Petition — Kelce v. U. S. Financial Inc.
Supreme Court brief1981
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| FILED Fs
80-1101 DEC 31 1980
CLERK}
In the Supreme Court of oe | f
United States
Ocroser TERM, 1980
In re U.S. Frvanctau INCORPORATED,
a Delaware Corp. & Affiliates, Debtors.
Rosert D. KEtce,
. Petitioner,
vs.
U.S. Frvancrau [NcorporaTED,
a Delaware corporation, and affiliates,
and Swan Constructors, INc.,
a California corporation,
Respondents.
Petition for a Writ of Certiorari
to the United States Court of Appeals
for the Ninth Circuit
William D. Scheid
Law, SCHEID AND F'ARABEE
A Professional Corporation
3100 First of Denver Plaza
633 Seventeenth Street
Denver, Colorado 80202
Telephone: (303) 573-4800
Counsel for Petitioner
December 3U, 1980
a
SORG PRINTING COMPANY OF CALIFORNIA, 346 FIRST STREET. SAN FRANCISCO 94108
(i)
QUESTION PRESENTED
Whether property to which a bankruptcy reorganization
debtor had but bare legal title and no equitable interest
when it filed under the Bankruptcy Act, may be liquidated
and distributed to general creditors under a reorganization
plan?
(ii)
TABLE OF CONTENTS
Page
RPS EELS NORE oe aS EPR RT ED RT (i)
UU We FN SNNIIUD ys cnnescthisiwonsenenetanecineceenes 1
Grounds on Which Jurisdiction Is Invoked...................... 1
Statutory Provisions Involved......................-c-scsessecceeeeeeees 2
TO NN OU as ico nasieh cei hcncupeleemsiicicnbnances 3
Reasons for Granting the Writ..................2...:.scssecsceeeeeoeees 4)
1. The Decision of the Court of Appeals Conflicts
with this Court’s Decision in Pearlman v, Reli-
ance Insurance Company, 371 U.S. 132 (1962)...... )
2. The Decision Below Raises Significant and Recur-
ring Problems of Considerable Practical Impor-
tance in the Administration of Both the Bank-
ruptey Act and the Bankruptcy Code..................... 8
GRR TARE TIT ASS EI ee i SANOMO RA AERO ERE os phe 11
Following
___ERASSEESINE SE RS I cP OM Ee EE Pe Page 11
Appendix at
Order (of Bankruptey Court) .-.-.....2cccccsciccescsscosvensceserqeeces 1
Judgment (of Bankruptcy Court) 0.2... eeeeeeeeeeeeeees 3
Findings of Fact and Conclusions of Law (Bankruptcy
BCE EES SPST LEN COT COROT TONY SIRE EONS MORE D TT TS RCO IE 5
Amendment to Memorandum of Opinion Re: Defend-
ants’ Motion for Judgment on the Pleadings or for
Summary Judgment (Bankruptcy Court).................... 11
Memorandum of Opinion Re: Defendants’ Motion for
Judgment on the Pleadings or for Summary Jude.
MOREE TERMINI YT CTE) ccoivecescgeecsevccsncsnsecbseveseccnccneicenes 13
Judgment on Appeal (District Court) ...0000200.22....ee- 19
Copiers CCOCEE CE AOR a) acne csetccdcecniceesesnccees 22
Order (Denying Rehearing (9th Circuit) )...0000.00000000.... 42
(ii1)
TABLE OF AUTHORITIES
Cases
Pages
Pearlman v, Reliance Insurance Company, 371 U.S.
5 RS a eo een Se 5, 6. 7, 8, 9, 9 n.6, 10
Case v. Los Angeles Lumber Products Co., 308 U.S.
| RU cocescnAibstpiiciceaenlaiiniladgbceed olaisnecinanchigetoaibanasel 4n.4,5,8
In re Telemart Enterprises, Inc., 425 F. 2d 761 (9th
Cir. 1975) cert. denied, 424 U.S. 969 (1976)................ 10
STATUTES
NO UR Oi tee 5
UE I Oi i ili scictesninacdi 2,10
PN as 2, 10
Ve er 2,5
Re SS ERTS CU eee ae ONSEN 2,9
ee ee) EIR AD ct icine Leased phates bisnnd opt Lastnnionmmoneint 3,8
MISCELLANEOUS
pe RD |, hf | Seinen eee 3
Blum & Kaplan, The Absolute Priority Doctrine, 41
a UI lita cicttciectnerincsisiietcnninines
124 Cong. Ree. S 17,413 (October 6, 1978)... )
H. R. Rep. No, 95-595, 95th Cong., 1st Sess, (1978)......
©
In the Supreme Court of the
United States
Octosrr Term, 1980
In re U.S. Frvancrau INcoRPORATED,
a Delaware Corp. & Affiliates, Debtors.
Rosert D. Kewce,
Petitioner,
VS.
U.S. Frvanciau [ncorporaTen,
a Delaware corporation, and affiliates,
and Swan Constructors, Inc.,
a California corporation,
Respondents.
Petition for a Writ of Certiorari
to the United States Court of Appeals
for the Ninth Circuit
COURT OF APPEALS
The opinion delivered by the Court of Appeals for the
Ninth Circuit is not yet reported, The decision of the Bank-
ruptey Court from which appeal was taken is reported at
3 Bankr. Ct. Dec. (C.F.R.) 507 (July 22, 1977).
GROUNDS ON WHICH JURISDICTION IS INVOKED
The Court of Appeals for the Ninth Circuit delivered its
opinion affirming the District Court on October 2, 1980.1
1. Herbert J. Solomon, Trustee for Respondents, is the only
party to this proceeding whose name is not included in the caption.
2
Petitioner’s Petition for Rehearing was denied by the Court
of Appeals by its Order dated November 24, 1980. This Court
has jurisdiction to review the judgment of the Court of
Appeals by Writ of Certiorari pursuant to 28 U.S.C. § 1254.
STATUTORY PROVISIONS INVOLVED
Former 11 U.S.C. § 110 (§ 70 of the Bankruptcy Act, as
amended)
The trustee of the estate of a bankrupt and his suc-
4 cessor or successors, if any, upon his or their appoint-
ment and qualification, shall in turn be vested by
operation of law with the title of the bankrupt as of
the date of the filing of the petition initiating a pro-
ceeding under this Act....
Former 11 U.S.C. § 586 (§ 186 of the Bankruptcy Act, as
amended )
A trustee, upon his appointment and qualification, shall
be vested with such title as a trustee appointed under
section 44 of this Act would have.
Former 11 U.S.C. § 621 (§ 221 of the Bankruptcy Act, as
amended)
The judge shall confirm a plan if satisfied that...
(2) the plan is fair and equitable, and feasible ....
, 11 U.S.C. § 541(d) (§$541(d) of the Bankruptey Code)
Property in which the debtor holds, as of the com-
mencement of the case, only legal title and not an
equitable interest .. . becomes property of the estate
under subsection (a) of this section only to the extent
of the debtor’s legal title to such property, but not to
the extent of any equitable interest in such property
that the debtor does not hold.
3
11 U.S.C. § 1129(b)(1) (§ 1129(b)(1) of the Bankruptcy
Code)
Notwithstanding section 510(a) of this title, if all of
the applicable requirements of subsection (a) of this
section other than paragraph (8) are met with respect
to a plan, the Court, on request of the proponent of the
plan, shall confirm the plan notwithstanding the re-
quirements of such paragraph if the plan does not
discriminate unfairly, and is fair and equitable, with
respect to each class of claims or interests that is im-
paired under, and has not accepted, the plan.
STATEMENT OF THE CASE
The jurisdiction of the District Court was invoked be-
cause the issues presented arise under the Bankruptcy Act,
as amended.?
On and shortly after July 23, 1973, Respondent U.S.
Financial Incorporated and various of its subsidiaries, in-
cluding Respondent Swan Constructors, Inc.,? filed petitions
for arrangement under Chapter XI of the Bankruptcy Act,
(former 11 U.S.C. §§ 701 et seq.) in the United States Dis-
trict Court for the Southern District of California. All
proceedings were consolidated for joint administration. On
August 29, 1975, Petitioner commenced an action in the
Bankruptcy Court for the Southern District of California
pursuant to Part VII of the Bankruptcy Rules, to reclaim
certain real property which Petitioner had transferred to
USF in exchange for preferred stock of USF in a trans-
2. References to the Bankruptcy Act refer to former 11 U.S.C.
§§ 1 et seq., as amended to July 23, 1973, the date on which Re-
spondent U.S. Financial Incorporated filed its Petition under Chap-
ter XI of the Bankruptcy Act. References to the Bankruptcy Code
refer to the Bankruptey Code of 1978 (11 U.S.C. §§ 101 et seq.).
3. Hereinafter Respondents U.S. Financial Incorporated and
Swan Constructors, Inc., are referred to jointly either as “USF” or
“Respondents’’.
4
action in which Petitioner relied upon false and misleading
financial statements of USF. Subsequently, the USF Chap-
ter XI proceedings were converted to Chapter X proceed-
ings (former 11 U.S.C. §§ 501 et seg.), and Herbert J.
Solomon was duly appointed and qualified to act as Trustee
for the reorganization of the Respondents.
The grounds upon which Petitioner based his claim for
reclamation of the real property were:
(i) under California law, Petitioner had the right to
rescind the transaction by reason of the fraud of Respond-
ents and that thus Respondents, and later their Trustee,
held only bare legal title to the remaining property, which
Petitioner beneficially owned ; and
(ii) under California law, Respondents, and later their
Trustee, held the real property in constructive trust for the
benefit of Petitioner by reason of Respondents’ fraud.
On May 18, 1977, the Trustee for Respondents moved for
Judgment on the Pleadings. The Bankruptcy Court granted
Respondents’ Motion by Order entered on August 11, 1977.
Appendix p. 1. In granting Respondents’ Motion, the Bank-
ruptey Court held that, while under California law, Re-
spondents’ fraud would entitle Petitioner to reclaim the
real property, nevertheless, the “absolute priority rule”
precluded reclamation in Chapter X proceedings.* Appendix
pp. 10, 18. The Bankruptcy Court confirmed a plan of reor-
ganization which provides for the liquidation of the debtors’
property, including the property claimed by Petitioner, and
distribution of the proceeds to general creditors. Appendix
p. 9.
