UNITED STATES DISTRICT COURT DISTRICT OF NEW JERSEY
August 26, 1998
IN RE: CHARLES DOWELL AND SUSAN DOWELL, DEBTORS.
The opinion of the court was delivered by: Irenas, District Judge
HONORABLE JOSEPH E. IRENAS
Presently before this Court is the appeal of Charles Dowell ("Dowell") and Susan Dowell (collectively "debtors") from the orders of the Bankruptcy Court, entered in favor of appellees Brick Real Estate, Inc. ("Brick") and Weichert Real Estate ("Weichert"), on December 9, 1997 and January 9, 1998, denying a motion for relief from a violation of the automatic stay of 11 U.S.C. § 362(a) and reconsideration of this denial. This court has jurisdiction to hear this appeal pursuant to 28 U.S.C. § 158(a)(1).
Upon the filing of a bankruptcy petition, § 362(a) of Title 11 automatically stays "any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate," 11 U.S.C. § 362(a)(3), and "any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title," 11 U.S.C. § 362(a)(6). *fn1 Subject to the automatic stay, 11 U.S.C. § 553 preserves the right of a creditor to offset mutual debts with the debtor, as long as both debts arose prior to the bankruptcy petition. The doctrine of recoupment allows a creditor to bypass both of these restrictions and extinguish certain mutual claims that could not be setoff under 11 U.S.C. § 553. Lee v. Schweiker, 739 F.2d 870, 875 (3d Cir. 1984).
Dowell was a real estate salesman whose compensation was based on commission, but who received monthly draws from Brick which was to be deducted from future commissions when earned. At the time he filed a Chapter 13 petition, Dowell had received draws which substantially exceeded the commissions earned up to that point. In this appeal we are asked to decide whether an employer violates the automatic stay, 11 U.S.C. § 362(a), by deducting amounts attributable to pre-petition draws or advances from gross commissions *fn2 earned on sales made post-petition.
Relying on two assumptions debtors argue that Brick's offsetting pre-petition draws against post-petition gross commissions violates the automatic stay. First, the debtors assume that draws or advances should be characterized as "loans" giving rise to a pre-petition liability. The second assumption, which is really the other side of the same coin, is that under the broad definition of property of the estate in a Chapter Thirteen filing, 11 U.S.C. § 1306(a)(2), the gross commissions earned by Brick on post-petition sales made by Dowell (before reduction for prior draws or advances) form part of the bankruptcy estate. Based on these assumptions, the debtors argue that the actions of the employer amounted to an offset of mutual debts proscribed by the automatic stay under §§ 362(a)(3) or (6). Without challenging either of these assumptions, the Bankruptcy Court held that pre-petition draws could be offset against the post-petition gross commissions under the equitable doctrine of recoupment.
Neither of the two assumptions is correct. The term claim, as defined in 11 U.S.C. § 101(5), is defined as a "right to payment," and § 101(12) defines debt as "a liability on a claim." In order to violate the automatic stay, or the restrictions of § 553, the draws or advances made by Brick to Dowell must have created a repayment obligation independent of any contractual right Brick might have to reimbursement from future gross commissions earned on his sales. Under established contract law and tax law the draws and advances made against future commissions were taxable income and, as such, did not give rise to a claim by the employer for repayment independent of the calculation of such future commissions. As a necessary corollary, gross commissions payable to Brick upon a sale made by Dowell did not become the property of Dowell, or his estate, but only the amount paid to him after any reduction for previous draws or advances.
Although the bankruptcy court erroneously accepted the premise that the draws created a "claim" of Brick against Dowell, the effect of its decision was to uphold Brick's deduction of pre-petition draws in computing post-petition payments owed to Dowell. Therefore, I concur with the Bankruptcy court's decision and will affirm the judgment.
On December 4, 1995, Dowell became a Brick salesman pursuant to a written agreement (the "Agreement") which was modified by a letter agreement dated May 15, 1996. Brick made an immediate $20,000 loan to Dowell. The Agreement required that $10,000 of the $20,000 would be interest free and "forgiven" on January 15, 1996. *fn3 The other $10,000 was to be repaid by December 5, 1997, with interest at the rate of seven percent per annum. Brick issued promissory notes for each of the $10,000 loans, the second of which was secured by a mortgage on Dowell's Voorhees, New Jersey residence.
