Opinion
Case No. 95-14794-SSM
March 10, 1999
C. Thomas Brown, Esquire, Silver Brown, P.C., Fairfax, VA, of Counsel for Ruppert Landscape Company, Inc.
Thomas P. Gorman, Esquire, Tyler, Bartl, Burke Albert, P.L.L.C., Alexandria, VA, of Counsel for Gordon P. Peyton, chapter 7 trustee
MEMORANDUM OPINION
This matter is before the court on a motion by Ruppert Landscape Company, Inc. ("Ruppert"), to compel the chapter 7 trustee, Gordon P. Peyton, to abandon $18,021.12 in funds that were paid to the trustee post-petition and that Ruppert claims are subject to a security interest in its favor. The trustee opposes the motion primarily on the basis of laches but also on the ground that the claimed security interest has either been lost or is invalid as against the trustee's "strong-arm" powers. There is also a suggestion, not well developed, that the claimed security interest should be equitably subordinated. A hearing was held on February 2, 1999. Neither the trustee nor Ruppert chose to present testimony, but the court received, without objection, a number of exhibits offered by Ruppert. At the conclusion of the hearing the court took the motion under advisement. Having reviewed the facts and the applicable law, the court determines that the motion should be granted.
An opposition was also filed by National American Insurance Company and Gulf Insurance Company — the original petitioning creditors — taking no position as to the propriety of abandonment, but objecting to many of the "background facts" asserted in the motion, since those are the subject of separate litigation brought against Ruppert in the United States District Court for this district and now before the Fourth Circuit.
Facts
This case began with the filing of an involuntary petition against Green Thumb Enterprises, Inc., a landscaping company ("Green Thumb" or "the debtor"), by two bonding companies on October 27, 1995. An order for relief under chapter 7 of the Bankruptcy Code was entered on February 22, 1996. On March 26, 1996, an order was entered on the debtor's motion converting the case to chapter 11. The case was then reconverted to chapter 7 on August 19, 1996, and Gordon P. Peyton was appointed as trustee.
Prior to the filing of the involuntary petition, Ruppert had entered into an agreement to purchase Green Thumb's assets. Those assets were subject to a blanket UCC security interest in favor of Nationsbank, N.A., to secure two promissory notes: one dated August 5, 1994, in the original principal amount of $1,500,000.00, and another dated August 27, 1993, in the original principal amount of $370,000.00. A written security agreement granted Nationsbank a security interest in Green Thumb's accounts, chattel paper, general intangibles, documents, instruments, and inventory, including proceeds. Financing statements reflecting the security interest were filed on May 16, 1994 with the Clerk of the Loudoun County Circuit Court. In order to obtain clear title to Green Thumb's assets, Ruppert bought the two notes from Nationsbank on July 31, 1995, for what is represented to have been $800,000.00, and as part of the transaction received an assignment of Nationsbank's security interests.
On September 27, 1995, a garnishment summons was issued by the Circuit Court of Fairfax County, Virginia, against Green Thumb's accounts at George Mason Bank to enforce an $18,021.12 judgment previously obtained by Brian D. Berlands and Jane D. Berlands. It is represented that the Bank deducted that sum from the account and mailed a check to the clerk of the circuit court. Ruppert learned of the garnishment and filed a motion to intervene in order to assert its claim to the garnished funds. By order of October 27, 1995 (the same day as the involuntary petition was filed), the circuit court granted the motion to intervene, while expressly making no ruling "as to the respective rights and priorities of the garnished funds in this matter between the parties hereto." Because of the automatic stay, no further action was taken at that time with respect to the garnishment.