The District Court for the Southern District of California
affirmed the decision of the Bankruptcy Court on July 14,
4. The “absolute priority rule” was made applicable to Chapter
X reorganization proceedings in Case v. Los Angeles Lumber Prod-
ucts Co., 308 U.S. 106 (1939). The rule is discussed in more detail
at pages 5-6, infra.
5
1978, (Appendix p. 19), and the United States Court of
Appeals for the Ninth Circuit affirmed the District Court
by opinion rendered on October 2, 1980. Appendix p. 22.
Petitioner’s Petition for Rehearing was denied on Novem-
ber 24, 1980. Appendix p. 42.
REASONS FOR GRANTING WRIT
1. The Decision of the Court of Appeals Conflicts With This
Court's Decision in Peariman v. Reliance Insurance Company,
371 U.S. 132 (1962).
The Court of Appeals held that the absolute priority rule
precluded Petitioner’s reclamation of the real property on
either a rescission or e constructive trust theory. The Court
held that, even though the real property was beneficially
owned by Petitioner, and Respondents and their Trustee
held but bare legal title, the proceeds of the property must
be distributed to Respondents’ creditors. This holding con-
flicts with this Court’s decision in Pearlman v. Reliance
Insurance Company, 371 U.S. 132 (1962) (“Pearlman”).
Pearlman involved a conflict between state law property
rights and § 64 of the Bankruptcy Act (former 11 U.S.C.
§ 104), which prescribed priorities for distribution of a
bankrupt’s property in a straight bankruptcy liquidation
(former 11 U.S.C. Chapters I-VI). The instant case in-
volves a conflict between state law property rights and Sec-
tion 221(2) of the Bankruptcy Act (former 11 U.S.C.
§ 621(2)) which provides that a reorganization plan to be
confirmed by a court must be “fair and equitable.” This
“fair and equitable” requirement has long been held to
mean that distributions under a plan of reorganization must
comply with the “absolute priority rule.” Case v. Los An-
geles Lumber Products Co., supra n.4, The absolute priority
rule requires that a reorganization plan prov.de that prop-
erty of a Chapter X debtor be distributed to claimants on
6
the basis of the claimants’ priorities upon involuntary liqui-
dation of the debtor; that is, senior claimants must receive
full compensation before junior claimants may participate.
Blum & Kaplan, The Absolute Priority Doctrine, 41 Chi. L.
Rev. 651 (1974). The absolute priority rule governs distri-
butions under reorganization plans and must be satisfied
before any plan may be found to be “fair and equitable.”
Pearlman set down the rules governing the interplay be-
tween state law property rights and Bankruptcy Act distri-
bution rules. This Court held that:
One argument against the [claimant’s claim] is that
this controversy is governed entirely by the Bank-
ruptey Act and that § 64... which prescribes priorities
for different classes of creditors, gives no priority to
[the claimant’s] claim for reimbursement. But the
present dispute—who has the property interest in the
fund, and how much—is not so simply solved. Own-
ership of property rights before bankruptcy is one
thing; priority of distribution in bankruptcy of prop-
erty that has passed unencumbered into a bankrupt’s
estate is quite another.
371 U.S. at 135.
In holding that the absolute priority rule precluded Peti-
tioner from reclaiming the subject real property notwith-
standing the fact that the property was beneficially owned
by Petitioner, the Court of Appeals clearly contradicted
the admonishment of Pearlman that “[o]wnership of prop-
erty rights before bankruptcy is one thing; priority of dis-
tribution . . . is quite another.” It is clear that under the
rule of Pearlman Petitioner is entitled to reclaim the sub-
ject property. Pearlman held that
“[I]f the [claimant] at the time of adjudication was,
as it claimed, either the outright legal or equitable
owner of this fund, or had an equitable lien or prior
7
right to it, this property interest of the [claimant]
never became a part of the bankruptcy estate to be
administered, liquidated, and distributed to general
creditors of the bankrupt. . . . Consequently our ques-
tion is not who was entitled to priority in distributions
under § 64, but whether the [claimant] had, as it
claimed, ownership of, an equitable lien on, or a prior
right to this fund before bankruptcy adjudication.
371 U.S. at 136. In the case at bar, the question is not
whether Petitioner is entitled to priority in a distribution
under a plan governed by the absolute priority rule, but
whether Petitioner had equitable ownership or a prior right
to the subject real property at the time Respondents filed
their Petitions under the Bankruptcy Act.* The answer
lies not in a rule of priority of distribution but rather in
applicable state property law. The Bankruptcy Court’s
findings and conclusions make it clear that Petitioner had
superior title under applicable state law. Appendix at 8, 16.
Pearlman made it clear that two separate questions are
involved in any distribution of property under the Bank-
ruptey Act. First, what property is subject to distribution?
Secondly, what are the rules which govern the priority of
distribution of property which has been determined to be
subject to distribution? The holding below conflicts with
Pearlman in holding that property equitably owned by Peti-
tioner could be distributed to the general creditors of Re-
spondents. Further, it used the absolute pricrity rule, which
concerns the second question, to decide the first question.
5. It appears that had USF been liquidated under the straight
bankruptey liquidation provisions rather than under Chapter X,
Petitioner would have long ago had his property.
8
2. The Decision Below Raises Significant and Recurring Problems
of Considerable Practical Importance in the Administration
of Both the Bankruptcy Act and the Bankruptcy Code.
The holding of the Court of Appeals reflects a determi-
nation of law that has important ramifications for all claim-
ants in a reorganization proceeding who claim that they
hold a superior title or interest than that of the debtor in
an asset in the possession of the debtor on the date of com-
mencement of proceedings under the Bankruptcy Act. Al-
though the instant case involves a stockholder seeking to
reclaim property which he beneficially owned and to which
he held a superior title, the principle of law announced by
the Court of Appeals goes to the very roots of the interplay
between state law property rights and Bankrupte” Act dis-
tribution rules. Although it was thought that Pearlman
clearly outlined the rules by which one determines whether
property is subject to distribution to general creditors
under the Bankruptcy Act,® the Court of Appeals’ decision
in this case casts a shadow of confusion on Pearlman in
contradicting it in a Chapter X context. Petitioner is ad-
vised by the Administrative Office of the United States
Courts that there were 202 Chapter X cases pending at
June 30,. 1980.
The issue presented here will remain important and re-
curring, notwithstanding the passage of the new Bank-
ruptey Code. Just as under the Bankruptcy Act, a plan of
reorganization proposed under the Chapter XT Bankruptcy
Code (11 U.S.C. § 1101 et seq.) must be “fair and equi-
table.” 11 U.S.C. § 1129(b)(1). Under Case v. Los Angeles
6. Although Pearlman was not a Chapter X case, and the Court
of Appeals distinguished it for that reason, we note that this Court
spoke broadly when it said that “[T]he Bankruptey Act simply
does not authorize a trustee to distribute other people’s property
among a bankrupt’s creditors.” 371 U.S. at 135-36.
9
Lumber Co., supra, n.4, it follows that the “absolute pri-
ority rule” will apply and this was the Congressional intent.
H. R. Rep. No. 95-595, 95th Cong., Ist Sess. (1978) 413. Sinee
the distribution requirements of the absolute priority doe-
trine were relied upon by the Court of Appeals to overcome
the California law as to title, the decision stands as author-
ity for the identical proposition under the Bankruptey
Code. In enacting the provisions of the Bankruptey Code
relating to title of debtor’s estates (11 U.S.C. § 541) Con-
gress intended to reiterate “[T]he general principle that
where the debtor holds bare legal title without any equitable
interest, that the estate acquires bare legal title without any
equitable interest in the property.” 124 Cong. Ree. S 17,413
(October 6, 1978). The logie of the holding below applied
to the provisions of the Bankruptcy Code would thwart that
intention.
Barkruptcy courts are frequently faced with conflicting
claims of title to and interest in property of debtors, and
this Court has consistently held that such conflicting claims
must be resolved before it can be determined whether the
property may properly be distributed among general credi-
tors. For the first time since Pearlman, a circuit court has
held that the conflicting claims of title and interest are not
important—even if the claimant has superior title to the
property and beneficially owns it, the property can never-
theless be distributed to general creditors.
Thus, where a reorganization debtor holds property as
trustee under an express trust agreement, the trust property
would be subject to distribution to general creditors because,
although the beneficiary of the trust would have a claim
of equitable ownership of the property, that claim would be
inferior to the claims of secured creditors and no greater
than the claims of unsecured creditors by reason of the
10
erroneous application of the absolute priority rule in
the instant case. The question will continue to be raised
outside of the context of a trust. For example, the question
will frequently arise where a seller of goods seeks reclama-
tion under the Uniform Commercial Code. See In re Tele-
mart Enterprises, Inc., 425 F. 2d 761 (9th Cir. 1975), cert.
denied, 424 U.S. 969 (1976).
Tn all such instances, bankruptcy courts nationwide will
be presented with the interplay between state law property
rights existing before bankruptcy and distribution rules
contained in the Bankruptcy Code. Pearlman recognized
that “such property rights existing before bankruptcy in
persons other than the bankrupt must be recognized and
respected in bankruptcy.” 371 U.S. at 136. In the instant
case the appellate court, notwithstanding Pearlman, refused
to recognize and respect such property rights despite the
fact that § 70 of the Bankruptcy Act, applicable by reason
of § 186 of the Bankruptcy Act, and Pearlman both require
such recognition.
Bankruptcy courts and litigants alike need this Court
to throw light on the obvious division between the Court
of Appeals for the Ninth Circuit and this Court. It appears
that the problem was not resolved by Pearlman. The prompt
resolution of this question will obviously have immediate
and recurring importance beyond the Petitioner here, and
will affect and guide numerous bankruptcy courts and liti-
gants in resolving conflicting claims to property, in the
hands of the debtors when proceedings in bankruptcy reor-
ganization begin.
11
CONCLUSION
For all of the foregoing reasons, a Writ of Certiorari
should issue to review the judgment and opinion of the
Ninth Circuit.
