Opinion
Case No. 897-86023-478 and Case No. 897-86024-478 (Procedurally Consolidated Chapter 7 Cases), Adv. Proc. No. 800-8412-478
December 13, 2002
William B. Flynn, Esq., McCable Flynn, LLP, New York, New York, for Plaintiff.
Ronald M. Terenzi, Esq., Berkman, Henoch, Peterson Peddy, P.C., Garden City, New York, for Defendant.
MEMORANDUM DECISION AND ORDER AS TO THE COVENANT OF GOOD FAITH AND FAIR DEALING
Before the Court is an action brought by Neil Ackerman, as Trustee ("Trustee" or "Plaintiff") of the Estates of JAT Management of Ohio, Inc. and JAT Management, Ltd. ("Debtors" or "JAT"), against North Fork Bank ("Defendant" or "Bank"), which, in turn, was successor-in-interest to Continental Bank, for money damages in an amount to be determined by the Court, based on Federal and New York State common law principles of lender liability allegedly arising from breach of contract, failure to disclose material facts, breach of fiduciary duty, tortious interference with contractual relationships, breach of the Covenant of Good Faith and Fair Dealing, as well as fraud, material misrepresentation and improper setoff by the Defendant Bank, all of which it is alleged resulted in the destruction of Debtors' business. The trial of this adversary proceeding was conducted over a period of three days.
The Court notes that the caption of this adversary proceeding incorrectly sets forth the name of the Debtor as JAT Management of Ohio, Ltd.
The Court has jurisdiction over this action pursuant to 28 U.S.C. § 1334(a) and (b) and 157 and the Standing Order of the District Court in this District referring all bankruptcy cases to the Bankruptcy Judges of this District. This action is a core proceeding pursuant to 28 U.S.C. § 157(b)(2)(A), (C), (E) and (O). This decision constitutes the Court's findings of fact and conclusions of law pursuant to Fed.R.Civ.P. 52(c), as made applicable herein by F.R.Bankr.P. 7052.
FINDINGS OF FACT
The Plaintiff is the duly appointed and acting Trustee in the Debtors' chapter 7 cases, which were commenced on August 11, 1997 (the "Filing Date"), and which were consolidated for administrative purposes only by Order dated September 30, 1997. The Defendant is a domestic banking corporation incorporated under and/or duly licensed to do business under the laws of the State of New York. North Fork Bank is the legal successor-in-interest to Continental Bank ("Continental") as a result of a merger effective October 17, 1997 between Continental and Reliance Federal Savings Bank ("Reliance"), and is the legal successor-in-interest to Reliance as a result of a merger effective on or about February 22, 2000.
The Debtors developed a banking relationship with Continental during the period 1991 through 1995, at which time they maintained bank accounts with Continental. The Debtors utilized the bank accounts they maintained at Continental to deposit substantial sums of money for the purpose of paying payroll expenses and the claims of various subcontractors and material suppliers who furnished labor and materials to the Debtors on the various construction projects in which they were engaged (Brusca, Tr. 1/30/02, p. 35-37). Continental was aware of the fact that the Debtors' bank accounts were used as working capital accounts to pay subcontractors, overhead expenses and payroll (Brusca, Tr. 1/30/02, p. 37).
Continental required all monies collected by the Debtors on its Morgan's Foods construction projects to be deposited with the Bank (Brusca, Tr. 1/30/02, pp. 27-29; Wilkie, Tr. 2/11/02, p. 33; Exhs. 7 and 8).
During the period 1991 through 1995, JAT Management of Ohio, Inc. also maintained a short-term credit facility (the "Loan") with Continental, which was guaranteed by JAT Management, Ltd. and the principals of the Debtor and their spouses. The terms of the Loan provided that it was renewable every 90 days, at which time interest was paid on the outstanding balance (Brusca, Tr. 1/30/02, p. 38). The Loan further provided that the outstanding balance must be cleared (i.e., paid in full) for a 30 day period annually (O'Neill, Tr. 2/25/02, p. 40). The Loan credit facility began in the amount of $40,000, which increased over the years to the point that, when the loan was renewed on April 15, 1994 for an additional one year period, the amount of the credit line was $250,000. When this Loan came due in April 1995, it was again cleared for 30 days and renewed in or about May 1995 based again on a 90 day renewable line of credit, with a maximum credit limit of $350,000 (Wilkie, Tr. 2/11/02, p. 14).
The Loan was renewed for the last time by a note dated August 21, 1995 in the amount of $350,000, payable on November 20, 1995 (the "Note") (Exh. J1). As collateral for the Loan, Continental required a general security pledge of the Debtors' assets, including but not limited to accounts receivable, an assignment of contracts, and all deposits of the Debtor maintained at the Bank, as well as the personal guarantees of the principals of the Debtors, namely, Thomas Brusca ("Brusca"), Robert Wilkie ("Wilkie") and Jacqueline Namour ("Namour") (collectively, the "Principals") and their respective spouses. In connection with the renewal of the Loan in April/May 1995, an unaudited combined financial statement of the Debtors for the year ended 1994 was supplied to Continental by the Debtors in April of 1995 ("1994 Financial Statement") (Exh. N). Among other things, the 1994 Financial Statement listed current assets of $1,350,645.00, of which $1,200,038.00 consisted of accounts receivable. The Debtors were aware that Continental was to rely on the 1994 Financial Statement in deciding whether to provide credit to the Debtors. Continental did, in fact, rely on the 1994 Financial Statement in its decision to grant credit to the Debtors (O'Neill, Tr. 2/25/02, p. 40). The parties agree that a covenant of good faith and fair dealing is implied in the various documents evidencing the Loan (Joint Trial Statement, p. 5, ¶ 19).
The Bank received as part of its Collateral an Assignment of Contract, dated April 15, 1994, with respect to a certain contract between JAT Management of Ohio, Inc. and Morgan's Foods whereby JAT was to construct East Side Mario's restaurants.
The Bank also received as part of its Collateral: "any and all monies, securities, drafts, notes items and other property of the Debtor and the proceeds thereof, now or hereafter held or received by, or in transit to, Secured Party from or for the Debtor, whether for safekeeping, custody, pledge, transmission, collection, or otherwise, and any and all deposits (general or special), balances, sums, deposits and credits of the Debtor with, and any and all claims of the Debtor against Secured Party, at any time existing." (General Security Agreement, ¶ 2, Second Amended Complaint, Exh. B.)
The 1994 Financial Statement was accompanied by the report of Benjamin J. Heitner, C.P.A., Debtor's accountant, dated March 28, 1995, stating that he " reviewed the accompanying balance sheet of JAT . . . as of December 31, 1994, and the related statements of income and retained earnings and cash flows for the period then ended, in accordance with the Statements on Standards for Accounting and Review services issued by the American Institute of Certified Public Accountants. All information included in these financial statements is the representation of the management of JAT. . . . A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, I do not express such an opinion" (emphasis supplied) (Exhs. N and 25).
The August 21, 1995 Note provides in the second paragraph that the Loan is secured by the Collateral described in the General Security Agreement dated April 15, 1994 (Second Amended Complaint, Exh B), which includes but is not limited to the Debtors' accounts receivable, and specifically provides in the third paragraph as follows:
Although only one amended complaint was filed in this adversary proceeding, it was mistitled as "Second Amended Complaint."
If at any time the Bank shall, in its discretion, consider the Collateral or any part thereof unsatisfactory or insufficient, and the undersigned shall not on demand furnish other collateral or make payment on account, satisfactory to the Bank, or if . . . the undersigned or any obligor, maker, endorser, acceptor, surety or guarantor of, or any other party to (the same, including the undersigned, being collectively referred to herein as "Obligors") any of the Obligations or to the Collateral, shall . . . make any misrepresentation to the Bank for the purpose of obtaining credit, . . . or if the financial condition or responsibility of any Obligor shall so change as, in the opinion of the Bank, to impair its security or increase its credit risk, then, all Obligations although not yet due shall, at the option of the Bank, without notice or demand, forth with become and be immediately due and payable, any term or provision of any Obligation to the contrary notwithstanding.