After the re-conversion of this case to chapter 7, Ruppert brought a motion for relief from the automatic stay in order to enforce its security interest against Green Thumb's receivables. On December 20, 1996, after a full evidentiary hearing, this court modified the automatic stay to permit Ruppert to collect the debtor's prepetition accounts receivable. The court's findings were set forth orally on the record, and, as subsequently summarized by the United States District Court, included determinations that "(1) the transaction between Ruppert and NationsBank was a purchase, and . . . the NationsBank notes are not paid off; (2) the Green Thumb/Ruppert transaction was a valid transaction not entered into for any ulterior purpose; and (3) Ruppert had a valid and perfected lien on the assets of Green Thumb." National American Ins. Co. v. Ruppert Landscaping Co., Inc., No. 97-847-A, Mem. Op. at 4 (E.D. Va., Mar. 20, 1998).
On April 8, 1997, the state circuit court, based on its determination "that no action has been taken in this matter for an extended period of time," ordered that the garnished funds be returned to George Mason Bank. A check in the amount of $18,021.12 was issued by the clerk of the circuit court on April 11, 1997, payable to the Bank. The Bank then paid the funds over to the chapter 7 trustee, who is holding them for distribution. Ruppert's motion to compel the trustee to abandon the funds was filed on December 15, 1998.
Discussion
Under § 554, Bankruptcy Code,
(b) On request of a party in interest and after notice and a hearing, the court may order the trustee to abandon any property of the estate that is burdensome to the estate or that is of inconsequential value and benefit to the estate.
Abandonment simply relinquishes the bankruptcy estate's interest in the property and otherwise leaves undisturbed any interests in the property that existed on the date the bankruptcy case was commenced. Here, Ruppert represents that the balance remaining due on the two NationsBank notes greatly exceeds $18,021.12, and that there is therefore no equity in the funds for the benefit of the bankruptcy estate. Accordingly, it is urged, the funds are of "inconsequential value and benefit to the bankruptcy estate" and should be turned over to Ruppert. The trustee does not deny that the funds at issue are encompassed by the written security agreement but — as will be discussed — does challenge whether a lien continues to exist based on Ruppert's alleged procedural default in the state court garnishment proceedings.
No evidence was presented as to the balance due on the notes. The trustee, however, apparently does not dispute that more than $18,021.12 is owed. Rather, the trustee's position seems to be that Ruppert did not aggressively collect Green Thumb receivables which would have reduced the balance of the note. No evidence was offered in support of this assertion, however.
A.
The chapter 7 trustee, as noted above, first argues that Ruppert's claim to the funds — coming as it does only after the bankruptcy estate has been fully administered and a final report and account before distribution submitted to the United States Trustee — is simply too late and is therefore barred by the doctrine of laches. For a party to succeed in asserting the defense of laches, two elements must be proved: "(1) lack of diligence by the party against whom the defense is asserted, and (2) prejudice to the party asserting the defense." Mogavero v. McLucas, 543 F.2d 1081, 1083 (4th Cir. 1976), quoting Costello v. United States, 365 U.S. 265, 282, 81 S.Ct. 534, 543, 5 L.Ed.2d 551 (1961). The trustee relies on the fact that Ruppert waited more than three years after the bankruptcy filing, and more than two years after the trustee's appointment, to formally assert a claim to the funds. Ruppert's inaction, it is argued, led the trustee to believe that the funds were unencumbered. As a result, the trustee states, he decided it made economic sense to pursue numerous preference complaints on behalf of the estate, using the funds turned over to him by George Mason Bank to cover litigation costs such as attorneys fees. The trustee argues that since he changed his position to his detriment in reasonable reliance on Ruppert's failure to assert a claim to the funds, that claim should be barred.
At oral argument, the trustee suggested that Ruppert's failure, in and of itself, to file the present motion in the span of three years is sufficient to sustain the defense of laches. However, such an argument is misplaced. It is well established that mere passage of time does not warrant a finding of laches. In re TB Capital, Inc., 1995 WL 506850 (Bankr. E.D. Va. 1995) (Tice, J.).
It was represented at the hearing that the trustee has recovered approximately $90,000.00 from the pursuit of preferences.