Respectfully submitted,
Law, ScHEID AND F'ARABEE
A Professional Corporation
By Wii D. ScHerw
William D, Scheid
/s/ Jeffrey L. Beattie
Counsel for Petitioner
3100 First of Denver Plaza
633 Seventeenth Street
Denver, Colorado 80202
Telephone: (303) 573-4800
December 30, 1980
Appendix
THomas Henry Coteman, Esq.
Jayson Burton Lumiss, Esq.
Rirxinp, Stertine & Lockwoop,
INCORPORATED
9454 Wilshire Boulevard, 6th Floor
Beverly Hills, California 90212
(213) 278-0970
Attorneys for Herberi J. Solomon,
Reorganization Trustee of U.S.
Financial and Swan Constructors
United States District Court
Southern District of California
Bankruptcy No. 17007, et al
Complaint No. 21
In re U.S. Frvancrau Incorporate,
a Delaware corporation and Affiliates,
Debtors.
Rosert D, Ketce,
Plaintiff,
v.
U.S. Frvanctar Iycorporatep, a Delaware
corporation, and Affiliates, and Swan
Constructors, Inc., a California corpo-
ration,
Defendants.
ORDER
At San Dreco, Cauirornis, Tuts 11 Day or Aveaust, 1977.
7%
2 Appendix
The Motion of Herbert J. Solomon, Reorganization Trus-
tee of defendants U. S. Financial Incorporated and Swan
Constructors Inc., for Judgment on the Pleadings or, in the
Alternative, for Summary Judgment, having been heard
by this Court on June 6, 1977, and the Court having read
and considered the files and records of the above-entitled
adversary proceeding and having heard the arguments of
counsel, plaintiff having appeared by Law, Nagel & Clark,
by Jeffrey L. Beattie, Esq., and the Reorganization Trustee
having appeared by Rifkind, Sterling & Lockwood, Incor-
porated, by Jayson Burton Lumish, Esq., and Findings of
Fact and Conclusions of Law having been made and filed
herewith;
Now, THeEreForeE, It Is HereBy OrperRED, ADJUDGED AND
DECREED :
That the Motion for Judgment on the Pleadings filed
herein by Herbert J. Solomon, Reorganization Trustee of
defendants U. S. Financial Incorporated and Swan Con-
structors, Inc., he and the same hereby is granted, and
that the Reorganization Trustee be and he hereby is author-
ized to sell, dispose of or otherwise deal with that portion
of the 939 Coast Boulevard property known commonly as
the “Annex,” free and clear of any claim of plaintiff based
upon any purported right to rescission or reclamation.
/s/ Herpert Katz
Herbert Katz, Bankruptcy Judge
Appendiz 3
o
United States District Court
Southern District of California
Bankruptcy No. 17007, et al
Complaint No. 21
In re U.S. Frnancrat INCORPORATED,
a Delaware corporation and Affiliates,
Debtors.
Rosert D, Ketce,
Plaintiff,
v.
U.S. Frvanciar Incorporatep, a Delaware
corporation, and Affiliates, and Swan
Constructors, Inc., a California corpo-
ration,
Defendants.
JUDGMENT
At San Dreco, Cauirornia, Tus 11th Day or Aveust, 1977.
The Motion of Herbert J. Solomon, Reorganization Trus-
tee of defendants U. S. Financial Incorporated and Swan
Constructors Inc., for Judgment on the Pleadings or, in the
Alternative, for Summary Judgment, having been heard
by this Court on June 6, 1977, and the Court having read
4 Appendix
and considered the files and records of the above-entitled
adversary proceeding and having heard the arguments of
counsel, plaintiff having appeared by Law, Nagel & Clark,
by Jeffrey L. Beattie, Esq., and the Reorganization Trustee
having appeared by Rifkind, Sterling & Lockwood, Incor-
porated, by Jayson Burton Lumish, Esq., Findings of Fact
and Conclusions of Law having been made and filed here-
with, and this Court having ordered that the Motion for
Judgment on the Pleadings be granted, and good cause
appearing therefor;
Now, THeErerore, It Is HEREBY OrpERED, ADJUDGED AND
Decreep that Judgment on the Pleadings is hereby entered
against Plaintiff and in favor of Defendants on Complaint
No. 21.
/s/ WerBert Karz
Herbert Katz, Bankruptcy Judge
Appendix 5
United States District Court
Southern District of California
Chapter X
No. 17007-K
Complaint No, 21
In re
U.S. Frvancut, Inc., a Delaware
co) poration, and affiliates,
Debtors.
RoBert D. KEtcez,
Plaintiff,
v.
U.S. Fryancut, Inc., a Delaware
corporation, et al.,
Defendants.
FINDINGS OF FACT AND
CONCLUSIONS OF LAW
The Motion of Herbert J. Solomon, Reorganization Trus-
tee of defendants U. S. Firyanctar, Inc., and Swan Con-
structors, Inc., for Judgment on the pleadings or, in the
alternative, for Summary Judgment, having been heard
by this court on June 6, 1977, and the court having read
and considered the files and records of the above entitled
adversary proceeding and having heard the arguments of
counsel, plaintiff having appeared by Law, Nagel & Clark,
by Jeffrey L. Beattie, Esq., and the Reorganization Trustee
having appeared by Rifkind, Sterling & Lockwood, Incor-
porated, by Jayson Burton Lumish, Esq., the court hereby
makes its findings of fact and conclusions of law as follows:
FINDINGS OF FACT
1. In December 1968, plaintiff ROBERT D. KELCE
(“KELCE”) owned approximately 98 condominium units
6 Appendix
known as “939 Coast” in La Jolla, California, together with
a two story apartment building adjacent thereto, known as
the “Annex.”
2. In December 1968, KELCE and defendant U. S.
FINANCIAL, INC., (“USF”) entered into a contract
whereby USF obtained an option to purchase the 939 Coast
property for $5 million, payable $1 million down, the bal-
ance to be evidenced by a promissory note secured by the
property.
3. In or about March 1969, USF offered to purchase the
property in exchange for preferred stock.
4. Ultimately the transaction was concluded. USF re-
ceived the property and KELCE received the consideration
he was to receive, which included 300,000 shares of USF
Preferred Stock, Series A, and 100,000 shares of USF Pre-
ferred Stock, Series B.
5. The Series A stock was to be redeemed at the rate of
60,000 shares per year at a redemption price of $10 per
share.
6. Redemptions of the Series A stock were made in 1970,
1971 and 1972. However, no redemptions have been made
thereafter and KELCE still owns 120,000 shares of the
Series A stock.
7. All other consideration received by KELCE has since
been disposed of by him, as has the consideration received
by USF, save and except for the property previously de-
scribed as the “Annex,” which has a value of $161,000.00.
8. This action was commenced by plaintiff in order to
reclaim that portion of the property and proceeds of the
sale thereof which are still in the possession of the T'rustee
in exchange for that portion of the Series “A” stock which,
when valued at his purchase price of $10.00 per share,
equals the value which the reclaimed property had on the
date he transferred it to defendants.
Appendix 7
9. For purposes of this motion it will be assumed that
plaintiff is in fact a defrauded shareholder, having acquired
his shares in reliance upon a materially false, misleading
and fraudulent financial statement.
CONCLUSIONS OF LAW
10. This court has jurisdiction of the parties and of the
subject matter of the above entitled adversary proceeding.
11. The issue to be decided, based upon the pleadings
on file, is whether a defrauded shareholder, preferred or
otherwise, may obtain rescission and reclamation in a Chap-
ter X reorganization of those assets with which he parted
which are still in the possession of the defendant.
12. This question divides itself into segments as follows:
(1) Under California law, is the remedy of partial
rescission available to this plaintiff.
(2) If so, does the application of the absolute pri-
ority rule deny the remedy of rescission and reclama-
tion to plaintiff; and
(3) Does the intervening creditor rule bar the relief
sought.
13. Except for applicable bankruptcy considerations,
California law governs this transaction.
14. The precise issue here raised is a question of first
impression.
15. In California the general rule is that one must re-
scind all of his contract and may not retain rights which he
deems desirable and repudiate the rest.
16. The purpose of rescission is essentially to restore
the parties to the status quo ante.
17. However, there have been exceptions made to the
general rule by which partial rescission, which is what the
plaintiff here seeks, is allowed.
8 Appendix
18. California Civil Code §1691(b) provides that a
plaintiff need not restore all of the consideration received
by him where, as here, the defendant is unable to do so.
19. It has also been so held where, without plaintiff’s
fault, it is impossible to effect a full rescission.
20. <A review of the facts in this case, together with the
law of California, has led the court to conclude that this
case is one where, absent the bankruptcy proceedings, par-
tial rescission would be a proper remedy.
21. The only way to do equity in this situation is to
allow partial rescission and reclamation so the defrauded
party can salvage something. To hold otherwise here would
be an injustice and countenance fraud.
22. If plaintiff is successful in his rescission action, he
would make what otherwise would be at best an unsecured
claim into a secured claim. That is, as he presently stands,
he is a member of the class of creditors who, because of
the hopeless insolvency of defendant, would receive nothing
by way of distribution under the “absolute priority rule”
as embodied in Section 221(2) of the Bankruptey Act.
23. If, however, he has a right to rescind and reacquire
the property songht in his complaint, then, to that extent
he would become a secured creditor and be able to effectu-
ate a larger dividend on his claim than otherwise possible.
24. In the present reorganization proceeding, all credi-
tors and stockholders are victims of a massive frand.
25. Congress, in enacting Section 221(2), intended in
a Chapter X proceeding to differentiate between equity
owners and general creditors. The scheme as set forth
therein provides for full and complete compensation of
each class of claims in descending order before the next
class can participate.
Appendix 9
26. To comply with that purpose a plan must rank
claims beginning with secured creditors, then senior unse-
cured creditors, then subordinated creditors, and finally
shareholders. Consequently any arrangement “by which
the subordinate rights and interests of the stockholders are
attempted to be secured at the expense of the prior rights”
of creditors “come within judicial denunication.” Northern
Pacific Railway Co. v. Boyd, 228 U.S, 482, 505 (1913).
