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In re Ollag Construction Equipment Corp.


June 26, 1978


Appeal and cross appeal from an order of the Western District of New York, John T. Elfvin, Judge, affirming a judgment of the Bankruptcy Court that appellant's security interest in the bankrupt's property is void as against appellee. Reversed and remanded to the Bankruptcy Court on appeal of Manufacturers and Traders Trust Co. Affirmed on cross appeal of Karl Goldman.

Kaufman, Chief Judge, Feinberg, Circuit Judge, and Werker, District Judge.*fn*

Author: Kaufman

KAUFMAN, Chief Judge:

When financial storms rage, unsecured creditors take on collateral as ballast. The security thus gained is often tenuous, however, for if bankruptcy is involved, it may be dissolved by the trustee's challenge. In this case, we are called upon to decide whether Manufacturers & Traders Trust Company ("the Bank") may enforce a security interest in the property of the bankrupt Ollag Construction Equipment Corp. ("Ollag"), or whether, as Ollag's trustee contends, the Bank's claim is a voidable preference under § 60 of the Bankruptcy Act.*fn1 Since we believe that the courts below inadequately considered the crucial issue of Ollag's solvency when the security interest was created, we reverse and remand to the bankruptcy court for further findings.


Ollag's financial demise was triggered when the construction business operated in Lancaster, New York, by the four Gallo brothers - Leopold, Anthony, Michael, and James - fell on hard times. An equipment leasing firm, Ollag was but one of the three corporate constituents of this family enterprise. It was a wholly-owned subsidiary of Deplan Contracting Inc. ("Deplan"), a construction firm that accounted for more than ninety percent of Ollag's rentals. The third Gallo corporation, Sheldon Builders Supply Corp. ("Sheldon"), owned the real estate quartering the Deplan and Ollag facilities.

In late 1972, the Gallos learned that Deplan's financial condition was grave because approximately $300,000 in accounts payable had not been recorded in the company's books. Deplan's creditors became aware of this state of affairs in January 1973, as Deplan began to default on a number of construction projects. Meetings were held to discuss refinancing the stricken business. The principal creditor participants were the Bank and the Travelers Indemnity Company ("Travelers"). The Bank held Deplan's note in the sum of $200,000, collateralized by a security interest in equipment Deplan owned separately from Ollag. It had also obtained a mortgage on Sheldon's real estate, and payment guaranties from Ollag and the Gallos and their wives. Travelers had written performance and payment bonds for Deplan's projects, and Ollag, Sheldon, and the Gallos had also agreed to indemnify Travelers against liability on these bonds,*fn2 a fact of which the Bank claims ignorance.

While the discussions continued, the security interest at issue in this case came into being. In February 1973, Leopold Gallo, Ollag's president, executed at the Bank's request a chattel mortgage on Ollag's inventory and equipment to serve as security for Ollag's guaranty of Deplan's note.*fn3 The proposed refinancing never occurred. By March 1973, it was readily apparent that, even with an infusion of new funds, Deplan would soon be insolvent again. Although Deplan attempted to avert disaster by filing a petition under Chapter XI to rearrange its debts, even that maneuver failed. To no one's surprise, Deplan was adjudicated a bankrupt.

In June, Travelers, having undertaken to finish Deplan's construction projects after the latter's default, filed an involuntary petition against Ollag. The Bank, without delay, submitted a reclamation petition asserting its security interest in Ollag's equipment. The trustee counterclaimed, seeking an avoidance of the Bank's claim.*fn4 The rather complex issues presented by these stratagems are now before us. Bankruptcy Judge McGuire decided that the Ollag security interest was invalid both under New York law and as a voidable preference under § 60 of the Bankruptcy Act. On review by the district court, Judge Elfvin reversed the determination that the security interest transgressed New York law, but affirmed the judgment on the basis of § 60. Both the Bank and the trustee appealed.


We have little difficulty in disposing of the trustee's contention on his appeal that the security agreement was void because it did not further any of Ollag's corporate purposes and had not been ratified by Ollag's shareholders in accordance with N.Y. Bus. Corp. Law § 908.*fn5 It is clear that the security agreement did in fact serve a valid corporate purpose by attempting to avert the bankruptcy of Ollag's parent and principal customer, Deplan.*fn6 Accordingly, under N.Y. Bus. Corp. Law § 202(a)(7), shareholder ratification of the agreement was unnecessary.*fn7

Nevertheless, the trustee argues that even if shareholder approval was not required, the security agreement is without force because Leopold Gallo, president of Ollag, did not have authority to execute it on its behalf. But Leopold's right to act for Ollag was conclusively established by a resolution adopted by Ollag's board of directors before any suggestion of trouble in the Gallo enterprises. It granted any one officer of Ollag authority to execute security agreements with the Bank on behalf of Ollag. Accordingly, we have no hesitation in finding that the security agreement complied with New York law.*fn8


We now turn to the trustee's assertion that the Bank's security interest in Ollag's inventory and equipment is a voidable preference. The Bank argues that of the seven prerequisites for voidability under § 60 of the Act,*fn9 the trustee has failed to establish two. It asserts that Ollag was not insolvent when the security interest was taken and, moreover, that the Bank did not have reasonable cause to believe that Ollag was then insolvent. We remand for further findings on both issues.


