Summary of a Recent
Judicial Development in
Bankruptcy

Trustee's Motion To Compromise
PACA Claims Denied

Harrison M. Pittman
Staff Attorney

The United States Bankruptcy Court for the Eastern District of California has denied a bankruptcy trustee's motion to compromise the claims made by two claimants to the proceeds resulting from the settling of three adversary proceedings. In re Churchfield, 277 B.R. 769 (Bankr. E.D. Cal. 2002). The district court denied the motion to compromise because the bankruptcy trustee failed to make the necessary prima facia showing of a real and substantial factual or legal controversy. See id. at 777. The bankruptcy court ruled that the proceeds collected by the bankruptcy trustee were not part of the debtors' Perishable Agricultural Commodity Act trust, but instead were property of the estate under section 541(a)(3) of the bankruptcy code. See id. at 775.

Charles and Jamie Churchfield, debtors, filed a Chapter 7 bankruptcy petition on January 14, 1998. See id. at 772. The debtors owned and operated a sole proprietorship through which they purchased perishable agricultural commodities. See id. The debtors were subject to the Perishable Agricultural Commodity Act ("PACA") regulations and licensing requirements, including the PACA statutory trust provisions set forth in section 499e(c)(2). See id.

The statutory trust provision of the PACA , 7 U.S.C. Sec. 499e(c)(2), provides that:

Perishable agricultural commodities received by a commission merchant, dealer, or broker in all transactions, and all inventories of food or other products derived from perishable agricultural commodities, and any receivables or proceeds from the sale of such commodities or products, shall be held by such commission merchant, dealer, or broker in trust for the benefit of all unpaid suppliers or sellers of such commodities or agents involved in the transactions . . . .

Id. at 775 (emphasis supplied).

The PACA trust "applies to all of the debtors' produce-related inventory and proceeds thereof, regardless of which produce supplier was the source of the inventory." Id. Moreover, "[n]o specific tracing of inventory or proceeds is required; and it is the debtor, or the trustee opposing the PACA trust, who must determine which assets, if any, are subject to the trust." Id. (citing In re Fresh Approach, Inc., 51 B.R. 412, 422 (Bankr. N.D. Tex. 1985)).

The debtors made several preferential transfers in September and October of 1997 to third parties that had previously supplied goods and services to the debtors. See id.The trustee filed four adversary proceedings to recover the value of these preferential transfers. See id.Three of the adversary proceedings resulted in settlements and were approved by the bankruptcy court as compromises of controversies. See id. The trustee collected approximately $16,000.00 as a result of these settlements. See id.

Lamb-Weston, Inc., and J.R. Simplot Company ("PACA claimants") asserted rights against the settlement recovery proceeds. See id. The PACA claimants contended that they were entitled to the settlement proceeds because they were beneficiaries of a PACA trust held by the debtors. See id.

After reviewing the PACA claimants' demands and the relevant case law, the trustee conceded that the PACA trust extended to the settlement recovery proceeds. See id. at 773. However, the trustee claimed an offset for the cost of pursuing the adversary proceedings and for collecting the settlement proceeds. See id. The trustee negotiated a compromise with the PACA claimants with respect to the offset issue whereby $13,801.37 of the approximately $16,000.00 in settlement proceeds would be given to the PACA claimants. See id. The remaining funds would be used to cover the estate's administrative expenses. See id. The trustee filed a motion to compromise the claims asserted by the PACA claimants'. See id. at 772.

The court noted that a bankruptcy trustee has "express authority to compromise a controversy or settle a dispute affecting the administration of the estate, subject to court approval." Id. at 773 (citing Fed. Rule of Bankr. P. 9019). The court also noted that a bankruptcy court "has a duty to make an informed, independent judgment as to the reasonableness of the proposed compromise." Id. at 773-74 (citing Protective Committee for Independent Stockholders of TMT Trailer Ferry, Inc. v. Anderson (TMT Trailer Ferry), 390 U.S. 414, 424 (1968)). The court stated that a bankruptcy court examining the "fairness, reasonableness, and adequacy of a proposed settlement must consider . . . (a) the probability of success in the litigation, (b) the difficulties, if any, in the matter of collection; (c) the complexity of the litigation involved and the expense, inconvenience and delay necessarily attending it; and (d) the paramount interest of the creditors and a proper deference to their reasonable views." Id. at 774 (citing In re A & C Properties, 784 F.2d 1377, 1381 (9th Cir. 1986)). The court added that "[i]mplicit in the A & C Properties test is the foundational requirement that the trustee must make a prima facia showing of a real and substantial controversy over the facts and/or the application of the law." Id. Finally, the court explained that "'[t]he bankruptcy court must carefully weigh the value of the settled claim against the value to the estate by the settlement.'" Id. (quoting In re Hermitage Inn, Inc., 66 B.R. 71, 72 (Bankr. D. Colo. 1986)).