One of the difficulties the court faces in ruling on the defense of laches is that neither side presented testimony to support its position. Both counsel proffered explanations why certain actions were taken, but representations of counsel are not evidence and cannot be considered by the court unless they are at least informally stipulated to by the opposing party. Therefore, the court is left to consider the pleadings and Ruppert's exhibits, and to draw reasonable inferences from them.
Turning to the first element of laches — lack of diligence — the court is certainly troubled by Ruppert's apparent sloth in pursuing its claim to the funds. Ruppert could have, but did not, seek relief from the automatic stay from this court after the filing of the bankruptcy petition in order to allow the state circuit court to adjudicate the respective rights of the parties to the garnished funds, or it could have sought removal of the garnishment proceedings to this court. 11 U.S.C. § 362(d); 28 U.S.C. § 1452. In December 1996, it did obtain limited relief from the automatic stay to collect the debtor's prepetition accounts receivable. It may be that the lifting of the automatic stay did not technically extend to the collection of funds at issue, but even assuming that it did not, Ruppert has offered no explanation as to why it did not seek further relief. Instead, it simply let the state court proceedings languish for another three months, at which point the state court ordered the funds returned to the garnishee, George Mason Bank. Although Ruppert was given notice that the garnished funds were being returned, it then inexplicably waited another 20 months to assert a claim in this court against the chapter 7 trustee for those funds. Even accepting, as Ruppert's attorney represents, that there may have been some genuine difficulty in determining what had happened to the funds after they were returned to George Mason Bank, it is difficult to understand why, if Ruppert had been at all diligent, it should have taken well over a year to determine that they had been paid over to the chapter 7 trustee.
The order terminated the automatic stay as to "all pre-petition accounts receivable, and which secured property is more particularly described in a Security Agreement dated August 27, 1993[.]" Furthermore, the pleadings and exhibits associated with the relief from stay motion never referred to or mentioned the garnished funds.
Laches, however, requires more than mere passage of time or lack of diligence. As noted above, there must be prejudice to the opposing party. In the present case, a finding of prejudice to the trustee is not supported by the record. Trustee's counsel contends that the preference actions would have never been commenced had the trustee thought that the funds he was counting on to finance the litigation were subject to Ruppert's security interest. Had the litigation not been successful, so that the funds turned over by George Mason Bank were the only assets available to pay the claims of the trustee's professionals, the argument would have much greater force. However, the trustee has apparently recovered approximately $90,000 in preferences. Additionally, even granting that the trustee may have been induced to go after the preferences in the actual belief that he held clear title to the funds, it is far from clear that he was not put on at least constructive notice of adverse claims to the funds. At the time the trustee began administering the case, he should have been aware that Ruppert asserted a "blanket lien" against the debtor's assets. The existence of that lien was asserted by Ruppert in its relief from stay motion. The trustee filed a response to that motion and participated in the hearing. When the garnished funds were turned over by George Mason Bank some months later, the trustee was not free simply to assume that no lien or security interest attached to them. Although there may well be additional facts and circumstances that would support the trustee's position that he reasonably relied to his detriment on Ruppert's extended failure to lay claim to the funds, the trustee has not presented them. Since the trustee has not carried his burden of proof with respect to detrimental reliance, the defense of laches must fail.
B.
The trustee next argues that the bankruptcy estate's claim to the funds is superior to Ruppert's, because, under his "strong-arm" powers as trustee, he has the rights of a hypothetical judgment lien creditor who, as of the commencement of the bankruptcy case, obtains a judgment lien on all the debtor's assets. § 544(a)(1), Bankruptcy Code. As an initial matter, the court notes that a proceeding to determine the relative priorities of Ruppert's actual lien and the trustee's hypothetical lien normally requires an adversary proceeding. F.R.Bankr.P. 7001. It is true that abandonment proceedings are an express exception to that portion of Rule 7001 that requires an adversary proceeding in order to recover money or property. In the nature of things, it will often be necessary, in order to determine whether property should be abandoned, to rule on the existence, extent, and priority of liens. Nevertheless, where the trustee seeks to invoke one of his special powers under the Bankruptcy Code to set aside or avoid transfers and interests, the Bankruptcy Rules would appear to require that a formal adversary proceeding be brought for that purpose. In any event, in order to dispose of the present motion, it is only necessary to determine whether there is a reasonable likelihood that the trustee would succeed on the merits if an avoidance action were brought. If so, abandonment would properly be denied in order to give the trustee an opportunity to file an appropriate adversary proceeding.