A debtor is insolvent under the Bankruptcy Act if "the aggregate of [its] property . . . shall not at a fair valuation be sufficient in amount to pay [its] debts."*fn10 For purposes of § 60 of the Act, insolvency is determined as of the time of the alleged preferential transfer.*fn11

In February 1973, Ollag's physical assets consisted entirely of construction equipment valued at approximately $100,000 to $165,000.*fn12 Its only liabilities of any significance were its contingent obligations as guarantor of Deplan's note and as indemnitor on Deplan's performance and payment bonds. But these liabilities were tied to certain intangible assets. For example, although the face amount of Ollag's guaranty on Deplan's note was $200,000, Ollag had a right of subrogation to recover against Deplan on the Bank's claims. Moreover, Ollag could demand contribution from the co-guarantors, Sheldon and the Gallos. Similarly, Ollag's indemnity liability to Travelers might have been offset by a recovery over against Sheldon and the Gallos, who were also co-indemnitors. All of this leads us to the conclusion that there were important factors weighing on the question of Ollag's insolvency which were not considered below.

Learned Hand's landmark opinion in Syracuse Engineering Co. v. Haight, 97 F.2d 573, 576 (2d Cir. 1938), taught us that contingent subrogation and contribution rights must be valued as assets in determining solvency. See also Updike v. Oakland Motor Car Co., 53 F.2d 369, 371 (2d Cir. 1931); Wingert v. President Director & Company of Hagerstown Bank, 41 F.2d 660 (4th Cir.), cert. denied, 282 U.S. 871, 75 L. Ed. 769, 51 S. Ct. 77 (1930). Cf. Schwartz v. Commissioner of Internal Revenue, 560 F.2d 311, 317 (8th Cir. 1977). In the case at bar, we are left in murky obscurity regarding the actual value of Ollag's contingent assets. The courts below treated Ollag's subrogation right against Deplan as effectively valueless.*fn13 It is obvious, however, that, holding a valid security interest in Deplan's equipment as collateral for the $200,000 note, the Bank could expect to collect a substantial portion of its debt even if Deplan were insolvent. Indeed, the Bank eventually recovered approximately $139,000 through the sale of Deplan's equipment. As subrogee, Ollag was the successor to all of the Bank's rights against Deplan, including the Bank's security interest in Deplan's equipment. N.Y.U.C.C. § 9-504(5). See, e.g., First National Bank v. Jefferson Sales & Distributors, Inc., 341 F. Supp. 659 (S.D. Miss. 1971), aff'd per curiam, 460 F.2d 1059 (5th Cir. 1972). Accordingly, we must conclude that the bankruptcy judge's finding, affirmed by Judge Elfvin, that Ollag's subrogation right against Deplan was of minimal worth is clearly erroneous.

But we must also consider the extent, if any, of Ollag's liability to Travelers under the indemnity agreement. The Bank contends that the trustee has failed to meet his burden of proof in establishing this liability, see Cohen v. Sutherland, 257 F.2d 737 (2d Cir. 1958), and if it is excluded, Ollag was almost certainly solvent in February 1973.*fn14 On the record before us, however, we cannot agree. Although the liability was not specifically assessed below, there is evidence in the record from which a valuation might be estimated.*fn15 We leave the question of the sufficiency of this evidence to the bankruptcy court in the first instance. Accordingly, we reverse the determination that Ollag was insolvent in February 1973 and remand to the bankruptcy court for specific findings of the value, as of February 1973, of:

(1) Ollag's physical assets;

(2) Ollag's right of subrogation to the Bank's secured claim against Deplan;

(3) Ollag's rights of contribution against Sheldon and the Gallos as co-guarantors of Deplan's note to the Bank and co-indemnitors on Travelers' performance and payment bonds;

(4) Ollag's expected liability to Travelers under the indemnity agreement covering the performance and payment bonds, assuming that liability is established.

These assessments are to be made with "such detail and exactness as the nature of the case permits." Kelley v. Everglades Drainage District, 319 U.S. 415, 420, 87 L. Ed. 1485, 63 S. Ct. 1141 (1943). We recognize that valuation of contingent assets and liabilities is an arduous task, and on occasions only approximations can be made. For this reason, reversals under Bankruptcy Rule 752*fn16 are appropriate only when the reviewing court cannot determine the basis of the ruling below. In re D.H. Overmyer Co., 510 F.2d 329 (2d Cir. 1975). Nevertheless, although we do not decide whether the decision below would have passed muster under Rule 752 absent the clear undervaluation of Ollag's subrogation claim against Deplan, we note that more detailed findings originally could have obviated the need to remand the case.


Since we do not decide whether Ollag was insolvent when the security interest was taken, we cannot resolve the related question whether the Bank had reasonable cause to believe that the debtor was insolvent at that time. But we must conclude that, as a sophisticated creditor deeply involved in Deplan's financial woes and well aware of the close relationship between Deplan and Ollag, the Bank was "on inquiry" with respect to matters affecting Ollag's financial condition. See In re Hygrade Envelope Corp., 366 F.2d 584, 588-89 (2d Cir. 1966); Miller v. Wells Fargo Bank International Corp., 406 F. Supp. 452, 464-65 (S.D.N.Y. 1975), aff'd, 540 F.2d 548, 555-56 (2d Cir. 1976). Proper inquiries would certainly have disclosed the existence of Ollag's indemnity agreement with Travelers. Accordingly, we hold that the Bank is chargeable with knowledge of that arrangement. If the bankruptcy court determines on remand that Ollag had a negative net worth in February 1973, it should then consider whether, with knowledge of all information available upon diligent inquiry into the Gallo enterprise's affairs, the Bank would have had reasonable cause to conclude that Ollag was insolvent.

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