Before LUMBARD, Chief Judge, and MOORE and FRIENDLY, Circuit Judges.
This is an appeal from an order directing appellant, Fore Improvement Corporation (the landlord), to turn over to the trustee in bankruptcy (appellee), $1,750, which had previously been deposited as security by the bankrupt, TruSeal Aluminum Products Corp. (the tenant), under a written lease between it and appellant.
The lease was executed on November 19, 1955, on which date the deposit was received by the landlord as security. The tenant failed to pay rent for the months of December 1957 and January 1958. The landlord by court process was awarded possession of the premises on February 13, 1958. On March 4, 1958, a default judgment against the tenant for arrears of rent and damages in the amount of $3,012.82 was entered in the District Court of Nassau County. On March 10, 1958, an involuntary petition in bankruptcy was filed and on April 11, 1958, the tenant was adjudged a bankrupt. Appellant concedes that at all times the $1,750 has been deposited in its general bank account, in violation of section 233, New York Real Property Law.*fn1
The appellee purporting to assert the tenant's rights to the deposit sought an order directing appellant to turn over the deposit to him. The Referee so directed and the district court confirmed the order. The question now before the court is whether the appellant may setoff its creditor claim upon the judgment for unpaid rent against the trustee's claim for the return of the deposit.
Section 233 provides that any rent deposit "shall continue to be the money of the person making such deposit"; it "shall be held in trust"; "shall not be mingled with the personal moneys" or "become an asset of the person receiving the same." The trust character of the deposit is thus clearly established.If commingled, a trust is still created by operation of law.
Little benefit is gained by speculating on the legal consequences of steps not taken by the parties. New York cases indicate that commingling would give rise to an action for conversion (Mallory Associates v. Barving Realty Co., 1949, 300 N.Y. 297, 90 N.E.2d 468, 15 A.L.R.2d 1193; 2710 Eighth Ave., Inc. v. Frank Forman Pharmacy, Inc., 1943, 180 Misc. 376, 42 N.Y.S.2d 887). There was no such action. When the rent was in arrears and the landlord commenced an action therefor, a set-off might have been pleaded but no such defense was interposed. Only after bankruptcy were there any proceedings directed towards the deposit calling for any declarations of its legal status. Then, and only then, was the question of the effect of possible mutual obligations raised. But the right to set-off is determined by the provisions of section 68 of the Bankruptcy Act,*fn2 notwithstanding the fact that the obligations involved are creatures of state law.*fn3 And it is clear that the requirement of mutuality in section 68 precludes set-off where the party asserting it holds in trust the funds sought by the trustee in bankruptcy.*fn4 "In general where the liability of the one claiming a set-off arises from a fiduciary duty or is in the nature of a trust, the requisite mutuality of debts or credits does not exist, and such person may not set off a debt owing from the bankrupt against such liability" (4 Collier, Bankruptcy (14th ed.) 726). The rationale of this rule is simply that the liability arising from a fiduciary duty is entirely independent of the debt owing from the bankrupt. Cf. Topas v. John MacGregor Grant, Inc., 2 Cir., 1927, 18 F.2d 724, 52 A.L.R. 807. There is no mutuality because the indebtedness is "all on the side of" the bankrupt, Libby v. Hopkins, 104 U.S. at page 309, supra, note 4; the trust res is not owing to the bankrupt's estate but rather is owned by it. Since section 233 makes the landlord a trustee by operation of law, appellant does not qualify under the setoff provisions of the Bankruptcy Act. Sommers v. Timely Toys, Inc., 2 Cir., 1954, 209 F.2d 342.
Appellant argues that the trust relationship exists only while the deposit is kept separate and that upon commingling "the trust [is] dissolved subject to reinstatement" (In re Smith, 2 Cir., 1959, 263 F.2d 153, 155); hence, the conversion of the trust assets alters the relationship to that of debtor and creditor. thus, contends appellant, there are offsetting debor-creditor claims. However, the existence of a chose in action for conversion does not create a creditor status.
Appellant also argues that it is anomalous for the district court to disallow a set-off here, when the New York courts will grant a set-off of rent due in an action brought by the tenant to recover the commingled deposit. Pollack v. Springer, 1949, 196 Misc. 1015, 95 N.Y.S.2d 527.*fn5 Moreover, it is pointed out that at any time prior to the commencement of the action, by the simple ceremony of setting apart necessary to correct an earlier commingling the landlord's right to security might have been revived. 160 Realty Corp. v. 162 Realty Corp., Sup., 113 N.Y.S.2d 618, affirmed 1952, 280 App.Div. 762, 113 N.Y.S.2d 678. But this ceremony was not performed; the deposit remained commingled.
Section 233 is emphatic in its language and is declarative of the public policy of New York State in prohibiting the commingling of rent security deposits. The statute may appear to be highly technical but such statutes frequently have to be literally construed to obtain the desired compliance. Nor is it of any moment that New York law may permit set-off where the tenant seeks to recover his deposit. As noted above, federal law determines the right, if any, to set-off in an action brought by a trustee in bankruptcy. Congress has the power to create the governing rule for the rights and obligations that stem from actions affecting bankrupt estates.*fn6 Section 68 of the Bankruptcy Act represents an exercise of such power. Compare Clearfield Trust Co. v. United States, 1943, 318 U.S. 363, 63 S. Ct. 573, 87 L. Ed. 838 and D'Oench, Duhme & Co. v. Federal Deposit Ins. Corp., 1942, 315 U.S. 447, 62 S. Ct. 676, 86 L. Ed. 956, with Austrian v. Williams, 2 Cir., 1952, 198 F.2d 697, certiorari denied 344 U.S. 909, 73 S. Ct. 328, 97 L. Ed. 701. The determination of set-off would seem to be intimately related to the distribution of the bankrupt's assets, the essential basis for federal concern. Appellant, seeking to retain the rent deposit to extinguish pro tanto its judgment for unpaid rent, thereby asserting a set-off, is, in effect, seeking a priority and hence is barely distinguishable from the adverse claimant who "submits himself to the jurisdiction of the bankruptcy court to resolve certain equities among the claimants which have special relevance in the context of distribution in insolvency." Hill, The Erie Doctrine in Bankruptcy, 66 Harv.L.Rev. 1013, 1046 (1953). Furthermore, aside from its obligation to apply federal law, a New York court might incline toward a different view where a trustee brings the claim as opposed to a tenant suing in his own right. The trustee in bankruptcy represents the totality of the bankrupt's creditors, a group into which the landlord here should fall without a preference since, by virtue of the section 233 violation, it failed to obtain for itself the rights thereunder which compliance would have bestowed.