Opinion
Substantively Consolidated As Case No. 99-10629-RGM, Ad. Proc. No. 01-1175
September 27, 2002
MEMORANDUM OPINION
In this suit the chapter 7 trustee asserts that a limited liability company organized by the debtor post-petition is property of the bankruptcy estate because it was organized and operated with money that was property of the estate. This memorandum opinion supplements the findings of fact and conclusions of law stated on the record at the conclusion of the trial. The parties submitted written briefs in lieu of oral closing arguments.
Delores Barros Johnson filed a voluntary petition in bankruptcy in this court on February 10, 1999. David W. Johnson, her husband, filed a voluntary petition in bankruptcy pursuant to chapter 11 of the United States Bankruptcy Code on January 17, 2001, which was converted to a case under chapter 7 on April 16, 2001. The chapter 7 cases were substantively consolidated on April 16, 2001. The debtors owned certain real property situate in the District of Columbia known as 1209 and 1211 U Street, N.W. Prior to the filing of either petition, the debtors managed the properties. They rented the offices, collected rents and maintained the buildings. Mrs. Johnson asserts that she assigned her portion in the rents to Mr. Johnson, although the evidence as to whether this actually occurred and if so whether it was before or after the commencement of her bankruptcy case is unclear. What is clear is that neither Mr. nor Mrs. Johnson accounted to the trustee for the receipt of rents during the period that each debtor was in chapter 7 and never turned the rents over to the trustee. Mrs. Johnson was denied a discharge for various reasons, principally relating to the unreliability of the information provided by her in this case and on her schedules and statement of financial affairs. Mrs. Cunningham has objected to Mr. Johnson's discharge. That matter is pending.
Ultimately, 1211 U Street, N.W. was sold at foreclosure to Helen Cunningham, the lender secured by a first trust on the property. Under the law of the District of Columbia, residential tenants have certain rights of first refusal if a building in which they reside is offered for sale. While it is not clear that any of the tenants in this building were residential tenants or are entitled to any such rights — the building is represented as a commercial office building with a restaurant on the first floor — Mrs. Johnson organized Parta Valarta, a D.C. limited liability company, to exercise those rights. Parta Valarta obtained the assignment of those rights, if any, from two tenants in the building. The maneuver appears to have stymied Mrs. Cunningham's ability to sell the property and convert her holdings to cash. Whether there are any rights to exercise and, if so, the value of them, are issues in litigation in the Superior Court for the District of Columbia.
The trustee seeks to have this court determine that Parta Valarta is property of the estate because it was organized with and operated with money that was property of the estate, particularly, the rents that should have been turned over to the trustee. Mrs. Johnson asserts that her consideration for her interest in Parta Valarta was the post-petition personal services and money derived from her post-petition employment. The parties are in agreement that interests in limited liability companies may be issued in consideration of personal services.
Post-petition earnings are not property of a chapter 7 bankruptcy estate. This is a part of the fresh start to which a debtor is entitled. However, rents derived from property of the estate are property of the estate and must be turned over to the chapter 7 trustee. This rule has not been followed as it ought to have been in this case. The question is whether those rents can be traced to Parta Valarta and, if so, whether Parta Valarta is property of the estate because it was created and operated with rents that were property of the estate.
With respect to the tracing of the rents, the court is well satisfied that there were rents that were property of the estate and that should have been turned over to the trustee. The debtors converted those rents to their own use by diverting them to Parta Valarta. Mrs. Johnson does not account for the use of the rents. She asserts without significant support that they were used in the maintenance of the buildings themselves. However, it is clear that if any of the rents were used in the maintenance or management of the building, all of the rents were not used in this fashion. It is also clear that the Johnsons could not have paid all their personal bills, particularly including legal bills, solely from the income arising from their employment. They needed addition money to support themselves and their legal adventures and used the rents for these purposes, including Parta Valarta.
The debtors argue that the trustee must trace — dollar for dollar — any rents into Parta Valarta. This is not necessary. The rationale behind the lowest intermediate balance test is that in a trust fund situation where trust funds and non-trust funds have been commingled, the fiduciary will first withdraw the non-trust fund money so that he will not violate his fiduciary duties and misappropriate trust funds for improper purposes. Property of the estate and the Johnsons' personal funds were commingled. Mrs. Johnson had an obligation to pay her personal expenses from her post-petition earnings and to turn over the rents — which were property of the estate — to the chapter 7 trustee. If the rationale of the lowest intermediate balance test is applied in this case, the funds withdrawn from the commingled account for personal expenditures would first have been withdrawn from her post-petition earnings. Since her earnings were insufficient to pay those expenses in full, she used the rents to satisfy those obligations. Parta Valarta is not a personal expense item. It was an investment.
It is a separate and discrete asset and should have been funded only after Mrs. Johnson had paid her personal living expenses in full and only from post-petition earnings. These conditions were not, and could not, be satisfied. By analogy to the lowest intermediate balance test, the rents should be allocated to the investment that would not otherwise have been possible without the misappropriation of funds.
There is a second reason that the dollar-for-dollar tracing must be rejected. The debtor failed to provide the trustee with an accounting of her income and expenses as ordered by the court. At a recent hearing both she and her husband were held in contempt for this failure. She ought not be permitted to require the trustee to carefully trace the flow of the rents while she herself — with adequate information on hand to provide the required accountings — refuses to provide the trustee with the very information necessary to accomplish this task.
The court is well satisfied that but for the diversion of rents from the bankruptcy estate to Parta Valarta, the Parta Valarta investment would not have been feasible and would not have been made. The investment in Parta Valarta was made with the trustee's funds. The debtors' interest in Parta Valarta is recoverable by the trustee because it was made with the estate's funds. Additionally, the interest of the debtors' is held in constructive trust for the bankruptcy estate. Finally, the transfer of rents to the debtors' for investment purposes (or for any other purpose) was not authorized by the court and occurred post-petition. As such, it is avoidable un 11 U.S.C. § 549. The debtors' interest in Parta Valarta LLC is, therefore, property of the bankruptcy estate.