Opinion
No. 00-80181, No. 00-8117.
April 5, 2001.
OPINION
When a first priority lienholder subordinates its security interest to a third priority lienholder, what effect does this have on the second lienholder who is not a party to the transaction? One line of cases elevates the second lienholder to first place. Another line elevates the third lienholder to first place to the extent of the first lienholder's claim, leaving the second unaffected. This issue is before the Court on cross motions for judgment on the pleadings.
The main parties to this Adversary Proceeding are three creditors of the Chapter 12 Debtor, William D. Batterton (DEBTOR). The DEBTOR is a nominal defendant and takes no position on the priority dispute. There are a variety of disputed issues pending in the Chapter 12 case and in another adversary proceeding that concern these creditors and the DEBTOR. For the purpose of determining the effect of the subordination agreement, however, the material facts are not disputed. Prior to the subordination, Ipava State Bank (IPAVA) held a perfected first priority security interest in crops, livestock, equipment and proceeds. Schuyler-Brown FS, Inc. (SCHUYLER-BROWN) held a junior lien on the same collateral. SCHUYLER-BROWN concedes that it failed to perfect its lien on equipment. The DEBTOR owes SCHUYLER-BROWN approximately $52,000. The DEBTOR owes IPAVA approximately $479,000, all but $10,000 of which is also secured by two real estate mortgages.
In early 1999, the DEBTOR needed to borrow funds for his 1999 operating expenses. The DEBTOR applied for and obtained a $75,000 loan from the USDA Farmers Home Administration, n/k/a Farm Services Agency (FSA). The loan was payable in full with interest on February 1, 2000.
The DEBTOR granted FSA a security interest in crops, livestock and equipment, which FSA properly perfected.
As a condition to making the loan, FSA required that IPAVA subordinate its security interest to FSA. IPAVA agreed and executed a subordination agreement dated April 7, 1999, that provides: In consideration of loan(s) made or to be made by the United States of America, acting through the Farmers Home Administration, (hereinafter referred to as the Government) to William D. Batterton of Astoria, Illinois (hereinafter referred to as the borrower) for the year(s) 1999, which loans are or are to be secured by lien(s) or security interests granted by the borrower to the Government on or in his livestock and farm equipment and on all crops planted, growing, or to be planted or grown, during such year(s) (whenever harvested), upon the following described land in the County of Fulton, State of Illinois: All Land Farmed. The undersigned hereby subordinates in favor of the Government any lien or security interest he now has or may acquire on or in: (a) The crops of borrower (except his lien on or security interest in crops grown in any year for that year's rent or for that year's real estate payment; (b) the livestock and farm equipment purchased or refinanced by the borrower with Farmers Home Administration loan(s); (c) the livestock and farm equipment owned by the borrower other than that purchased or refinanced with Farmers Home Administration loan(s), to the extent such lien or security interest is to secure accounts resulting from advances to be made or supplies to be furnished.
SCHUYLER-BROWN was not a party to the subordination agreement.
The DEBTOR filed his Chapter 12 petition on January 26, 2000, a few days before his loan with FSA was due. The adversary complaint was filed on August 2, 2000 in order for the Court to determine the effect of the subordination agreement on the relative priority of the three security interests. The sole issue is the effect of the subordination agreement on the priority of each parties' security interest in the DEBTOR'S livestock and 1999 crops and proceeds thereof.
Because SCHUYLER-BROWN failed to perfect its security interest in the equipment, SCHUYLER-BROWN agrees that its interest in equipment is subordinate to both IPAVA and FSA.
The determination of rights in property, even where the property is an asset of a bankruptcy estate, is governed by state law. Butner v. U.S., 440 U.S. 48, 99 S.Ct. 914, 59 L.Ed. 2d 136 (1979). Agreements to subordinate the priority of personal property security interests are recognized by the Uniform Commercial Code. The U.C.C. provides no interpretative guidance, however, to aide resolution of the priority issue before the Court. Illinois courts are silent on the issue. Where a federal court is confronted with an issue of state law that has not been decided by the state's courts, it is the federal court's role to predict how the issue would be determined by the state's highest court and apply the predicted rule. MindGames, Inc. v. Western Pub. Co., Inc., 218 F.3d 652, 655-56 (7th Cir. 2000). Because the issue derives from a uniform law, it is appropriate to seek guidance from other jurisdictions. In re Bartoni-Corsi Produce, Inc., 130 F.3d 857, 34 UCC Rep.Serv.2d 90 (9th Cir. 1997); Reliance Ins. Co. v. Bank of America Nat. Trust Sav. Ass'n, 2001 WL 62597 (N.D. Ill. Jan. 25, 2001).
