Bank Argues Court Correctly Found Government Waived Setoff Rights

Calore Express Co. filed a bankruptcy petition and then received court permission to borrow money from Fleet National Bank to continue operating. In return, Calore granted the bank a senior lien and a security interest in its post-petition assets. Calore owed payroll taxes to the IRS. The IRS made no mention of setoffs in its claims. The General Services Administration (GSA) owed Calore some money. Later, the IRS filed a motion stating that its pre-petition claims were subject to offsetting with the money due to Calore from the GSA. This motion was opposed by Fleet National Bank and Calore. In the process, an IRS attorney informed the GSA's collection branch that it should freeze all payments to Calore so it could determine the offset.

The bankruptcy court found that the IRS attorney's action violated the automatic stay and suggested that the government effectuate its offsets by seeking relief from the automatic stay. After a hearing, the court denied the government's stay motion, finding that it waived its right to assert its setoff claims. The court held that even if its rights weren't waived, the bank's security interest in Calore's accounts receivable trumped the government's setoff rights. See In re Calore Express Co., No. 96- 12212-RGS (Feb. 24, 1998) (For a summary, see Tax Notes, March 30, 1998, p. 1639; for the full text, see Doc 98-10319 (14 pages) or 98 TNT 57-17 .)

A U.S. district court upheld the bankruptcy court's decision, finding that post- and pre-petition setoffs are subject to the same limitations and, thus, the bankruptcy court had jurisdiction to rule on them at the lift-stay hearing. The court also found that the bankruptcy court correctly assumed jurisdiction over the government's setoff motion as part of a core proceeding and because any setoffs against Calore's accounts receivable would have an impact on a bankruptcy court decision regarding the administration of the estate. The court concluded that the bankruptcy court did not abuse its discretion in holding that the government waived setoff rights. (For a summary of this opinion, see Tax Notes, Dec. 25, 2000, p. 1730; for the full text, see Doc 2000-33666 (25 original pages) or 2000 TNT 245-12 .)

Fleet Bank argues that both the district and bankruptcy courts correctly concluded that the government waived its setoff rights. The bank maintains that the bankruptcy court acted within its discretion in concluding that the government did not have a valid claim for setoff and that both the bankruptcy court and the district court did not err in examining the government's actions and corresponding after effect on the debtor's and Fleet's rights. It also insists that the automatic stay imposed under the bankruptcy code applies to the setoff of post-petition obligations and claims. Finally, the bank contends that the bankruptcy court correctly held that the bank's secured interest has priority over the government's claimed setoff right.

Fleet Boston Financial Services is the parent corporation of Fleet National Bank which is the successor, by merger, to Appellee Fleet Bank of Massachusetts.

There are no publicly held companies that own 10% or more of the stock of Appellee Fleet Bank of Massachusetts.

TABLE OF CONTENTS

[1] In this appeal, Appellant United States of America (the "Government") is seeking further appellate review of an order denying relief from an automatic bankruptcy stay. Although neither party raised the issue of jurisdiction below, this Court must first establish that it may exercise jurisdiction before embarking on the merits of the appeal. Williams v. United States (In re Williams) 215 B.R. 289, 297 (D.R.I. 1997). This Court's jurisdiction is called into question by a case decided after the District Court's decision was rendered. In re Henriquez, 261 B.R. 67 (1st Cir. BAP 2001).

[2] It is settled law in this jurisdiction that orders GRANTING relief from stay are, for purposes of 28 U.S.C. section 158(a)(1), final orders subject to appeal. However, the Court in Henriquez concluded that orders denying relief from stay may, in some instances, be interlocutory in nature and therefore not appealable. As such, a "blanket final order label should not be affixed . . . without analysis of the nature and posture of the underlying dispute." In re Henriquez, 261 B.R. at 71. This Court must first determine whether the bankruptcy court's order "completely resolved all of the issues pertaining to the claim including the issues pertaining to relief." Id. at 70 (quoting Pegasus Agency, Inc. v. Grammatikales (In re Pegasus Agency, Inc.), 101 F.3d 882, 885 (2nd, Cir. 1996)).

[3] The facts in Henriquez are substantially similar to the case at bar. In Henriquez, the order denying relief from stay decided only that the creditor failed to convince the bankruptcy court "that it had a sufficiently colorable (senior) claim" to warrant relief. Id. at 71-72. The court determined that the issues between the parties were not finally resolved and must await determination of the trustee's adversary proceedings and thus, the order denying relief from stay was not yet "final." Similarly, in the case at bar, the Government failed to convince the Bankruptcy Court that it had a sufficiently colorable claim to set off certain accounts receivable. As in Henriquez, such a determination is not "final." As such, the Government's appeal must be dismissed.

STATEMENT OF ISSUE PRESENTED FOR REVIEW

[4] Did the Bankruptcy Court and the District Court properly deny the Government's Motion for Relief from Stay in which the Government belatedly sought to setoff against taxes owed by the Debtor to the Government certain receivables due from the Government to the Debtor where Appellee Fleet Bank of Massachusetts (the "Bank" or "Fleet") held a superpriority lien in connection with those receivables and had previously been granted relief from stay in order to collect those receivables?

STATEMENT OF THE CASE

[5] This appeal represents the Government's third try at convincing a Court that it should be permitted relief from the automatic stay in the Bankruptcy proceeding. The Government argued below and argues here that it is entitled to setoff certain monies owed by the General Services Administration ("GSA") to the debtor, Calore Express Company, Inc. ("Debtor"), against certain tax obligations allegedly owed by the Debtor to the Internal Revenue Service ("IRS"). By virtue of an order of the Bankruptcy Court entered at the commencement of the bankruptcy proceedings and renewed on numerous occasions throughout the course of those proceedings, Fleet held a superpriority lien on the Debtor's accounts receivable, including those GSA monies. (JA:61) ¹ As a result of a June 17, 1996 Order of the Bankruptcy Court, the Bank was permitted to exercise its rights to collect those GSA receivables. (JA:643)

[6] However, unbeknownst to the Court, the Bank or the Debtor, the Government's counsel had previously instructed the GSA not to pay those receivables. When the Government's action was eventually discovered by the Debtor, the Bankruptcy Court (Hillman, J.) ruled that the Government had violated the automatic stay. The Court entered an order requiring the Government to immediately release its instructions to the GSA not to pay the accounts receivable. (JA:673) The Government did not appeal this Order and complied with the Order.

[7] Subsequently, the Government filed a motion before the Bankruptcy Court seeking relief from the automatic stay in order to effect a setoff of additional GSA monies owed to the Debtor against certain post-petition tax liabilities which the Debtor had allegedly incurred. (JA:674) On August 21, 1996 the Bankruptcy Court issued the Memorandum of Decision and Order at issue in this case, denying the Government's motion to setoff. (JA:833, 859) The Government appealed that Order to the United States District Court which affirmed the Bankruptcy Court's Order and denied the Government's appeal. (BA:3A) This appeal followed.