27. While plaintiff KELCE may have acquired his
shares for property, rather than money, and in a private
transaction, rather than on the open market, he neverthe-
less is, and remains a shareholder and should not be
allowed, in view of the “absolute priority rule,” to obtain
senior creditor standing merely because a portion of the
consideration he paid for his stock is fortuitously still in the
possession of the defendant.
28. The court agrees with Professors Slain and Kripke
who state, in their article entitled “The Interface Between
Security Regulations and Bankruptey—Allocating the Risk
of Tilegal Securities Issuance Between Securityholders and
the Issuer’s Creditors,” 48 N.Y.U.L. Rev, 261, 294 (1973),
that
“Regardless of one’s view as to the propriety of parity
treatment, it is clear that the resciding [sic] stock-
holders should not wind up as a secured party, ... The
general creditors should not be further prejudiced by
the fortuitous fact that the shareholders can trace the
issuer’s use of his investment.”
29. The Plan of Reorganization in this Chapter X pro-
ceeding is a plan of liquidation.
30. The Federal bankruptey power being paramount
and supreme over competing or conflicting State law by
virtue of the Supremacy clause of the United,States Con-
stitution, the State law must give way.
a tian ee |
10 Appendiz
31. Having determined that rescission and reclamation
is not available to plaintiff because of the “absolute priority
rule,” it is unnecessary to discuss the effect of the “inter-
vening creditor rule.”
32. In light of the foregoing, the Motion for Judgment
on the Pleadings filed herein by Herbert J. Solomon, Re-
organization Trustee of defendants U. S. FINANCIAL,
INC. and SWAN CONSTRUCTORS, INC., must be
granted.
DATED: AUGUST 11, 1977
/s/ Herpert Katz
Herbert Katz, Bankruptcy Judge
Appendix 11
United States District Court
Southern District of California
Chapter X
NO. 17007 K
Complaint No. 21
In re
U. S. Fovancrar, Inc., a Delaware corpo-
ration, and affiliates,
Debtors.
Rosert D. Kewce,
Plaintiff.
Vs.
U.S. Fovancuat, Ivc., et al.,
Defendants.
AMENDMENT TO MEMORANDUM OF OPINION
RE: DEFENDANTS MOTION FOR JUDGMENT ON
THE PLEADINGS OR FOR SUMMARY JUDGMENT
The Memorandum of Opinion in the above entitled mat-
ter, heretofore entered and filed by the court on July 22,
1977, is hereby amended as follows:
1) The paragraph commencing at page 2, lines 19
through 21, is stricken and the following paragraph inserted
in its stead:
This action was commenced by plaintiff in order to
reclaim that portion of the property and proceeds of
the sale thereof, of the above described transaction,
including the “Annex,” which are still in the possession
of the trustee in exchange for that portion of the
Series “A” stock which, when valued at his purchase
price >f $10.00 per share, equals the value which the
reclaimed property had on the date it was transferred
to defendants.
12 Appendiz
The paragraph commencing on page 4 lines 27 through
30 is stricken and the following paragraph inserted in its
stead:
Pursuant to a stipulation entered into by and between
plaintiff and defendant, approved by the court on July
20, 1977, plaintiff has the right to contend or prove
that he should be classified as a member of Class 5B
of the Plan of Reorganization and receive all distribu-
tions allocable to him as a member of that class, which,
together with Class 5A will receive basically 80/95ths
of the 2 million shares issuable under the Plan.
DATED: AUGUST 11, 1977
/s/ Hersert Karz
Herbert Katz, Bankruptcy Judge
Appendix 13
United Siates District Court
Southern District of California
Chapter X
NO. 17007-K
Complaint No. 29 [sic]
In re
U.S. Frvancut, Inc.,
a Delaware corporation and affiliates,
Debtors.
Rosert D. Ketce,
Plaintiff.
v.
U.S. Frvancut, Inc., et al.,
Defendants.
MEMORANDUM OF OPINION RE. DEFENDANTS
MOTION FOR JUDGMENT ON THE PLEADINGS
OR FOR SUMMARY JUDGMENT
The issue to be decided, based upon the pleadings on file,
is whether a defrauded shareholder, preferred or other-
wise, may obtain rescission and reclamation in a Chapter
X reorganization.
FACTS
In December 1968, plaintiff owned approximately 98 con-
dominium units known as “939 Coast” in La Jolla, Califor-
nia, together with a two story apartment building adjacent
thereto, known as the “Annex.”
In December 1968, plaintiff and U. S. FINANCTAL
(USF) entered into a-contract whereby USF obtained an
option to purchase the 939 Coast property for $5 million,
14 Appendix
payable $1 million down, the balance to be evidenced by a
promissory note secured by the property.
Subsequently, about March 1969, USF offered to pur-
chase the property in exchange for preferred stock. Ulti-
mately the transaction was concluded. USF received the
property and plaintiff received the consideration he was
to receive, which included 300,000 shares of USF Preferred
Stock, Series A, and 100,000 shares of USF Preferred
Stock, Series B.
The Series A stock was to be redeemed at the rate of
60,000 shares per year at a redemption price of $10 per
share. Redemptions were made in 1970, 1971 and 1972. None
have been made thereafter and plaintiff still owns 120,000
shares of the Series A stock. All other consideration re-
ceived by plaintiff has since been disposed of by him, as has
the consideration received by USF, save ard except for the
property previously described as the “Annex.”
This action was commenced by plaintiff in order to re-
claim the “Annex” for the 120,000 shares of Series A stock
he still holds, which is now worthless.
For purposes of this motion it is assumed that plaintiff
is in fact a defrauded shareholder, having acquired his
shares in reliance on a materially false, misleading and
fraudulent financial statemertts. [sic]
Under these facts, in the context of 4 Chapter X proceed-
ing, may such a defrauded shareholder obtain rescission
and reclamation of those of the assets with which he parted
which are still in the possession of the defendant?
The question seems to divide itself into segments as fol-
lows:
1. Under California law, is the remedy of of [sic] par-
tial rescission available to this plaintiff?
Appendiz 15
2. If so, does the application of the absolute priority
rule deny the remedy of rescission and reclamation to plain-
tiff, and
3. Does the intervening creditor rule bar the relief
sought.
It is undisputed that California law governs this trans-
action.
It is also undisputed by the parties that the precise issue
here raised is a question of first impression.
RESCISSION
In California the general rule is that one must rescind
all of his contract and may not retain rights which he deems
desirable and repudiate the rest. Simmons v. California In-
stitute of Technology, 34 Ca.2d 264, 275 (1949).
The purpose of rescission is essentially to restore the
parties to the status quo ante. Dreiske v. Los Angeles Inv.
Securities Corp., 13 Ca.App 2d 59 (1936).
However, there have been exceptions made to the general
rule by which partial rescission, which is what the plaintiff
here seeks, is allowed.
As is stated in California Civil Code § 1691(b) is that
plaintiff need not restore all the consideration received by
him where, as here, the defendant is unable to do so.
It has also been so held that where, without plaintiffs
fault, it is impossible to effect a full rescission. Stagerman
v. Vanderventer, 57 Ca.App 2d 753 (1943).
Here, the defendant no longer has but a portion of the
property transferred to it by plaintiff, having sold most
of it in the ordinary course of business, and plaintiff has
but a portion of the property given it by defendant, having
had a great portion of it redeemed under the mandatory
redemption provisions of the Series A stock.
16 Appendix
Counsel for both sides argue other authorities for and
against the remedy of partial rescission. A review of the
facts in this case, together with the law of California, leads
one to the conclusion that this case is one, where, absent
the Bankruptcy proceeding, partial rescission, that is, re-
turn of the consideration still in the hands of the parties,
is a proper remedy.
There is no way, at this stage to return everyone to the
status quo in existence in 1969. The fact remains however,
for purposes of this motion, that plaintiff was defrauded.
The only way to do equity, in this situation is to allow
partial rescission and reclamation so the defrauded party
can salvage something. To hold otherwise here would be
an injustice and countenance fraud.
Having determined that partial rescission is available,
it must next be determined whether the fact that the de-
fendant is in a Chapter X proceeding bars the exercise of
the remedy.
If plaintiff is successful in his rescission action, he would
make what otherwise would be at best an unsecured claim
into a secured claim. That is, as he presently stands, he is
a member of the class of creditors who, because of the
hopeless insolvency of defendant would receive nothing by
way of distribution under the “absolute priority rule” as
embodied in §221(2) of the Bankruptcy Act.
If he can establish his fraud claim, he would then fall
into the class with all other stock fraud claimants and,
under the terms of the plan which has been approved in
this case, would share pro rata with those claimants.
If however, he has a right to rescind and reacquire the
“Annex,” then, to that extent he would become a secured
creditor and be able to effectuate a larger dividend on his
claim than otherwise possible.
Appendiz 17
Here all creditors and stock holders are victims of a
massive fraud. The Congress, in enacting §221(2) intended,
in a Chapter X proceeding, to differentiate between equity
owners and general creditors. The scheme as set forth pro-
vides for full and complete compensation of each class of
claims in descending order before the next class can par-
ticipate. 6A Collier on Bankruptcy, § 11.06, pp 613-14 (14th
Ed. 1972) and citations therein contained.
To comply with that purpose a plan must rank claims
begining with secured creditors, then senior unsecured
creditors, then subordinated creditors, and finally share-
holders. Consequently any arrangement “hy which the
subordinate rights and interests of the stockholders are
attempted to be secured at the expense of the prior rights”
of creditors “comes within judicial denunciation.” Northern
Pacific Railway Co. v. Boyd, 228 U.S. 482, 505 (1913).
Plaintiff is a shareholder.
While he may have acquired his shares for property,
rather than money, and in a private transaction, rather
than on the open market, he nevertheless is, and remains
a shareholder and should not be allowed, in view of the
“absolute priority rule,” to obtain senior creditor standing
merely because a portion of the consideration he paid for
his stock is fortuitously still in the possession of the de-
fendant.
The court agrees with Slain and Kriple, [sie] The Inter-
face Between Security Requlations and Bankruptcy—Allo-
cating the Risk of Illegal Securities Issuance Between Secur-
ityholders and the Issuer’s Creditors, 48 N.Y.U.L.Rev, 261
(1973), at p, 294.