Under § 544, Bankruptcy Code,
(a) The trustee shall have, as of the commencement of the case, and without regard to any knowledge of the trustee or of any creditor, the rights and powers of, or may avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by —
(1) a creditor that extends credit to the debtor at the time of the commencement of the case, and that obtains, at such time and with respect to such credit, a judicial lien on all property on which a creditor on a simple contract could have obtained such a judicial lien, whether or not such a creditor exists[.]
The trustee does not contend that under Virginia law a judgment lien or an execution lien is superior to a prior perfected security interest. Rather, his argument, stripped to its essentials, is that Ruppert lost whatever lien it had in the funds when it failed to post a bond in the state court garnishment proceedings. This follows, says the trustee, because Virginia law requires a third-party claimant to garnished funds to give a suspending bond as a condition of contesting an execution creditor's claim. The only authority cited by the trustee for this proposition is an unpublished circuit court opinion, Virginia Broadcasting Corp. v. Harding, Virginia Lawyers Weekly (098-8-282, August 24, 1998) (summary). In that case, a garnishment summons was issued by the Circuit Court of the City of Charlottesville in the amount of $19,033.03 in favor of a judgment creditor. A third-party creditor subsequently filed motions to quash the garnishment and to intervene as a necessary party. The circuit court denied the motions on the ground that a third-party creditor has no standing to object to the garnishment without giving a suspending bond. The court reasoned that, because garnishment is a proceeding to enforce the lien against intangibles that arises under Virginia law when a writ of fieri facias is delivered to the sheriff, the requirements of Va. Code Ann. § 8.01-365, which include the giving of a suspending bond in order to try title, are applicable.
Section 8.01-365 reads in relevant part:
When a writ of fieri facias issued from a circuit court . . . is levied on property, or when a lien is acquired on money or other personal estate by virtue of § 8.01-501, and when some other person than the one against whom the process issued claims the property, money, other personal estate, or some part or the proceeds thereof, then . . . the claimant, if such suspending bond as is hereinafter mentioned has been given,. . . may apply to try the claim, by motion to the adverse party, to the circuit court of the county or city wherein the property, money, or other personal estate is located.
(emphasis added). The suspending bond must be given in an amount equal to twice the value of the property, and the motion to try title must be filed within thirty days of giving the bond. Va. Code Ann. § 8.01-370.
This court does not read either Harding or Va. Code Ann. § 8.01-365 as standing for the proposition that a lien, otherwise properly perfected as to third parties, is extinguished if the secured creditor fails to give a bond when challenging a garnishment of its collateral by another creditor. First, the requirements of § 8.01-365 are strictly procedural and affect the secured creditor's rights only within the context of the garnishment itself. Second, the Virginia Supreme Court, while holding that a motion to quash an execution is not available to a stranger to a judgment, has stated that such a third-party claimant, as an alternate to the "swift, direct, and summary method" provided by § 8.01-365 to determine conflicting claims to property levied upon, retains the right to bring a common-law action of trespass against the sheriff. Barbuto v. Southern Bank, 231 Va. 63, 68-69, 340 S.E.2d 813, 817 (1986). The continued availability of an action for trespass would seem inconsistent with the notion that the execution has totally extinguished the third party's rights. Third, even assuming that failure to post a bond would, under § 8.01-365, have deprived Ruppert of standing to contest the garnishment, it would not have been the failure to post a bond which would have caused the loss of the lien but rather the entry of the order of payment. In the present case, no order of payment or other judgment effecting the rights of the parties was ever entered in the garnishment action, and the action itself was ultimately dismissed for failure to prosecute. Additionally, the state circuit court granted Ruppert's motion to intervene notwithstanding the failure to file a bond. Thus, as matters stood at the commencement of Green Thumb's bankruptcy case, Ruppert's standing to contest the garnishment remained fully intact. Accordingly, the court concludes that the trustee has not shown a reasonable likelihood that he would succeed in an adversary proceeding to avoid Ruppert's security interest in the garnished funds.