STATEMENT OF RELEVANT FACTS

[8] As the Bankruptcy Court noted in its Decision, the facts supporting its denial of the Government's Motion for Relief from Stay are "not in dispute" (JA:834) and are all found in the record from the proceedings below.

1. FLEET HAD A SUPERPRIORITY LIEN THROUGHOUT THE BANKRUPTCY COURT

3. The Liens to be created and granted as provided in paragraph

3. THE GOVERNMENT EXPRESSLY DISCLAIMED ANY RIGHT TO SETOFF.

[11] The Government first filed a Request for Payment of certain taxes allegedly owed to the IRS on Nov. 20, 1995. (JA:99) The Government filed another Request for Payment on Dec. 5, 1995. (JA:100) Neither of these Administrative Claims contained any mention of setoff. (Id.)

[12] In addition, the Government filed a Proof of Claim on Dec. 7, 1995 in connection with its claim for unpaid taxes. (JA:101) That Proof of Claim specifically provided that "THIS CLAIM IS NOT SUBJECT TO ANY SETOFF OR COUNTERCLAIM." (JA:102) (emphasis added) In addition, the Proof of Claim stated that:

The amount of all payments on this claim has been credited and

[13] On Jan. 25, 1996, the Government filed a second Proof of Claim for unpaid taxes, which purported to amend the first Proof of Claim. (JA:173) That second Proof of Claim contained the identical language that "THIS CLAIM IS NOT SUBJECT TO ANY SETOFF OR COUNTERCLAIM." (JA:174) (emphasis added)

[14] A few days later, the Government filed another Proof of Claim (JA:177), this time on behalf of the GSA, seeking repayment of "overcharge claims . . . arising from transportation services rendered for the account of the UNITED STATES OF AMERICA." (JA:179) (emphasis in original) That Proof of Claim was signed on behalf of the United States Attorney's office in Boston, Massachusetts (JA:181), which office had been on the official service list for this proceeding since as early as the entry of the original Borrowing Order. (JA:57, 60)

[15] In addition, the Debtor's various amended Disclosure Statements and Reorganization Plans were filed on Feb. 20, 1996 (JA:184, 253), March 4, 1996 (JA:270, 329), and March 7, 1996 (JA:334, 407). ⁴ These were served on the Government. (JA:256, 332, 410) Each of these contained a reference to the Debtor's ongoing government contract business and the disputed tax liabilities. (JA:187-189, 273-275, 337-339). Indeed, the Government itself filed an objection to the Debtor's Reorganization Plan. (JA:433) Neither that Objection nor a subsequent Pretrial Memoranda submitted by the Government contained any reference to potential setoffs. (JA:433, 484)

[16] On May 31, 1996, Debtor filed a Motion to authorize the sale of certain assets. (JA:534) That Motion specifically addressed Fleet's superpriority lien and the IRS tax obligations, and attached a list of the specific government contracts at issue. (JA:539-540, 543, 557-558) At a hearing in connection with that Motion, which was attended by counsel for the Government, the Court denied the Motion due to its failure to address the Government's tax claims. (JA:609- 610) Again,there was no mention of any setoff rights that the Government might assert against those specifically itemized GSA receivables.

[17] Finally, as late as June 6, 1996, the Government filed an amendment to its 12/5/95 Request for Payment of Taxes. ⁵ (JA:602) That Request still did not contain any assertion of any potential setoff. (JA:602, 846)

[18] Thus, over the course of an entire year of active involvement by the Government in these proceedings, ⁶ while Fleet was loaning on the Debtor's accounts receivables which included monies owed the Debtor by the GSA, the Government never once suggested that those receivables were far less than appeared because of some setoff rights it would later claim. Rather, the Government expressly disclaimed any right to setoff.

4. THE GOVERNMENT FAILED TO DISCLOSE ITS INSTRUCTIONS TO FREEZE GSA

[20] That same day, Government's counsel sent a letter to the General Services Administration ("GSA") instructing it to freeze any payments otherwise due to the Debtor. (JA:650) This letter was not served upon any party in the Bankruptcy Proceeding.

[21] On June 17, 1996, the Bankruptcy Court held a hearing on Fleet's Emergency Motion. (JA:622), Government's counsel was in attendance. (JA:623) However, Government's counsel (i) did not object to or even comment on Fleet's Motion for Relief from Stay, (ii) did not object to extending the Borrowing Order through July 16, 1996, and (iii) did not mention that he had just instructed the GSA to freeze some of the very receivables that Fleet was looking to collect. (JA:625-637) The Court allowed Fleet's Motion and permitted Fleet to begin collection of the Debtor's receivables. (JA:643) However, it was clear at the hearing that Fleet intended to continue to lend for several weeks during the collection efforts, on the very accounts which the Government had already instructed the GSA to "freeze." (JA:636, 639)

[22] Approximately two (2) weeks later, the Debtor inadvertently learned of the Government's freeze when it contacted the GSA to collect monies owed to it. (JA:646) The Debtor filed an Emergency Motion, asserting that the Government's actions in freezing the GSA payments amounted to a violation of the automatic stay. (JA:645) At an emergency hearing on July 2, 1996, the Bankruptcy Court found that the Government's freeze of the GSA payments violated the automatic stay provisions of 11 U.S.C. section 362 and ordered the Government to release the freeze. (JA:673) The Government did not seek reconsideration of that Order and did not appeal the Order, even though it acknowledged that it could have. (JA:671)

5. THE GOVERNMENT BELATEDLY ATTEMPTED TO SEEK RELIEF FROM STAY TO

[24] The Government appealed that Decision to the District Court which affirmed the Bankruptcy Court's Decision. (BA:3A-26A) It is that Bankruptcy Court Decision which is the subject of the instant appeal.

SUMMARY OF ARGUMENT

[25] While the common law doctrine of setoff is preserved in bankruptcy proceedings, setoff is subject to the automatic stay imposed in all bankruptcy proceedings and may not be exercised without first obtaining relief from the stay. In addition, setoff is an equitable doctrine and the allowance or disallowance of setoff lies within the sound discretion of the bankruptcy court. Setoff rights may be waived if they are not asserted in a timely fashion.

[26] Here, it was well within the Bankruptcy Court's discretion to deny the Government's request for relief from stay to exercise certain setoff rights where the Government had inexplicably delayed the assertion of those rights for more than a year after the bankruptcy proceeding was first filed. During that one year period, the Bank had loaned to the Debtor based upon the Debtor's outstanding accounts receivables. The Government had never advised the Court, the Debtor or the Bank that it had potential setoff rights against those receivables, and, indeed, had expressly disclaimed such rights in various filings. Under these circumstances, the Bankruptcy Court's denial of the Government's request for relief from stay was not clearly erroneous.

