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Sept. 15 — Money may be fungible, but the source of sale proceeds can have a big impact for creditors in bankruptcy as one secured creditor learned the hard way.
Judge James E. Shadid struck down the decision of the bankruptcy court, which essentially decided one creditor could be paid from the proceeds of a farm sale, even though the creditor didn't have a lien on the farm. The bankruptcy court elected to pretend the proceeds had actually come from the sale of certain farm equipment and crops, on which the creditor did have a lien, even though they were actually sold years earlier.
That approach didn't go over well with Shadid, who found that once the equipment and crop sale proceeds had been distributed, the bankruptcy court couldn't just conjure them back into the bankruptcy estate under the theory that money is fungible.
The bankruptcy court relied on a doctrine called marshaling, which isn't found in the Bankruptcy Code, but is routinely used by bankruptcy courts. Marshaling is used when one creditor has a lien on a debtor's asset, but another creditor has a lien on multiple assets.
“The doctrine requires the senior creditor to exhaust the funds it has sole access to before proceeding against the collateral in which the junior lender also holds an interest,” according to Bloomberg Law: Bankruptcy Treatise.
In this case, senior creditor First Community Bank (FCB) had a lien on the debtors' farm as well as their equipment and crops. Junior creditor West Central FS, Inc. only had a lien on the equipment and crops.
The debtors had filed for Chapter 12, a chapter of the Bankruptcy Code exclusively designed to protect family farmers and family fishermen. After the crops and equipment were sold but before those proceeds were distributed, West Central asked the court to require FCB to marshal its liens against the farm, which would free up the proceeds from the other assets for West Central. At this point, the debtors were aiming to keep their farm under their Chapter 12 plan.
The bankruptcy court initially denied marshaling, finding that it would be “grossly inequitable to force FCB to forego the immediate payment of the equipment proceeds.” The court also rejected a settlement proposal West Central offered as an alternative to marshaling.
“As applied by Illinois courts, marshaling is an either/or proposition,” the bankruptcy court said. “If the proper conditions for its application are not present, marshaling is rejected and the junior creditor is left with the natural consequences of its subordinate status.” But the bankruptcy court added that the outcome might be different if the farm was sold. The crop and equipment proceeds were then distributed to FCB with no objection by West Central.
When the debtors weren't able to get their Chapter 12 plan confirmed, they converted their case to a Chapter 7 liquidation and eventually sold the farm. West Central once again sought marshaling, and this time the bankruptcy court agreed, despite objections from the debtors, the bankruptcy trustee, and the IRS.
“The effect of marshalling is to treat FCB's claim, now satisfied, as having been paid from the proceeds of the real estate first and then the crop proceeds second, thus freeing up the net equipment proceeds for full allocation to West Central and the remaining portion of the crop proceeds to West Central as well, to the extent of its allowed claim,” the bankruptcy court said.
The district court rejected this retroactive approach to marshaling. It said that invoking marshaling requires: “(1) the existence of two creditors of the same debtor; and (2) the existence of two funds belonging to a common debtor; with (3) only one of the creditors having access to both funds; and with (4) the absence of prejudice to the senior secured creditor if the doctrine is applied.”
The court found that the bankruptcy court's “reservation of West Central's marshaling request” in the event of a future farm sale was “inconsistent with [its] analysis that marshaling is an either/or proposition — the factors for marshaling are present or they are not.” The court agreed that the elements for marshaling didn't exist when the bankruptcy court first denied it, and found that those elements were never subsequently present after the crop and equipment proceeds were distributed.
At the time the second marshaling request was made, the debtor didn't have two funds because the crops and equipment had long been sold and the proceeds distributed. After the proceeds were distributed, West Central ceased to be a secured lien holder. When the bankruptcy court ordered marshaling, FCB was actually the only remaining lien holder with its lien on the farm sale proceeds. Therefore, the court found that the requirements for marshaling weren't present and reversed the bankruptcy court's decision.
The court added that while West Central was to some extent a “victim of timing,” it was “not blameless,” noting that it failed to object to the distribution of the proceeds to FCB.
“Had West Central objected and prevailed, and the funds not been distributed to FCB and stayed in the estate, there would have arguably been two funds available when the real estate was sold,” the court said. The court was unmoved by West Central's claim that the only reason it didn't object was because it was relying on the bankruptcy court's assertion that the issue could be revisited if the farm was sold.
Carrie L. Magerl of Magerl, Gross & Associates, Jacksonville, Ill., represented the debtors.
D. Robert Lindstrom of Lindstrom Law, Galesburg, Ill., represented West Central.
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