Appeal from the United States District Court for the Northern District of Indiana, South Bend Division. No. 84 C 591-William C. Lee, Judge.
Richard A. Posner and John L. Coffey, Circuit Judges, and Hubert L. Will, Senior District Judge.*fn*
This appeal requires us to examine the Bankruptcy Code's provision on set offs, which states that the Code "does not affect any right of a creditor to offset a [prebankruptcy] mutual debt owing by such creditor to the debtor . . . against a [prebankruptcy] claim of such creditor against the debtor." 11 U.S.C. § 553(a). The debtor, Elcona Homes Corporation, was (and still is, for this is a reorganization case) a manufacturer of mobile homes. Shortly before it went broke, Linda Markle had ordered a mobile home from one of its dealers, Monro Homes, Inc. The price was $36,700. Markle paid $14,000 down, and Elcona agreed to sell the home to Monro for $22,700. This was, of course, the difference between the retail price and the amount of the down payment; so the latter amount represented Monro's profit.
Payment of the balance was to be due when Monro delivered the home to Markle and set it up for her. Green Tree Acceptance, Inc., the creditor in the case, agreed to finance Markle's purchase by giving Monro $22,700 in exchange for an assignment of the installment contract that Monro had signed with Markle. So instead of making her monthly payments to Monro, Markle would make them to Green Tree, and Green Tree's profit would come from the interest it charged Markle. Upon receipt of the $22,700 from Green Tree, Monro would remit an equal amount to Elcona to pay for the mobile home. The parties refer to the type of arrangement by which Green Tree financed Monro's business as "retail proceeds" financing. It bears a family resemblance to the more common "floor-planning" system of dealer financing, but there the lender takes a security interest in the goods before the dealer sells them and here it was afterward.
This was not the first time that Green Tree had financed Monro's sales of Elcona homes; and a practice had developed of Green Tree's paying Elcona directly rather than paying Monro for remittance to Elcona. This meant that instead of Green Tree's paying Monro $22,700 for the installment contract and Monro's then turning around and paying Elcona $22,700 for the mobile home, Green Tree would be expected simply to pay $22,700 to Elcona. Elcona preferred this arrangement, since it protected it (how far we shall see) against the risk of Monro's defaulting. This was not only the practice between the parties but also, they have stipulated, the practice generally followed in the mobile home industry.
Elcona's bankruptcy occurred after the sale to Markle but before Green Tree had paid Elcona. Now it happened that Elcona owed Green Tree $16,000 (more or less) on an earlier transaction. Green Tree decided to set off this debt against the $22,700 that normally it would have sent directly to Elcona, and therefore sent Elcona only the difference between $22,700 and $16,000 (actually somewhat less, but like the exact amount owed Green Tree in the earlier transaction, that is a detail of no importance to this appeal). The bankruptcy judge did not consider this a proper set off. Since the $22,700 was not a debt that Green Tree owed Elcona but a debt it owed Monro, there was no mutual indebtedness between Elcona and Green Tree, as the statute requires. (Elcona adds that Green Tree was really just an escrow agent of Monro, Elcona's real debtor.) The district judge (after a procedural bobble recounted in In re Elcona Homes Corp., 810 F.2d 136 (7th Cir. 1987)) reversed the bankruptcy judge. He thought the evidence showed "a mutuality of obligations between Green Tree and Elcona and vice versa because it was both the industry practice and the practice between the parties for the lender (Green Tree) to pay the manufacturer (Elcona) directly the amount due the manufacturer from the dealer. That being the case, Green Tree was entitled to setoff the debt owed it by Elcona." Elcona appeals.
The set-off provision in the Bankruptcy Code seems at first glance inconsistent with the usual result in bankruptcy, which is that all unsecured creditors are treated alike ("equity is equality"). But it is no more than the usual result precisely because the principle that unsecured creditors shall be treated alike is riddled with exceptions. There are all sorts of preferences (for the Internal Revenue Service, for employees having wage claims, for persons who extend credit to the debtor after the petition for bankruptcy is filed, etc.) and discriminations (e.g., against creditors treated preferentially on the eve of bankruptcy). And it might be more accurate to say not that there is a principle (however qualified) of equal treatment among creditors but that bankruptcy provides a mechanism for enforcing pre-bankruptcy entitlements given by state or federal law, with some exceptions. But the idea of equal treatment is a useful as well as persistent one. An important purpose of bankruptcy law is to prevent individual creditors from starting a "run" on the debtor by assuring them that they will be treated equally if the debtor is precipitated into bankruptcy, rather than being given either preferential treatment for having jumped the gun or disadvantageous treatment for having hung back.
The principle is not absolute, as we have stressed, but its exceptions generally are intelligible; and we will be helped in determining the scope of the set-off exception -- which on its face is arbitrary -- if we can understand its rationale, too.
Set offs outside of bankruptcy are in no wise anomalous or problematic; no third party's rights comparable to those of unsecured creditors in bankruptcy are affected, and circuitous proceedings are avoided. But in bankruptcy an unsecured creditor fortunate enough to owe his debtor as much as or more than the debtor owes him can, by setting off his debt against the debtor's, in effect receive 100 cents on the dollar, while the other unsecured creditors, who have nothing to set off against the debtor, might be lucky to collect 10 cents on the dollar. The difference in treatment seems based on a fortuitous difference among the unsecured creditors, and therefore arbitrary. Let us inquire further.
