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In re Erie Forge & Steel Corp.

decided: March 22, 1972.

IN THE MATTER OF ERIE FORGE & STEEL CORPORATION, BANKRUPT. APPEAL OF THOMAS O. SCHRADER


Adams, Gibbons and James Rosen, Circuit Judges.

Author: Adams

Opinion OF THE COURT

ADAMS, Circuit Judge.

This bankruptcy case presents a novel question regarding voidable preferences. Where a bank, prior to any bankruptcy proceedings, offsets a note in default against the debtor's checking balance in the bank, thus satisfying the note in full, and then, after the initiation of the bankruptcy proceedings, in accordance with its prior agreement with a second bank, purchases an interest in a note from the debtor held by the second bank, has a voidable preference been created to the extent of the payment to the second bank?*fn1 In order to illuminate clearly this issue, only the essential facts of the relevant transactions will be set forth below.

In 1965, the First National Bank of Pennsylvania (First National) and the Marine Midland Grace Trust Company of New York (Marine Midland) agreed to loan up to $1,000,000 to Erie Forge & Steel Corporation (Erie Forge). The agreement stipulated that Marine Midland would provide 60% of the loan and First National, the balance. The banks also agreed that in the event either of them received a payment which would alter the 60-40 participation ratio in the outstanding debt, such bank would purchase an interest in the note or notes payable by Erie Forge to the other bank so as to restore the ratio to 60-40.*fn2

The loan was consummated, and in 1968 it was refinanced. Marine Midland received a term note in the amount of $405,000, and First National received a note for $270,000.*fn3 Each note provided for the quarterly payment of principal and interest at the offices of Marine Midland. On March 31, 1969, Erie Forge defaulted, and on April 11th, Marine Midland gave written notice of the default and, pursuant to the loan agreement, demanded payment in full. At this time, Erie Forge owed $360,000 plus interest on its note to Marine Midland, and $240,000 plus interest on the note to First National.*fn4

Erie Forge maintained a substantial checking account at First National. On April 28, 1969, First National offset $244,720, the balance due on Erie Forge's note to it, including interest, against the balance in Erie Forge's checking account, leaving $192,248.44 in the checking account.*fn5 It is conceded that this action by First National was wholly proper, and by itself did not constitute a voidable preference in favor of First National. See 11 U.S.C. § 108(a) (1970).

Two days later, on April 30, 1969, Erie Forge filed a Petition for an Arrangement with its unsecured creditors under Chapter XI of the Bankruptcy Act.*fn6 On May 7, 1969, in accordance with the loan agreement, First National forwarded its check for $146,832 to purchase a 40% interest in the balance of $360,000 due on Erie Forge's note to Marine Midland.*fn7 In return, First National received a participation certificate entitling it to receive 40% of whatever Marine Midland recovered on its note. Marine Midland then filed a claim in the bankruptcy proceeding for the full $360,000 plus interest and other sums due it on separate notes not in issue here.

The trustee of the debtor's estate (trustee) filed a turnover petition with the referee, seeking recovery of the $144,000 paid by First National to Marine Midland, on the ground that it constituted a voidable preference in favor of Marine Midland. On the basis of the undisputed facts, as set forth above, the referee dismissed the petition, and the district court affirmed the dismissal. This appeal followed.

The precise issue before us is whether, on the facts as stated above, Marine Midland received a voidable preference when First National purchased from it a 40% participation in Marine Midland's account receivable of $360,000.

The general rule is that a debtor has an absolute right to prefer one general creditor to another, and to satisfy his debts to that creditor in preference to satisfying debts to others. It is only where the debtor becomes insolvent that the bankruptcy laws restrict a debtor from bestowing a preference on a particular creditor. In such case, a preference becomes voidable under certain circumstances, and the debtor's trustee may require that the money paid to the preferred creditor be returned to the debtor's estate for the benefit of all the creditors. The Bankruptcy Act defines a preference as follows:

"A preference is a transfer, as defined in this title, of any of the property of a debtor to or for the benefit of a creditor for or on account of an antecedent debt, made or suffered by such debtor while insolvent and within four months before the filing by or against him of the petition initiating a proceeding under this title, the effect of which transfer will be to enable such creditor to obtain a greater percentage of his debt than some other creditor of the same class." 11 U.S.C. § 96(a) (1) (1970).

Whether a preference exists must be tested by the statutory definition, except as modified by Sections 96(e) or 110(e), which are inapplicable here. Collier has set forth the six elements for the creation of a preference by the debtor as the:

"* * * (1) making or suffering a transfer of his property, (2) to or for the benefit of a creditor, (3) for or on account of an antecedent debt [resulting in the depletion of the estate], (4) while insolvent, and (5) within four months of bankruptcy or of the original petition under Chapters X, XI, XII, or XIII of the Act, (6) the effect of which transfer will be to enable the creditor to obtain a greater percentage of his debt than some other ...


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