Int'l Fidelity Ins. Co. v. Ashland Lumber Co., 250 Va. 507, 512, 463 S.E.2d 664, 667 (1995), the Virginia Supreme Court noted, but did not decide, the issue of whether, in the specific context of a garnishment, a third-party claimant to the funds could proceed by motion to intervene rather than by motion under § 8.01-365.
C.
Finally, the trustee argues that it is fundamentally unfair to the unsecured creditors to allow the garnished funds to be turned over to Ruppert. The reasons stated are that Ruppert is not a holder in due course of the NationsBank notes; that it only acquired the notes to facilitate its purchase of Green Thumb's assets; that it has been dilatory in collecting the receivables securing those notes; and that, in effect, Ruppert is really asking the bankruptcy estate to reimburse it for money it paid to acquire Green Thumb's assets. Without quite using the term, what the trustee is essentially arguing is that Ruppert's security interest should be equitably subordinated to the claims of the unsecured creditors in this case under § 510, Bankruptcy Code. Section 510 provides in relevant part as follows:
(c) . . . [A]fter notice and a hearing the court
(1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or
(2) order that any lien securing such a subordinated claim be transferred to the estate.
Equitable subordination, unless accomplished through a plan of reorganization, normally requires the bringing of an adversary proceeding. F.R.Bankr.P. 7001. Accordingly, as with the trustee's "strong arm" defense, the court cannot make a final ruling in the context of a motion to abandon, but is limited to determining whether there is a reasonable likelihood that the trustee would be successful if an equitable subordination action were brought.
The Supreme Court in United Sates v. Noland, — U.S. —, 116 S.Ct. 1524, 134 L.ed.2d 748 (1996) explained that, although Congress, in enacting § 510(c), "included no explicit criteria for equitable subordination," the language of the statute "clearly indicates congressional intent at least to start with existing doctrine." 116 S.Ct. at 1527. That existing doctrine, as the Court observed, was judge-made and was generally triggered by the occurrence of three factors: (1) "the creditor has engaged in `some type of inequitable conduct'"; (2) "the misconduct `resulted in injury to the creditors of the [estate]'"; and (3) "that the subordination is `not inconsistent with the provisions of the Bankruptcy [Code].'" Id. at 1526 (quoting In re Mobile Steel Co., 563 F.2d 692, 700 (5th Cir. 1977); see also FEE Commercial Corp. v. Holmes (In re ASI Reactivation, Inc.), 934 F.2d 1315, 1321 (4th Cir. 1991) (citing the same three considerations for equitable subordination of a claim). Nevertheless, the court must be wary that "[l]ike other forms of equitable relief, equitable subordination in bankruptcy is not to be invoked lightly." Claxton v. Walsh (In re Claxton), 76 B.R. 539, 546 (Bankr. E.D. Va. 1987) (Bostetter, J.).
At the heart of the matter is whether Ruppert engaged in inequitable conduct by acquiring the notes from Nationsbank rather than simply paying them off. In applying equitable subordination, courts have often had difficulty in defining the boundaries of inequitable conduct. Systems Impact, Inc. v. Hagerty (In re Systems Impact, Inc.), 229 B.R. 363, 371 (Bankr. E.D. Va. 1998), quoting Fabricators, Inc. v. Technical Fabricators, Inc. (In re Fabricators, Inc.), 926 F.2d 1458, 1467 (5th Cir. 1991). At minimum, inequitable conduct ordinarily involves fraud, illegality, and breach of fiduciary duties. See 4 Collier on Bankruptcy ¶ 510.05[4], at 510-26 (Lawrence P. King, ed., 15th ed. Rev. 1998) ([E]vidence of . . . `egregious conduct' such as fraud, spoliation, or overreaching is generally required.") The trustee bears the burden of demonstrating whether equitable subordination is warranted.