Although the right of set off has been a part of Anglo-American bankruptcy law since 1705, see Act of 4 Anne, ch. 17, § 11, its rationale has never been made clear. To say that it "recognize[s] the possible injustice in compelling a creditor to file its claim in full and accepting possible dividends thereon, while at the same time paying in full its indebtedness to the estate," 4 Collier on Bankruptcy para. 553.02, at p. 553-10 (King 15th ed. 1988) (footnote omitted), is to say very little; for why is it not an equal or greater injustice to advance one unsecured creditor over another merely because the first happens also to be owed money by their common debtor? Nor is it helpful to point out that "it is only the balance which is the real and just sum owing by or to the bankrupt," Prudential Ins. Co. v. Nelson, 101 F.2d 411, 43 (6th Cir. 1939), for if the set off is allowed, the other unsecured creditors will not receive "the real and just sum owing" to them.
The only sense we can make of the rule is that it recognizes that the creditor who owes his debtor money is like a secured creditor; indeed, the mutual debts, to the extent equal, secure each party against the other's default. This reasoning figured in Congress's decision to retain the right of set off in the 1978 overhaul of bankruptcy law. See the useful discussion in Comment, Setoff in Bankruptcy: Is the Creditor Preferred or Secured?, 50 U. Colo. L. Rev. 511, 519-23 (1979). The reasoning may seem circular, however, for it is only by virtue of the Bankruptcy Code's preserving the right of set off that the creditor has, in the event of his debtor's bankruptcy, a form of security for the debt he is owed. (But of course not all defaulting debtors are bankrupt.) And one might suppose that if the theory of the set off is that it provides the creditor with security, the creditor would have to prove that the parties had intended a right of set off as a means of securing the creditor--that is, would have to prove that the creditor had been counting on the right in extending credit to the debtor on the terms he did. See Columbia Aircraft Co. v. United States, 163 F. Supp. 932, 934 (S.D.N.Y. 1958) (L. Hand, J.). But such proof is not in fact required.
Banks argue that the right to set off deposits (a bank deposit is a debt of the bank to the depositor) against the depositor's debts to the bank facilitates the provision of bank credit and lowers the rate of interest, by giving the bank security in the event of the depositor's going broke. But the more secure the bank is, the less secure the depositor's other creditors will be, so they will charge higher interest rates. This, however, is a general characteristic of secured lending. The secured lender faces a lower risk of loss in the event of default and therefore will lend at a lower interest rate, but unsecured lenders, facing a higher risk of loss because fewer assets will be available to satisfy their claims in the event of default, will charge higher interest rates. Nevertheless secured financing is so firmly established a commercial practice that it is hard to believe it does not serve important commercial purposes, and it is fairly apparent what they might be: lenders differ in their ability to monitor their borrowers (in order to prevent the borrower from increasing the riskiness of its activities) and to bear risk, and thus a combination of secured and unsecured financing enables a borrower to appeal to the different capabilities and preferences of different lenders.
Yet if deposits are intended to secure the bank's loans, why not treat the bank as a secured creditor rather than creating a general right in all creditors to set off their debts against the bankrupt's debts to them? Maybe the answer is simply that set offs are just another form of secured financing that the Bankruptcy Code has decided to recognize, though under a different name and with different restrictions. But the underlying rights of creditors which are asserted in bankruptcy proceedings are the creation of state law, not of the Bankruptcy Code; for the general principle see Butner v. United States, 440 U.S. 48, 54-57, 59 L. Ed. 2d 136, 99 S. Ct. 914 (1979), and for its application to set offs see Boston & Maine Corp. v. Chicago Pacific Corp., 785 F.2d 562, 565 (7th Cir. 1986). Maybe the right question to ask, therefore, is not why the Code allows set offs (for it also allows secured creditors to withdraw their collateral from the pool available to other creditors), but why it places restrictions on them. Against this view of set offs as a species of secured financing, however, it can be argued that, apart perhaps from such special situations as that of banks dealing with their depositor-borrowers, set offs are recognized in state law for their procedural convenience -- the consolidation of offsetting claims in the same suit -- and that this convenience should receive little weight in bankruptcy. Professor Gilmore thought the express exemption of set offs from the filing requirements in Article 9 (secured financing) of the Uniform Commercial Code, see § 9-104(i), was absurd: "Of course a right of setoff is not a security interest and has never been confused with one: the statute might as appropriately exclude fan dancing." 1 Gilmore, Security Interests in Personal Property § 10.7, at pp. 315-16 (1965). This view seems extreme and has been questioned, see Clark, The Law of Bank Deposits, Collections and Credit Cards para. 11.3 (rev. ed. 1981); see also id., para. 1.8; 4 Collier on Bankruptcy, supra, para. 553.15, but certainly there is no evidence here that the existence of mutual debts (if that is what they were) between Elcona and Green Tree reflected a desire by the parties to secure each other's obligations; it appears to have been an accident.
But we need not resolve these questions, or press our inquiry into the rationale for the Bankruptcy Code's treatment of set offs further, in order to decide this case. Whether that treatment reflects a felt tension between the right of set off and the normal practice in bankruptcy of treating unsecured creditors equally, or whether one denies the tension, points out that the recognition by state law of a right of set off makes the set off a form of secured financing, and argues (contrary to our earlier point) that there really is no policy of treating unsecured creditors in bankruptcy equally, the statute itself speaks of a "a mutual debt" (emphasis ours), see 4 Collier on Bankruptcy, supra, paras. 553.04, , and therefore precludes "triangular" set offs. See, e.g., ...