(Exh. J1) (emphasis supplied). In addition, the General Security Agreement dated April 15, 1994 expressly identifies, at paragraph 4, the following to be Events of Default:
(a) if at any time Secured Party shall, in its sole discretion, consider the Obligations insecure or any part of the Collateral unsafe, insecure or insufficient, and Debtor shall not on demand furnish other collateral or make payment on account, satisfactory to the Secured Party; . . . (c) if any warranty, representation or statement of fact made to Secured Party at any time by or on behalf of Debtor is false or misleading in any material respect when made . . . .
(Second Amended Complaint, Exh. B).
There is no evidence of any fiduciary relationship between the Bank and the Debtors. The relationship between the parties was strictly a contractual one.
Prior to the Filing Date and during the time period of the events covered by the pleadings, the Debtors were engaged in the construction industry, either as general contractors or as project managers, in New York and various other states. The difference between a general contractor and a project manager primarily involves financial risk (Wilkie, Tr. 2/11/02, p. 13). A project manager is hired to oversee and manage a project usually for a set fee or a percentage of the contract price. Id. The project manager does not assume any financial risk with respect to the project. Id. However, a project manager may be paid a bonus if the project is brought in early, on time or under budget. Id. A general contractor, on the other hand, assumes the financial risk of the project. Id. A general contractor bids a job according to the owner's set of plans. Id. If the owner accepts the bid, the general contractor is held to the terms of its accepted bid. Id. The general contractor can make a larger profit on the construction project job by negotiating a better price with its subcontractors than had been estimated in the accepted bid. Id. Conversely, the general contractor assumes the risk that its costs for completing the project will not run over the bid price. Id. An essential difference between a project manager and a general contractor is that a general contractor is responsible for paying subcontractors and suppliers and a project manager is not (Brusca, Tr. 1/30/02, p. 95). The Debtors conducted approximately 99% of their business as general contractors (Wilkie, Tr. 2/11/02, pp. 12-13).
The Debtors were primarily engaged in the business of constructing or renovating franchised theme restaurants for various companies such as Morgan's Foods, a public company which is a franchisee of both Kentucky Fried Chicken and East Side Mario's, and Pepsico, a public company and the national franchiser of Pizza Hut and East Side Mario's restaurants (Wilkie, Tr. 2/11/02, p. 32). Toward late spring, summer and early fall of 1995, the Debtors were engaged almost exclusively in the construction of East Side Mario's theme restaurants on behalf of Pepsico (Brusca, Tr. 1/30/02, p. 40). During the period from spring to fall of 1995, the Debtors were engaged in approximately four such construction jobs, including Alpharetta, Georgia; Charlotte, North Carolina; Hollywood, Florida; and Denver, Colorado (Busca, Tr. 1/30/02, p. 40). The Debtors acted as general contractors on the Georgia and North Carolina projects and as project manager on the Florida and Colorado projects.
The Denver, Colorado project is sometimes referred to herein as the Westminster, Colorado project.
Based on meetings with Pepsico, the Debtors expected a great deal of work out of East Side Mario's since, at the time, Debtors were the only contractors building East Side Mario's theme restaurants, and the Pepsico construction program envisioned some 1,500 East Side Mario's restaurants over three years (Brusca, Tr. 1/30/02, p. 55; Wilkie, Tr. 2/11/02, p. 18). In addition, the Debtors were given indications that they would be the exclusive builder of East Side Mario's in the northeast, where there was anticipation of building 500 restaurants (Wilkie, Tr. 2/11/02, p. 18). However, Pepsico was plagued by internecine feuding.
Pepsico believed that its Pizza Hut franchise had reached its saturation point in 1995 (Brusca, Tr. 1/30/01, pp. 42-43). Both Pizza Hut and East Side Mario's were Italian theme restaurants and, since Pizza Hut reached the end of its expansion, that division of Pepsico had a lot of people who were looking at the prospect of soon being out of work. Id. This led to some corporate infighting, especially when East Side Mario's was put under the same auspices as Pizza Hut. Id. The result of this corporate infighting was that there was an added layer of administration and accounting that had to be navigated before the Debtors could get paid for their work. Id. As a result, the payments on the Debtors' East Side Mario's construction projects became delayed in the summer of 1995. According to Mr. Brusca, it "took forever to get paid." (Brusca, Tr. 1/30/02, p. 43). Moreover, in order to timely perform under the construction contracts, JAT was required, even on projects on which it acted as the project manager and not the general contractor, to advance monies to the subcontractors and wait to be reimbursed for such advances by East Side Mario's (Brusca, Tr. 1/30/02, pp. 177-78; Wilkie, Tr. 2/11/02, pp. 94-95). This caused cash flow problems for the Debtors, which became worse in June and July 1995 (Brusca, Tr. 1/30/02, p. 44), and strained relations between the Debtors and East Side Mario's (Brusca, Tr. 1/30/02, p. 100). To illustrate the deteriorating relationship, by letter dated July 6, 1995 from JAT to Mr. David Dwyer of East Side Mario's, JAT expressly stated that the "problems we are experiencing with construction payment schedules are becoming potentially explosive" (Exh. B2).
Subsequent to the Debtors' execution of the August 21, 1995 Note in favor of Continental and due to the financial pressure upon the Debtors as a result of these delayed payments, the Debtors approached Continental to explore the possibility of increasing the credit line available to them by $150,000, to a total credit line of $500,000 (Brusca, Tr. 1/30/02, p. 44; Wilkie, Tr. 2/11/02, p. 15; O'Neill, Tr. 2/25/02, p. 41). Toward that end, there were several meetings between the Principals of the Debtors and officers of the Bank in order to discuss this matter (Brusca, Tr. 1/30/02, p. 45-50; Wilkie, Tr. 2/11/02, p. 15). During these meetings the Debtors told the Bank that they expected 14 new construction projects from East Side Mario's and Morgan's Foods in the coming year and discussed their current cash flow problems with the Bank. Id. The Bank expressed a willingness to work with the Debtors but requested additional information on which to base a credit decision. Id. Ultimately, the Bank requested interim year-to-date financials in order to assess the Debtors' request for an increased line of credit (Brusca, Tr. 1/30/02, p. 50), as well as projections for the next 12 months (O'Neill, Tr. 2/25/02, p. 42).
During the same period, the Debtors advised the Bank that they were awaiting payments of approximately $400,000 which were overdue to them from East Side Mario's on various projects. (Brusca, Tr. 1/30/02, p. 51-52). The Principals advised the Bank that, upon receipt of these substantial funds, the Debtors intended to deposit them into the Debtors' bank accounts at the Bank (Brusca, Tr. 1/30/02, pp. 52-54). O'Neill testified at Trial that the Bank may have been aware that the Debtors intended to use these funds specifically to pay subcontractors and suppliers on East Side Mario's projects (O'Neill, Tr. 2/25/02, p. 92), and it is very likely that the Bank was aware of this, as the Bank was familiar with the Debtors' business operations and required the Debtors to deposit all of their receivables into the depository accounts maintained with the Bank.