“Regardless of one’s view as to the propriety of parity
treatment, it is clear that the rescinding stockholders
should not wind up as a secured party. ... The general
18 Appendix
creditor should not be further prejudiced by the for-
tuitous fact that the shareholders can trace the issuer’s
use of his investment.”
The Federal bankruptcy power being paramount and
supreme over competing or conflicting State law by virtue
of the Supremacy Clause of the United States Constitution,
the State law must give way.
Having determined that rescission and reclamation is not
available to plaintiff because of the “absolute priority rule,”
it is unnecessary to discuss the effect of the “intervening
creditor rule.”
Motion for Judgment on the Pleadings is granted.
Counsel for defendant will prepare and submit an appro-
priate order and, unless waived, proposed findings of fact
and conclusions of law within 7 days from the date hereon,
as required by Rule 7 of the Local Rules of the United
States District Court for the Southern District of Cali-
fornia.
DATED: JULY 22, 1977
/s/ Herpert Katz
Herbert Katz, Bankruptcy Judge
Appendix
United States District Court
Southern District of California
Bankruptey No. 17007, et al.
Complaint No. 21
Appeal No. 14
In re U.S. Fryanciar INcoRPORATED, |
a Delaware corporation, and Affiliates,
Debtors.
Rosert D. Kece,
Plaintiff-A ppellant,
v.
U.S. Frvanciau INcoRPORATED,
a Delaware corporation, and Affiliates,
and Swan Constructors, INc., a
California corporation,
Defendants-A ppellees.
|
19
20 Appendix
JUDGMENT ON APPEAL
Plaintiff’s appeal from the judgment of the Bankruptcy
Court granting defendants’ motion for judgment on the
pleadings came on regularly for hearing on June 26, 1978,
the plaintiff-appellant appearing through Law, Nagel &
Clark, by Jeffrey L. Beattie, Esq., and the defendants-
appellees appearing through Rifkind, Sterling & Lockwood,
Incorporated, by Jayson Burton Lumish, Esq. The court
having read and considered the briefs submitted by the
respective parties, having further read and considered the
files and records of the above-captioned proceedings, and
having heard the arguments of counsel, has decided that the
bankruptcy court was correct and its decision should be
affirmed.
There is no precedent directly addressing the interplay
between the absolute priority rule and the common law right
of recission in the context of a Chapter X reorganization
brought about by massive fraud on the part of the bankrupt.
The court is cognizant of the authogty cited by appellee
but finds that it is not controlling in this particular Chapter
X proceeding. In an ordinary bankruptcy, fraud by ‘he
bankrupt is the exception, and recovery of property from
the bankruptcy estate on a recission/constructive trust
theory is justifiable. It is not justifiable, however, when
fraud permeates the bankrupt organization and victimizes
all who dealt with it.
It must be remembered that there is no right to the
imposition of a constructive trust. The constructive trust
is an equitable remedy for achieving justice and avoiding
unjust enrichment. Healy v. Commissioner, 345 U.S. 278
(1953) ; Burgess v. Williamson, 506 F.2d 870 (5th Cir. 1975).
It should not be imposed when these equitable geals would
not be served. As previously mentioned, this case involves
a massive fraud; everyone who did business with United
Appendix 21
States Financial: secured creditors, general creditors, and
shareholders alike, to some extent have been victims of
that fraud. There is no justification for giving this plaintiff
preferential treatment due to the fortuitous circumstances
that he happened to bvy his stock with real property and a
piece of that real property happens to still remain in the
bankrupt’s estate. Such a result would be unjust enrichment
of the plaintiff at the expense of the secured and general
creditors.
The position of this court and the bankruptcy court is
supported by recent articles of leading commentators writ-
ing on the subject Slain & Kripke, The Interface Between
Securities Regulation and Bankruptcy—Allocating the Risk
of Illegal Securities Issuance Between Securityholders and
the Issuer’s Creditors, 48 N.Y.U.L. Rev. 261, 280 (1973);
Huff, The Defrauded Investor in Chapter X Reorganiza-
tions: Absolute Priority v. Rule 10b-5, 50 Am. Bankr. L.J.
197 (1966). These articles are very persuasive and con-
tributed to the court’s conclusion that imposition of a con-
structive trust is not justified in this case.
Ir Is Heresy Orperep, ApJuDGED AND DecreeEp that the
judgment of the Bankruptcy Court granting defendants’
motion for judgment on the pleadings is affirmed in all
respects.
Dated: July 8, 1978
/s/ Gorpon THoMpPson, JR.
Gordon Thompson, Jr., Judge
United States District Court
22 Appendix
Umted States Court of Appeals
for the Ninth Circuit
No. 78-2802
No. 79-3684
Bankruptcy No. 17007
In re
U.S. Frvancrau IncorporaTep,
a Delaware Corp. & affiliates,
Rosert D. Kerce,
Plaintiff-A ppellant,
vs.
U.S. Financia IncorporaTep, a Delaware
corporation, and affiliates, and Swan
Constructors, Inc., a California
corporation,
Defendant-Appellee.
OPINION
Appeal from the United States District Court
for the Southern District of California
Gordon Thompson, Jr., Judge Presiding
Argued and submitted July 1, 1980
Before: SKOPIL and FERGUSON, Circuit Judges, and
LYDICK,® District Judge
*The Honorable Lawrence T. Lydick, United States District
Judge, Central District of California, sitting by designation.
Appendix 23
FERGUSON, Circuit Judge
Claimant Robert Kelce appeals from the entry of judg-
ments on the pleadings against him in two proceedings
under Chapter X of the Bankruptcy Act,’ consolidated on
appeal. We affirm both judgments.
BACKGROUND
As of December, 1968, Kelee owned a condominium pro}-
ect and an adjacent apartment building in La Jolla, Cali-
fornia. That month, Kelee entered into an agreement with
the debtor, U.S. Financial Ine. (“USF”) whereby USF
obtained an option to purchase Kelce’s La Jolla properties
for $5 million. The option agreement specified that USF
would pay $1 million down and would sign a $4 million
promissory note payable in five equal annual installments
and secured by a deed of trust on the property. Subse-
quently, USF declined to purchase the property in accord-
ance with the terms set out in the option agreement.
Instead, USF offered to purchase the property for $1 mil-
lion down, $3 million Series A redeemable preferred stock
(300,000 shares at $10 per share par value) and $1 million
in Series B convertible preferred stock (100,000 shares at
$10 per share par value). USF provided Kelce with mate-
1. 11 US.C.A. § 501 et sea. (1970). These actions were brought
under the Bankruptey Act of 1898, as amended. That Act has since
been revised by the Bankruptcy Reform Act of 1978, Pub. L.
95-598. Unless otherwise noted, all references to the provision of
the Bankruptey Act contained herein refer to the Bankruptey Act
of 1898, as amended.
2. Shortly after U.S. Financial, Ine. filed its petition for an
arrangement under Chapter XI, several of its subsidiaries filed
similar petitions. All proecedings were consolidated for joint admin-
istration. As used herein, all references to “USF” refer to U.S.
Financial, Inc. and its affiliates.
24 Appendiz
rially false, misleading and fraudulent’ financial statements
for the three years ending December 31, 1968, and Kelce
relied on those financial statements in accepting USF’s
proposal.
Prior to USF’s collapse, Kelce converted his Series B
stock for approximately $1.5 million, thereby realizing a
$500,000 profit. Redemptions of Kelce’s Series A preferred
stock were made in 1970, 1971 and 1972. No redemptions
were made after 1972, and Kelce still owns 120,000 shares
of Series A stock.
In 1973, USF filed a petition for arrangement under
Chapter XI of the Bankruptcy Act (11 U.S.C.A. § 301 [sic]
et seq.). At the time of filing, USF still owned four condo-
minium units and the apartment building. The history and
collapse of USF is described by Judge Anderson in Jn Re
U.S. Financial Securities Litigation, 609 F.2d 411 (9th Cir.
1979).
II. RESCISSION AND RECLAMATION
On August 29, 1975, Kelce filed a complaint for rescission
and reclamation of the property still owned by USF. He
also sought reclamation of the proceeds of any sale of that
property subsequent to the filing of USF’s Chapter XI
petition.
In late 1975, the Chapter XI proceedings were converted
into Chapter X proceedings. Herbert Solomon was ap-
8. The courts below, in ruling on the trustee’s motions for judg-
ments on the pleadings, were required to accept Kelce’s allegations
of fact as true. Austad v. United States, 386 F.2d 147, 149 (9th Cir.
1967). In reviewing their decision, we also assume the truth of
Kelce’s allegations, and we therefore assume that Kelce is a de-
frauded shareholder, having relied on materially false, misleading,
and fraudulent financial statements supplied by USF.
Appendiz 25
pointed and qualified to act as reorganization trustee, and
he subsequently filed a motion for judgment on the plead-
ings or for summary judgment dismissing Kelce’s claim.
The bankruptcy court sustained the trustee’s motion for
judgment on the pleadings, holding that although Kelce
was entitled to partial rescission and reclamation under
California law, the absolute priority rule barred any re-
covery by Kelce. The district court affirmed and this appeal
followed.
A. Title
Kelece contends that the courts below erred in holding
that his state law right of rescission is superceded by Chap-
ter X of the Bankruptcy Act. He argues that property is
not “property of the debtor’ and therefore does not pass
into the bankrupt estate if the debtor held voidable rather
than nondefeasible title to the property at the time of filing.
It is clear, however, that the trustee did acquire title
to the property at issue here. Section 186 of the Bankruptey
Act, 11 U.S.C.A. § 586, provides that a Chapter X trustee
acquires the same title as a trustee in ordinary bankruptey
receives pursuant to § 70a,° 11 U.S.C.A. § 110(a). Contrary
to Kelce’s assertions, a trustee in ordinary bankruptey does
take title to property to which the debtor held voidable title,
4.
See 11 U.S.C.A. § 616, which provides in pertinent part:
A plan of reorganization under this Chapter—
eee
(2) may deal with all or any part of the property of the
debtor ....