[27] In addition, even if the Government had not waived its right to relief from stay to effect a setoff, the Bank's security interest in the Debtor's receivables has priority over the Government's alleged setoff rights. As a preliminary matter, the Bank's security interest in the Debtor's receivables first arose in 1993, prior to the Bankruptcy proceeding and prior to the time for which the Government claims it is owed unpaid taxes. In addition, there is no evidence that any of the those unpaid taxes accrued prior to the Bank's court-ordered superpriority lien on those receivables. Moreover, the Government had notice of the Bank's lien prior to the accrual of its setoff rights. Accordingly, under either UCC section 9-312 or section 9-318, the Bank's security interest has priority over any setoff rights of the Government.

[28] The decision of the Bankruptcy Court, and the affirmation of that decision by the District Court, should be affirmed.

ARGUMENT

[29] The Government has appealed from the denial of its request for relief from the automatic stay imposed in this bankruptcy proceeding. Pursuant to Section 362(d)(1) of the Bankruptcy Code (11 U.S.C. section 362(d)(1)), a party may obtain relief from the automatic stay provisions only if it can show "cause." Neither the statute nor the legislative history defines "cause" sufficient to sustain a Section 362(d)(1) motion. The courts have viewed "cause" as a broad and flexible concept that must be addressed on a case by case basis. In re M.J. & K Co. Inc. 161 B.R. 586, 590-591 (S.D.N.Y. 1993). As an initial matter, the Government, as the moving party, has the burden of showing a "legally sufficient basis" for lifting the automatic stay. Id. at 590. See also Sonnax Indus., Inc. v. Tri Component Prods. Corp. (In re Sonnax Indus. Inc.), 907 F.2d 1280, 1285 (2nd Cir. 1990). Only if the movant makes such a showing does the burden shift to the party opposing the request. Absent a showing of cause, the court should simply deny relief from stay. See Sonnax, 907 F. 2d at 1285.

[30] As discussed infra, setoffs are subject to the automatic stay. The stay of a claim to setoff enables the Court to determine the rights of the parties before a debtor or estate is deprived of its interest in funds. Thus, a creditor may not setoff without first obtaining relief from stay. Stephenson v. Salisbury (In re Corland Corp.), 967 F.2d 1069, 1076 (5th Cir. 1992)(the automatic stay does not defeat their rights to setoff; rather, setoff is merely stayed pending an "orderly examination of the debtors and creditors rights.")

[31] In the case at bar, the Government argues that it has shown cause within the meaning of Section 362(d)(1) because it claims it has a valid setoff against the accounts receivable. (JA:695) The Government put the cart before the horse. The Government merely claimed it had a setoff right and did not show that its claim was legally sufficient to justify lifting the stay. Rather, the Bankruptcy Court found otherwise and, as will be discussed more fully below, correctly denied the Government relief from stay.

I. THE COURT CORRECTLY CONCLUDED THAT THE GOVERNMENT WAIVED ITS

A. THE BANKRUPTCY COURT ACTED WITHIN ITS DISCRETION IN

[34] Applying these principles, the Bankruptcy Court (as upheld by the District Court) concluded that the Government waived its right to assert setoff claims by:

(1) failing to object to the numerous requests for orders

[35] The Government argues in its brief that such a waiver only could be based on a voluntary and intentional relinquishment of those rights, and that the Bankruptcy Court (and, hence, the District Court) had no basis for concluding that the Government's conduct rose to that level. The Government's argument ignores the numerous cases on which the Bankruptcy Court and the District Court relied; cases in which courts concluded that the Government or private parties had waived their setoff rights based on conduct and silences similar to those of the Government in this case. For example, in a closely analogous case, In re Lykes Bros. Steamship Co, Inc., the court held that the Government had waived its right to a setoff against a debtor in bankruptcy because it had filed a proof of claim without asserting that right, failed to timely assert its setoff right and had acted inconsistently with its exercise of its setoff rights. ¹¹ 217 B.R. at 311-312. Similarly, in Southeast Banks v. Grant (In re Apex Internat'l Mgmt. Services), the Government (specifically, the IRS) filed a proof of claim stating that it was not subject to any setoff. 155 B.R. at 595-596. The Government then did nothing while a secured creditor of the bankrupt debtor, with the bankruptcy court's approval, pursued receivables owed by the Government (specifically, the Air Force). Rather, the IRS waited until the secured creditor succeeded in its collection efforts before asserting a setoff right. Noting that the doctrine of setoff is based on fairness, the court in Apex concluded that the Government's silence constituted a waiver of its rights, particularly where (as is the case here) the secured creditor relied to its detriment on the Government's omission. Id. ¹²

[36] The cases on which the Government relies are factually distinct from the case at bar and wholly fail to support the Government's argument, holding on several occasions that parties had waived their rights based on their conduct or silence. For example, in Garfinkle v. Weil, 672 F.2d 1340 (11th Cir. 1982), a party who contracted to purchase a hotel from a bankrupt estate opposed an operative term of the contract and related court order, and therefore sought to recover its deposit. The court there concluded that the appellants had waived their right to assert claims related to the challenged contract provision, stating: "Appellants acquiesced in the contracting process and were silent after the referendum vote. Their conduct warrants the inference of relinquishment of a known right." Id. at 1348. ¹³ The First Circuit has recognized that "every waiver need not be express; at times, one can fairly be deduced from conduct or from a collocation of the circumstances." Irons v. F.B.I. 811 F.2d 681, 686 (1st Cir. 1987). ¹⁴

[37] The Government's conclusory effort to explain away the undeniable impact of its prior conduct and silences is contrary to applicable law and cannot avoid the determination that there is no other reasonable explanation for its conduct. See, e.g., Irons, 811 F.2d at 686 (waiver where party's acts are "so manifestly consistent with and indicative of an intent to relinquish . . . [setoff right] that no other reasonable explanation of his conduct is possible"); In re Metropolitan International, Inc., 616 F.2d 83, 86 (3d Cir. 1980) ("waiver can be determined as a matter of law where only one reasonable conclusion can be drawn from the undisputed facts").

B. THE BANKRUPTCY COURT AND THE DISTRICT COURT DID NOT ERR IN

[39] Contrary to the Government's argument, the District Court was correct in finding that reliance on the Government's acts or omissions is relevant to a determination of waiver. See, e.g., In re Lykes Bros., 217 B.R. at 313 (Government waived its setoff rights in part because of detrimental reliance on information supplied by the Government); Southeast Banks v. Grant (In re Apex Internat'l Mgmt. Services), 155 B.R. at 595 (when another creditor relies to its detriment on the omission of a setoff claim in a Proof of Claim, the creditor asserting a setoff will have waived that right).

