Opinion
No. 99-82828, Adv. No. 00-8048
March 14, 2001.
OPINION
This matter is before the Court on cross motions for summary judgment. The parties dispute whether a cooperative corporation may offset the value of a member's stock against the member's indebtedness to the cooperative and whether such a setoff effected within ninety days of the member's bankruptcy filing is an avoidable preference under 11 U.S.C. § 547 (Section 547). The stock at issue here consists of capital stock purchased by the member upon joining the cooperative and patronage stock issued to the member by the cooperative in lieu of cash dividends.
COOPERATIVES
Cooperative corporations or associations are organizations created for the benefit of their members or patrons. Cooperatives often function as wholesalers of goods supplied to retailers of the goods who are members of the cooperative. This type of cooperative allows its members to benefit financially through the power of volume discount purchasing from manufacturers and suppliers and through the elimination of the wholesaler's profit. Ordinarily, the profits of a cooperative are distributed to its members in the form of patronage refunds or dividends in amounts determined by the level of purchases made from the cooperative by the members.
Both statutes regulating cooperatives and by-laws of cooperatives frequently provide for the retention by the cooperative of all or a portion of its operating profit in order to furnish additional capital to the organization. Some cooperatives use a revolving fund plan where each member is credited with equity credits on the cooperative's books evidencing his proportionate share of the retained profits. Other cooperatives issue additional shares of stock known as patronage stock to its members as evidence of each member's share of the retained profit.
Subchapter T of the Internal Revenue Code, 26 U.S.C. § 1381-1388, deals with the tax treatment of cooperatives and patrons of cooperatives. The Internal Revenue Code defines "patronage dividend" to mean an amount paid to a patron by a cooperative on the basis of the quantity or value of business done with such patron, pursuant to a standing obligation of the cooperative to pay such an amount, and which is determined by reference to the net earnings of the cooperative for business done with or for its patrons. 26 U.S.C. § 1388(a). A cooperative is permitted to issue stock to its members as evidence of retained patronage dividends. 26 U.S.C. § 1388. Patronage dividends may be retained on a "qualified" or "nonqualified" basis. Qualified dividends are deductible when issued while nonqualified dividends are deductible when redeemed. 26 U.S.C. § 1382.
FINDINGS OF FACT
Tru Serv Corporation (TRU SERV) is a Delaware corporation that operates as a cooperative. By-Laws, Art. VIII, Sec. 1. TRU SERV functions as a wholesale supplier of hardware and lumber goods to its members, who are retail hardware and lumber supply stores. By-Laws, Art. II. The Debtor, Schertz Hardware, Inc. (DEBTOR) was a TRU SERV member.
Each TRU SERV member is required to purchase sixty shares of Class A Common Stock, $100 par value, for each store owned up to a maximum of three hundred shares for five or more stores. By-Laws, Art. VII. The By-Laws provide for the issuance of Class B Common Stock as evidence of retained patronage dividends. With respect to each annual patronage dividend, TRU SERV must pay at least twenty percent in cash but may pay each member up to eighty percent of such patronage dividends in shares of Class B Common Stock. By-Laws, Art. VIII, Sec. 3(a). Class B Common Stock may be issued as "qualified" in accordance with Section 1388(c) of the Internal Revenue Code or as "nonqualified" in accordance with Section 1388(d) of the Internal Revenue Code, as determined by TRU SERV. By-Laws, Art. VIII, Sec. 2(a).
The By-Laws provide that TRU SERV shall have a lien on, and a right of setoff against, all stock issued to a member, including patronage stock, for all indebtedness of the member to TRU SERV. By-Laws, Art. VII, Sec. 8. As a condition of membership, each member must enter into a Member Agreement. A Member Agreement may be terminated according to the terms contained in the agreement. By-Laws, Art. VIII, Sec. 3. The Member Agreement between TRU SERV and the DEBTOR is not a part of the record.
The By-Laws expressly provide that TRU SERV becomes obligated to redeem a member's stock and to pay the redemption price (based upon the stock's par value), subject to TRU SERV'S right of setoff, upon the occurrence of any one of the following three events:
(1) Termination of the Member Agreement. By-Laws, Art. VII, Sec. 6(a) and 7(a).