The trustee makes no allegation that Ruppert is an "insider" of the debtor such that its conduct or dealings with the debtor would be subject to "rigorous scrutiny." See Pepper v. Litton, 308 U.S. 296, 60 S.Ct. 238, 84 L.Ed. 281 (1939).
In the instant matter, the trustee correctly notes that the unsecured creditors are at a disadvantage as a result of Ruppert's purchase of the debtor's assets and acquisition of the notes from NationsBank. Whether Ruppert's advantage is unfair is a different matter. The trustee did not present any evidence to show that Ruppert's acquisition of the Nationsbank notes was improperly motivated or wrongful or had any purpose other than to obtain unencumbered title to the assets it was purchasing. The trustee has the burden of proof on equitable subordination. Given the lack of evidence, this court is left with no choice but to find that the trustee has not made out a case. Additionally, this court's prior determination, in connection with the motion for relief from stay, that the sale of the debtor's assets to Ruppert "was a valid transaction not entered into for any ulterior purpose" substantially undercuts the trustee's argument and makes it highly unlikely that he could succeed in an action for equitable subordination of Ruppert's lien.
It is not necessary, in the context of the present motion, to determine whether the court's findings in disposing of the motion for relief from stay would have preclusive effect. The general rule is that a hearing on relief from the automatic stay is not an appropriate vehicle for litigating the debtor's affirmative defenses or counterclaims. 3 Collier on Bankruptcy ¶ 362.08[6], at 362-109 et seq. (Lawrence P. King, ed., 15th ed. rev. 1998); Little Creek Development Co. v. Commonwealth Mortgage Corp. (In re Little Creek Development Corp.), 779 F.2d 108 (5th Cir. 1986) (affirming bankruptcy court ruling striking extrinsic state law defenses from debtor's response to relief from stay motion); Grella v. Salem Five Cent Savings Bank, 42 F.3d 26 (1st Cir. 1994) (order granting relief from the automatic stay did not have preclusive effect on trustee's counterclaim to avoid a preference). Congress specifically put relief from stay hearings on a fast track. § 362(e), Bankruptcy Code. By contrast, an adversary proceeding may (depending on the issues) proceed at a more deliberate pace, including the opportunity to conduct more extensive discovery than would be practical in the compressed time frame in which a relief from stay motion must be resolved. Collier, supra, at ¶ 362.08[1], p. 362-79; Grella, supra, 42 F.3d at 31-32 (lift stay hearings "do not involve a final adjudication on the merits of claims, defenses, or counterclaims, but simply a determination as to whether a creditor has a colorable claim to property of the estate") (emphasis added). But see The Estate Constr. Co. v. Miller Smith Holding Co., Inc., 14 F.3d 213 (4th Cir. 1994) (Although relief from stay ruling was not technically res judicata on issue of debtor's lack of equity in property, where bankruptcy judge considered all available evidence, district court in subsequent fraudulent conveyance action could rely on bankruptcy judge's findings).
D.
For the foregoing reasons, the court concludes that the $18,021.12 paid into the Fairfax Circuit Court and subsequently turned over to the trustee by George Mason Bank remains impressed with a security interest in favor of Ruppert. Since there is no suggestion that the trustee can provide adequate protection for his use of the funds, the funds are of no benefit to the bankruptcy estate. Accordingly, a separate order will be entered directing the trustee to abandon the funds to Ruppert. Given Ruppert's substantial delay in asserting its rights to those funds during the time they have been in the hands of the trustee, an award of interest on the funds is inappropriate.