[40] Finally, the Government's lengthy attempt to rationalize its conduct on which the Bankruptcy and District Courts relied in reaching their conclusions regarding the waiver of the Government's setoff rights is inaccurate and unpersuasive. The Government acknowledges that it did not assert its setoff rights in response to the Bank's numerous requests for borrowing orders or its Lift Stay Motion, but argues that it "had no reason to object" to those filings. Under 11 U.S.C. section 364(c), borrowing orders as a matter of law gave the Bank super-priority over all other claims, including the unsecured tax obligation claims of the Government. Simply because the Government apparently did not understand how the borrowing orders would impact the Government's setoff rights does not excuse its failure to attempt to protect those rights. As noted above, setoff rights must be asserted to be retained. They are not automatic or self-executing. Darr v. Muratore, 8 F.3d at 860; Melamed v. Lake County National Bank, 727 F.2d at 1404. Moreover, as the Third Circuit has explained in denying setoff rights due to a waiver based on a party's conduct: "The appellant can take no solace in the fact that it acted based on a miscomprehension of the law. . . . [I]ntent is evidenced by clear actions or language which is indicative of the actor's resolve." In re Metropolitan International, Inc., 616 F.2d at 86. This is true even if the Government made a good faith mistake about the preservation of its rights. In re Brockton Shoe, 8 F. Supp. at 961.

C. THE GOVERNMENT SHOULD BE BOUND BY ITS OWN DISCLAIMERS OF

[42] The Government next argues that its objections to the Debtor's Third Amended Plan of Reorganization adequately asserted its setoff rights and superceded its previously filed Proofs of Claim. ¹⁵ That document was filed on April 1, 1996, almost ten months after the Government received notice of the Bank's lending relationship with the Debtor and its super-priority status in this bankruptcy matter; nearly as long since the Government first appeared in this case and had multiple opportunities to disclose and seek approval for its planned setoff; and just two days before the scheduled plan confirmation hearing. ¹⁶ By the time the Government finally revealed its setoff claim, it repeatedly had misled the Bankruptcy Court and the secured lender regarding its plans, both by its affirmative representations and its silences. In addition to filing two Proofs of Claim expressly denying any setoff rights, it also failed to object to the original Borrowing Order, any of the numerous Orders and Stipulations continuing that Order, or either the initial Plan of Reorganization or the First or Second Amended plans. Plus, it attended numerous hearings in this bankruptcy proceeding, several of which directly addressed the Bank's continued lending to the Debtor collateralized by, among other things, the very receivables the Government seeks to setoff against the bankruptcy estate. Finally, as the "icing on the cake", unilaterally and without any notice to the Bankruptcy Court, the Debtor, the Bank or any other party to this bankruptcy proceeding, the Government instructed the GSA not to pay receivables owed to the Debtor. (JA:650). That bold instruction ignored the requirement that a creditor is stayed from exercising a right to setoff without permission of the court. In re Britton, 83 B.R. at 919. ¹⁷

[43] The failure to reveal its instructions to the GSA clearly represents the Government's waiver of its setoff rights, either because it alone was an intentional omission or because it was the "final straw" in a series of conduct and omissions that cumulatively lead to the undeniable conclusion that the Government waived its setoff rights.

II. THE BANKRUPTCY COURT'S DENIAL OF THE GOVERNMENT'S SETOFF CLAIM

A. BANKRUPTCY COURTS HAVE WIDE DISCRETION TO DENY SETOFF RIGHTS.

[45] It is well-established that bankruptcy courts have wide discretion to deny setoff rights. The United States Supreme Court (ironically, in a case on which the Government relies) long ago stated that the right of setoff in the context of bankruptcy "is permissive rather than mandatory." Cumberland Glass Manufacturing Co. v. Charles De Witt, 237 U.S. 447, 455 (1915). Since then, this Court and many other jurisdictions have held that setoff in the context of bankruptcy is not automatic. Darr v. Muratore, 8 F.3d at 860. In discussing the law of setoff in the First Circuit, the Darr Court stated:

[A]llowing setoff undermines the basic premise of bankruptcy

[46] Courts, in their discretion, have authority to deny setoff claims based on equitable considerations. See Cumberland Glass, 237 U.S. at 455 (the matter of setoff "is placed within the control of the bankruptcy court, which exercises its discretion . . . upon the general principles of equity"). As one court explained:

Congress designed the Bankruptcy Code to provide for equal and

B. THE BANKRUPTCY COURT MAY EXERCISE ITS DISCRETION TO DENY

[48] Consistent with the Bankruptcy Court's decision in this matter, other courts have denied setoff rights in the context of motions for relief from stay. ²⁰ For example, in In re Britton, 83 B.R. at 921, the court denied the Government's motion for relief from an automatic stay on the basis that the Government had waived its right to exercise the setoff for which it sought to lift the stay. Similarly, in State of Illinois v. Lakeside Community Hospital (In re Lakeside Community Hospital), the Illinois Department of Revenue moved to lift an automatic stay to setoff their tax claims against amounts due to a Chapter 11 debtor from another department of Illinois State government. The bankruptcy court denied the motion, and the United States District Court for the Northern District of Illinois upheld that denial on principles of equity. 151 B.R. at 893. ²¹

[49] The Government's reliance on Grella v. Salem Five Cent Savings Bank, 42 F.3d 26 (1st Cir. 1994) and In the Matter of Vitreous Steel Products Company, 911 F.2d 1223 (7th Cir. 1990) is misplaced. The issue in both of those cases was the res judicata or collateral estoppel effect to be given to a decision by the bankruptcy court granting a motion to lift the automatic stay. While both cases limit the preclusive effect of a bankruptcy court's order to lift the stay, noting the limited nature of such a hearing, neither holds or implies that the bankruptcy court should not consider the validity of the movant's claimed security interest when deciding such a motion. Indeed, Grella is quite explicit to the contrary, stating:

This is not to say that bankruptcy courts can never CONSIDER

[50] In the case at bar, the Bankruptcy Court considered the waiver defense against the Government and -- using the Grella Court's preliminary injunction analogy -- the Court simply concluded that the Government failed to show a reasonable likelihood of success" with respect to its setoff claim. This decision was well within the Court's discretion, and should be upheld. See, e.g., United States v. Atkinson (In re Cascade Roads, Inc), 34 F.3d at 766 (denial of IRS's setoff request upheld where bankruptcy court did not abuse its discretion). ²²

III. THE AUTOMATIC STAY APPLIES TO POST-PETITION OBLIGATIONS.

[51] Contrary to the weight of authority, the Government disengenuously argues that the automatic stay imposed under the Bankruptcy Code does not apply to the setoff of post-petition obligations and claims. The Government's argument ignores the numerous cases in which courts have concluded that the automatic stay imposed pursuant to the Bankruptcy Code indeed applies to post- petition claims and obligations, and that a bankruptcy court has discretion to refuse to deny the setoff of such claims and obligations, just as it does with pre-petition setoffs. In fact, the Government was a party in at least two cases in which the court disagreed with the Government's contention that it could setoff post- petition obligations without first receiving relief from stay. ²³