(2) Two-thirds vote of the Board of Directors and upon written demand for redemption. By-Laws, Art. VII, Sec. 6(b)(i) and 7(a).
(3) TRU SERV'S exercise of an option to purchase all or any portion of the member's stock in excess of the number of shares required to be held by the member, or which are distributed as nonqualified written notices of allocation. By-Laws, Art. VII, Sec. 6(b)(ii).
The DEBTOR purchased and was issued sixty shares of TRU SERV Class A Common Stock, $100 par value, in consideration for its payment of $6,000. During its tenure as a TRU SERV member, the DEBTOR was issued qualified Class B Stock and nonqualified Class B Stock as patronage dividends.
The DEBTOR filed its Chapter 7 petition on September 1, 1999. Prior to June 15, 1999, the DEBTOR was indebted to TRU SERV for an amount in excess of $100,000. On June 15, 1999, TRU SERV offset the par value of all of the DEBTOR'S stock against the DEBTOR'S account balance and issued a credit memo reflecting the setoff as follows:
Source of Credit Amount Class A Stock $6,000 Qualified B Stock 7,400 Non Qualified B Stock 3,600 Total Credit $17,000
THE PARTIES' THEORIES
The Trustee's (TRUSTEE) complaint is filed in two counts. In Count I, the TRUSTEE seeks to avoid as a preferential transfer under Section 547(b), TRU SERV'S pre-petition setoff, within ninety days of the filing of the Chapter 7 petition, of the $17,000 value of the DEBTOR'S stock against the account balance owed TRU SERV by the DEBTOR. The TRUSTEE does not assert an alternative avoidance claim under 11 U.S.C. § 553(b). In Count II, the TRUSTEE seeks to avoid a post-petition transfer under 11 U.S.C. § 549(a) alleging that after the filing of the Chapter 7 petition, TRU SERV offset the DEBTOR'S cash portion of a patronage dividend in the amount of $685.71 against the pre-petition account balance.
In its answer, TRU SERV denied liability and asserted an affirmative defense alleging that, as of the date of the bankruptcy filing, TRU SERV had not yet effected a setoff. TRU SERV later abandoned this defense and admitted, in the joint pretrial statement, that it effected a setoff of the value of the DEBTOR'S stock in the amount of $17,000 on June 15, 1999, within ninety days of the DEBTOR'S bankruptcy filing on September 1, 1999. TRU SERV maintains that the setoff was valid in accordance with the terms and provisions of the By-Laws and is not avoidable under Section 547.
With regard to the preference claim, the TRUSTEE'S main argument is that the DEBTOR'S interest in stock is an equity interest, does not constitute a debt of the corporation and is not subject to a valid setoff by the corporation against amounts due the corporation from the stockholder. In support of his position, the TRUSTEE cites four opinions. In In re Beck, 96 B.R. 161 (Bkrtcy. C.D. Ill. 1988), the court held that a farm cooperative did not have a right of setoff preserved under Section 553 against the debtor/member's retained earnings account where the cooperative was not obligated to redeem the account as of the petition date in the absence of a demand to redeem made by the debtor. In Matter of Greensboro Lumber Company, 157 B.R. 921 (Bkrtcy. M.D. Ga. 1993), the court held that a rural electric cooperative could not offset a debtor's capital credits against the debtor's pre-petition debt because the credits were not yet due the debtor and the cooperative's by-laws did not permit the cooperative to retire or pay the accrued credits prior to the time that they became due and payable under a redemption schedule contained in the by-laws. In In re Axvig, 68 B.R. 910 (Bkrtcy. D. N.D. 1987), the court held that an agricultural cooperative could not offset the debtor's capital stock in the cooperative since, under North Dakota law, the debtor's interest was not immediately due and payable and thus did not represent a debt for purposes of Section 553. In In re Cosner, 3 B.R. 445 (Bkrtcy. D. Or. 1980), the debtor's equity credits in a farm cooperative were not a presently payable debt of the cooperative, according to the cooperative's redemption schedule, and thus could not be offset against the debtor's debt to the cooperative.
