court stated that if the evidence demonstrated a functional unity between the corporate debtors, the admission by the defendant as to insider status as to one debtor would be persuasive evidence that he should be deemed an insider as to all the corporate debtors. Attributing insider status between a corporate debtor and individual debtors is a different matter entirely.
As an insider creditor of AFI, DAVLIN did have some financial power over the HOBBICKS, but mere financial power over an individual debtor does not impute insider status. In re Strickland, 230 B.R. 276, 285 (Bankr.E.D.Va. 1999). The HOBBICKS were sophisticated business people who owned and operated several other nightclubs with little or no participation by or assistance from DAVLIN. DAVLIN'S relationship with the HOBBICKS was limited, in large part, at least since 1992, to the AFI enterprise. Accordingly, the Court finds that DAVLIN was not an insider of the HOBBICKS, individually.
According to the HOBBICKS' Statement of Affairs, they were principals of Peaches in Paradise, Inc., d/b/a/ Baywatch Bar and Grill, Bahama Mama's Inc., d/b/a Bahama Mama's and Sugar Bears of Peoria, Ltd, d/b/a/ The End Zone, each of which filed a Chapter 7 petition in this Court.
DAVLIN and his law firm apparently assisted the HOBBICKS by reviewing income tax returns prepared by an accountant, for one or more of these corporations in the mid-1990's, but, from the testimony adduced at trial, this was the extent of his involvement in the HOBBICKS' other business endeavors.
B. The Postpetition Transfers
Section 549(a) of the Bankruptcy Code authorizes a trustee to avoid a postpetition transfer of "property of the estate" that was not authorized by the Bankruptcy Code or the Court. 11 U.S.C. § 549(a). The TRUSTEE seeks to recover the $25,620.48 DAVLIN has received from the Purchasers since the filing of the petitions. After his demand that future payments be made to him met with resistance from DAVLIN, the TRUSTEE acquiesced in the Purchasers' continued payments to DAVLIN, because of DAVLIN'S leverage over the continued use of the name "Chantilly Lace," in order to protect the future value of the stream of payments from the Purchaser. The payments were not, however, authorized under any provision of the Bankruptcy Code nor were they made to DAVLIN with any approval by this Court. Given this Court's determination that there was no absolute assignment; that the payments to be made to DAVLIN under the purchase agreement were part of the asset sale price; and that the purpose of the provision providing for direct payments to DAVLIN was to assure him that he would receive the balance of each monthly payment, it follows that the Purchaser's post-petition payments are property of the DEBTORS' bankruptcy estates and that the TRUSTEE is entitled to recover those payments as well. To the extent that the earmarking doctrine is asserted by DAVLIN as a defense to the TRUSTEE'S Section 549 claim, it is rejected for the same reasons outlined above.
C. Declaratory Relief
The TRUSTEE also seeks the entry of a declaratory judgment finding that the balance due under the purchase agreement and the DWE Assignment constitutes property of the bankruptcy estates and an order directing DWE to make all future payments due to the TRUSTEE. For the reasons set forth above, the TRUSTEE is entitled to the relief sought.
D. Allocation Between the Separate Bankruptcy Estates
Given the above rulings made by this Court, the final issue to be addressed is the proper allocation of the monies paid or to be paid by the Purchasers between the separate bankruptcy estates of AFI and the HOBBICKS. The TRUSTEE proposes to divide any monies he recovers between the bankruptcy estates of AFI and the HOBBICKS based upon an exhibit affixed to the purchase agreement when the business was sold to Chantilly Time which sets forth a value of $392,000 for the real estate, as improved, and a value of $527,375 for the inventory and equipment. The provision in the purchase agreement allocating the purchase price of $490,306.52 to the real property, assets and non-competition agreement and goodwill is left blank. According to the testimony at trial, the parties never agreed to an allocation. The exhibit attached to the agreement, upon which the TRUSTEE relies, is not referred to in the agreement. When deposed by the TRUSTEE, Joseph Hobbick testified that the assets had a fair value of $919,000, but that the Purchaser was not willing to pay full fair market value. In his opinion, no value was attributable to the noncompetition agreement. He testified that an allocation of the purchase price between the real estate and the inventory and equipment, based upon the proportionate values set forth in the exhibit would be fair. Based upon those figures, AFI, as owner of the inventory and equipment, would have a 57.3% interest in the monies paid under the purchase agreement and the HOBBICKS, as owners of the real estate, would have a 42.7% interest. DAVLIN does not offer an alternative method of apportioning the funds nor does he fault the TRUSTEE'S proposal.
In contrast to the DEBTORS' perspective as sellers, the offer submitted by the Purchaser, dated November 25, 1996, two days before the purchase agreement was executed, specifically allocated the purchase price of $490,306.52 as follows:
Inventory $ 20,000.00 Building 200,000.00 Equipment 230,000.00 Covenant Not to Compete 35,000.00 Telephones Goodwill 5,306.52
TOTAL $490,306.52
Based upon these figures, the proportionate value of the real estate, when compared with the total value of the inventory, equipment, telephones and goodwill, is 43.9%.