[52] First, the Government argues that the stay does not apply to post-petition obligations and claims because the Bankruptcy Code only expressly provides for the setoff of mutual debts and credits which arose pre-petition, and that the Government, therefore, may exercise a post-petition setoff without prior court approval. This argument is without merit. The United States District Court for the District of Massachusetts, as cited by the District Court below, has noted that, notwithstanding the Code's "silence" concerning post- petition setoffs, relevant "legislative history . . . suggests the Congressional intent that the same limitations should apply with respect to post-petition setoff as are adopted for pre-petition setoff to prevent creditors taking precipitous action in order to avoid more stringent post-petition limitations." Framingham Winery v. J.A.G., Inc. (In re J.A.G., Inc.), 7 B.R. 624, 628 (D.Mass. 1980), citing House Report No. 95-595, 95th Congress 1st Session, 186 (1977). ²⁴

[53] Similarly, other courts have concluded that the automatic stay applies to post-petition setoff claims just as it does to pre- petition claims. See, e.g., Braniff Airways, Inc. v. Exxon Co., 814 F.2d 1030, 1040 n.13 (5th Cir. 1987) (a party must move to lift the automatic stay before exercising post-petition setoff); Pruett v. American Income Life Insurance, 220 B.R. 625, 628 (E.D. Ark. 1997) (a creditor's exercise of right to post-petition setoff is subject to automatic stay); Okwukwu v. Internal Revenue Service, 210 B.R. at 196 ("A creditor seeking to exercise post-petition setoff must first move for relief from the automatic stay"); Hudson v. United States (Internal Revenue Service), 168 B.R. at 452 (same, quoting Collier on Bankruptcy); 222 Liberty Associates v. Prescott Forbes Real Estate Corp. (In re 222 Liberty Associates), 110 B.R. 196, 200 (E.D. Penn. 1990) (failure to obtain relief from stay for post-petition setoff violates Bankruptcy Code). ²⁵

[54] The Government heavily relies on Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995), and its own self-serving and unsupported analysis of the Bankruptcy Code to conclude that the Code -- specifically section 362 -- does not impose limitations on the exercise of post-petition setoff rights. Briefly, the Government argues that section 362(a)(7) expressly refers only to pre-petition setoffs and, therefore, does not apply to post-petition setoffs; and that section 362(a)(3) does not refer to setoffs at all and would render section 362(a) superfluous if applied to post-petition setoffs. The District Court below affirmed the Bankruptcy Court's rejection of this argument:

The Government's reading of Strumpf is too broad while its

[55] Other courts confirm the appropriateness of the District Court's reading of section 362. For example, holding that the defendant real estate broker violated the automatic stay by setting off a post-petition obligation of the debtor without court approval, the Eastern District of Pennsylvania reasoned:

11 U.S.C. section 362(a)(3) is not limited in its application to

[56] Likewise, other courts agree with the District Court's interpretation of Strumpf: "It is a fundamental axiom of bankruptcy law that the automatic stay is pervasive and exemptions from the stay are strictly construed. The logic of the foregoing compels a narrow reading of Strumpf." Holden v. United States (Internal Revenue Service) (In re Holden), 236 B.R. 156, 163 (D. Vt. 1999), aff'd 258 B.R. 323 (D. Vt. 2000) (holding that a freeze on a tax refund due to the debtor violated the automatic stay) (citation omitted). Despite the Government's assertions to the contrary, the Strumpf ruling has not been interpreted as "a limitation of the scope of Section 362(a)(3), but on its finding that the action at issue did not deprive the estate of property." In re National Environmental Waste Corporation, 191 B.R. 832, 836 (C.D. Cal. 1996) (holding that contract rights constitute property of the estate); In re Holden, 236 B.R. at 163 (quoting In re National Environmental Waste Corporation). ²⁶

[57] Accordingly, the Bankruptcy Court and District Court in this matter recognized that the Strumpf ruling is strictly limited to the matter it addressed: whether a bank violated the automatic stay by placing a temporary administrative hold on payment of an account while awaiting a ruling on its motion for relief from the automatic stay. The Strumpf Court did not say or even imply that a permanent refusal to pay would comply with section 362(a)(3); nor did it consider the policy implications of such a holding in a post-petition context where the difficulties of reconciling section 362(a)(3) with the preservation of a post-petition setoff contained in section 553(a) would not be present. ²⁷

[58] Even assuming, arguendo, that the Bankruptcy Code does not apply to post-petition setoff rights, there is authority that there is NO right to offset post-petition debts and obligations. See, e.g., Sherry & O'Leary v. Tom Mistick & Sons, 148 B.R. 248, 253 (W.D. Penn. 1992) (a creditor cannot set off a post-petition claim against either a pre-petition or a post-petition debt). Even if such a right does exist outside the Bankruptcy Code, it is not automatic and requires court approval. Drawing analogy from a Supreme Court decision, one court has stated:

Whether and in what circumstances a court may allow a set-off of

The courts have split on the question of whether, as a matter of

[59] Finally, the Government's criticism of the District Court's policy considerations regarding the need to require advance judicial approval of setoffs of post-petition obligations to a debtor is inconsistent with legislative history and relevant case law. The Government argues -- again without support -- that the District Court's statement that "[i]t stands to reason that post-petition setoffs would also impact the debtor's cash flow, and thus the bankruptcy court would have an interest in monitoring such practices" cannot withstand scrutiny. (Gov. Brief at 43). Contrary to the Government's argument, other courts have advanced the same policy considerations as the District Court in the case at bar. When considering whether to allow a setoff of post-petition obligations, one court determined that "[s]etoff is permissible in Chapter 11 cases, but only where it does not undermine the debtor's ability to reorganize." Paris v. Transamerica Insurance Group, 78 B.R. at 158 (and cases cited). See also, Small Business Association v. Rinehart, 887 F.2d 165, 168 (8th Cir. 1989) ("A primary purpose of the automatic stay is to afford debtors in Chapter 11 reorganizations the opportunity to continue their business with their available assets"). Cf. In re Lincoln, 144 B.R. 498, 502 (D.Mont. 1982) (in Chapter 12 case, equities required denial of setoff where funds were necessary to debtor's effective reorganization). Likewise, Congress recognized that "[i]n order to accomplish a successful reorganization, it is important that business proceed as usual for the debtor. Setoff is an interruption in the conduct of business, and may have detrimental effects on the attempted reorganization." House Report, at 183, U.S. Code Cong. & Admin. News 1978 at 6144.

[60] The Government's argument that post-petition setoff rights are not subject to review by the bankruptcy court is without merit. The overwhelming weight of authority supports the conclusion that claimants must seek bankruptcy court approval before exercising post- petition setoffs, and the Government's arguments do not detract from the persuasiveness of these cases and the precedent they set for this matter.