. Section 70(a), 11 U.S.C.A. §110(a), provides in pertinent
The trustee of the estate of a bankrupt .. . upon his...
appointment and qualification, shall in turn be vested by
operation of law with the title of the bankrupt as of the date
of the filing of the petition initiating a proceeding under this
| ae
26 Appendiz
but he takes that title subject to the defrauded party’s
claim for rescission and reclamation. See 4A Collier on
Bankruptcy { 70.41 at 483 (14th ed. 1979). “[T]he trustee
in bankruptcy takes title to the bankrupt’s property sub-
ject to the retroactive divestment effected by such a rescis-
sion.” (emphasis supplied). A Chapter X trustee, therefore,
does take title to property which is subject to a state law
for rescission, There is, however, a critical distinction be-
tween Chapter X and Chapter XI proceedings which may
affect the ultimate disposition of property taken subject
to a rescission claim. That distinction is the necessary appli-
cation of the absolute priority rule in Chapter X proceed-
ings. See Protective Committee v. Anderson, 390 U.S. 414,
441 (1968); In Re Equity Funding of America Securities
Tatigation, 603 F.2d 1353, 1356 n.4 (9th Cir. 1979).
Kelece cites several cases in support of his claim for
rescission and reclamation, As the district court noted,
however, none of these cases addressed the interaction be-
tween the absolute priority rule and the common law right
of rescission in Chapter X proceedings. As such, none is
controlling here.
In Pearlman v. Reliance Insurance Co., 371 U.S. 132
(1962), the Supreme Court held that the debtor’s surety
was entitled to recover funds specifically set aside to seeure
the surety’s obligation. The debtor had no colorable owner-
ship claim to the funds in question, thus the trustee never
obtained title at all. Moreover, Pearlman involved an ordi-
nary bankruptcy, and thus the Court was not presented
with an opportunity to diseuss the absolute priority rule,
or a shareholder’s right to rescission and reclamation in
the context of a Chapter X reorganization. In fact, the case
has only once been applied in a Chapter X ease, In re Bruce
Construction Corp., 217 F. Supp. 926 -(S.D. Fla. 1963).
Appendix 27
Bruce, like Pearlman, involved a surety, and, as in Pearl-
man, the Bruce debtor had no colorable claim to title over
the fund.
Similarly, none of the Ninth Circuit cases cited by Kelee
involved Chapter X proceedings and they therefore do not
discuss the absolute priority rule. In Matter of Paderewski,
564 F.2d 1353 (9th Cir. 1977), a trustee in ordinary hank-
ruptey claimed title to a one-half interest in a community
property residence. An interlocutory divorce decree, which
had not been appealed and which therefore had become
final, had not awarded each party a one-half interest in the
residence, Since the bankrupt did not have a one-half inter-
est, the trustee did not receive a one-half interest. Again
this was not a Chapter X case. Moreover, the hankrupt
clearly did not have title to one-half of the property in
issue, and neither, therefore, did the trustee, In contrast.
USF did have title to the property in issue here, however
defective, and the trustee was vested with that title.
In re Forester, 529 F.2d 310 (9th Cir. 1976). involved
the subrogation of a second lien holder’s claims to collateral
to those of a first lien holder. This court made clear that
the trustee in ordinary bankruptev is vested with the hank-
rupt’s title at the moment of bankruptey. Id. at 316. Our
holding is not inconsistent with that maxim.
In re Telemart Enterprises, Inc., 425 F.2d 761 (9th Cir.
1975), cert. denied, 424 U.S. 969 (1976), concerned reclama-
tion under the Uniform Commercial Code bv a seller of
goods to a bankrupt purchaser. While we held that a seller
could reclaim goods when a bankrupt received voidable
title, we were not faced with a Chapter X reorganization
and thus did not have to resolve the absolute priority issue.
As discussed below, that rule changes the foens of our in-
28 Appendix
quiry and mandates that we refuse to permit Kelce to
reclaim the property and proceeds at issue.
B. The Absolute Priority Rule
The Supreme Court has long recognized that a reorgani-
zation plan cannot be “fair and equitable,” as it must be
before it can be approved® or confirmed,’ if it fails to comply
with the absolute priority rule. Case v. Los Angeles Lwmber
Products Co., 308 U.S. 106, 115-19 (1939) ; Protectwe Com-
mittee v. Anderson, supra, 390 U.S. at 441. This rule
requires that
[bjeginning with the topmost class of claims against
the debtor, each class in descending rank must receive
full and complete compensation for the rights sur-
-rendered before the next class below may properly
participate.
6A Collier on Bankruptcy, [11.06 at 210-11 (14th ed.
1979) (citations omitted).
We cannot square the absolute priority rule with Kelce’s
claim for rescission and reclamation. Were we to allow his
claim, we would be permitting Kelce to transform his
claim as a defrauded shareholder into a secured claim, in
derogation of the rights of senior classes and in violation
of the absolute priority rule.
The absolute priority rule is designed to vindicate the
reasonable expectations formed by claimants when their
6. See section 174, 11 U.S.C.A. § 574, which provides in perti-
nent part:
. . . the judge shall enter an order approving the plan or
plans which in his opinion comply with the provisions of sec-
jsut kg of this title, and which are fair and equitable, and
easible....
7. See section 221, 11 U.S.C.A. § 621, which provides in perti-
nent part:
. The judge shall confirm a plan if satisfied that—
(2) the plan is fair and equitable, and feasible... .
Appendiz 29
investments or loans were made. Matter of Stirling Homex
Corp., 579 F.2d 206, 214 (2d Cir. 1978), cert. denied, 439
U.S. 1074 (1979); Slain & Kripke, The Interface Between
Securities Regulation and Bankruptey—Allocating the Risk
of Illegal Securities Issuance Between Security Holders
and the Issuer’s Creditors, 48 N.Y.U. L.Rev. 261, 286-87
(1973) (“Slain & Kripke”) ; Huff, The Defrauded Investor
in Chapter X Reorganizations: Absolute Priority v. Rule
10b-5, 50 Am. Bankr. L.J. 197, 204 (1976); Note, The Pro-
posed Bankruptey Act: Changes in the Absolute Priority
Rule for Corporate Reorganizations, 87 Harv. L.Rev. 1786,
1790 (1974). In the instant case, those expectations will not
be vindicated—instead, they will be violated—by allowing
rescission and reclamation. Kelee is in reality seeking
relief from the general unsecured creditors of the corpo-
ration. Because of USF’s insolvency and ultimate liquida-
tion, the percentage which the general creditors would
realize would be reduced were Kelce allowed to rescind
and reclaim. The absolute priority rule will not tolerate
this eventuality. Matter of Stirling Homer Corp., supra,
579 F.2d at 213; Scott v. Abbott, 160 F.2d 573, 581 (Sth
Cir.), cert. denied, 212 U.S. 571 (1908).
Professors Slain and Kripke have analyzed the expecta-
tions of shareholders and creditors. They point out that
shareholders accept two risks: the risk of business insol-
vency and the risk of illegality in securities issuance. Gen-
eral creditors also accept the risk of insolvency, but they ex-
pect that their claims will be given priority in the event of
bankruptcy. The expectation of priority is implicit in their
contracts with the issuer. 7d. at 286. Shareholders bargain
for equity-type rewards in exchange for equity-type risks,
but general creditors do not:
In theory, the general creditor asserts a fixed dollar
claim and leaves the variable profit to the stockholder;
30 Appendix
the stockholder takes the profit and provides a cushion
of security for payment of the lender’s fixed dollar
claim. The absolute priority rule reflects the different
degree to which each party assumes a risk of enter-
prise insolvency; no obvious reason exists for reallo-
cating that risk.
Slain & Kripke, supra, 48 N.Y.U. L.Rev. at 286-87.
Kelce argues that he did not bargain for equity type
risks because he received preferred stock. We note, how-
ever, that Kelce sold his Series B stock at a profit of
$500,000. While Kelce lost money on his transactions with
USF taken as a whole, he clearly took advantage of his
shareholder position in converting his Series B stock. We
will not allow Kelce to benefit from his shareholder status
when he may opt out of that status when he choses. We
note that “[w]hen a corporation becomes bankrupt, the
temptation to lay aside the garb of a stockholder, on one
pretense or another, and to assume the role of a creditor,
is very strong, and all attempts of that kind should be
viewed with suspicion.” Newton National Bank v. Newbegin,
74 F. 135, 140 (8th Cir. 1896), cited in Matter of Stirling
Homex Corp., supra, 579 F.2d at 213. Moreover, we view
the Series B transaction as an indication of Kelce’s gaining
equity-type rewards, and therefore as an indication of his
acceptance of equity-type risks.
It is also appropriate to impose the risk of illegality in
securities issuance on shareholders, even though their in-
vestment may be based on an inaccurate picture of the
corporation garnered from false financial statements.
When the rescission right is enforced in bankruptev
or reorganization .. . the effect is to allocate [the risk
of illegality in securities issuance] to general creditors.
It is difficult to conceive of any reason for shifting even
Appendiz 31
a small portion of the risk of illegality from the stock-
holder, since it is to the stockholder, and not to the
creditor, that the stock is offered.
Slain & Kripke, supra, 48 N.Y.U. L.Rev. at 288.
This scheme of risk allocation is particularly appropriate
in the instant case, Initially, every creditor and stockholder
was victimized by the massive fraud perpetrated by USF.*
In view of the extent of the fraud, it is equitable to impose
the risks of insolvency and illegality on those whose invest-
ment, by its very nature, is a risky one.® Secondly, as noted
by the bankruptcy judge in his conclusions on Kelce’s claim
for parity with general unsecured creditors,’ Kelee’s trans-
actions presented USF with an opportunity to perpetrate
its fraud:
Had the transaction been concluded as originally strue-
tured, that is as a sale on a promissory note secured
by a Deed of Trust on the property sold, USF wonld
have shown the value of the property on the asset side
subject to the liability on the note. Here however, be-
cause of the exchange of the property for stock, it made
it possible for USF to show the asset free of encum-
brances and in addition USF had the abilitv to show
on its capital contribution side the share[s] of stock
which could have misled creditors into thinking addi-
tional capital had been contributed. In other words,
Kelece gave USF the opportunity (whether it used it
or not) to flail with a double edged sword in preparing
its financial statements.