A meeting was held at the Bank on or about October 12, 1995 regarding the Debtors' continuing cash flow problems and request for additional financing, which was attended by Brusca, Wilkie, and Benjamin J. Heitner, C.P.A. ("Heitner" or the "Accountant"), on behalf of the Debtors, and by Peter O'Neill ("O'Neill"), William Riley and James Webster, on behalf of Continental (O'Neill, Tr. 2/25/02, p. 43). At that meeting, the Debtors submitted to the Bank the JAT Forecasted Schedule of Estimated Contract Revenues for Twelve Months Ended September 30, 1996 (the "JAT Projections") (Exh. 29) and an unaudited Combined Interim Financial Statement prepared by Heitner covering the nine months of 1995 up to and including September 30, 1995 (the "1995 Financial Statement") (Exh. O). To the Bank's consternation, the 1995 Financial Statement showed a prior period downward adjustment (the "Downward Adjustment") in the Debtors' accounts receivable for 1994 of approximately $598,000; i.e., the interim year-to-date financials restated the accounts receivable as of December 31, 1994 to show that they were actually $598,000 less than the $1,200,038 in receivables set forth in the 1994 Financial Statement (Exhs. 25 and 26). The Debtor had released the 1994 Financial Statement to the Bank in April 1995, and the Bank asserts that the Principals were aware at that time that this $598,000 receivable had been paid in February 1995 and hence was not a valid account receivable, but did not disclose this fact to the Bank (O'Neill, Tr. 2/25/02, pp. 50-51). In essence, the Bank asserts that the 1994 Financial Statement was false and misleading at the time that it was given to the Bank. At Trial, Heitner characterized the Downward Adjustment as "material," especially in view of the fact that the Bank may have been relying on the 1994 Financial Statement to decide whether or not to provide credit to the Debtors (Heitner, Tr. 2/25/02, pp. 11-13). The Principals never adequately explained at Trial the circumstances surrounding this $598,000 Downward Adjustment, but it appears from the testimony of the Bank's witnesses that one large receivable may have been paid, in cash, in an off-the-books transaction and the cash distributed among the Principals (O'Neill, Tr. 2/25/02, p. 46). As Mr. O'Neill testified, "They basically made the account disappear" (Tr. 2/25/02, p. 46). O'Neill further testified that, after the October 12, 1995 meeting, the loan officers conferred with the Bank's legal counsel regarding the Downward Adjustment and the legal ramifications thereof. According to Mr. O'Neill:
The 1995 Financial Statement was accompanied by Heitner's Accountant's Report dated October 10, 1995, which specifically states that he " compiled the accompanying balance sheet of JAT . . . as of September 30, 1995, and the related statement of income and retained earnings and cash flows for the nine months then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants. A compilation is limited to presenting in the form of financial statements, information that is the representation of management. I have not audited or reviewed the . . . financial statement and . . . do not express an opinion . . . on them" (emphasis supplied) (Exhs. O and 26).
We had issues of if in fact this could be construed as a fraudulent misrepresentation of financial information. We had issues regarding whether or not the bank had a right under our legal documents to make immediate demand for repayment of the loan. We had issues as to whether or not this was an event that needed to be reported to any other agency.
(O'Neill, Tr. 2/25/02, p. 47). In sum, the Bank believed that "we had a major problem loan now on our hands because the financial condition of the company was significantly changed from where it had been" when the Loan was made (O'Neill, Tr. 2/25/02, p. 47).
On or about October 16, 1995, East Side Mario's finally made a substantial payment to the Debtors in the approximate amount of $163,000 which the Debtors deposited in their accounts at the Bank on October 18, 1995 (Brusca, Tr. 1/30/02, pp. 53-54, Exh. 10 and 11). On or about the date of the deposit, the Debtors issued checks from the bank accounts maintained at Continental to third parties, including but not limited to subcontractors and suppliers on East Side Mario's projects and on Morgan's Foods projects, which totaled approximately $160,000 (Brusca, Tr. 1/30/02, p. 58; Wilkie, Tr. 2/11/02, p. 30). Continental, upon the advice of counsel, had made a determination some time after the October 12, 1995 meeting that they needed to reduce their exposure on this Loan (Exh. 31, pp. 103-04). Thus, on Monday, October 23, 1995, when the deposited funds became available funds, Continental summoned the Principals to a meeting and handed them letters addressed to JAT Management of Ohio, Inc. (Exh. 12), JAT Management, Ltd. (Exh. 13) and each of the Principals and their respective spouses (Exh. 14), indicating that the Bank was accelerating the Loan (Brusca, Tr. 1/30/02, pp. 60-64). The letter addressed to JAT Management of Ohio, Inc. (the "Demand Letter") stated explicitly that Continental was (I) accelerating the due date of the loan due to "a significant deterioration in the financial condition of the [Debtors], combined with a material change to the financial statement of December 31, 1994, which was the basis for our credit decision"; and (ii) demanding immediate payment in full" of the Loan (Exh. 12). Moreover, Continental froze all the monies in all the depository bank accounts which the Debtors maintained with Continental and placed all of the funds in these accounts in a suspense account (Brusca, Tr. 1/30/02, p. 76). The guarantors were advised in their letters that "Continental Bank has elected to accelerate the payment due date on [the Loan]" and "[i]f the obligation remains unpaid, the Bank will call upon your guaranty to satisfy this indebtedness" (Exh. 13 and 14). As a result of the acceleration of the Loan and the freezing of the JAT accounts, approximately $160,000 in checks that the Debtors had written from said accounts bounced. When Brusca asked for "a week to find alternate financing," the Bank refused (Brusca, Tr. 1/30/02, p. 64). It is undisputed that payment was not made by the Debtors or the guarantors. Eight days later, on October 31, 1995, the funds in the frozen bank accounts were applied by the Defendant Bank to the balance due to the bank of the Loan in the sum of $350,000, leaving an outstanding balance due to the Bank in the sum of approximately $190,000 (Wilkie, Tr. 2/11/02, p. 43).
The Debtors also deposited additional funds into the bank accounts maintained at Continental on October 19 and 20, 1995, which brought the total deposits made in October 1995 to the sum of approximately $176,000.
The Note dated August 21, 1995 specifically states that the Bank, in its sole discretion, can accelerate a loan although not yet due, without notice or demand, if the Obligor makes any misrepresentations to the Bank for the purpose of obtaining credit or if the financial condition of the Obligor shall so change as, in the opinion of the Bank, to impair its security or increase its credit risk (Exh. J-1).
There was conflicting testimony at Trial as to whether, between October 12, 1995, the date on which the Bank became aware of the $598,000 Downward Adjustment, and October 23, 1995, the loan officer had given the Debtor any verbal notice that the Bank was planning to accelerate the Loan. It is undisputed that, on Friday, October 20, 1995, employees of the Debtors seeking to cash their payroll checks were turned away by the Bank. When Brusca spoke to O'Neill about this over the telephone, Brusca was told that it was a "mistake" and, indeed, the payroll checks were cashed later on the same day. It is clear, however, that the $163,000 check from East Side Mario's, drawn on a Delaware Bank, did not become available funds until Monday, October 23, 1995, at which time Continental froze the Debtors' account.
The General Security Agreement dated April 15, 1994 provides, at paragraph 5, as follows:
Upon the occurrence of any Default and at any time thereafter, Secured Party may, without notice or demand upon Debtor, declare any or all Obligations of Debtor immediately due and payable and Secured Party shall have the following rights and remedies (to the extent permitted by applicable law) in addition to all rights and remedies of a secured party under the UCC, or of Secured Party under any loan agreement, document or instrument evidencing any of
(Second Amended Complaint, Exh. B) (emphasis supplied). On October 31, 1995, Continental exercised its right of set-off and seized the funds in the Debtors' frozen accounts to pay down the Loan balance.
At the time the Loan was accelerated, the facts and circumstances known to the Bank were as follows:
(a) The Downward Adjustment of the Debtors' Accounts Receivable resulted in a loss of one-half of the accounts receivable the Bank relied on when approving the August 1995 line of credit;
(b) The Debtors were experiencing severe cash flow problems as a result of Pepsico's tardy payments on the construction projects; and
(c) The Debtors' Principals and their respective spouses had personally guaranteed the Loan and, according to their personal financial statements furnished to Continental, the Principals and their spouses had a combined net worth far in excess of the amounts owed to the Bank (Exhs. 33, 34 and 35). However, when the Bank called the Loan, the guarantors were unable to cover the accelerated indebtedness of approximately $190,000.00.