IV. THE BANK'S SECURED INTEREST HAS PRIORITY OVER THE GOVERNMENT'S

[62] The cases on which the Bankruptcy Court relied are Atlantic Kraft Corp. v. The Gibson Group, Inc. (In re Gibson Group), 126 B.R. 759 (S.D. Ohio 1991) and Credit Alliance Corp. v. National Bank of Georgia, 718 F.Supp. 954 (N.D. Ga. 1989). Relying on yet another case reaching the same conclusion, the In re Gibson Group court explained:

[A] right of setoff is to be treated as a security interest for

[63] Contradicting and without attempting to distinguish these authorities, the Government asserts that a setoff is not a secured interest and that section 9-312, therefore, does not apply here. The Government's assertion ignores its own position in a different section of its brief where it expressly acknowledges that "[s]ection 506(a) specifies that a claim subject to a right of setoff is considered a secured claim." ²⁹ (Gov. Brief at 41). Section 506(a) reads, in relevant part:

An allowed claim of a creditor secured by a lien on property in

[65] Moreover, the underlying issue here is not whether a right of setoff is a security interest, but whether in the bankruptcy context a right of setoff can be used to fully satisfy a claim which is subordinated to the claim of another creditor -- in this case the Government's second, priority claim under section 503(b)(1)(A)(B) versus the Bank's super-priority lien under section 364(c)(1). To ignore the priorities established under the Bankruptcy Code in favor of a setoff, as the Government apparently believes should be done, "undermine[s] a basic premise of bankruptcy law, the equality among creditors . . .," Darr v. Muratore, 8 F.3d at 860, even more than its application in a contest between unsecured creditors.

B. THE BANK ALSO HAS PRIORITY UNDER UCC SECTION 9-318.

[66] The Government argues that section 9-318, not section 9- 312, controls the outcome of this priority question. As discussed above, and as decided by the Bankruptcy Court, the Government is wrong -- it is section 9-312 that controls. Nevertheless, the Bank's secured interest in the Debtor's accounts receivable also trumps the Government's setoff claim under section 9-318.

[67] Even under section 9-318 and the cases on which the Government relies in support of this argument, a secured interest still has priority over a setoff claim where the setoff accrued after the claimant received notice of the secured interest. ³⁰ See also BarclaysAmerican/Business Credit, Inc. v. Paul Safran Metal Co., 566 F. Supp. 254, 257 (N.D. Ill. 1983) (setoff disallowed under section 9-318 where notice preceded accrual); West One Bank of Utah v. Life Ins. Co. of Virginia, 887 P.2d 880, 882 (Ct. Ap. Utah 1995) ("a secured creditor's perfected security interest takes priority over any subsequent right of setoff") (citations omitted). Here, the undisputed facts establish that the Government received notice of the Bank's secured interest well before the accrual of at least a significant percentage of the amount the Government seeks to claim as a setoff. The Bank perfected its security interest in June 1993. (JA:62) The Debtor filed for bankruptcy protection in May 1995. (JA:868). One month later, the Bankruptcy Court entered a Final Order granting the Bank a super-priority lien on the Debtor's accounts receivable and a super-priority administrative expense claim on this litigation. (JA:19, 61). Upon entry in June 1995, the Government (the United States Attorney's Office in Boston) received service of that Final Order, thereby receiving notice of the Bank's secured interest. ³¹ (JA:57-60). On July 31, 1995, the United States Attorney's Office in Boston submitted a Proof of Claim on behalf of the GSA for overpayments due to the Government by the Debtor. (JA:178-181) The Government also filed Requests for Payment of Internal Revenue Taxes in November and December 1995, reflecting that a portion of its claimed setoff right accrued at the end of June 1995, with a significant percentage of its setoff accruing months later. (JA:99, 102) The Government never even hinted to the Court or any of the parties to this bankruptcy proceeding that it had a setoff claim until it had no choice but to reveal its plans in June 1996 when the Debtor inadvertently learned of the Government's freeze on payments to the Debtor. When the Government finally did seek leave to exercise a setoff, it became clear that the bulk of its setoff claim accrued after notification of the Bank's security interest.

C. CONTRARY TO THE GOVERNMENT'S CLAIM, STATE LAW GOVERNS THIS

[69] Acknowledging that some courts have concluded that federal bankruptcy standards govern post-petition setoffs, the Sisk court, nevertheless noted that such courts "have cast those [federal] standards 'with an interested eye' toward the [forum state's] decision. Sisk, 698 F. 2d at 44 (citations omitted). The Sisk court continued:

Moreover, to refer to forum law, at least where that law is not

"[W]e do believe Article 9 governs the priority between that

D. EVEN UNDER FEDERAL LAW, THE BANK'S SECURED INTEREST HAS

[71] The Anti-Assignment Act on which the Government relies so stridently has no bearing on the outcome of the present priority question. Indeed, the Government's own citations do not support its reliance on this Act. In United States v. Shannon, 342 U.S. 288, 290 (1952), on which the Government relies, the United States Supreme Court held that the Anti-Assignment Act does not apply to assignments by operation of law, as distinguished from voluntary assignments. The Shannon Court's holding was nothing new; this has been Supreme Court law for over a century: "The rigor of this rule was very early relaxed in cases which were thought not to be productive of the evils which the statute was designed to obviate. And one of the first such exceptions was to transfers by operation of law." United States v. Aetna Casualty & Surety Co., 338 U.S. 366, 373 (1949), quoting United States v. Gillis, 95 U.S. 407 (1877).

[72] The Supreme Court also has held that assignments in bankruptcy are within this exception:

[T]his Court has held that the statute in question does not

[73] The Supreme Court's rule has long been followed and unquestionably remains in force. See, e.g., Keydata Corp. v. United States, 504 F.2d 1115, 1118 (U.S. Ct. Cl. 1974) (collecting cases holding that transfers made incident to bankruptcy proceedings are outside the ban of the Assignment of Claims Act); In re Robert E. Derecktor of Rhode Island, Inc., 142 B.R. 29, 30 (D. RI. 1992) (creditor not required to comply with the Act to perfect liens against Chapter 11 debtor because the Act's "focus is not on the perfection of liens and security interests, but rather the establishment of procedural requirements of assignees planning to assert claims against the government").

[74] The Government cites no case which holds that the Anti- Assignment Act negates the effectiveness of super-priority liens specifically authorized by 11 U.S.C. section 364. The order the Bankruptcy Court entered in this case pursuant to section 364, and which was renewed throughout the entire period of this bankruptcy, is very explicit that the priority status conferred does not depend upon any further act by the Bank. The Order provided:

This Order shall be sufficient and conclusive evidence of the

[75] It is untenable that a super-priority lender should not be able to rely upon the efficacy of such an order which the Bankruptcy Court grants pursuant to powers conferred on it by section 364 where unsecured financing is unavailable and the survival of the Debtor depends upon the willingness of lenders to grant immediate emergency financing to keep the Debtor afloat and to continue that financing while the Debtor attempts to reorganize. The purpose of the Anti- Assignment Act, which has been construed as preventing the danger of the Government becoming "embroiled in conflicting claims, with delay and embarrassment and chance of multiple liability," Martin v. National Surety Co., 300 U.S. 588, 594 (1937), citing Hobbs v. McLean, 117 U.S. 567, 576 (1886), is not served by making it a tool to frustrate the needs of the Debtor and the Bankruptcy Court under the Federal Bankruptcy laws. The creation of a super-priority lien pursuant to the authority conferred on a bankruptcy court under section 364 should be treated as an assignment by operation of law and not require the Bank to comply with the formal requirements of the Anti-Assignment Act when, as here, the Bank's lending is secured by an accounts receivable owed by the Government.