8. See Huff, The Defrauded Investor, supra, 50 Am. Bankr.
L. J. at 202-03 for a discussion of USF’s pre-petition activities.
9. Moreover, it would be manifestly unfair, in light of the ex-
tent of the fraud here, to allow Kelee to obtain secured creditor
status merely because he received stock for real property and a
— of that property remained in USF’s possession at the time
of filing.
10. See discussion infra.
32 Appendix
As between the creditors and Kelce, then, Kelce is the
lesser innocent, and Kelce should not be allowed to reclaim
the property at issue at the senior creditors’ expense.
Based on the above analysis, we conclude that the abso-
lute priority rule would be rendered meaningless were we
to allow Kelce to rescind and reclaim.’ The context of the
11. Kelce also points out that the commentators cited by the
courts below stress the rehabilitative aspects of Chapter X reorgan-
ization plans in formulating their conclusions. He argues that the
rationales relied on by those commentators do not apply to a Chap-
ter X plan of reorganization the goal of which is liquidation rather
than rehabilitation. We decline to make that distinction. The term
“reorganization plan” encompasses both plans which envision re-
habilitation and those whose goal is liquidation. See, e.g., United
States v. Key, 397 U.S. 322, 323 (1970): “The [reorganization]
plan, an atypical one for a corporate reorganization, does not con-
template the continued existence of the debtor as.a going concern,
but amounts in substance to a liquidation.” Other courts have con-
sistently noted that a Chapter X reorganization plan may provide
for liquidation and, if so, the same rules are to be applied as would
be were rehabilitation the ultimate goal. Appellants in Banker
Iife & Casualty Co. v. Kirtley, 338 F.2d 1006 (8th Cir. 1964),
for example, urged that ordinary bankruptcy provisions be applied
in a Chapter X reorganization which envisioned complete liquida-
tion. The court disagreed, recognizing that “Chapter X contains
numerous provisions not applicable to conventional bankruptcies,”
id. at 1009, including § 216(10), 11 U.S.C.A. §616(10), which
allows liquidation.
In addition, the eventual outcome of Chapter X proceedings may
not be clear at their outset. The reorganization trustee involved in
Matter of Stirling Homezx Corp., supra, 579 F.2d 206, for example,
“originally intended to formulate a plan of reorganization under
which Homex would continue operations. Borrowing proved impos-
sible, however, as did merger with or acquisition by a financially
sound company. He thus began the Herculean task of liquidating
Homex’s assets.” Id. at 209 n.4. It might well prove impossible to
reorganize a corporation were we to provide for the application of
different rules and standards to plans providing for rehabilitation
than we require for plans providing for liquidation. A trustee in
a Homez situation, where the goal of the plan changed over time,
would then have to comply with two different sets of standards.
Such confusion is unwarranted.
Finally, as we have noted, the absolute priority rule was designed
to reward expectations. Those expectations are formed at the time
Appendix 33
instant case is crucial to our holding; when all are de-
frauded, it is manifestly unfair to allow one shareholder
to benefit from that fraud at the others’ expense.
Ill. PARITY WITH GENERAL UNSECURED CREDI-
TORS
In the second case before this court, Kelee contends that
he deserves parity with general unsecured creditors since
he is a preferred shareholder asserting fraud claims. We
disagree and affirm the courts below.
Kelce filed a proof of claim in February, 1976, after
USF’s Chapter XT proceedings were converted to Chapter
X proceedings. The claim, as later amended, averred that
Kelece had been defrauded by USF in the sale of USF’s
preferred shares to him. Kelce sought general unsecured
creditor status for the difference in value between the price
paid for the Series A stock and the value of the unredeemed
shares. (If Kelee were granted parity with the general
unsecured creditors, he would receive compensation far
in excess of that he would receive as part of the class which
includes defrauded shareholders.)
The trustee subsequently filed a reorganization plan
which contemplated the liquidation of USF. As amended,
the plan divides USF’s creditors and stockholders into
several classes. Only three of these classes are relevant to
our discussion: Class 5B, which includes general unsecured
creditors’ claims, Class 6, which includes defrauded subor-
dinated debenture holders’ claims, and Class 7, including
of investment or loan, and by definition are not affected by the
ultimate goal of a reorganization plan. We would do violence to
the provisions of Chapter X were we to recognize such a liquidation-
rehabilitation distinction, and we decline to do so.
34 Appendix
defrauded shareholder claims.” Classes 5B and 6 were cre-
ated as a result of a compromise, which provided that the
defrauded equity holders were to accept a lower rank than
the general unsecured creditors, In return, they were re-
lieved of their burden of proving that they were actually
defrauded. Kelce did not participate in these negotiations,
and he subsequently objected to approval of the plan. Kelce
then entered into a stipulation with the trustee which pro-
vided that no provision of the plan would prevent Kelce
from obtaining Class 5B status.* The plan was confirmed,
Kelee filed an amended claim for $1,837,155, and the trustee
objected. |
Both the bankruptcy court and the district court below
held that Kelce is properly a member of Class 7. We agree.
12. A “creditor” for purposes of the Bankruptcy Act is a
“holder of any claim,” § 106(4), 11 U.S.C.A. § 506(4). Claims are
defined to “include all claims of whatever character against a debtor
or its property, except stock, whether or not such claims are prov-
able under section 103 of this title and whether secured or un-
secured, liquidated or unliquidated, fixed or contingent,” § 106(1),
11 U.S.C.A. § 506(1) (emphasis supplied). The reorganization plan
for the liquidation of USF, as approved by the bankruptcy court,
provides that the defrauded shareholders are creditors. For pur-
poses of this opinion we assume, without deciding, that defrauded
shareholders can be creditors. See Matter of Stirling Homex Corp.,
supra, 579 F.2d at 212.
13. The stipulation provides in pertinent part:
Herbert J. Solomon, the duly qualified and acting Trustee
... and Robert D. Kelce . . . by their respective undersigned
counsel, hereby stipulate and agree as follows:
1. Approval of the Trustee’s Restated Amended Consoli-
dated Plan of Reorganization . . . is without prejudice to, or
waiver of, the right of Kelee to contend or prove that Kelce
should be classified as a member of Class 5B of the Plan and
that he should receive all distributions allocable to him as a
member of Class 5B.
2. Paragraph 1 of this Stipulation is meant by the parties
to remove any provision of the Plan as a defense to the pos-
sible change of classification contemplated thereby and shall
not be construed as a waiver by the Trustee of any defenses
he may otherwise have to such classification change.
Appendix 35
Section 197 of the Bankruptcy Act, 11 U.S.C.A. § 597,
requires the bankruptcy judge to “fix the division of credi-
tors and stockholders into classes according to the nature
of their respective claims and stock.” This provision “ac-
cords the court a broad latitude in classification of credi-
tors, and classifications should be based on substantial
differences in the nature of claims.” Scherk v. Newton, 152
F.2d 747, 751 (10th Cir. 1945). The requirement that classes
be fixed “according to the nature of their respective claims”
requires courts to recognize differences in the rights of
ereditors which mandate differences in treatment. Matter
of Stirling Homex Corp., supra, 579 F.2d at 211, citing
Scherk v. Newton, swpra, 152 F.2d at 750,
Kelce argues that the absolute priority rule has nothing
to do with membership in a class of creditors. We disagree.
The absolute priority rule would be rendered meaningless
if inferior claimants were classified with superior claim-
ants. Courts would then have no basis for ranking clainis
as “senior” or “junior.” It is true that reorganization courts
are
given a discretionary power of classification to be exer-
cised as the exigencies of each individual case require.
* * *
Nevertheless, the power of the reorganization court
thus broadly defined has certain limits which are al-
ways present. The foremost of these is the “fixed prin-
ciple” or “absolute priority” rule of the Boyd case
which governs all reorganization plans in determining
whether they are fair and equitable. This means that
in classifying the various claims and interests, the
classes established must be accorded the priority rank
to which their claims and interests against the estate
entitle them, and the principle of absolute priority may
not be violated by any scheme of classification which
places claimants of different rank in the same category
for treatment.
36 Appendiz
6 Collier on Bankruptcy (Pt. 2) 99.10 at 1596-97 (14th ed.
1979) (emphasis supplied).
As discussed in Section II, supra, the nature of Kelce’s
claim is significantly different from that of a general unse-
cured creditor. Kelce, for example, realized a $500,000 profit
on the sale of his Class B preferred stock. As the bank-
ruptcy judge below noted, Kelce’s interest
smacks of an equity investment with the gains attend-
ant thereto....
Kelce’s position appears to be that he was satisfied
to be an equity holder while things were going well,
but now that things have turned sour, he wants another
position, that of a general creditor.
That position seems patently unfair and inequitable
to the general creditor body.
Kelee cannot be included in Class 5B because of the
nature of his claim. It is true that the reorganization plan
itself designates defrauded shareholders as creditors. But
all unsecured creditors need not be classified together. In
fact, they may not be classified together if certain claims
“are of such a nature as to give them some right of pri-
ority or preference over other claimants. These creditors,
then, must be separately classified and accorded the pri-
ority to which they are entitled.” 6 Collier on Bankruptcy
(Pt. 2) 79.13 at 1620-21 (14th ed. 1979).
Kelce contends that his claim properly belongs in Class
5B by virtue of the Supreme Court’s decision in Oppen-
heimer v. Harriman National Bank, 301 U.S. 206 (1937).
He argues that his inclusion in Class 7 therefore neces-
sarily constituted subordination without cause, We agree
with the Second Circuit, however, in concluding that Op-
penheimer is not controlling here. See Matter of Stirling
Homex Corp., supra, 579 F.2d at 211 n.8, Furthermore, we
Appendia 37
hold that Kelce’s Class 7 classification was proper'* and
that there was, therefore, no exercise of the courts’ powers
of equitable subordination.**
The Oppenheimer claimant bought stock in a bank in
1930. The bank subsequently closed, and, during liquidation,
Oppenheimer sued for rescission based on fraud. He ob-
tained a money judgment, but the Second Circuit ordered
that he not be paid until all creditors’ claims had been
satisfied. The Supreme Court reversed, holding that Oppen-
heimer’s claim was entitled to parity with other unsecured
creditors’ claims. Oppenheimer, supra, 301 U.S. at 215.