In their motions for summary judgment, both parties took the position that there was no genuine issue of material fact and the motions could be decided as a matter of law. Based on the allegations contained in TRU SERV'S motion, however, the TRUSTEE, in his response, suggests that termination of the Member Agreement between TRU SERV and the DEBTOR is a precondition to a valid setoff and that a genuine issue of material fact exists as to whether such termination actually occurred prior to the setoff. The TRUSTEE points out that TRU SERV'S account statement for the DEBTOR shows a post-petition "credit from investment" issued to the DEBTOR in the amount of $685.71 and that this is inconsistent with a prior stock redemption (and setoff) based, presumably, upon a termination by TRU SERV of the DEBTOR'S Member Agreement. For the following reasons, this Court agrees that a genuine issue of material fact exists that precludes summary judgment for either party.
STANDARDS FOR SUMMARY JUDGMENT
Under Federal Rule of Civil Procedure 56(c), made applicable to adversary proceedings in bankruptcy by Federal Rule of Bankruptcy Procedure 7056, summary judgment is proper if the pleadings, depositions, answers to interrogatories, and admissions on file, together with any affidavits, show that there is no genuine issue of material fact and that the moving party is entitled to judgment as a matter of law. Celotex Corp. v. Catrett, 477 U.S. 317, 322, 106 S.Ct. 2548, 91 L.Ed.2d 265 (1986). The burden is on the moving party to show that there is no factual dispute. Id. at 322. Inferences to be drawn from underlying facts must be viewed in the light most favorable to parties opposing the motion. Anderson v. Liberty Lobby, Inc. 477 U.S. 242, 255, 106 S.Ct. 2505, 91 L.Ed.2d 202 (1986). However, a material factual dispute is sufficient to prevent summary judgment only when the disputed fact is determinative of the outcome under applicable law. Id. at 248. When each side seeks summary judgment, that does not by itself indicate that there are no genuine issues of material fact. In re Schreiber, 163 B.R. 327, 331 (Bkrtcy. N.D. Ill. 1994). The court must rule on each motion separately in determining whether or not each judgment should be entered, in accordance with applicable principles, and the court can deny both motions if both parties fail to meet their burden. Id; In re TennOhio Transportation Company, 247 B.R. 715 (Bkrtcy. S.D. Ohio 2000).
DISCUSSION
The evidence is sparse. Neither party has submitted any affidavits, deposition transcripts, answers to interrogatories or admissions. Nor have the parties filed a stipulation to facts. The parties have attached copies of several documents to their pleadings and neither party has objected to the admissibility of any document. The Court will assume, for the purpose of this Opinion, that the parties have stipulated to the admissibility of all documents attached as exhibits to the various pleadings even though an express stipulation is not a part of the record.
The TRUSTEE alleges and TRU SERV now concedes that on June 15, 1999, TRU SERV effected a pre-petition setoff by crediting the par value of the DEBTOR'S Class A Common Stock and Class B Common Stock, in the aggregate amount of $17,000, to the balance owed TRU SERV by the DEBTOR. TRU SERV maintains that the setoff was permitted by the By-Laws and that a valid pre-petition setoff is protected by 11 U.S.C. § 553 (Section 553) and, as such, is a defense to an avoidance action under Section 547. According to the TRUSTEE, the setoff was invalid. The TRUSTEE contends that a stockholder's equity interest in a corporation evidenced by shares of stock does not constitute a "debt" that is subject to setoff, and that any attempted setoff of stock is invalid and not protected by Section 553. In the alternative, the TRUSTEE argues that even if TRU SERV has setoff rights with respect to its stock, there is a genuine issue of material fact as to whether any of the three alternative preconditions to setoff set forth in TRU SERV'S By-Laws was satisfied prior to the setoff.
Although no federal right of setoff is created, Section 553(a) provides that, with certain exceptions, whatever right of setoff otherwise exists is preserved in bankruptcy. Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 19, 116 S.Ct. 286, 289, 133 L.Ed.2d 258 (1995). The existence of a right of setoff is determined by applicable state law. Matter of Martin, 130 B.R. 930, 938 (Bkrtcy. N.D. Ill. 1991); In re Knudson, 929 F.2d 1280 (8th Cir. 1991).