[76] Likewise, the Government's argument that the setoff rights of the United States cannot be subordinated to the rights of private citizens does not apply in this context. Indeed, the Government is way off point with this argument, as none of the cases it cites concern bankruptcy matters; neither the Judgment Setoff Act on which the Government relies nor any of the statutory provisions at issue in the Government's cases (namely, the Administrative Procedures Act, the Tucker Act and the Federal Tort Claims Act) have any bearing on this case; and there is no basis for the Government's implication that it somehow is protected in this matter by sovereign immunity.

[77] It is disingenuous for the Government to seemingly seek to invoke the protection of sovereign immunity at this late stage of this matter. It also is unpersuasive, as section 106 of the Bankruptcy Code (11 U.S.C. section 106) (as opposed to the numerous unrelated statutes the Government's brief addresses) abrogates sovereign immunity in many types of bankruptcy matters, including those related to setoff and secured interests, arising under Sections 362 and 553 of the Bankruptcy Code. ³³ See C.F. Foods v. Internal Revenue Service, 265 B.R. 71, 84-85 (E.D. Penn. 2001) (a very recent discussion of the breadth of section 106); Jove Engineering, Inc. v. Internal Revenue Service, 92 F.3d 1539, 1549 (11th Cir. 1996) (section 106 constitutes an unequivocal waiver of sovereign immunity in matters involving enumerated sections of Bankruptcy Code). ³⁴ Courts applying this statutory provision repeatedly have held that the Government waives any sovereign immunity in a bankruptcy proceeding when it files a proof of claim against a debtor. See, e.g., Internal Revenue Service v. Brickell Investment Corp. (In re Brickell Investment Corp.), 171 B.R. 149 (S.D. Fla. 1994) (IRS waived sovereign immunity by filing claims against debtor for unpaid taxes); Price v. United States (In re Price), 130 B.R. 259, 268 (N.D. Ill. 1991) (by filing proof of claim, IRS waived sovereign immunity and thus could be held in contempt for violating stay). Indeed, some courts have held that the mere existence of a Government claim against a debtor in bankruptcy (even without filing a proof of claim) constitutes a waiver of immunity. See, e.g., Town & Country Home Nursing Services, Inc. v. Blue Cross of California, et al (In re Town & Country Home Nursing Services, Inc.), 112 B.R. 329, 334 (9th Cir. BAP 1990), aff'd 963 F.2d 1146 (9th Cir. 1991) (Government waived sovereign immunity by taking offsets against debtor, even without filing proof of claim); T.F. Stone Companies, Inc. v. Harper (In re T.F. Stone Companies, Inc), 170 B.R. 884, 886-887 (N.D. Tex. 1994), aff'd 72 F.3d 466 (5th Cir. 1995) (collecting and agreeing with cases holding that the filing of a proof of claim is not a prerequisite to waiver of sovereign immunity under section 106(a)); Inslaw, Inc. v. United States (In re Inslaw, Inc.), 76 B.R. 224, 229-233 (D. D.C. 1987) (discussing at length why the language and legislative history of section 106 do not require the filing of a proof of claim for waiver of sovereign immunity to be found).

[78] It also is disingenuous and unpersuasive for the Government to rely on cases and statutes completely unrelated to the Bankruptcy Code in support of its assertion that the Government's setoff automatically should take priority over a secured creditor (indeed, one granted super-priority status). Not one of the cases cited in any of the briefs or court opinions in this case holds or even implies that the Government should receive preferential treatment over private citizens. On the contrary, the U.S. Supreme Court has held that the Bankruptcy laws apply to the Government, in particular the IRS, just as they do to private citizens. United States v. Whiting Pools, Inc., 462 U.S. at 209. As the Second Circuit has said:

[T]he Government in essence asks us to find that the bankruptcy

[79] Applying this rule, numerous courts have denied the Government's setoff rights just as if the claimant been a private party. See, e.g., Shugrue v. Fischer (In re Ionosphere Clubs, Inc.), 164 B.R. at 843-844 (stating that "the Bankruptcy Code is oriented toward the prevention of preferential treatment of creditors," and denying the Government's motion for relief from stay denied because a "bankruptcy court should deny setoff to those creditors who violate the automatic stay"); In re Holder, 182 B.R. at 775 (denying Government's motion for relief from stay based on same standards applied to all other categories and types of creditors). Cf. In re National Environmental Waste Corp., 191 B.R. at 835 (when governmental actions are conducted in government's capacity as commercial actor, governmental unit should be held to same standards of action as any non-governmental party under automatic stay). ³⁵

[80] Thus, while the Government makes a great effort to explain the relevance of the cases and statutes upon which it relies in support of this argument, it cannot avoid the reality that the only significant cases are those that apply the federal law applicable to this matter -- the Bankruptcy Code.

[81] The novelty and absurdity of the Government's arguments related to the Anti-Assignment Act and subordination of its claims to a private citizen is highlighted by the fact that there is no reference to any of these types of arguments in ANY of the bankruptcy cases cited in any of the briefs or opinions in this matter. Apparently, other courts and the Government itself repeatedly have recognized that the Government cannot hide behind the cloak of sovereign immunity or otherwise receive preferential treatment in a bankruptcy situation such as this merely because of its identity. Nothing in its brief supports the Government's attempt to persuade this Court to change voluminous and long-standing precedents on this issue. Pursuant to those precedents, the Bank's priority status remains intact even under applicable federal law.

CONCLUSION

[82] For the foregoing reasons, appellee Fleet Bank of Massachusetts respectfully requests that this Court affirm the Bankruptcy Court's denial of the Government's request for relief from stay.

Respectfully submitted,

[83] The undersigned hereby certifies that this brief contains 15,934 words in conformance with this Court's August 3, 2001 Order permitting the Appellee's brief to contain up to 17,500 words.

Debra K. Mayfield, Esq.

[84] I, Debra K. Mayfield, hereby certify that on this 5th day of October, 2001, I did serve a copy of the within Brief of Appellee Fleet Bank of Massachusetts on counsel of record, via first class mail, postage prepaid, as follows:

Robert Metzler, Esquire

² Although the Government asserts that service on the United States Attorney does not constitute service on either the IRS or the GSA (Gov. Brief at 4-5), a month later, the United States Attorney's office filed a Proof of Claim on behalf of the GSA, noting that "the United States Attorney for the District of Massachusetts is the attorney for the UNITED STATES OF AMERICA in this matter and service of the UNITED STATES OF AMERICA in this matter should be performed in accordance with Rule 2002 of the Rules of Bankruptcy Procedures and as otherwise required bylaw." (JA:178-181) (emphasis in original).