Significantly, the Oppenheimer decision was based on the
National Bank Act, 12 U.S.C. §1 et seqg., which requires
14. This court has upheld the classification of rescission claims
with claims of “holders of promissory notes which are unsecured
.’ In re Los Angeles Land & Investments, Ltd., 282 F. Supp.
448, ‘ABA (D. Hawaii 1968), aff'd, 447 F.2d 1366 (9th Cir. 1971)
(per curiam). That ease involved land sales based upon unregistered
publicly offered contracts, and is easily distinguishable from the
instant ease. The rescission claims in Los Angeles Land were held
by those who had contracted to purchase land, and not by share-
holders who had acquired equity. Moreover, the Los Angeles Land
trustee recommended, and the courts approved, the classification at
issue there. We have noted that reorganization courts have broad
discretion in classifying creditors and stockholders. We concluded
that the Los Angeles Land classification was acceptable based
absolute priority rule. In the instant case, the trustee carefully
recommended separate classification for defrauded shareholders and
general unsecured creditors, and we have concluded that that classi-
fication is the appropriate one.
15. We have not subordinated Kelce’s claim, nor have the
courts below. Kelce is responsible for his classification here. Kelce,
unlike the general unsecured creditors, had control over the manner
in which he was paid for his property. As noted above, Kelce pro-
vided. USF with an opportunity to further perpetrate its fraud.
Furthermore, Kelee converted his Class B stock at a sizable profit,
thereby accepting the rewards of an equity holder. By originally
accepting preferred stock, Kelee accepted a position subordinate to
that of general creditors, We would be unjustifiably subordinating
the ordinary unsecured creditors were we to include Keilce’s claim
within Class 5B.
38 Appendiz
“ratable” and not “fair and equitable” distribution, Two
years after the Oppenheimer decision, the Supreme Court
held that the “fair and equitable” standard required adher-
ence to an absolute priority rule in Case v. Los Angeles
Lumber Products Co., supra, 308 U.S. 106 (1939).** Our
conclusion that Oppenheimer is not controlling here is
bolstered by two subsequent Supreme Court opinions in
which the question of defrauded shareholder’s proper rank-
ing was left unanswered. See Protective Committee v.
Anderson, swpra, 390 U.S. at 423 & n. 8, 453; Tcherepnin v.
Knight, 389 U.S. 332, 346 (1967). Moreover, as discussed
infra, there would have been no compromise necessary here
had this question been authoritatively resolved by Oppen-
heimer.
Given the significant differences set out above between
Kelce’s claim and the claims of the general unsecured
creditors, we cannot hold that the classification scheme
devised here violates § 197 or § 221(2). We are not holding
that a defrauded shareholder may never be classified with
general unsecured creditors. We merely hold that, given
the particular facts of this case, the absolute priority rule
would be violated if Kelee were granted Class 5B status.”’
16. The court in Case applied the “fixed principle” of Northern
Pacific Railway Co. v. Boyd, 328 U.S. 482 (1913).
17. At oral argument, Kelce’s counsel argued that the reliance
by the courts below on the absolute priority rule was misplaced. If
that rule bars all equity holders from being classified with general
unsecured creditors, he argued, there would have been no basis for
a compromise here. We disagree. The question of whether defrauded
shareholders may achieve parity with ordinary unsecured creditors
was clearly an open question at the time of compromise. See Pro-
tective Committee v. Anderson, supra, compromise. See Protective
Committee v. Anderson, supra, 390 U.S. at 423 & n.8, 453;
Tcherepnin v. Knight, supra, 389 U.S. at 346. (In fact, Kelce’s
argument that Oppenheimer mandates the equal treatment of de-
frauded shareholders and general unsecured creditors, if valid,
would also negate any reason for compromise.) See also Matter of
Appendix 39
We note again the massive fraud which victimized every
USF shareholder and creditor. We could not countenance
a classification scheme whereby Kelce would, by virtue of
the fraud here, be allowed to share equally with defrauded
unsecured creditors who expected priority in the event
of insolvency. Since the relative expectations of the parties
would not be realized were Kelce included in Class 5B, the
absolute priority rule will not allow us to permit that
classification.
The Second Circuit recently reached much this same
conclusion in Matter of Stirling Homex Corp., supra, 579
F.2d 206, when it held that defrauded shareholders could
fairly and equitably be classified below general unsecured
creditors. The court relied on several theories in reaching
its conclusion: it stressed the necessity of classifying claims
according to the priority to which they are entitled; the
varying expectations of equity holders and of creditors,
and the general equity powers of reorganization courts.
Equity Funding Corp. of America, 416 F.Supp. 132, 151 (C.D. Cal.
1975) :
‘there is authority for the proposition that a fraud claim, even
if based upon stock acquisition, is on a parity with general
unsecured claims in a reorganization proceeding. Acceptance
of this proposition would probably violate the expectations of
all parties, because stockholders ordinarily are entitled to no
recovery from an insolvent company.
This bona fide issue has not been authoritatively resolved.
In light of this dispute, it was not unreasonable for the trustee
and the other equity holders to negotiate a compromise. Trustees
have long utilized compromises in avoidance of litigation, Protective
Committee v. Anderson, supra, 390 U.S. at 424, and the compromise
negotiated here was correctly held to satisfy the requisite “fair and
equitable” standard.
Furthermore, as outlined above, we are not holding that de-
frauded shareholders may never be classified with general unsecured
creditors. Our holding is limited to the facts of this case.
40 Appendiz
Id. at 213-14." While we do not decide the instant case on
equity grounds, we find support for our holding in the
Second Circuit’s recognition of the importance of recog-
nizing differences in expectations when classifying claims
against the debtor.
An argument might be made that Kelce, as a defrauded
preferred shareholder, was entitled to priority over the
defrauded common shareholders. In Petition of Portland
Electric Power Co., 162 F.2d 618 (9th Cir.), cert. denied,
332 U.S. 837 (1947), for example, we held that the rights
of preferred stockholders must be recognized in bankruptcy
proceedings. Jd. at 622. The stockholders in Portland, how-
ever, were classified as stockholders, not as creditors whose
claims were based on fraud. Moreover, Kelce is not arguing
that he is entitled to a different classification from that of
defrauded common shareholders; he contends that he more
properly belongs in Class 5B than in Class 7. As presented
to us, our task is to determine which of those two classes
should more properly include Kelce.” As such, we have
18. This court noted the Stirling Homez decision in In re
Equity Funding of America Securities Litigation, 603 F.2d 1353
(9th Cir. 1979). While we neither rejected nor approved the deci-
sion, we characterized its holding that defrauded shareholders
should be classified beneath ordinary unsecured creditors as the
“majority rule.” Id. at 1356 n.5.
19. At orai argument, petitioner’s counsel suggested that pre-
ferred shareholders are more similar to subordinated debenture
holders than they are to common shareholders. This argument was
not presented to the courts below and is not properly before us.
In addition, we note that the stipulation signed by Kelee and the
trustee allowed Kelee to attempt to show that he should have been
included in Class 5B, not in Class 6.
In addition, counsel for Kelce argued that the rulings of the
courts below amounted to a rescission of the stipulation between the
trustee and Kelee. This argument borders on the frivolous.
The stipulation provided that Kelce could attempt to prove that
he more properly belonged in Class 5B. He was allowed to make
that attempt; as such, he was not precluded from making an
attempt by virtue of an existing, approved plan. The stipulation
did not mandate that Kelce be included in Class 5B; it merely
allowed him to raise the claim.
Appendix 41
determined that Kelce was correctly placed in Class 7. In
addition, we note that due to USF’s insolvency, none of the
equity holders would receive any compensation were it
not for the compromise negotiated by the trustee and the
other equity holders. Classifying Kelce with the common
shareholders, therefore, does not do violence to the pro-
visions of the Bankruptcy Act.
Finally, we note that Congress has now expressly pro-
vided that defrauded shareholders’ claims be classified be-
low those of general unsecured creditors. See § 510 of the
Bankruptcy Reform Act of 1978, 11 U.S.C.A. § 510(b)
(1979) .”
Accordingly, we AFFIRM.
20. Section 510 of the Bankruptcy Reform Act of 1978 provides
in pertinent part:
(b) Any claim for recission [sic] of a purchase or sale of
a security of the debtor or of an affiliate or for damages
arising from the purchase or sale of such a security shall be
subordinated for purposes of distribution to all claims and
interests that are senior or equal to the claim or interest
represented by such security.
(ec) Notwithstanding subsections (a) and (b) of this sec-
tion, after notice and a hearing, the court may—
(1) under principles of equitable subordination, sub-
ordinate for purposes of distribution all or part of an al-
lowed claim to all or part of another allowed claim or all
or part of an allowed interest to all or part of another
allowed interest ....
42 Appendix
Filed
Nov. 24, 1980
Richard Deane
Clerk U.S. Court of Appeals.
In the
United States Court of Appeals
For the Ninth Circuit
No. 78-2802
Bankruptcy No. 17007
7%
In re U.S. Frvanciau INCORPORATED,
a Delaware Corp. & Affiliates,
Debtors.
Rosert D, Ketce,
Plaintiff-Appellant,
vs.
U.S. Frvanciar [ycorporaten,
a Delaware corporation, and affiliates,
and Swan Constructors, Inc., a Cali-
fornia corporation,
Defendant-A ppellee.
ORDER
Before: SKOPIL and FERGUSON, Circuit Judges, and
LYDICK,”® District Judge
. The panel as constituted in the above case has voted to
deny the petition for rehearing. Judges Skopil and Fergu-
son voted to reject the suggestion for rehearing en banc
and Judge Lydick made no recommendation regarding the
en banc request.
The full court has been advised of the suggestion for en
bane rehearing and no judge of the court has requested a
vote on the suggestion for rehearing en banc.
Fed. R. Ap. P. 35(b).
The petition for rehearing is denied and the suggestion
for rehearing en banc is rejected.
*Honorable Lawrence T. Lydick, United States District Judge,
Central District of California, sitting by designation.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.