Memorandum of Decision Re: Postconfirmation Subordination

IN THE UNITED STATES BANKRUPTCY COURT FOR THE NORTHERN DISTRICT OF CALIFORNIA
In re FOODSOURCE, INC.,                                                    No. 1-84-00703      Debtor. ___________________________/ In re FOODSOURCE SALES CORP.,                                       No. 1-84-00869      Debtor. ____________________________/ CHARLES SIMS,      Plaintiff,    v.                                                                                      A.P. No. 92-1134 FOOD PRESERVATION RESEACH, LTD., and FOOD PRESERVATION RESEARCH 1981,      Defendants. ______________________________/
Memorandum of Decision
I. Introduction      The two debtors were in essence failed tax shelters. Investors purchased shipping containers at inflated prices, with most of the purchase price in the form of a long-term note. The income stream from the containers was supposed to be sufficient to service the the notes, so that the investors would never have to actually pay on the note, but they could deduct the note amount in their income tax returns. Not surprisingly, there was no little or no income stream and the tax courts disallowed the investors' deductions. Along with thousands of investor claims totalling over $300 million, about 300 general creditors with claims totalling about $5 million were left unpaid when the bankruptcy petitions were filed.      The confirmed Chapter 11 plan in this case, proposed jointly by the Trustee and the creditors' committees, places the general unsecured creditors in a separate class from the investors and provides that they be paid before funds are distributed on account of most investor claims. There were no objections to this treatment, and the court found it fair and equitable to treat the totally innocent creditors more favorably than those who had been motivated by the hope of a tax shelter.      Defendants Food Preservation Research, Ltd., and Food Preservation Research 1981, have filed claims totalling almost $600,000.00. They assert that these claims should be allowed in Class 3 with the general unsecured creditors. The former trustee, now the liquidating agent under the plan, has brought this action for a declaration that defendants' claims belong in Class 6 with the investors.
II. Appropriateness of Postconfirmation Subordination
     The court was resistant to this action when it was filed because generally speaking the confirmation of a plan is supposed to be the end of litigation. However, a careful review of the plan makes it clear that postconfirmation subordination actions were both provided for by the plan and necessary to give the plan its intended effect. The propriety and necessity of this action is now clear to the court. In fact, the definition of Class 6 specifically includes claims which the court determines should be subordinated. The disclosure statement also gave full and fair notice that postconfirmation subordination actions might be brought.
III. Sale of Securities
     The definition of Class 6 specifically includes claims arising out of the sale of securities. In prior motions in this case, the court decided that the claims of the two defendants did not arise out of the sale of securities and were therefore not automatically subject to subordination under section 510(b) of the Bankruptcy Code. Now that the court better understands the nature of defendants' claims, it sees that it was wrong in its initial analysis. Defendants' claims are clearly based on the sale of securities as that term is defined both under nonbankruptcy law and (more importantly, now that a plan has been confirmed) under the terms of the plan itself.
IV. Equities of the Case
     The two defendants in this adversary proceeding, Food Preservation Research, Ltd., and Food Preservation Research 1981, are limited partnerships created by the debtors as an alternative form of tax shelter. While most investors paid a cash down payment and gave the debtors a large note for the purchase of a shipping container, these defendants gave some cash and large notes to the debtors for "research and development." The notes of the other investors were to be paid from income derived from the containers; the notes of these defendants were to be paid from "royalties" from patents obtained by the research. Just as there was never any significant income from the containers, there were never any significant royalties from the research.       While the form of their investment was different, there is no difference in substance between defendants and the other investors. The other investors purchased containers individually or fractionally; these defendants invested in partnership form. The other investors paid cash down for a shipping container; defendants paid about the same amount of cash for research. The other investors gave a large note for phantom income; defendants gave a large note for phantom royalties. The motivation for other investors was the promise that they would have a tax deduction for the full amount of their note and not really have to worry about paying it; that was the same motivation as defendants had.      Defendants take the position that since they were victims of the debtors and did no wrong themselves, they cannot be subordinated. While culpable conduct may be necessary for equitable subordination outside the confines of a confirmed plan, when a plan is confirmed which provides for different classes of unsecured claims the task for the court is simply to place each claim in with like claims, so that no creditor receives a windfall and the purpose of the plan is not thwarted.      The purpose of the plan in this case is to pay the relatively smaller class of true creditors in full before paying a dividend to the larger class of investors who became ensnared in this bankruptcy by trying to get a tax shelter rather than merely extending credit. The purpose of the plan would be thwarted if the dividend of the general unsecured creditors was diluted by the claims of the defendants, and the defendants would receive an unintended windfall. The court's role in equity is to see that defendants' claims are placed in the proper class. That class is Class 6, along with the other investors who tried and failed to obtain a tax shelter too good to be true.      For the foregoing reasons, judgment shall be entered in favor of plaintiff declaring that defendants' claims are allowed as Class 6 claims. Plaintiff shall also recover any costs of suit.      This memorandum constitutes the court's findings and conclusions pursuant to FRCP 52(a) and FRBP 7052. Counsel for plaintiff shall submit an appropriate form of judgment forthwith.
Dated: December 20, 1993                                                                           _______________________                                                                                                                      Alan Jaroslovsky                                                                                                                      U.S. Bankruptcy