The U.C.C. is codified in Illinois at 810 ILCS 5/1-101 et.seq. and provides in material part : "9-316. Priority Subject to Subordination. Nothing in this Article prevents subordination by agreement by any person entitled to priority."
The scenario at bar is one of several types of "circular priority systems" which have caused courts great consternation. Fortunately for this Court, the circular priority system arising from a contractual subordination is the simplest and is one about which a clear majority rule exists. The majority rule (or the "Gilmore rule") is cogently illustrated by Professor Gilmore:
"A judge who finds himself face to face with a circular priority system typically reacts in the manner of a bull who has been goaded by the picadors: he paws the ground and roars with rage." Grant Gilmore, Security Interests in Personal Property § 39.1, at 1020-21 (1965).
Id. at 1021.
To start with, A, B and C have claims against debtor X or his property which are entitled to priority in alphabetical order: the classical example is that of first, second and third mortgages on Blackacre. A subordinates his claim to C's. Blackacre is sold and the resulting fund is insufficient to satisfy all three claims. There is a comforting unanimity, among courts and commentators, on the proper distribution of the fund:
1. Set aside from the fund the amount of A's claim.
2. Pay the amount so set aside to
a) C, to the amount of his claim;
b) A, to the extent of any balance remaining after C's claim is satisfied.
3. Pay B the amount of the fund remaining after A's claim has been set aside.
4. If any balance remains in the fund after A's claim has been set aside and B's claim has been satisfied, distribute the balance to
a) C,
b) A.
Thus C, by virtue of the subordination agreement, is paid first, but only to the amount of A's claim, to which B was in any event junior. B receives what he had expected to receive: the fund less A's prior claim. If A's claim is smaller than C's, C will collect the balance of his claim, in his own right, only after B has been paid in full. A, the subordinator, receives nothing until B and C have been paid except to the extent that his claim, entitled to first priority, exceeds the amount of C's claim, which, under his agreement, is to be first paid. (Footnotes omitted).
Id.
As the majority rule favors it, so FSA favors the majority rule. IPAVA concurs with one devilish twist. IPAVA argues that since it subordinated only to FSA, it should (contrary to the Gilmore rule) retain its priority over SCHUYLER-BROWN so that SCHUYLER-BROWN is relegated to third place as to the crops and livestock.
SCHUYLER-BROWN not surprisingly favors the minority rule which holds that when A subordinates to C, A moves to the back of the line while the others move forward so that B is now first, C second and A third. The leading authority adopting this minority position is AmSouth Bank, N.A. v. JD Financial Corp., 679 So.2d 695, 32 UCC Rep.Serv.2d 316 (Ala. 1996). For their leading authority, IPAVA and FSA rely upon the Texas Supreme Court's decision in ITT Diversified Credit Corp. v. First City Capital Corp., 737 S.W.2d 803, 4 UCC Rep.Serv.2d 927 (Tex. 1987) which adopted the Gilmore rule verbatim. The same rule has also been adopted in Duraflex Sales Service Corp. v. W.H.E. Mechanical Contractors, 110 F.3d 927 (2nd Cir. 1997), Matter of Cliff's Ridge Skiing Corp., 123 B.R. 753 (Bkrtcy. W.D.Mich. 1991), and Grise v. White, 247 N.E.2d 385, 6 UCC Rep.Serv. 391 (Mass. 1969). Two other leading commentators also support the Gilmore rule. Barkley Clark, The Law of Secured Transactions Under the Uniform Commercial Code ¶ 3.10[2], at 3-182 (rev.ed. 2000); Anderson on the Uniform Commercial Code § 9-316:6 (3d ed. 1999).
An undeniable principle of fairness and equity with which all courts agree is that the second place lienholder should not be adversely affected by a contract to which it is not a party. IPAVA'S suggestion that SCHUYLER-BROWN should be demoted to third place on account of the subordination agreement is repugnant to this principle and must be rejected.
SCHUYLER-BROWN'S position that IPAVA'S subordination allows it to take over first place, although not without support, must also be rejected. The AmSouth Bank rule yields an unanticipated and unwarranted windfall to the second place lienholder. SCHUYLER-BROWN is not claiming to have given consideration for or relied upon its elevation to first place. Neither is it a third party beneficiary of the subordination agreement. This Court is of the opinion that the better policy is to permit the second lienholder neither to suffer a detriment nor receive a benefit from a subordination agreement to which it is not a party. This policy is reflected in the Gilmore rule. Further, this Court believes that the Gilmore rule would be adopted by the Illinois Supreme Court if faced with this issue.
