Before L. HAND, Chief Judge, SWAN and CHASE, Circuit Judges.
This appeal brings up for review an order with respect to the claims of three creditors, the appellees, in an arrangement proceeding under Chapter XI of the Bankruptcy Act, 11 U.S.C.A. § 701 et seq. The debtor, Calton Crescent, Inc., was formerly the owner of an apartment house located in New Rochelle, New York. In January, 1946, it sold the apartment house, which was its only property, and in May 1946 filed its petition for arrangement. Thereafter the purchase price received for the property was converted into cash, and the debtor is now able to pay a dividend in its arrangement proceeding of 43.61% to the holders of its debenture bonds. The appellees, being the holders of certain of such bonds, filed claims based thereon for the face amount thereof. The appellant, Manufacturers Trust Company as trustee under the indenture pursuant to which the debenture bonds were issued and in its individual capacity as a creditor,*fn1 filed objections to the appellees' claims on the ground that the circumstances under which their bonds were acquired make it equitable to subordinate their claims to those of the other debenture holders so as to limit the dividends payable to the appellees to what the bonds actually cost them. The referee in bankruptcy dismissed the objections and allowed the appellees claims at their face amount. This order was confirmed by the district court, 80 F.Supp. 822, and the objector has appealed. The legal questions presented are, first, whether the issue as to subordination is to be determined by state law or federal law and, second, whether, under the law found applicable, the appellees' dividends should be limited as the objector contends.
As to the first question the appellant is right - federal law controls the distribution to creditors in bankruptcy. The Supreme Court has declared the rule very definitely. In Prudence Realization Corporation v. Geist, 316 U.S. 89, at page 95, 62 S. Ct. 978, at page 982, 86 L. Ed. 1293, the court said; "* * * The court of bankruptcy is a court of equity to which the judicial administration of the bankrupt's estate is committed, Securities and Exchange Commission v. United States Realty & Improvement Co., 310 U.S. 434, 455-457, 60 S. Ct. 1044, 1053, 1054, 84 L. Ed. 1293, and it is for that court - not without appropriate regard for rights acquired under rules of state law - to define and apply federal law in determining the extent to which the inequitable conduct of a claimant in acquiring or asserting his claim in bankruptcy requires its subordination to other claims which, in other respects, are of the same class."
Later cases have reiterated the rule. American Surety Co. v. Sampsell, 327 U.S. 269, 272, 66 S. Ct. 571, 90 L. Ed. 663; Heiser v. Woodruff, 327 U.S. 726, 732, 66 S. Ct. 853, 90 L. Ed. 970; Vanston Bondholders Protective Committee v. Green, 329 U.S. 156, 161-163, 67 S. Ct. 237, 91 L. Ed. 162. For earlier cases on the general subject, see Pepper v. Litton, 308 U.S. 295, 303-304, 60 S. Ct. 238, 84 L. Ed. 281; American United Mut. Life Ins. Co. v. City of Avon Park, 311 U.S. 138, 146, 61 S. Ct. 157, 85 L. Ed. 91, 136 A.L.R. 860. From these decisions we understand the rule to be that, a although the state law determines the title, validity and amount of a claim, the bankruptcy law, including what federal judges think to be equitable, determines what dividends shall be distributable to the claimant. In other words, in addition to those modifications which the Bankruptcy Act itself has imposed upon distribution with respect to preferences, priorities and the like, the courts must impose any other modifications which they deem necessary in the interest of justice.