Pre-petition setoffs do not enjoy unqualified immunity in bankruptcy proceedings, and are subject to the "improvement in position test" set forth in Section 553(b), which is one of the TRUSTEE'S enumerated avoiding powers. 11 U.S.C. § 550(a). As explained by the Fourth Circuit in Durham v. SMI Industries Corp., 882 F.2d 881 (4th Cir. 1989), the avoiding power provided the trustee by Section 553(b) is mutually exclusive of that provided by Section 547(b):
Section 547(b) provides that a trustee may avoid, and proceed to seek recovery of, any transfer made by a debtor to a creditor within 90 days prior to filing for bankruptcy that has the effect of enabling that creditor to receive more than it would in the bankruptcy proceeding had the transfer not been made. However, under section 553(b), a valid setoff executed within 90 days of the date of the filing of a bankruptcy petition is nonetheless protected from avoidance under section 547, except for any insufficiency. Where a pre-petition setoff is asserted in defense to a proceeding brought by a trustee the court must first determine whether the setoff is valid under section 553. Only if the court finds the setoff invalid, and further concludes that no right of setoff exists in bankruptcy, is section 547 applied.
882 F.2d at 882. Accord, In re Rehab Project, Inc. 238 B.R. 363 (Bkrtcy. N.D. Ohio 1999); In re Kalenze, 175 B.R. 35 (Bkrtcy. D. N.D. 1994); In re Centolella, 142 B.R. 624 (Bkrtcy. N.D. N.Y. 1992); In re Remillong, 131 B.R. 727 (Bkrtcy. D. Mont. 1991).
Therefore, the threshold question is whether the June 15, 1999 transaction in question is a valid setoff that may only be attacked by the TRUSTEE, if at all, under Section 553(b). If the setoff was valid, TRU SERV has established its defense to the TRUSTEE'S preference claim and is entitled to summary judgment on Count I. If the setoff was invalid, the Court must then inquire whether TRU SERV had a valid, unexercised right of setoff as of the petition date. If so, this right is preserved by Section 553(a) and TRU SERV must effectively be treated as a secured creditor with the right of setoff being its "collateral." 11 U.S.C. § 506(a). If not, then TRU SERV may not benefit from Section 553 and the inquiry proceeds to the merits of the TRUSTEE'S Section 547 claim. With this groundwork laid, the Court will first address whether the June 15, 1999 setoff was valid.
Since a valid setoff is an affirmative defense to a preference claim, its proponent has the burden of proof with respect to the elements of setoff. In re Rehab Project, Inc., supra at 373. In order to establish the defense, TRU SERV must prove the following elements:
1. That at the time of the setoff, TRU SERV held a claim against the DEBTOR. 2. That TRU SERV owed a debt to the DEBTOR that arose prior to the time of the setoff. 3. That the claim and the debt are mutual. 4. That TRU SERV has a right to setoff under applicable nonbankruptcy law.
See, Rehab Project, at 372-373. Although not addressed by either party, the Court finds that the applicable nonbankruptcy law is Delaware law, since TRU SERV is a Delaware corporation and the right of setoff is found in its By-Laws.
Based upon the record before the Court, there is no doubt that the 1st and 3rd elements are satisfied. The parties agree that the DEBTOR was indebted to TRU SERV for an amount in excess of $100,000 prior to June 15, 1999. Neither is it disputed that TRU SERV'S claim against the DEBTOR and TRU SERV'S debt to the DEBTOR (assuming it exists) are mutual, i.e., between the same parties standing in their same capacity. See, e.g., In re Sentinel Products Corp., 192 B.R. 41, 45 (N.D.N Y 1996).
The TRUSTEE contends that stock is always equity, and never debt, so that stock may never be validly offset, rendering satisfaction of the 4th element impossible. Several courts in various contexts have considered whether a member's patronage interest in a cooperative is properly characterized as debt or equity. The Seventh Circuit considered the issue in the context of an absolute priority rule analysis in Matter of Wabash Valley Power Ass'n, Inc., 72 F.3d 1305 (7th Cir. 1995). Wabash Valley Power Cooperative (Wabash), an Indiana not for profit corporation, was a generation and transmission cooperative serving twenty-four rural electric membership cooperatives. Wabash's Chapter 11 plan classified its members as creditors holding unsecured claims for patronage capital. An unsecured creditor objected to confirmation of the plan on the basis that it violated the absolute priority rule, arguing that the patronage capital accounts evidenced equity interests junior to unsecured creditors.