Brusca, one of the guarantors of the Loan, testified that the Bank knew that he expected a substantial distribution of Federated Department Stores stock as part of a payout of a substantial judgment (Brusca, Tr. 1/30/02, p. 90). According to Brusca, the value of the stock was approximately $190,000, the approximate balance of the Debtors' Loan to Defendant Bank. However, Brusca's assurances were not given any credence by the Bank once the Debtors' 1994 Financial Statement was restated. Mr. O'Niell testified that "We had been given an explanation [for the restated financial statement] that if in fact was true, raised some questions about the propriety of our borrower . . ." (Tr. 2/25/02, p. 47).
The 1995 Financial Statement understated the 1995 year-to-date accounts receivable as of September 30, 1995, as it failed to take into account receivables owed to the Debtors by East Side Mario's for construction work already performed but not yet billed which the Debtors claim amounted to $1,100,000 (Brusca, Tr. 1/30/02, p. 181; Wilkie, Tr. 2/11/02, pp. 34-35; Exh. 28). This is significant because, as the Debtors utilized an accrual method of accounting, the Debtors recognized income when earned, not when received (Heitner, Tr. 2/25/02, p. 36). Thus, the receivables owed to the Debtors by East Side Mario's should have been included as assets on the balance sheet of the Debtors as of September 30, 1995. Notably, East Side Mario's believed that the amount owed to the Debtors was less than $500,000, and those amounts were "in dispute because of a number of defaults or potential defaults under the various contracts" (Exh. B11). The Bank acknowledges that it was made aware of this "seven figure" receivable some time in October 1995 (O'Neill, Tr. 2/25/01, pp. 98-99; Exh. 31, p. 110). However, by this time, the credibility of the Debtors and the Principals had been thoroughly discredited and the Bank did not lend any credence to this claim.
There is uncontroverted testimony that during the period of time when the 1995 Financial Statement was being prepared the Debtors were changing over from a rudimentary computerized accounting system to a more sophisticated one; that Namour, who was in charge of the changeover, was on maternity leave; and that there was some resulting confusion in the Debtors' offices (Wilkie, Tr. 2/11/02, pp. 98-99; Heitner, Tr. 2/25/02, pp. 19, 25). Namour, as a certified public accountant as well as a Principal of the Debtor, was more intimately aware of the Debtors' day-to-day operations than was Heitner. This apparently accounts for the fact that the work in process was not taken into account for purposes of this interim year-to-date financial statement.
When the checks written to subcontractors on various East Side Mario's projects and Morgan's Foods projects were dishonored by the Bank, the subcontractors were entitled under the subcontracts to stop work (Exh. A, ¶ 4.7.1).
In October 1995, all of the East Side Mario's projects were substantially complete except for the Colorado project (Brusca, Tr. 1/30/02, p. 97), on which the Debtors acted as the project manager. (Brusca, Tr. 1/30/02, p. 95). The Colorado project was a "joint pay" project (Brusca, Tr. 1/30/02, p. 107; Exh. B3). On a "joint pay" project, a check is issued by the owner and made payable jointly to the contractor and the subcontractor. In the case of the Colorado project, in theory, the Debtors would submit a payment requisition to East Site Mario's, and East Side Mario's would issue a check to the order of the Debtors and the subcontractor, jointly (Brusca, Tr. 1/30/02, p. 97-98; Wilkie, Tr. 2/11/02, pp. 71-72). Also, in theory, upon receipt of the check from East Side Mario's, the Debtors would endorse the check as the contractor/project manager, send it out to the project superintendent on the job site and ask the superintendent to have the subcontractor sign a waiver of lien before distributing the check to the joint payee subcontractor (Brusca, Tr. 1/30/02 pp. 97-98, 169; Wilkie, Tr. 2/11/02, pp. 71-72). In actuality, however, even though the Colorado project was a "joint pay" project on which JAT acted as project manager and East Side Mario's bore the responsibility to make timely payment (the construction contract provided that the time limits were of the essence), East Side Mario's failed to timely remit payment to JAT with respect to payment requisitions. The record shows that, "as of October 19, 1995, East Side Mario's had not made a single payment to a single subcontractor" (Exh. G, p. 3).
By letter dated October 20, 1995 from the Debtors to Mr. David Dwyer of East Side Mario's, the Debtors (a) expressed their frustration with East Side Mario's untimely payments under the Colorado contract; (b) requested written confirmation of exactly when all submitted, past due, invoices would be fully processed and checks received; (c) advised East Side Mario's that the Debtors would no longer "front any Subcontractor requirements" and that any resulting delays on the project would be attributable to the owner's "inability to timely turn around check requests"; and (d) required that, in the future, joint party checks would be due ten days after the receipt of invoices by East Side Mario's (Exh. B3).
When payments to the subcontractors were not forthcoming from East Side Mario's, by facsimile transmission on October 30, 1995, the Debtors issued a "stop work" order to its subcontractors on the Colorado project (Exh. B4). In response, by letter dated November 1, 1995 (Exh. B5) from Brian A. Cole, Esq., corporate counsel to East Side Mario's, the Debtors were informed that their threat to stop work "constitutes anticipatory repudiation of your obligations" under the construction contract, and by letter dated November 3, 1995 (Exh. B6) (the "Termination Letter"), East Side Mario's terminated the Contract to Build the Colorado project, effective November 10, 1995, due to the work stoppage and declared "a default under all other contracts between [East Side Mario's Operating Corp.] and its affiliates (on the one hand) and JAT and its affiliates (on the other hand)." The Termination Letter does not cite dishonored checks as a reason for the termination.
At the time that East Side Mario's terminated the Colorado contract, the completion date was only two weeks away and JAT was owed approximately $340,000 (Case No. 897-86023-478, Doc. No. 29). At the time that East Side Mario's terminated the other three construction contracts with respect to the Georgia, North Carolina and Florida projects, substantially all work had been completed on them and the only performance remaining was for East Side Mario's to pay the Debtors for the completed projects (Wilkie, Tr. 2/11/02, p. 116, Exh. G). In fact, JAT's surety on the North Carolina project claimed that East Side Mario's withheld final payment of $95,729.00 which it had approved for payment on the Georgia project and $22,694.53 that was awaiting approval on the Florida project strictly because "problems surfaced in [the] Westminster [Colorado project]" (Exh. G, pp. 2-3). The surety also charged that the payments made by East Side Mario's with respect to the North Carolina project were deposited by JAT into its account at Continental and that these contract funds were seized by the Bank to set off the balance of the JAT Loan (Exh. G, p. 2, n. 1), notwithstanding the fact that these funds should have been used to pay subcontractors and suppliers. As to the issue of the Bank taking trust funds, the only project active at the time the Bank seized the funds was the Colorado project, which was a joint pay job where the subcontractors were paid directly by East Side Mario's by way of two-party check (Wilkie, Tr. 2/11/02, pp. 71-72).
Prior to the Filing Date, East Side Mario's commenced an action for breach of contract against JAT in the United States District Court in Witchita, Kansas (the "Kansas Action"), and JAT asserted counterclaims against East Side Mario's and named Pizza Hut as a third party in the Kansas Action. (Case No. 897-86023-478, Doc. No. 29). Prior to the Filing Date, JAT commenced an action in New York State Court against East Side Mario's, Pizza Hut, Inc. and Pepsico, Inc. for breach of contract, fraud, misrepresentation, defamation, and slander, which was dismissed due to the forum clause in the construction contracts, and thereafter JAT commenced an action in North Carolina State Court against East Side Mario's and an unrelated third party (the "North Carolina Action"). Id. In sum, as of the Filing Date, JAT had asserted potential claims against East Side Mario's and Pizza Hut totaling $1,115,898.69, including $38,174.28 allegedly due and owing to JAT under the Georgia contract; $186,553.90 allegedly due and owing to JAT under the Florida contract; $341,496.51 allegedly due and owing to JAT under the Colorado contract; and $549,674.00 allegedly due and owing to JAT under the North Carolina contract. Id. By Order dated June 8, 1999, this Court granted the Trustee's Application to settle all claims by and among the Debtors' estates, East Side Mario's Operating Corp, Pizza Hut, Inc, East Side Mario's Restaurant Inc, East Side Mario's of Texas Inc, Tricon, Inc, and Pepsico Inc, and their parent, subsidiary or affiliated companies, for $250,000 (the "Settlement Funds"). New York Surety Company, the Debtor's surety on the North Carolina project, offered to be a signatory and party to the settlement upon receipt of $123,250.00 of the Settlement Funds in partial settlement of its claims against these bankruptcy estates, and agreed that its remaining claims will be reduced to a general unsecured claim in the sum of $122,750.00, inclusive of interest, and reserved all rights it may have against the Principals of the Debtors. The Settlement also provided that the Kansas Action and the North Carolina Action would be dismissed with prejudice.