In the case at bar validity and amount of the bonds held by the appellees are not in dispute; nor is the legal title. The appellant does contend, however, that it is inequitable to allow them to recover full dividends. The amount of their respective claims and the cost thereof are as follows:
Claimant Face am't of bonds Cost
Regine Becker $44,500 $3,060.63
Emily K. Becker 52,800 5,010.00
Walter A. Fribourg*fn2 50,000 2,124.80
The aggregate dividend payable upon the three claims amounts to $64,237.53, while the aggregate cost of their bonds to the claimants was only $10,195.43. The difference, namely, $54,042.10, the appellant contends, must be distributed under equitable bankruptcy principles to the other holders of debenture bonds. These holders whose bonds aggregate $107,150 (including the $5,000 of bonds mentioned in note 2, supra) will therefore receive approximately 94% of the face value of their claims. Before passing to a consideration of the equitable principles which are said to require this rather extraordinary result, a statement of the facts should be made.
The debtor was organized in 1933 to take title to the New Rochelle apartment house pursuant to a plan of reorganization necessitated by the foreclosure of a mortgage executed in 1927. Under this plan a new first mortgage of $175,000 was placed on the property and the debtor issued its debenture bonds, in the authorized principal amount of $256,800, which were to mature in 1953 and to bear interest, not exceeding 6% per annum, if declared by the directors out of net earnings for each calendar year. These bonds, together with the debtor's capital stock, were issued to the holders of participation certificates in the old 1927 mortgage, one share of stock and $50 of debenture bonds being exchanged for each $100 of participation certificates. The total amount of debentures issued was $254,450, debentures of the face amount of $2,350 being retained for certificate holders who had not deposited their certificates. No interest has ever been paid on the debenture bonds.
Early in 1942 the debtor submitted to its shareholders an offer from a prospective purchaser to pay $220,000 for the apartment house, but the proposed sale did not obtain the requisite approval by the stockholders. Had the sale been approved the debenture bondholders would have received about five cents on the dollar on the face amount of their bonds. One who opposed the sale was Sanford Becker, the holder of 50 shares of stock and $5,000 face amount of debentures. Being in default under its first mortgage the debtor was in a precarious condition. Sanford Becker offered to find a client who would lend the debtor $15,000 upon a second mortgage on condition that he and his brother Norman Becker be given places on the debtor's five man board of directors and be allowed to select the real estate agent to manage the property; the debtor imposed the further condition that all shareholders and debenture holders be given an opportunity to participate in the proposed second mortgage. In April 1942 this offer was accepted by the debtor, but none of its shareholders or debenture holders except Fribourg, availed themselves of the opportunity to participate in the second mortgage. The Becker brothers were then elected directors; Sanford became treasurer and Norman secretary, and Mr. Kelly continued as president. Sanford Becker's clients who lent the money secured by the second mortgage were his mother, Regine Becker, his wife, Emily K. Becker and his friend, Walter A. Fribourg.They each advanced $5,000.*fn3 Neither of the Becker ladies was a shareholder or debenture holder at this time; Fribourg had shortly before acquired 50 shares of stock and $5,000 of debentures.*fn4 On three occasions thereafter, when the debtor again came into default under its first mortgage, the appellees advanced further sums, aggregating about $8,000, to enable such defaults to be cured.*fn5 These further advances were repaid without interest during 1945. The second mortgage was always in default from the end of 1942 but the appellees never threatened to foreclose it and, after the debtor's property was sold in January 1946, it was paid in full with interest. In October 1943 when both the first and second mortgages were in default the appellees obtained an assignment of rents;*fn6 the property, however, continued to be operated, as before, by the same managing agent. In the summer of 1944, the three directors other than the Becker brothers, sold their stock and debentures and resigned as officers and directors of the debtor. Their places as directors were filled by nominees of the Becker brothers, and Norman Becker became president in place of Mr. Richard Kelly.
There is no contention that the conduct of the appellees above recounted was "inequitable." It was obviously very beneficial to those debenture holders who retained and have proved their bonds in the arrangement proceeding. It forestalled foreclosure by the first mortgagee, and enabled the debtor to retain its property until it could be sold for a price of $300,000, which is enough to enable all debenture holders to receive a dividend of 43.61% on the face amount of their bonds. No complaint is made as to the price at which the debtor sold, nor ...