The Seventh Circuit found the issue to be "an extraordinarily elusive question." Id. at 1316. Applying Indiana law, the court held that the patronage capital accounts were not equity interests but were correctly classified as claims, the proportionate payment of which under the Wabash plan did not violate the absolute priority rule. Contra, Southern Pacific Transportation Co. v. Voluntary Purchasing Groups, Inc. 252 B.R. 373 (E.D.Tex. 2000) (under Texas law, the patronage stock redemption claims held by members of a purchasing cooperative had to be treated as equity interests for purposes of the absolute priority rule.)
The Seventh Circuit's holding in Wabash is not necessarily controlling in the case at bar, since Wabash was decided under Indiana law in the context of the absolute priority rule. However, Wabash makes two important points that are applicable here. First, whether a cooperative member's patronage interest is debt or equity must be decided based upon the definition of "claim" contained in the Bankruptcy Code. Id. at 1316. Second, resolution of the issue is not susceptible to interjurisdictional uniformity and must be determined according to applicable state law and the relevant articles and by-laws used by the particular cooperative organization. Id. at 1317.
As defined in the Bankruptcy Code, the terms "claim" and "debt" are coextensive. Pennsylvania Dept. of Public Welfare v. Davenport, 495 U.S. 552, 110 S.Ct. 2126, 109 L.Ed.2d 588 (1990). The term "debt" is broadly defined to mean "any liability on a claim." 11 U.S.C. § 101(12). "Claim" is equally broadly defined to mean "right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured." 11 U.S.C. § 101(5)(A). It follows from these definitions that if the DEBTOR'S interest in stock includes or is reduced to a right to payment, such right to payment may be considered to be a "debt" of TRU SERV.
Whether a right to payment exists is a question of state law. Butner v. United States, 440 U.S. 48, 55, 99 S.Ct. 914, 918, 59 L.Ed.2d 136 (1979). According to the Delaware Supreme Court, by-laws are to be treated as a contract between the corporation and its stockholders. Centaur Partners IV v. National Intergroup, Inc., 582 A.2d 923, 926 (Del.Supr. 1990). By-laws are subject to the same rules of construction as contracts. Hibbert v. Hollywood Park Inc., 457 A.2d 339, 342-43 (Del.Supr. 1983). While asserting his position that stock is equity not subject to a valid setoff, the TRUSTEE has not offered any authority that TRU SERV'S By-Laws should not be interpreted and enforced as written under Delaware law. Accordingly, this Court will construe and enforce the By-Laws as a contract between TRU SERV and the DEBTOR.
The By-Laws are unambiguous. Once TRU SERV becomes obligated to redeem its stock, the member has a right to payment of the par value of the stock, subject to TRU SERV'S right to offset any debt balance owed by the member. The member's "right to payment" is a "claim" as defined by the Bankruptcy Code, and a "debt" for purposes of Section 553(a). The four opinions relied upon by the TRUSTEE support the same conclusion under the law of those four states. In each case, the court looked to the by-laws, articles of incorporation and applicable state law to determine if and when a cooperative becomes "indebted" to redeem and pay its member the value of the member's stock or equity credits, thus giving rise to a concurrent right of setoff. This Court finds that the right of setoff contained in TRU SERV'S By-Laws is valid and enforceable under Delaware law. The right of setoff is enforceable when TRU SERV becomes obligated to redeem a member's stock, which obligation creates a concurrent right to payment in favor of the member.
The By-Laws provide for the setoff right against both Class A capital stock and Class B patronage stock. The Court is not aware of any basis why the right of setoff is not equally applicable to both classes.