No evidence was produced at Trial of any subcontractor asserting a mechanic's lien on any of the East Side Mario's projects or asserting trust fund rights as to funds seized by the Bank.
While the Debtors claimed that, as of the date of the acceleration of the Loan, they were anticipating additional construction projects worth several million dollars (see the JAT Projections, Exh. 29), the evidence elicited at Trial demonstrated that few of those projects were actually built.
The Debtors admit that the default declared by East Side Mario's to JAT under the various East Side Mario's construction projects was a contributing factor to putting the Debtors out of business (Wilkie, Tr. 2/11/02, p. 66-67). In fact, prior to the Filing Date, the Debtors instituted suit against East Side Mario's and others, claiming, among other things, that JAT was put out of business because, in reliance on East Side Mario's false representations that they were going to build some 1,500 restaurants, JAT expended a great deal of money gearing up for these projects and then East Side Mario's wound up building only about a dozen restaurants (Exh. E).
There was no probative evidence presented at trial regarding the value of the Debtors' business as a going concern as of October 1995.
Continental filed a secured proof of claim in the amount of $174,562.33 in respect of the indebtedness in each of the Debtors' bankruptcy cases on or about September 11, 1997.
Eventually, the three Principals personally paid off the outstanding balance of the Loan to the Defendant Bank, the final payment being made by Brusca in 1998.
ISSUES PRESENTED
1. Whether Continental properly accelerated the Loan pursuant to the Loan documents.
2. Whether Continental's acceleration of the Loan was done in violation of the covenant of good faith and fair dealing, and done in bad faith.
3. If Continental did breach its duty of good faith and fair dealing, whether the Debtors sustained foreseeable damages, including but not limited to being forced to cease and terminate their business operations and to file for chapter 7 relief.
4. Whether the Debtors were induced to deposit funds into their bank accounts maintained at Continental, in reliance upon any representations made by Continental that checks drawn on such accounts would be honored and third parties would be paid therefrom.
5. Whether Continental knew the funds deposited by the Debtors into such bank accounts were "trust funds" that were intended to be used to pay subcontractors and suppliers under the terms of the Debtors' construction contracts.
6. Whether Continental had a right to set off against the funds deposited by the Debtors in the bank accounts the balance due under the Loan.
DISCUSSION
I. Continental Properly Accelerated the Loan.
The determinative issue in this case is whether Continental impermissibly accelerated the Loan without notice to the Debtors. As stated above, the Note contained an "insecurity clause" which provided that if "the Bank shall, in its discretion, consider the Collateral or any part thereof unsatisfactory or insufficient, and the [Debtors] shall not on demand furnish other collateral or make payment on account, satisfactory to the Bank, . . . or the financial condition or responsibility of any Obligor shall so change as, in the opinion of the Bank, to impair its security or increase its credit risk, then all Obligations although not yet due shall, at the option of the Bank, without notice or demand, forthwith become and be immediately due and payable." At the October 12, 1995 meeting, the Bank was presented with an interim year-to-date financial statement for the nine months ended September 30, 1995 prepared by Heitner, the Debtors' Accountant. This 1995 Financial Statement contained, at page 3, a notation "prior period adjustment" and showed a negative $598,555. It is this Downward Adjustment which formed the basis of the Bank's decision to demand immediate payment of the loan, as provided for in the Note, because of "a significant deterioration in the financial condition of the [Debtors], combined with a material change to the financial statement of December 31, 1994, which was the basis for our credit decision." Continental took the position that the $598,000 Downward Adjustment from the prior period 1994 Financial Statement on which the Bank relied in extending the $350,000 Loan, constituted an Event of Default under the Loan documents and, on October 23, 1995 issued a demand letter seeking the immediate repayment of the Loan. The only response by the Debtors to the Bank's demand letter was Brusca's inquiry as to whether the checks already written would be paid. Brusca was informed that they would not be paid, and he then asked the Bank if the Debtors could have a week to find alternative financing, as the Debtors believed they had five to seven days before the checks they had written would be presented for payment.
The Bank, through O'Neill, testified that when presented with the 1995 Financial Statement, there was major concern at the Bank because it felt that it was misled and defrauded by the prior financial statement. When O'Neill asked Heitner at the October 12, 1995 meeting about the Downward Adjustment, the Accountant said it was due to an account receivable listed in the 1994 Financial Statement which was collected in 1995 as cash and not put through the books and records of the company and, therefore, needed to be adjusted as it was no longer an asset of the Debtors. When O'Neill asked the Accountant when this event took place, he was told some time in February 1995. This was of particular moment to the Bank because the 1994 Financial Statement was prepared and given to the Bank after February 1995, which gave rise to the possibility that the misrepresentation in the 1994 Financial Statement may have been intentional. The Bank contended that, after the October 12, 1995 meeting, there were conversations with Brusca alerting him that the credit line would not be continued. However, this contention was disputed by Brusca.
Perhaps the most probative testimony is that of Heitner, who does not have a stake one way or the other in this case. Heitner indicated that he thought that the prior period adjustment of $598,000 was due to an account receivable on the books in 1994 being diverted to an off the books receipt in 1995. He further testified that, in his opinion, this error constituted a material change in the financial condition of the Debtors. In fact, when asked if he considered the change material, he answered, "Absolutely" (Heitner, Tr. 2/25/02, p. 12). Heitner stated that upon learning of this change he felt that the Bank should be made aware of it and that he would necessarily have had to have discussions with the Principals concerning an adjustment of this magnitude. This contradicts the testimony of Brusca and Wilkie who denied ever having discussed the substance of the 1995 Financial Statement with Heitner. Heitner further testified that he was very concerned about the adjustment and felt a conflict between the duty he owed to the Bank, which he knew was relying on the financial statement, and the confidentiality of his clients. Finally, Heitner convinced the Debtors that they had to make the Bank aware of this adjustment, which was done at the October 12, 1995 meeting.
In sum, it is clear that the Bank had the right to accelerate the Loan without notice under the "insecurity clause" of the Note if it believed that there was insufficient collateral or if there was a material change in the financial condition of the Debtors. Given the testimony of the Accountant and the $598,000 adjustment regarding the 1994 accounts receivable, the Bank was within its contractual rights in accelerating the Loan.
II. Covenant of Good Faith and Fair Dealing.
"Under New York law, there exists in every contract a covenant of good faith and fair dealing." Pan Am Corp. v. Delta Airlines, Inc., 175 B.R. 438, 508 (S.D.N.Y. 1994). The purpose of the covenant of good faith and fair dealing is to preclude the parties to a contract from engaging in conduct that will destroy or impede the right of the other party to receive the benefits of the contract. However, "an obligation of good faith and fair dealing cannot be implied where such obligation would be inconsistent with other express terms of the contractual relationship," and it "cannot frustrate the operation of an express contractual term bargained for at arm's length." National Westminster Bank, U.S.A. v. Ross, 130 B.R. 656, 679 (S.D.N.Y. 1991), aff'd aff'd sub nom., Yaeger v. National Westminster Bank, 962 F.2d 1 (2d Cir. 1992). As further stated by the National Westminster Court:
[A]lthough the obligation of good faith is implied in every contract, it is the terms of the contract which govern the rights and obligations of the parties. The parties' contractual rights and liabilities may not be varied, nor their terms eviscerated, by a claim that one party has exercised a contractual right but has failed to do so in good faith.
