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Durham v. Smi Industries Corp.

decided: August 17, 1989.


Appeal from the United States District Court for the Western District of North Carolina, at Charlotte. Robert D. Potter, Chief District Judge. CA-87-454-P-C-C.

Ervin, Chief Judge, and Hall and Wilkins, Circuit Judges.

Author: Wilkins

WILKINS, Circuit Judge:

SMI Industries, Inc., a creditor of Continental Commodities, Inc., appeals from the district court judgment affirming a bankruptcy court ruling that its receipt of a check as part of a check exchange by the two companies constituted an avoidable preferential transfer under the Bankruptcy Code, 11 U.S.C.A. § 547(b) (West 1979). We reverse and remand.*fn1


SMI and Continental are scrap metal dealers that until November 1983 engaged in a substantial amount of business with each other, selling each other materials on open account. Although the total dollar figures of the open account invoices often grew quite large, the net balance due either party at any one time was relatively small. Periodically, in order to reduce these account debts, SMI and Continental would either make mutual accounting entries cancelling corresponding debts and credits, or they would exchange checks for the outstanding balances. The check exchanges were carefully coordinated to allow simultaneous deposits in their respective bank accounts to ensure that the checks would clear.

In late August 1983 SMI and Continental made such a check exchange. Continental sent SMI 17 checks totalling $273,137.62 from August 25 to August 26, representing amounts it owed SMI for invoiced deliveries from September 3, 1982 to June 28, 1983. On August 29 SMI sent Continental its check for $271,967.20 for invoiced deliveries by Continental from February 22, 1983 through August 16, 1983. Both parties deposited the checks into their bank accounts on August 30.

On November 18, 1983, less than 90 days later, Continental filed a petition in bankruptcy under Chapter 7. See 11 U.S.C.A. §§ 701, et seq. (West 1979 & Supp. 1989). In November 1985 Continental's Trustee filed an adversary action against SMI seeking to recover $273,137.62, which represented the total amount of the checks Continental had sent SMI as part of the check exchange. The bankruptcy court held in favor of the Trustee, finding that Continental's remittance of the checks to SMI constituted avoidable preferential transfers, 11 U.S.C.A. § 547(b) (West 1979), that were not part of a valid setoff under 11 U.S.C.A. § 553 (West 1979). The bankruptcy court ruled in the alternative that since 11 U.S.C.A. § 502(d) (West 1979) prohibits a creditor who refuses to disgorge a preference from asserting a claim against the estate, and since the Trustee had brought other preference actions against SMI,*fn2 SMI was precluded from asserting that it had exercised a valid right of setoff.

The district court affirmed, finding that SMI's payment constituted a transfer under the Code, which defines "transfer" very broadly in 11 U.S.C.A. § 101(50) (West Supp. 1989) (formerly § 101(40) (West 1979)), and was a preference under section 547. Durham v. SMI Indus., Inc., 90 Bankr. 162 (W.D.N.C. 1988). The district court refused to consider whether the check exchange was a valid setoff since it found that SMI had failed to appeal the bankruptcy court's alternative holding that section 502(d) barred SMI from asserting that the transfer was part of a valid setoff.*fn3


Section 547(b) provides that a trustee may avoid, and proceed to seek recovery of, any transfer made by a debtor to a creditor within 90 days prior to filing for bankruptcy that has the effect of enabling that creditor to receive more than it would in the bankruptcy proceeding had the transfer not been made. However, under section 553(b), a valid setoff executed within 90 days of the date of the filing of a bankruptcy petition is nonetheless protected from avoidance under section 547, except for any insufficiency. Where a pre-petition setoff is asserted in defense to a proceeding brought by a trustee the court must first determine whether the setoff is valid under section 553. Only if the court finds the setoff invalid, and further concludes that no right of setoff exists in bankruptcy, is section 547 applied. See In re Hinson, 65 Bankr. 675, 677 (Bankr.W.D.Tenn. 1986). We hold that the lower courts erred by attempting to resolve this case under section 547 after SMI asserted that it and Continental had completed a pre-petition setoff of their mutual debts.


Before we can determine whether the setoff was effective, we must address whether SMI is barred from asserting a setoff pursuant to section 502(d). Section 502(d) provides, in pertinent part, that "the court shall disallow any claim of any entity from which property is recoverable under section . . . 550 [providing for recovery of avoided transfers] . . ., unless such entity . . . has paid the amount . . . for which such entity or transferee is liable." Since a court can only disallow a claim after one has been filed under 11 U.S.C.A. § 501(a) (West 1979), "claim" in section 502(d) includes only one for which a proof has been filed. Setoff, however, "is an affirmative defense which must be pled and proven by the party asserting it." First Nat'l Bank v. Hurricane Elkhorn Coal Corp. II, 763 F.2d 188, 190 (6th Cir. 1985). SMI, in asserting that the check exchange constituted a setoff of mutual debts, was not seeking to assert a "claim" against the bankruptcy estate. To the contrary, SMI was asserting that because the check exchange was a valid setoff under section 553(b), the corresponding debts were cancelled.

Section 502(d), therefore, does not preclude a defendant in an adversary proceeding from asserting the affirmative defense of pre-petition setoff merely because the trustee has asserted that the defendant has failed to disgorge an unrelated preference. Having concluded that SMI's designation of issues presented on appeal to the district court challenged the bankruptcy court holding that section 502(d) bars SMI from asserting the affirmative defense of pre-petition setoff, we reverse and hold that SMI was entitled to ...

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