Dowell's earnings were to be based on commissions earned with a provision for periodic draws until his sales volume reached the desired level:
Brick Real Estate shall retain all commissions against the total outstanding accumulated draws until the draws have been repaid in full. Thereafter, each commission earned by you shall be paid to you unless there are outstanding draws in which case Brick Real Estate shall retain the commission and apply it against the outstanding draws. Any portion of any commission in excess of the outstanding draws shall be paid to you. It is the mutual objective of Brick and Dowell that as soon as possible the draw arrangement will cease and Dowell will be paid each commission as it is earned once the outstanding draws have been repaid in full. See Agreement, Exh. A. to Certif. of Steven Brick, dated November 14, 1997, in opposition to Appellee's motion, at 1-2. From December 11, 1995 through September 26, 1996, Brick made ten monthly advances of $6,500. During that same period gross commissions totaled only $34,996.25 so that Dowell received no additional income, leaving a balance of $30,003.75 of draws in excess of earned commissions.
On October 4, 1996, debtors filed a petition for Chapter 13 bankruptcy. The only debt listed in the petition to Brick was the $10,000 note secured by a mortgage on Dowell's Voorhees, New Jersey home. The balance of draws over commissions was not listed as a debt anywhere in the bankruptcy petition. Dowell treated the pre-petition draws as income and reported them on his state and federal income tax returns. *fn4
On the day Dowell filed his petition he received one more draw for $5,000. *fn5 Thereafter Brick advanced "advances," totaling an additional $4,661.75. One advance was for $2000, while the remaining four of $429, $429, $1,306.50 and $497.25 appear to have been calculated as a percentage of specifically anticipated sales. In all, Brick withheld $23,455.83 from post-petition commissions on sales made by Dowell to satisfy the post-petition advance of $9,661.75 as well as some of the draws made prior to the bankruptcy filing. However, when Dowell terminated his association with Brick in September of 1997 there remained more than $16,209.67 in pre-petition draws which were not covered by earned commissions. *fn6 See Exh. C to Certif. of Steven Brick, dated November 14, 1997, in opposition to Appellee's motion.
After terminating his relationship with Brick, Dowell filed a motion before the Bankruptcy Court seeking a determination that Brick had violated the automatic stay by offsetting pre-petition draws against gross commissions earned by Brick on post-petition sales made by Dowell. Bankruptcy Judge Wizmur considered the briefs, affidavits and arguments of the parties and in an order dated December 9, 1997, denied the motion. She found that Brick had not violated the automatic stay because it withheld the commissions from Dowell pursuant to Brick's valid rights of recoupment. Dowell filed a motion for reconsideration which the Bankruptcy Court denied by Order dated January 9, 1998. Dowell now appeals from both the December 9, 1997 and January 9, 1998, orders.
II. STANDARD OF REVIEW
The standard of review applied by a district court when reviewing the ruling of a bankruptcy court is determined by the nature of the issues presented on appeal. Findings of fact are not to be set aside unless they are "clearly erroneous." See Fed. R. of Bankr. P. 8013; In re Indian Palms Assocs., Ltd., 61 F.3d 197, 203 (3d Cir. 1995); J.P. Fyfe, Inc. v. Bradco Supply Corp., 891 F.2d 66, 69 (3d Cir. 1989). Questions of law are subject to de novo or plenary review. In re Brown, 951 F.2d 564, 567 (3d Cir. 1991); J.P. Fyfe, 891 F.2d at 69.
The appellants rest their claim on what they perceive to be an inherent tension between the fundamental protections of the automatic stay of the Bankruptcy code and the limitations on setoff under 11 U.S.C. § 553, with the equitable doctrine of recoupment. They argue that this tension can be relieved by distinguishing post-petition earnings from pre-petition earnings. Under the debtors' theory, income related to pre-petition services but paid post-petition would be subject to recoupment, while income from services post-petition is not. We need not address this issue since its application to the case at bar is grounded on two misconceptions. The first is that the draws are loans which constitute a claim automatically stayed under § 362(a). Not only did debtors treat the pre-petition draws as taxable income, but this treatment is also consistent with the law governing the relationship between Brick and Dowell. The second misconception is that the post-petition gross commissions earned by Brick become property of the estate before pre-petition draws are offset. Under the Agreement Dowell's right to payment was contingent upon the draw balance being reduced to zero.