Id. (emphasis supplied). See also Gillman v. Chase Manhattan Bank, N.A., 73 N.Y.2d 1, 534 N.E.2d 824, 537 N.Y.S.2d 787 (1988) ("We know of no authority supporting [the] proposition [that a lending institution] violate[s] the implied standard of good faith inherent in every contract by failing to warn of the impending segregation" of the debtor's account as permitted by the security agreement; "[i]n contending that we should hold this arrangement to be unconscionable as being unreasonably favorable to the bank, the [debtor] necessarily asks us to disturb the allocation of risks to which the parties have agreed. We decline to do so.") Accord, Murphy v. American Home Products Corp., 58 N.Y.2d 393, 448 N.E.2d 86, 461 N.Y.S.2d 232 (1983) ("New York does recognize that in appropriate circumstances an obligation of good faith and fair dealing on the part of a party to a contract may be implied and, if implied, will be enforced. In such instances the implied obligation is in aid and furtherance of other terms of the agreement of the parties. No obligation can be implied, however, which would be inconsistent with other terms of the contractual relationship"); Bronx Chrysler Plymouth, Inc. v. Chrysler Corp., 212 F. Supp.2d 233, 249 (S.D.N.Y. 2002) ("While the implied covenant may be used to protect a legitimate, mutually-contemplated benefit of the contract, a party may not invoke this covenant to have [the] Court create an additional benefit for which [the parties] did not bargain or to impose obligations that would be inconsistent with express contractual provisions"); Jofen v. Epoch Biosciences, Inc., 2002 WL 1461351, *9 (S.D.N.Y. July 8, 2002) ("The duty of good faith and fair dealing cannot . . . imply any covenant which is inconsistent with the terms of the contract."). Accord Continental Bank, N.A. v. Everett, 760 F. Supp. 713 (N.D. Ill. 1991), aff'd, 964 F.2d 701 (7th Cir. 1992) ("Implied duty of good faith provides a check against discretionary actions that are arbitrary or capricious, not those that are arguably justified under the contract and surrounding circumstances.") But see, Advanced Safety Systems NY, Inc. v. Manufacturers and Traders Trust Co., 188 A.D.2d 1009, 592 N.Y.S.2d 159 (4th Dep't 1992) ("Plaintiffs allege that [trust company's] actions were undertaken despite the fact that no monetary default had occurred, and at a time when [trust company] could not reasonably have deemed itself to be insecure. In our view, whether [trust company] acted in good faith presents an issue of fact sufficient to defeat summary judgment. We note that our holding is confined to the particular facts of this case.")
The principle that an obligation of good faith and fair dealing cannot be implied where such obligation would be inconsistent with other express terms of the contract applies to a lender's rights under a contract with a borrower. For example, in National Westminster, the Court held that the bank did not breach its duty of good faith under the loan agreement by refusing to lend funds since the loan agreement expressly stated that the bank would make advances in its sole discretion and that the agreement may be cancelled by the bank at any time without notice. In In re Bennett, 154 B.R. 140, 154 (Bankr. N.D.N.Y. 1992), report accepted, 154 B.R. 157 (N.D.N.Y. 1993), the bankruptcy court held that the duty of good faith and fair dealing could not serve to impinge upon a mortgagee's right to seek acceleration of the debt in the event of default and to the possibility of foreclosure as provided in the mortgage. The Bennett Court specifically stated that the mortgagee was not contractually bound to extract Bennett from his financial difficulties and was entitled to advance its own interests. Id. Accord, M/A-Com Security Corp. V. Galesi, 904 F.2d 134, 136 (2d Cir. 1990) ("Implied covenant of good faith does not extend so far as to undermine a party's general right to act on its own interests in a way that may incidentally lessen the other party's anticipated fruits from the contract.") In Fasolino Foods Co. v. Banca Nazionale Del Lavoro, 961 F.2d 1052, 1057 (2d Cir. 1992), the Second Circuit stated that "after you have signed a contract, you are not obliged to become an altruist toward the other party and relax the terms if he gets into trouble performing his side of the bargain." Id. Additionally, in In re Minpeco, USA, Inc., 237 B.R. 12 (Bankr. S.D.N.Y. 1997), the Court found that the bank's failure to give notice that it would not finance two of debtor's inventory purchases did not breach the implied covenant of good faith and fair dealing, since such notice was not required by the contract, as the bank, in its sole discretion, could decide whether to advance loans to finance particular inventory purchases. Id., at 26. The Court noted that "[u]nder the well-established case law in New York, this Court cannot make a finding or conclusion, with or without a trial, that [the bank] breached a purported [covenant of good faith and fair dealing] which contradicts the express terms of the only contract from which the covenant can be implied." Id., at 26-27.
The facts in Gillman v. Chase Manhattan Bank, N.A., 73 N.Y.2d 1, 534 N.E.2d 824, 537 N.Y.S.2d 787 (1988), are substantially similar to the facts presented in this case. In Gillman, the plaintiff was the assignee for the benefit of creditors of an account debtor of Chase Manhattan Bank, the defendant. In its action, the plaintiff contended that, even if the bank had a valid security interest, the standards of commercial reasonableness required that it notify the debtor before segregating the funds in the debtor's checking account. In particular, the plaintiff argued that the bank violated the implied standard of good faith inherent in every contract by virtue of UCC §§ 1-203 and 1-201 [19], both by failing to warn of the impending segregation and by showing continued confidence in the debtor when it renewed the letter of credit shortly before segregating the checking account. In effect, the plaintiff asserted that, assuming that the bank held a valid security interest in the account, it nevertheless had an implied good-faith duty to do the very thing — i.e., give advance notice of its intention of segregating the account — which could well have resulted in the depletion of the account and the destruction of its security interest. The Court of Appeals of the State of New York held in favor of the bank and, in doing so, explicitly distinguished K.M.C. Co. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985), stating that the question in K.M.C. did not involve a bank's actions with respect to a security interest specifically granted in a bank deposit, but involved whether a bank acted in good faith in refusing to continue to advance funds within the maximum limits of an agreed line of credit.
In the instant case, the provisions of the Note constitute the contract between the Debtors and the Bank. The Note expressly provides that if "the Bank shall, in its discretion, consider the Collateral or any part thereof unsatisfactory or insufficient, and the [Debtors] shall not on demand furnish other collateral or make payment on account, satisfactory to the Bank, . . . or the financial condition or responsibility of any Obligor shall so change as, in the opinion of the Bank, to impair its security or increase its credit risk, then, all Obligations although not yet due shall, at the option of the Bank, without notice or demand, forthwith become and be immediately due and payable, any term or provision of any Obligation to the contrary notwithstanding" (Exh. J1). Upon obtaining the 1995 Financial Statement which disclosed a discrepancy of $598,000 in the Debtors' 1994 accounts receivable — virtually half of the Debtors' 1994 receivables — the Bank determined, in its discretion, that its Collateral was inadequate and accelerated the Loan. Moreover, it was objectively reasonable for the Bank to believe, in view of the fact that half the Debtors' accounts receivable had disappeared without a trace, that there was a change in the Debtors' financial condition which impaired its security and increased its credit risk. Consequently, the Bank acted in good faith in exercising its rights under the Note to accelerate the Loan without prior notice, segregating the funds in Debtors' accounts and exercising its right of set-off. That is to say, the Bank complied with the express terms of the contract and, just as in Minepeco, this Court is constrained by New York law from making any finding that the Bank breached an implied covenant of good faith and fair dealing which contradicts the express terms of the Note, which is the only contract from which the covenant can be implied.