Absent an independent appraisal of the individual assets at the time the agreement was entered into, the best evidence of their market value is an allocation of the purchase price which is agreed to by the purchaser and seller. Unfortunately, in the present case, that portion of the agreement was not filled in. The only available evidence is the exhibit attached to the agreement, which sets forth the DEBTORS' opinion and the Purchaser's offer which contains its position. It is fortunate here that the discrepancy is negligible, and this Court finds that the ratios derived, viewed in tandem, offer a sufficient basis upon which to allocate the recoverable sums. Accordingly, this Court finds that the TRUSTEE is entitled to recover under Count II of the First Amended Complaint in the AFI bankruptcy, for preferences received by DAVLIN within ninety days of the filing of the bankruptcy petition, 57% of the recoverable transfer. Under Count II of the First Amended Complaint filed in the HOBBICKS' bankruptcy, the TRUSTEE is entitled to recover 43% of the sum determined to be recoverable. Similarly, the TRUSTEE'S recovery under Count III of the First Amended Complaints for monies received by DAVLIN after the filing of the bankruptcy petitions, is allocated 57% to the AFI bankruptcy estate and 43% to the HOBBICKS' bankruptcy estate. That same allocation will apply to future payments received by the TRUSTEE under the purchase agreement.
Pursuant to § 502(h) of the Bankruptcy Code and Fed.R.Bankr.P. 3002(c)(3), upon returning the amounts this Court has determined to be preferential transfers, DAVLIN may file a claim which will be treated as if it had arisen prepetition.
With respect to payments received by DAVLIN between ninety days and one year of the filing of the bankruptcy petitions, a different result must occur. Based upon this Court's finding that DAVLIN was an insider of AFI, the TRUSTEE is entitled to recover, under Count I of the First Amended Complaint brought in the AFI bankruptcy proceeding, 57% of the sums transferred to DAVLIN. The full amount of that recovery represents property of the AFI bankruptcy estate, and judgment will be entered in the TRUSTEE'S favor for that amount in Adv. No. 99-8169. Because this Court has determined that DAVLIN was not an insider of the HOBBICKS individually, the TRUSTEE is not entitled to recover the remaining 43% of the payments received by DAVLIN, representing the HOBBICKS' interests. Accordingly, judgment will be entered on Count I of the First Amended Complaint in Adv. No. 99-8168 in favor of DAVLIN and against the TRUSTEE.
According to the TRUSTEE, AFI paid DAVLIN $2,250 prior to the purchase agreement. Under the purchase agreement, DAVLIN received $36,423.58. On behalf of AFI, the TRUSTEE is entitled to recover the $2,250 plus 57% of $36,423.58, totaling $23,011.44.
This Opinion constitutes this Court's findings of fact and conclusions of law in accordance with Federal Rule of Bankruptcy Procedure 7052. A separate Order will be entered in each adversary proceeding.
O R D E R
For the reasons stated in an Opinion entered this day, IT IS HEREBY ORDERED that:
1. Judgment on Count I of the TRUSTEE'S First Amended Complaint is entered in FAVOR of DAVLIN and AGAINST the TRUSTEE.
2. Judgment on Count II of the TRUSTEE'S First Amended Complaint is entered in FAVOR of the TRUSTEE and AGAINST DAVLIN in the amount of $2,146.70, plus costs and prejudgment interest of 5.285% from September 21, 1999, the date the Complaint was filed.
3. Judgment on Count III of the TRUSTEE'S First Amended Complaint is entered in FAVOR of the TRUSTEE in the amount of $11,016.80, plus prejudgment interest of 5.285% from September 21, 1999, the date the Complaint was filed.
4. Judgment on Count IV of the TRUSTEE'S First Amended Complaint is entered in FAVOR of the TRUSTEE and AGAINST DAVLIN. It is declared that 43% of the remaining balance due DAVLIN under the purchase agreement is property of the HOBBICKS' bankruptcy estate. It is further declared that the sum of $8,179.85 currently held by the TRUSTEE, representing payments received under the purchase agreement, is property of the bankruptcy estate and may be properly retained by the TRUSTEE.
5. Counts V, VI, VII and VIII of the First Amended Complaint are DISMISSED.
O R D E R
For the reasons stated in an Opinion entered this day, IT IS HEREBY ORDERED that:
1. Judgment on Count I of the TRUSTEE'S First Amended Complaint is entered in FAVOR of the TRUSTEE and AGAINST DAVLIN in the amount of $23,011.44, plus costs and prejudgment interest of 5.285% from September 21, 1999, the date the Complaint was filed.
2. Judgment on Count II of the TRUSTEE'S First Amended Complaint is entered in FAVOR of the TRUSTEE and AGAINST DAVLIN in the amount of $2,845.63, plus prejudgment interest of 5.285% from September 21, 1999, the date the Complaint was filed.
3. Judgment on Count III of the TRUSTEE'S First Amended Complaint is entered in FAVOR of the TRUSTEE and AGAINST DAVLIN in the amount of $14,603.67, plus prejudgment interest of 5.285% from September 21, 1999, the date the Complaint was filed.
4. Judgment on Count IV of the TRUSTEE'S First Amended Complaint is entered in FAVOR of the TRUSTEE and AGAINST DAVLIN. It is declared that 57% of the remaining balance due DAVLIN under the purchase agreement is property of AFI OF ILLINOIS' bankruptcy estate. It is further declared that the sum of $10,976.73 currently held by the TRUSTEE, representing payments received under the purchase agreement, is property of the bankruptcy estate and may be properly retained by the TRUSTEE.
5. Counts V, VI, VII and VIII of the First Amended Complaint are DISMISSED.