A. Automatic Stay
The appellants claim that by withholding commissions earned after the filing of the bankruptcy petition, Brick has violated the bankruptcy code's automatic stay intended for the protection of debtors. 11 U.S.C. § 362. "The automatic stay is one of the fundamental debtor protections supplied by the bankruptcy code." In re University Medical Center, 973 F.2d 1065, 1074 (3d Cir. 1992); In re Atlantic Business & Community Corp., 901 F.2d 325, 327 (3d Cir. 1990). The stay "prohibits, inter alia, the commencement or continuation of a judicial or administrative proceeding against the debtor that could have been initiated before the petition was filed, or to recover on a claim that arose pre bankruptcy." United States v. Nicolet, Inc., 857 F.2d 202, 207 (3d Cir. 1988).
B. Setoff and Recoupment
Subject to the protections of the stay, 11 U.S.C. § 553 reserves the right of creditor to offset mutual debts owed by the creditor and the debtor, as long as both debts arose before the bankruptcy petition. In re University Medical Center, 973 F.2d 1065, 1079 (3d Cir. 1992). It is also well-settled in this Circuit that the doctrine of recoupment permits post-petition funds owing to a debtor to be recouped against pre-petition claims owed by the debtor to the same party: "[S]o long as the creditor's claim arises out of the identical transaction as the debtors', that claim may be offset against the debt owed to the debtor, without concern for the limitations put on the doctrine of setoff by Code section 553." University Medical Center, 973 F.2d at 1080 (quoting In re Davidovich, 901 F.2d 1533, 1539 (10th Cir. 1990). See also, In re Flagstaff Realty Associates, 60 F.3d 1031, 1035 (3d Cir. 1995); Lee v. Schweiker, 739 F.2d at 875; In re Hiler, 99 B.R. 238, 242-43 (Bankr. D.N.J. 1989).
Recoupment serves to avoid the inequities inherent in allowing a debtor to accept the benefits of a contract without also accepting the burdens. In re Flagstaff Realty, 60 F.3d at 1035 (citing In re University Medical Center, 973 F.2d at 1081; Lee v. Schweiker, 739 F.2d at 876; In re Hiler, 99 B.R. at 243.) The Bankruptcy judge found that the claims did arise out of one transaction and thus permitted recoupment as a defense to the claimed violation of the automatic stay.
The appellants urged the judge to adopt a distinction between post-petition income from pre-petition services and post-petition income from post-petition services. Thus, they argue that recoupment is well suited for a situation in which one earns a salary from actions which were taken in the past and produce a stream of payments in the future. They rely heavily on In re Ruiz, which held that "recoupment only applies if a debtors' pre-petition work product produces post-petition revenue which is not dependant upon debtors' post petition efforts." 146 B.R. 877, 880 (S.D. Fla. 1992).
C. Absence of "Claim" or "Liability"
We need not decide if the suggested dichotomy between pre-petition services and post-petition services in applying the doctrine of recoupment is correct, because we hold that pre-petition draws paid by Brick to Dowell did not constitute a claim against the debtor's estate. *fn7
11 U.S.C. § 101(12) defines debt as "liability on a claim." The code defines "claim" as the "right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured[.]" 11 U.S.C. § 101(5)(A). The Third circuit has "recognized the far-reaching scope of this definition." In re Remington Rand Corp., 836 F.2d 825, 829 (3d Cir. 1988)(citing In re Frenville, 744 F.2d at 336). "By defining claim in these terms. . . Congress unambiguously stated its intent to address all possible legal obligations in defining a bankruptcy claim[.]"). Id. Despite the breadth of the definition of "claim," a claim can exist only where the bankruptcy debtor had a legally enforceable obligation to repay.
