By Lisa M. Goolik, J.D.
A creditor, West Central FS, Inc., could not force a senior creditor, First Community Bank (FCB), to marshal its lien against a couple’s bankruptcy estate so that West Central’s secured claim in the debtors’ crops and equipment could be enforced against the proceeds from a sale of the debtors’ equipment that were distributed to FCB in 2011. Under the equitable doctrine of marshaling, a creditor that has a claim to two funds to satisfy his debt may not apply them in a way that defeats another creditor who may resort to only one of the funds. Although FCB also held a secured claim in the proceeds from the sale of the debtors’ farm realty, the U.S. District Court for the Central District of Illinois concluded that, at the time of West Central’s motion in 2013, marshaling was not an appropriate remedy. Because the funds were already distributed, there were no longer two funds in the debtors’ estate to satisfy FCB’s lien—a crucial element for marshaling (Ferguson v. West Central FS, Inc., Sept. 11, 2015, Shadid, J.).
Background. The debtors filed a petition for Chapter 12 bankruptcy protection in 2010. At the time, FCB had a mortgage against the debtors’ farm and a perfected security interest in their equipment and crops in the amount of $297,000. West Central held a perfected junior security interest in the equipment and crops for approximately $176,000, but did not have a claim against the farm realty.
In an attempt to pay off their debts, the debtors sold their equipment in August 2010 for $170,000. In 2011, FCB requested that the net equipment proceeds be distributed to it, and West Central requested that the bankruptcy court require FCB to marshal its liens against the realty to free up the proceeds of equipment and crops for West Central’s junior lien. Finding that it would be “grossly inequitable” to force the senior creditor, FCB, to accept a long-term secured claim in the realty, the bankruptcy court denied the request and ordered the equipment proceeds to be distributed FCB.
When the debtors were unable to confirm a Chapter 12 plan, largely due to significant tax liabilities, they voluntarily converted their case to Chapter 7. After conversion, the Chapter 7 trustee sold the debtors’ farm, and FCB received $128,000 in satisfaction of the remainder of its claim. Including the property transferred from the bankruptcy conversion, the estate was left holding $246,000.
Noting the court had previously indicated that liquidation of the farm might change its decision, West Central renewed its argument that FCB be forced to marshal its liens against the realty, effectively treating FCB’s distribution in 2011 as if paid from the sale of the farm and allowing West Central to recover from the remaining estate. Over the objections of the debtors, trustee, and the United States (seeking to recover its tax bill), the bankruptcy court granted West Central’s request.
Two funds. According to the court, the traditional elements of marshaling are: (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. While it was undisputed that West Central satisfied the first element, the court concluded that West Central failed to prove the remaining three elements.
At the time that West Central’s restated request for marshaling was granted, the debtors did not have two funds available to them, said the court. Although West Central believed the debtors held two funds stemming from the liquidation of the real estate and sale of the crops and equipment, the court noted that the proceeds from the crops and equipment were no longer part of the estate when the bankruptcy court ordered marshaling in 2013—they were already distributed to FCB in 2011.
In addition, when the proceeds were distributed to FCB, West Central’s security interest in the debtor’s crops and equipment ceased to exist, leaving West Central as an unsecured creditor. Accordingly, because the only monies that remained were from the proceeds of the sale of the realty, FCB was the only remaining lienholder.
Lastly, although West Central argued marshaling can be applied, despite injury to any third parties, as long as it does not prejudice creditors with an equal or senior interest, the court concluded that West Central was not on equal footing at the time marshaling was ordered. After the distribution, FCB remained a secured creditor, whereas West Central was an unsecured creditor.
Failure to object. While noting that there are few winners in bankruptcy, the court also noted that West Central could have taken additional steps to protect its interest. After the bankruptcy court denied its initial request for marshaling and allowed distribution of the equipment and crops proceeds to FCB, West Central should have filed an objection to the distribution of the equipment and crops proceeds, wrote the court. Had West Central objected and prevailed, the funds would have stayed in the estate, and there would have arguably been two funds available when the real estate was sold.
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