To be a third party beneficiary entitled to enforce a contract to which one is not a party, there must be a showing that the parties to the contract intended to confer a benefit upon the nonparty by name or description of a class and the nonparty must be a direct beneficiary, not merely an incidental beneficiary. Altevogt v. Brinkoetter, 51 Ill. Dec. 674, 421 N.E.2d 182, 85 Ill.2d 44 (Ill. 1981); People ex rel. Resnik v. Curtis Davis, Architects Planners, Inc., 78 Ill.2d 381, 400 N.E.2d 918, 36 Ill. Dec. 338 (Ill. 1980).
SCHUYLER-BROWN raises an additional issue which appears not to have previously been decided in any reported decision. IPAVA'S claim is secured by mortgages on the DEBTOR'S real estate valued by IPAVA at an amount greater than its claim. In addition to livestock and crops, FSA'S claim is secured by equipment which the DEBTOR values at $125,000. If IPAVA liquidated the real estate first, the value of that collateral might be sufficient to satisfy IPAVA'S claim, and if FSA looked first to the equipment for the satisfaction of its claim, the livestock and crops would be "freed up" for SCHUYLER-BROWN'S benefit. Through the equitable doctrine of marshaling, SCHUYLER-BROWN alleges that it could force IPAVA and FSA to resort to the other collateral first, with the likely result being that the value of the livestock and crops is available for SCHUYLER-BROWN'S benefit as if it held a first lien therein. As courts of equity, bankruptcy courts have the power to marshal a debtor's assets in appropriate situations. In re Maddox, 84 B.R. 251 (Bkrtcy. N.D. Ga. 1987).
The doctrine permits a junior lienholder to force a senior lienholder with other collateral to resort first to the other collateral so that the junior lienholder maximizes the value of its security interest. Herzog v. NBD Bank of Highland Park, 203 B.R. 80, 83 (N.D.Ill. 1996). The doctrine of marshaling has long been recognized by the Illinois Supreme Court. See, Doyle v. Murphy, 22 Ill. 502 (Ill. 1859).
SCHUYLER-BROWN then suggests that if the effect of the subordination agreement is to put FSA in first position as to the crops and livestock, to the extent of IPAVA'S claim, that the potential benefit of any marshaling claim it had against IPAVA prior to the execution of the subordination agreement has been lost. If so, depending upon the net result of its potential marshaling claim against FSA, SCHUYLER-BROWN might be adversely affected by the subordination agreement, contrary to the fundamental principle with which this Court agrees. This Court agrees in theory that it would be inequitable to SCHUYLER-BROWN to suffer the loss of the potential benefit of its marshaling claim because a third priority lienholder switches places with a first priority lienholder who has recourse against other collateral.
At this point, however, the application of the equitable doctrine of marshaling is not at issue. SCHUYLER-BROWN is free to assert a claim for marshaling in future proceedings as it deems appropriate. It is not necessary for the Court to speculate whether, how and in what context the doctrine might be appropriately applied.
CONCLUSION
The cross-motions for judgment on the pleadings ask the Court to issue a declaratory judgment as to the effect of the subordination agreement between IPAVA and FSA. For the reasons stated in this Opinion, the Court finds that the effect of the subordination agreement should be determined according to the Gilmore rule. This declaratory judgment is a final judgment that terminates this Adversary Proceeding. The specific application of the Gilmore rule and any claim of marshaling that might be raised is left for another day. Unless the parties reach a prior agreement as to their relative rights in the DEBTOR'S livestock and the 1999 crop proceeds, the Court shall make that determination in accordance with this Opinion in future proceedings to be heard in the course of the Chapter 12 confirmation process.
This Opinion constitutes this Court's findings of fact and conclusions of law in accordance with Federal Rule of Bankruptcy Procedure 7052.
ORDER
For the reasons stated in an Opinion filed this day, IT IS HEREBY ORDERED that:
1. The Motion for Judgment on the Pleadings filed by IPAVA STATE BANK is ALLOWED in part and DENIED in part;
2. The Countermotion for Judgment on the Pleadings filed by SCHUYLER-BROWN is DENIED; and
3. A declaratory judgment be and is entered declaring that the effect of the subordination agreement shall be determined by application of the Gilmore rule.