The bankruptcy court stated that the fundamental question in this case was "whether the funds recovered through the trustee's avoiding powers are subject to the PACA trust or whether they are property of the bankruptcy estate." Id. at 773. The court explained that "[e]ven though there may be a real controversy over the trustee's right of offset, that issue is not reached unless the [settlement proceeds are] actually subject to the PACA trust, or unless the court can also find that there is a real and substantial controversy on the PACA trust issue." Id.

Bankruptcy Code Sec. 541(a)(3) states that property of the estate includes "[a]ny interest in property that the trustee recovers under section . . . 550 . . . of this title." Id. Section 550(a) states that "'to the extent that a transfer is avoided under section . . .
547. . . of this title, the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property . . . .'" Id. The four adversary proceedings in this case were initiated by the trustee pursuant to section 547.

Based on its interpretation of the PACA Sec. 499e(c)(2) and Bankruptcy Code Secs. 550 and 541(a)(3), the bankruptcy court concluded that the settlement recovery was property of the bankruptcy estate and was not part of the PACA trust. Id. at 775. Examining the language of PACA Sec. 499e(c)(2), the court noted that the settlement recovery was not a "perishable agricultural commodity," that it was not "an inventory of food or other product derived from an agricultural commodity," and that it was not "a receivable or proceed from the sale of such commodities or products." Id. The court stated that "[b]y settling the adversary proceedings, the trustee did not recover PACA trust assets; he recovered a negotiated amount based upon the estimated 'value' of the avoidable transfers to the estate." Id. (citing Sec. 550(a)). The court added that it was "implausible to assume that the funds paid to settle the adversary proceedings over two years later were traceable to the same proceeds." Id.

The bankruptcy court noted that it made its decision despite the fact that many other courts have examined the language of Bankruptcy Code Sec. 541(d) and "have universally recognized that any property held by a debtor in a statutory PACA trust is excluded from the bankruptcy estate." Id. at 776 (citing C & E Enterprises, Inc. v. Milton Poulos, Inc. (In re Milton Poulos, Inc.), 107 B.R. 715, 718 (9th Cir. BAP 1989) and In re Fresh Approach, 51 B.R. at 419) (observing that the proposition that PACA trust assets are not property of the estate is "'so widely accepted as to be beyond dispute'")). Bankruptcy Code Sec. 541(d) provides that:

[p]roperty in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest . . . becomes property of the estate under subsection (a)(1) and (a)(2) of this section only to the extent of the debtor's legal title to such property, but not to the extent of an equitable interest in such property that the debtor does not hold.

Id. at 776.

Section 541(a) provides that property of the estate:

is comprised of all the following property, wherever located and by whomever held: (1) Except as provided in subsections(b) and (c)(2) of this section, all legal or equitable interests of the debtor in property as of the commencement of the case. (2) All interests of the debtor and the debtor's spouse in community property as of the commencement of the case . . . .

Id. at 774.

The bankruptcy court did not follow the proposition "universally recognized" by other courts because section 541(d) only qualified the assets defined in subsections (a)(1) and (a)(2), and the settlement proceeds involved in this action were "deemed to be property of the estate under Sec. 541(a)(3), not subsections (a)(1) and (a)(2)." Id. The court also reasoned that the trustee's right to avoid preferential transfers and the right to recover the value of an avoided transfer both "uniquely vest in the trustee and do not come into existence until after the bankruptcy case is commenced," and that the settlement funds involved in this action "did not come into existence until the Trustee settled the adversary proceedings with the preference defendants, over a year after the case commenced." Id.

The court also rejected the bankruptcy trustee's argument that an offset was necessary and appropriate in order to preserve some assets for the estate. See id. at 777. The trustee relied on Bank of Los Angeles v. Official PACA Creditors' Committee (In re Southland + Keystone), 132 B.R. 632 (9th Cir. BAP 1991)) for the proposition that "PACA trust assets collected by a third party and disgorged to the PACA trust beneficiaries, may be subject to offset to compensate the disgorging party for its hard collection costs." Id. at 773. The court stated that the facts in Southland + Keystone were distinguishable because in that case the debtor's prepetition accounts receivable fell within both the statutory definition of a PACA trust under 7 U.S.C. Sec. 499e(c)(2) and the 'trust' exclusion under 11 U.S.C. Sec. 541(d)," whereas the settlement funds at issue in the present case do not fall within either criteria. Id. at 777. Therefore, the court determined that the Southland + Keystone ruling was "not applicable to establish that there is a real and substantial controversy between the trustee and the PACA claimants, or that the proposed compromise of controversy over the offset issue is fair and equitable." Id.

The court concluded that there was not "a real and substantial factual or legal dispute sufficient to warrant the surrender of 83% of the estate to the two PACA claimants." Id. The court added that "[w]eighing the cost of the proposed compromise against the value to the estate, the court cannot conclude that the compromise is reasonable or in the best interest of the estate." Id.

This case summary was prepared in August, 2002.