With regard to the 2nd element, the TRUSTEE contends that there is no evidence in the record to prove that TRU SERV became obligated to redeem the DEBTOR'S stock prior to June 15, 1999. For purposes of setoff, a debt arises when all transactions required to create liability occur. U.S. Through Agr. Stabilization and Conservation Service v. Gerth, 991 F.2d 1428 (8th Cir. 1993); Accord, In re Telephone Warehouse, Inc., ___ B.R. ___, 2001 WL 218932 (Bankr.D.Del. Feb 28, 2001). TRU SERV'S By-Laws state that a stockholder has an immediate right to be paid the par value of its stock, subject to TRU SERV'S right of setoff, upon the occurrence of any one of three events: (1) termination of the Member Agreement, (2) vote of the Board of Directors and demand for redemption, or (3) TRU SERV'S exercise of an option to purchase outstanding Class B shares. If either of the first two triggering events occurred prior to June 15, 1999, then the DEBTOR had a right to be paid the par value of all of its stock, and a debt existed for its value that could be offset against amounts owed TRU SERV. If the third triggering event occurred prior to June 15, 1999, then TRU SERV owed the DEBTOR a debt for the value of the Class B shares that could be offset.
TRU SERV has failed to present direct evidence, by way of affidavit or otherwise, of the occurrence of any of the three events that give rise to the obligation to redeem and concurrent right to payment. Because the By-Laws expressly condition the right of setoff on the occurrence of at least one of the three triggering events, an inference could be drawn that the occurrence of one of the events must have preceded the setoff. However, it is also plausible that TRU SERV ignored the requirements of the By-Laws and exercised the setoff prematurely. Since inferences must be drawn against the movant, the Court finds that TRU SERV has failed to prove that it owed a debt to the DEBTOR for the value of the stock that arose prior to June 15, 1999. Accordingly, whether one of the three triggering events occurred prior to June 15, 1999 is a genuine issue of material fact that precludes summary judgment for TRU SERV.
In order for the TRUSTEE to prevail on his motion for summary judgment, the TRUSTEE has the burden of proving, initially, that TRU SERV'S June 15, 1999 setoff was not valid. Because this Court has already held that the right of setoff contained in TRU SERV'S By-Laws is enforceable under Delaware law, the TRUSTEE must prove that none of the three preconditions to setoff was fulfilled prior to June 15, 1999. TRU SERV'S failure to present evidence that any of the preconditions was fulfilled does not constitute evidence for the TRUSTEE that none of the preconditions were met. Like TRU SERV, the TRUSTEE has failed to present any evidence whatsoever that none of the conditions was met. Since all inferences must be drawn against the moving party, the absence of evidence requires the Court to infer, for purposes of the TRUSTEE'S motion, that at least one of the three preconditions was fulfilled prior to June 15, 1999. The TRUSTEE has failed to carry his burden of proof and his motion for summary judgment must be denied.
The Court finds that there is a genuine issue of fact as to whether any of the three preconditions to setoff were satisfied prior to exercise of the setoff by TRU SERV on June 15, 1999. The Court further finds that this issue of fact is material in that its determination is dispositive as to whether Section 553(b) is applicable to the transaction in question, in which case the TRUSTEE'S claim for relief under Section 547 must be denied. If either of the first two preconditions occurred prior to the time that TRU SERV effected the setoff, then the entire setoff was valid under Delaware law and protected under Section 553. If the third precondition occurred, then the setoff was valid as to the value of the Class B shares.
In Count II, the TRUSTEE alleges that on September 9, 1999, eight days after the bankruptcy filing, TRU SERV credited to the DEBTOR'S account the sum of $685.71 which the TRUSTEE characterizes as the "DEBTOR'S cash portion of a patronage dividend." TRU SERV alleges that the credit was not for a patronage dividend since TRU SERV had previously redeemed all of the DEBTOR'S stock. Neither party produced any evidence to support their respective positions. Accordingly, this Court finds that genuine issues of material fact exist with respect to the TRUSTEE'S claim under Count II. The parties' cross motions for summary judgment on Count II are denied.
This Opinion constitutes this Court's findings of fact and conclusions of law in accordance with Federal Rule of Bankruptcy Procedure 7052.
See written Order.
ORDER
For the reasons stated in an Opinion filed this day, IT IS HEREBY ORDERED that:
1. The TRUSTEE'S Motion for Summary Judgment is DENIED; 2. TRU SERV'S Motion for Summary Judgment is DENIED; and 3. The Clerk of the Court is directed to set the matter for Final Pretrial.