The Plaintiff relies heavily upon K.M.C. Co., Inc. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985), which held, on the facts in that case, that "at such time as Irving might wish to curtail financing KMC, as was its right under the agreement, this obligation to act in good faith would require a period of notice to KMC to allow it a reasonable opportunity to seek alternate financing, absent valid business reasons precluding Irving from doing so." Id., at 759. First, K.M.C. is distinguishable because the issue before the court was not whether the lender had wrongfully accelerated an existing loan, but whether the lender had wrongfully refused to extend additional credit without giving adequate notice that the loan would not be made. Moreover, even if the issue were identical, K.M.C. is not controlling precedent in the Second Circuit. The cases are clear that New York courts will not enforce an implied covenant of good faith and fair dealing upon a contracting party when that purported covenant is inconsistent with the express terms of the contract. See Gillman, 73 N.Y.2d at 15; National Westminster Bank v. Ross, 130 B.R. at 680; In re Minpeco, USA, Inc., 237 B.R. at 26-27. Here, the contract provides that the Bank could accelerate the loan without notice upon learning that the financial condition of the Debtors had changed to such an extent that the Bank's security was impaired and credit risk increased.
Further, the K.M.C. Court did not intend to apply the notice rule where the borrower had an impaired ability to pay or perform. In re Red Cedar Construction Co., 63 B.R. 228, 238, n. 8 (Bankr. W.D. Mich. 1986). The K.M.C. Court specifically held that "Irving's obligation to act in good faith would require a period of notice to K.M.C. to allow a reasonable opportunity to seek alternate financing, absent a valid business reason precluding its application." K.M.C., at 759. In this case, O'Neill testified that the Bank, on the advice of counsel, had decided that it had no choice but to reduce its exposure because it did not believe that the Debtors were capable of repaying the Loan. "A notice requirement which is intended to give the borrower sufficient time to secure alternate financing would be meaningless for a borrower who could not demonstrate objective credit worthiness; no amount of notice would suffice for such a borrower . . . ." Red Cedar, at 238.
In view of the foregoing, applying controlling law to the facts of this case, the Court finds that the Bank acted properly and within its rights in accelerating the Loan. Therefore, plaintiff's claims for breach of contract and violation of the obligation of good faith and fair dealing must fail.
III. Fraudulent Inducement.
The plaintiff alleges in the complaint that the Debtors were induced to deposit funds into their bank accounts maintained at Continental in reliance upon representations made by Continental that the checks drawn on such accounts would be honored and third parties would be paid therefrom. The complaint alleges that representatives of the Bank made such representations, but the plaintiff has failed to provide the name of the speaker. Courts do not require plaintiffs "to pinpoint precisely who uttered the statements" before the parties begin discovery. In re Ann Taylor Stores Sec. Litig., 807 F. Supp. 990, 1004 (S.D.N.Y. 1992). However, after extensive discovery and a three day trial, plaintiff has still failed to establish that any specific officer of the Bank ever made such a representation to the Debtors.
The Court has found that the Bank was very likely aware that the funds deposited by the Debtors in their accounts maintained at Continental would be used by the Debtors, among other things, to pay subcontractors and suppliers on the various construction projects for East Side Mario's and that the Debtors' construction contracts would be jeopardized if the checks were dishonored. The record demonstrates that, instead of indicating that the checks were dishonored due to insufficient funds, the Bank advised the payees to "refer to sender" for the reason that the checks were dishonored (Brusca, Tr. 1/30/02, p. 64). However, there is insufficient evidence in the record to indicate that the Bank, through its loan officers, ever made any representations to the Principals between October 12, 1995 and October 23, 1995 that, should the Debtors deposit funds into the depository accounts, the Bank would honor all of the checks presented for payment by third party payees. In fact, O'Neill testified that when Brusca made the deposit on October 18, 1995, Brusca asked whether he would be able to use any of the money and O'Neill responded that "I couldn't give him any assurances at that point. We wanted to be paid out the loan" (O'Neill, Tr. 2/25/02, p. 52). The record does indicate that two of the Debtors' clerical employees came to the Bank's offices to cash their paychecks on Friday, October 20, 1995 and, at first, the Bank refused to cash them, but, later the same day, the Bank characterized this as a "mistake" and proceeded to cash the paychecks. Apparently, the Bank was sending mixed signals to the Debtors, but the Court cannot find from the Bank's action of cashing the two paychecks that it made any affirmative representations to the Debtors that all other checks written on the account would be honored.
Consequently, the Court cannot make a finding that the Debtors were induced to deposit funds into their bank accounts maintained at Continental in reliance upon any false representations made by Continental that checks drawn on such accounts would be honored and third parties would be paid therefrom.
IV. Continental's Right of Set-Off.
In view of the fact that the Court has determined that the Bank acted properly in accelerating the Loan and that representatives of the Bank did not fraudulently induce the Debtors to deposit moneys from East Side Mario's into their bank accounts, the Court will next consider whether Continental had a right to set off against the $163,000 deposited by the Debtors on October 18, 1995 the balance due under the accelerated Loan.
It is undisputed that, to secure the Loan from Continental, JAT granted the Bank a security interest in substantially all of JAT's assets, including JAT's deposits in the bank accounts maintained at the Bank. The General Security Agreement provides, at paragraph 5(b), that in case of default, the Bank may, without notice or demand upon Debtors, "appropriate, set off and apply for the payment of any or all of the Obligations, any and all Collateral in or coming into the possession of [the Bank]" (emphasis supplied).
Under New York law, generally, in the absence of an agreement to the contrary, a bank is entitled to apply a deposit to the payment of a debt due it by the depositor. Daly v. Atlantic Bank of New York, 201 A.D.2d 128, 129, 614 N.Y.S.2d 418, 419 (1st Dep't 1994). This rule is based on the difference between "general" and "special" deposits. Funds in general accounts are considered the property of the bank, while funds in special accounts remain the property of the depositor. Swan Brewery Co. Ltd. v. U.S. Trust Co., 832 F. Supp. 714, 717 (S.D.N.Y. 1993). The distinction is important because while a "depository institution may apply the funds in a general account to set off debts owed to it by a depositor, it may not do so with funds in a special account." Id. at 718. Under New York law, in the absence of an agreement and proof to the contrary, a deposit is presumed to be general rather than special, and the burden devolves on the party who claims that the deposit is a special one to show that it was received by the bank with the express or clearly implied agreement that it should be kept separate from the general funds of the bank and that it should remain intact. Fenton v. Ives, 222 A.D.2d 776, 778, 634 N.Y.S.2d 833, 834 (3d Dep't 1995) Courts look to all of the circumstances surrounding the creation of an account to ascertain whether the depositor and the depository institution mutually intended the account to be special or general. Id., at 719-20. Even if the funds are deposited for a specific purpose, that is not determinative of the question of whether the account is a "general" or "special" account. In re Bennett Funding Group, Inc., 212 B.R. 206, 213 (2d Cir. BAP 1997), aff'd, 146 F.3d 136 (2d Cir. 1998). The existence or absence of an agreement that funds on deposit in the account were to be kept separate and isolated from other accounts in the bank or the bank's general funds is a critical factor. Id. The facts and circumstances may sometimes indicate an agreement due to the course of conduct between the parties. See, e.g., Noah's Ark Auto Accessories, Inc. v. First Nat'l Bank, 316 A.D.2d, N.Y.S.2d 663 (Sup.Ct., Monroe Co., 1970), aff'd, 37 A.D.2d 692, 323 N.Y.S.2d 408 (4th Dep't 1971), appeal denied, 29 N.Y.2d 485, 274 N.E.2d 753, 325 N.Y.S.2d 1025 (1971). In Noah's Ark, the plaintiff claimed that the set-off was improper because the account in question was a special account which had been opened solely for the purpose of transmitting funds from the pltiff to its creditor. The court found that the defendant had improperly set off funds from a special account, but only because the defendant bank had treated the account as a special account for several months in accordance with the plaintiff's instructions before the set-off. The court found that this indicated that "both parties had reached an agreement that this was to be a special account." Id., at 666.