Even when a particular transaction might, for some purposes be characterized as a loan, no claim will exist absent an obligation to repay. Thus, the House Report (Reform Act of 1978) on §101(12) [Then § 101(11)] tells us that loans against insurance policies cash values do not create "debts" or "claims" because the debtor is not liable to repay the loan. Rather, if and when the policy is payable, the insurance company will simply subtract this amount before paying under the policy. Therefore, the loan is not a claim as it is not a right to payment that can be asserted against the estate and the debtors' obligation is not a debt that will be discharged under the bankruptcy code. (HR Rep No. 595, 95th Cong. 1st Sess 310 (1977)).
It is axiomatic that amounts received as a loan do not constitute income under § 61 of the Internal Revenue Code of 1954. Dowell, quite properly, treated his pre-petition draws as income and reported them on his tax return. His Chapter 13 petition was consistent in that the $30,003.75 in excess draws was not listed as a debt. Even the $5,000 draw paid on the day the petition was filed was listed in Schedule I as income subject to $1250 deduction for "Payroll taxes and social security."
Dowell's treatment of his pre-petition draws is completely consistent with well established New Jersey law that "an employee who receives advances on account of future commissions is not required to repay any excess of the advances over the amount of commissions earned in the absence of an express agreement to pay." Summer v. Fabregas, 52 N.J. Super. 399, 403, 145 A.2d 659, 661 (1958); Roofing Sales Co. v. Rose, 103 N.J.L. 553, 557, 137 A. 211 (N.J. Sup. Ct. 1927); Toker v. Cohen, 67 N.J. Super. 68, 75, 169 A.2d 838, 841 (App. Div.1961). Indeed, the Agreement's distinction between the $20,000 in loans made to Dowell and the monthly draws buttresses the conclusion that such draws did not constitute debt.
The court will not infer an obligation to repay advances absent a contractual agreement, unless the surrounding circumstances require such an inference. Id. This has been specifically held to be the case with draws or advances paid to real estate brokers. See Veteran Realty Co. v. Marks, 9 N.J. Misc. 1207, 157 A. 452 (N.J. Sup. Ct.1931). This is the majority rule in a majority of jurisdictions. See 32 A.L.R.3d 802 (1971) (citing cases from twenty two jurisdictions which have adopted this presumption and two which reject this presumption.). One rationale for this rule is that the employer or principal pays the advances for the purpose of enhancing its own business. 32 A.L.R.3d 802 (1971); See, e.g., Agnew v. Cameron, 247 Cal. App. 2d 619, 55 Cal. Rptr. 733 (1967); Schlesinger v. Burland, 42 Misc. 206, 85 N.Y.S. 350 (1903); Perma-Home Corp. v. Nigro, 346 Mass. 349, 91 N.E.2d 745 (1963). The rule is also premised upon the superior bargaining power of the employer and therefore places upon him the burden of making any rights of repayment explicit in the contract. See Toker, 67 N.J. Super. 68, 169 A.2d 838 (1961).
Although the context of this case is a bankruptcy dispute, the result is no different than it would be in a contract dispute. In In re Sherman, 627 F.2d 594 (2d Cir. 1980) the employee was paid advance commissions before petitioning for bankruptcy. The trustee claimed that the employer could not deduct these advances before paying the estate renewal commissions. The court found this was not a violation of § 553 because there was no debt that could have been unlawfully offset. Id at 595 (citing the long line of New York cases which "hold uniformly that, in the absence, of a specific agreement to the contrary, a commission salesman who receives advances on account of anticipated commissions is not personally liable for repayment of the advances.").
The Agreement is very explicit about the distinction between loans, which are evidenced by notes, and monthly draws which were not subject to any obligation of repayment but are relevant only to the calculation of commissions owed by Brick to Dowell. As in Sherman, the bankruptcy judge did not need to consider § 553 setoffs or the complex doctrine of recoupment. See Sherman 627 F.2d at 595 ("The bankruptcy judge erred, therefore, in holding that Sherman owed appellant $22,494.40 and in applying the mutual debt test of [the predecessor of § 553]").
Even when the parties label unearned draws as "loans," such loans may not be claims in a bankruptcy sense if the loans are payable only when deducted from otherwise earned commissions. Tomer, 147 B.R. 461 (S.D. Ill. 1992) the debtor was paid advances on commissions to be earned on the sale of life insurance. However, these advances were specifically denoted as "loans" under the terms of the contract which provided that these loans would be repaid out of future commissions. See Tomer 147 B.R. 461, 463. After the petition was filed the trustee tried to collect the full commissions on pre-petition insurance sales without any deduction for these loans. The bankruptcy judge and the district court held that the contract provided for payment of commissions net of such loans, a result completely consistent with this court's holding in the instant matter. Id at 468-9.