In the instant case, each of the JAT entities maintained a general operating account at Continental which the Debtors used to meet payroll, presumably to pay withholding and FICA taxes, and to pay subcontractors and suppliers. There was no written agreement entered into between the Bank and the JAT entities that the funds in the accounts were to kept separate and isolated from the general funds of the Bank. Moreover, there is no evidence that the Debtors had ever instructed Continental that the accounts were to be used solely for the purpose of transmitting funds from the JAT entities to subcontractors and suppliers, or that Continental ever treated the accounts as "special" accounts. In sum, the evidence presented at trial is insufficient to overcome the presumption that the depository accounts were "general" accounts subject to set-off.
The plaintiff's Second Amended Complaint alleges at paragraphs 14-16 that the funds deposited into the Debtors' depository accounts at the Bank were "trust funds" earmarked for payment of subcontractors and suppliers and, therefore, wrongfully taken by the Bank to offset the balance due on the Loan. However, no timely action was brought in any Court to declare that the funds were trust funds. In the original complaint, the plaintiff alleged such cause of action under the New York Lien Law Article 3-A, which is not applicable to work performed outside of New York and the relevant construction projects were all outside of the State. Consequently, this statutory basis for the "trust funds" argument was dropped from the Second Amended Complaint. It is noteworthy, too, that no subcontractors have brought suit against the Bank alleging that the funds offset against the Loan were trust funds.
Assuming arguendo that Continental knew that the funds in the JAT bank accounts were the proceeds from construction projects, Continental still did not have a duty to inquire if there were any trust funds deposited in the JAT corporate account for the benefit of lien claimants prior to exercising its right of setoff. Gerrity Co. v. Bonacquisti Construction Corp., 136 A.D.2d 59, 525 N.Y.S.2d 926 (3d Dep't 1988), appeal after remand, 156 A.D.2d 800, 549 N.Y.S.2d (3d Dep't 1989), appeal denied, 75 N.Y.2d 708, 553 N.E.2d 1343, 554 N.Y.S.2d 883 (1990). In Gerrity, a supplier of a general contractor brought suit against Norstar Bank and the general contractor for diversion of trust fund assets, and the trial court granted summary judgment in favor of the plaintiff. Bonacquisti, the general contractor, had borrowed funds from Norstar under an unsecured line of credit evidenced by demand notes. Norstar conceded that it was generally aware that Bonacquisti was in the construction business and that Bonacquisti deposited checks which were the proceeds of its construction projects. When Bonacquisti defaulted on its Norstar loan, Norstar exercised its rights under their loan agreement and set off the entire outstanding indebtedness and accrued interest against the then existing balance in the Bonacquisti general checking account. The plaintiff in Gerrity was a supplier on one of Bonacquisti's construction projects and a statutory beneficiary of the trust funds created under Lien Law Article 3-A, as the project was for an improvement of real property. Norstar averred that when it made the set-off, it had no knowledge either that the trust funds were contained in the Bonacquisti account or that there were then unpaid claims of statutory trust beneficiaries. On appeal, the Appellate Division held that "[w]hen the deposit was made in the contractor's personal account, a presumption arose, upon which the defendant was entitled to rely, that the fund was not a trust fund and that there was no beneficiary entitled to any portion thereof and that presumption continued until annulled by knowledge or adequate notice to the contrary." Gerrity, 136 A.D.2d at 63, 525 N.Y.S.2d at 929 (emphasis supplied). The court further held that "[k]nowledge that Bonacquisti, as a general contractor, from time to time might have received payments constituting statutory trust funds would not, by itself, establish Norstar's bad faith, under the general criteria applied to determine what facts or circumstances put a transferee of trust assets on notice." Id. Consequently, the Appellate Division reversed and remanded.
On remand, the trial court again granted summary judgment in favor of the plaintiff after considering the testimony of an officer of Norstar. On appeal after remand, the Appellate Division found that the loan officer's testimony did not show an awareness on the part of Norstar that Bonacquisti used the checking account as the principal regular depository of Lien Law trust assets, for he denied actual knowledge of the trust character of the funds on deposit. Consequently, as Norstar was not shown to have actual knowledge of the existence of trust assets in the account, the court held it did not participate in diversion at time of set-off. Gerrity Co. v. Bonacquisti Construction Corp., 156 A.D.2d 800, 549 N.Y.S.2d 532 (3d Dep't 1989), appeal denied, 75 N.Y.2d 708, 553 N.E.2d 1343, 554 N.Y.S.2d 883 (1990).
Similarly, in the case at bar, O'Neill denied having actual knowledge that the funds were trust funds. Moreover, the October 16, 1995 check evidencing payment of $163,000 from East Side Mario's (Exh. 9) bears no notation whatsoever which would identify the funds as trust funds with respect to any construction project. Therefore, the plaintiff has not shown that the Bank had the requisite knowledge or notice which would prevent it from benefitting from the presumption that the deposit was not a trust fund and there was no beneficiary entitled to any portion thereof.
Consequently, there was nothing to stop Continental from exercising its set-off rights against the funds in these two depository accounts.
V. Continental's Actions Did Not Cause the Debtors' Business Failure.
The Debtors' complaint alleges that, due to the Bank's acceleration of the Loan and set-off of the indebtedness against the JAT bank accounts, the Debtors were put out of business and required to file the instant chapter 7 case. However, the correspondence between the Debtors and East Side Mario's (Exhs. B2 and B3) shows that the relationship between East Side Mario's and the Debtors had been deteriorating due to East Side Mario's failure to make payments on the construction projects. One letter written by Wilkie to East Side Mario's expressly stated that the "problems we are experiencing with construction payment schedules are becoming potentially explosive" (Exh. B2). As a result, the Debtors issued a stop work order on the Colorado project (Exh. B4) and, in response, East Side Mario's terminated the Debtors based on breach of the construction contract (Exh. B6). No mention is made in the Termination Letter of any bounced checks to subcontractors. In fact, the Debtors alleged in the pleadings filed in the Kansas Action and North Carolina Action that they were forced out of business by East Side Mario's and Pepsico. The Bank was not made a party to those lawsuits. At Trial, Wilkie admitted that East Side Mario's actions were a contributory factor in the Debtors' demise. In sum, although the Principals testified that the set-off by the Bank caused the Debtors' business to fail, that testimony was not corroborated by the documentary evidence.
The Court finds, based on a totality of the facts and circumstances, that the Debtors were not forced out of business solely because the Bank accelerated the Loan and applied the funds in the Debtors' bank accounts to offset the Debtors' indebtedness to the Bank. The Debtors' ever escalating problems with East Side Mario's appear to be the chief cause of the Debtors' financial problems and the Bank's actions were merely the straw that broke the camel's back.
CONCLUSION
1. Jurisdiction in this case is conferred upon the court pursuant to 28 U.S.C. § 1334 and 157 and the Order of Referral of Matters to the Bankruptcy Judges of this District issued by the United States District Court for the Eastern District of New York on August 28, 1986.
2. This action is a core proceeding pursuant to 28 U.S.C. § 1157(b)(2)(A), (C), (E) and (O).
3. There was no fiduciary relationship between the Bank and the Debtors. The relationship between the parties was strictly a contractual one.
4. The $598,000 Downward Adjustment to the Debtors' 1994 Financial Statement indicated a material change in the financial condition of the Debtor which, in the reasonable opinion of the Bank, impaired its security and increased its credit risk. Pursuant to the express terms of the contract between the parties, the Bank was entitled to declare a default and accelerate the Loan without notice or demand.
6. This Court will not enforce an implied covenant of good faith and fair dealing to require reasonable notice of the acceleration of the Loan, as such a covenant is inconsistent with the express terms of the Note entered into by and between the Debtors and the Bank in August 1995.
7. There was no legal impediment to the Bank exercising its contractual right to set off the Loan from the balance in the Debtor's general bank accounts.
8. The actions of the Bank did not cause the Debtors' business failure.
The Plaintiff's adversary proceeding against the Defendant Bank is dismissed.