In Sherman, the court did not allow the parties to recharacterize the salary as debt by listing it in the bankruptcy petition, as the parties designation is not dispositive. The omission here of the amounts in question from the bankruptcy petition does, however, provide additional proof that the debtors did not believe the draws to be debt when they filed.
Tax law also provides guidance. It is well settled that draws are generally to be treated as income and not as a loan. "[I]f the advances were loans, it is obvious that they did not constitute taxable income. On the other hand if the advances were compensation for services, even though those services were to be performed in the future, they constituted taxable income in the years received." Beaver v. IRS, 55 T.C. 85, 91 (1970); § 61(a)(1), I.R.C. 1954. By looking at all of the surrounding circumstances it is clear that these advances were compensation for future services and not debts under either the IRC or the Bankruptcy code.
The petitioner argues that the decision of the bankruptcy court places an attorney, advising clients in bankruptcy, in a precarious position, as they would be required to counsel clients to resign from their jobs so as to avoid offset from future earnings. As our decision indicates, this is not the result of bankruptcy, but is merely the result of the established rule that draws are salary and need not be paid back unless specifically required. Therefore, it is not the bankruptcy decision which creates this incentive, but the contract between the parties. Since the purpose of giving the draws is to ultimately produce profits for employers, the prevalence of this kind of arrangement suggests it is in fact often profitable. Dowell was a seasoned real estate salesman, and there is nothing in the record to suggest that Brick's compensation arrangement with him was unreasonable or unwise under the circumstances.
D. Dowell Is Only Entitled to Net Commissions
The Debtor claims that the gross commissions earned by Brick on sales made by Dowell are property under the estate under § 1306(a)(2). This section defines property of the estate in a Chapter Thirteen filing as broader than under other chapters because it includes "earnings from services performed by the debtor after the commencement of the case but before the case is closed, dismissed, or converted to a case under chapter 7, 11, or 12..." 11 U.S.C. § 1306(a)(2). The original Agreement defines Dowell's compensation as that of commissions in excess of his draws. Therefore, even if the draws amounted to liabilities, the Agreement requires that the balance on the draw account be reduced to zero before Dowell is entitled to any commissions. See In re Sherman; In re Tomer, 147 B.R. 461, 466 (S.D. Ill. 1992). The estate has the same right to the commissions as would Dowell, and no greater a right. Wiley v. Public Investors Life Insurance Co., 498 F.2d 101, 103 (5th Cir. 1974). The Agreement makes clear that Dowell's right to payment of commissions arose only after all draws and advances were offset. The Agreement provided:
Brick Real Estate shall retain all commissions against the total outstanding accumulated draws until the draws have been repaid in full. Thereafter, each commission earned by you shall be paid to you unless there are outstanding draws in which case Brick Real Estate shall retain the commission and apply it against the outstanding draws. Any portion of any commission in excess of the outstanding draws shall be paid to you. It is the mutual objective of Brick and Dowell that as soon as possible the draw arrangement will cease and Dowell will be paid each commission as it is earned once the outstanding draws have been repaid in full. *fn8
See Agreement, Exh. A. to Brick Certif., at 1-2. In Wiley, the court arrived at the same decision noting that "the Trustee's right can rise no higher than Wemyss' right at that time, and the only right of Wemyss under the contract was to be paid any renewal commissions which might remain after his indebtedness to Mutual was satisfied." Wiley, 498 F.2d at 103. In Tomer, the court concluded that "because the debtor Tomer has no entitlement to the payment of commissions until his roll-up liability to the company defendants was satisfied, the trustee, who steps into the shoes of the debtor at the commencement of the case, also has no entitlement to the commissions." In re Tomer, 147 B.R. 461, 470. (S.D. Ill. 1992).
For the foregoing reasons, this court will affirm the Bankruptcy Court's orders of December 9, 1997, and January 9, 1998. The Court will enter an order in conformance with this opinion.
Date: August 26. 1998
JOSEPH E. IRENAS, U.S.D.J.