³ The Bankruptcy Court docket is contained at pages 867-980 of the Joint Appendix. That docket reflects hearings as follows: in 1995, June 20 and 27*, July 12 and 18*, Aug. 1 and 21*, Sept. 7, Oct. 11, 17, 19*, and 27, Nov. 21*; in 1996, on Jan. 9 and 18*, Feb. 27, March 6 and 27, April 1, 3* and 16, June 10* and 17, July 2. The hearings marked with * addressed the continuation of the Court's Borrowing Order.

⁴ The original Disclosure and Plan was filed on Dec. 22, 1995 (JA:103,145), but the record is unclear as to whether the Government was served.

⁵ The tax claim for which the Government seeks to exercise a right of setoff in the amount of $239,591.83 resulted from unpaid post-petition payroll tax obligations incurred early in this bankruptcy proceeding (JA:675) for which the IRS filed a request for payment as an expense of administration on November 20, l995. (JA:99) Fleet has submitted an affidavit that as of August 1, 1996 it was owed $2,925,968.05 plus accrued but unpaid interest in the amount of $404,477.68 and legal fees in excess of $75,000.00. (JA:765-766, 847)

⁶ In a related proceeding, the District Court (J. Stearns) found that the Government's counsel had "receive[d] copies of all pleadings and orders filed in the case." (JA:1116)

⁷ Having found that any setoff rights were waived, neither the Bankruptcy Court nor the District Court reached the issue of whether the IRS and the GSA are separate entities and thus lack the requisite "mutuality" in order for the IRS to set off amounts the GSA owes the Debtor against taxes the Debtor owes to the IRS. Nevertheless, the District Court recognized that "courts are divided as to whether the United States should be considered a single entity for setoff purposes." (BA:14a) Cases holding that federal agencies are separate under the Bankruptcy Code include: State of Illinois v. Lakeside Community Hospital, (In re Lakeside Community Hospital), 151 B.R. 887, 891-892 (N.D. Ill. 1993) (holding that Congress intended "Governmental Units" to be distinguishable separate entities under the Bankruptcy Code); Shugrue v. Fischer, (In re Ionosphere Clubs, Inc.), 164 B.R. 839, 843 (S.D.N.Y. 1994) (following Lakeside, holding federal agencies distinguishable under section 553 and thus lacking mutuality); and Jarboe v. United States Small Business Administration (In re Hancock), 137 B.R. 835, 845-47 (N.D. Okla. 1992) (holding that different federal agencies could not effect setoff in bankruptcy because mutuality was lacking). While the District of Rhode Island held to the contrary in Lopes v. United States Dept. of Housing and Urban Development (In re Lopes), 211 B.R. 443 (D.R.I. 1997), the First Circuit has not addressed this issue. However, in Darr v. Muratore, 8 F.3d 854, 860 (1st Cir 1993), this Court reiterated its insistence on a strict application of the mutuality requirement; and in Depositors Trust Co. v. Frati Enters., 590 F.2d 377, 379 (1st Cir. 1979), this Court held that one subsidiary may not set off a debt owed to a bankrupt against a debt owing from the bankrupt to another subsidiary.

⁸ This Court reviews the bankruptcy court's decision "applying the 'clearly erroneous' standard to findings of fact and de novo review to conclusions of law." Grella v. Salem Five Cents Savings Bank (In re Grella), 42 F.3d 26, 30 (1st Cir. 1994).

⁹ Additional discussion and case citations regarding the bankruptcy court's discretion to deny setoff rights appear in section II(A), infra, on pages 31-33.

¹⁰ Citing In re Lykes Bros. Steamship Co., Inc., 217 B.R. 304, 312 (M.D. Fl. 1997); In re Customs Center, Inc., 163 B.R. 309, 317 (E.D. Tenn. 1994); In re Gehrke, 158 B.R. 465, 469 (N.D. Ia. 1993); Southeast Banks v. Grant (In re Apex Internat'l Mgmt. Services, Inc.), 155 B.R. 591, 595 (M.D. Fl. 1993). See also In re Brockton Shoe Mfg. Co., 8 F. Supp. 959, 961 (D. Mass. 1934).

¹¹ Interestingly, in In re Lykes, the IRS properly asserted its setoff rights at the initiation of the bankruptcy proceeding, thus illustrating that the IRS knows how to correctly assert its setoff rights. It was another agency of the Federal Government (the Commodity Credit Corp.) that failed to do so and, therefore, waived its setoff rights.

¹² See also In re Mauch Chunk Brewing Co., 131 F.2d 48, 49 (3d Cir. 1942) (setoff right is a privilege which is waived if not asserted and if creditor's conduct is inconsistent with the subsequent claim of setoff); In re Holder, 182 B.R. 770, 777 n. 13 (M.D. Tenn. 1995) (same; and citing numerous cases holding that a right to setoff was waived by a creditor's action or inaction or for reasons of equity); In re Britton, 83 B.R. 914, 919 (E.D. N. Car. 1988) (right of setoff lost if creditor's conduct is such as to mislead other parties to their detriment).

¹³ See also CBS, Inc. v. Merrick, 716 F.2d 1292, 1295 (9th Cir. 1983) (party's failure to invoke a deadline provision in a contract amounted to waiver of that provision).

¹⁴ See also Regional Properties, Inc. v. Financial & Real Estate Consulting Co., 752 F.2d 178, 182 (5th Cir. 1985) ("the equitable doctrines of laches, estoppel and waiver are grounded in the principle that a party with full knowledge of facts which entitle him to rescind a contract will be barred from asserting his rights where he fails to act promptly upon that right to the detriment of another").

¹⁵ Even if this document had been a timely assertion of the Government's setoff rights, it is woefully inadequate as it mentions only a small portion of the Government's total setoff claim. Specifically, it claims a $25,000 pre-petition setoff, but it makes no mention of a post-petition setoff claim in excess of $200,000. To add insult to injury, the Government did not properly serve its Objection on the parties in the bankruptcy proceeding, including the Bank. (JA:49)

¹⁶ The Government has argued the IRS did not know about its setoff rights until well into the pendency of this bankruptcy proceeding because it claims it had not yet learned of the GSA's debt to the Debtor or the significance of that debt to the secured lending relationship between the Bank and the Debtor. However, the Government cannot have it both ways: the IRS cannot assert a setoff right for debts owed by another branch of the Federal Government, while arguing that it could not take appropriate actions in this bankruptcy proceeding because it did not know about those debts. "It would be inconsistent to hold that the [IRS] acts in the same capacity as the [GSA] for purposes of allowing it to exercise a right of set-off but acts in a different capacity for purposes of its knowledge of Court orders and proceedings against other governmental agencies. This Court will not approve this inconsistency." Southeast Banks v. Grant (In re Apex Internat'l Mgmt. Services), 155 B.R. at 595.

¹⁷ Additional discussion and cases citations regarding this requirement appear in Section III, infra, at pages 39-40.

¹⁸ See also Geremia v. North Atlantic Fishing, Inc. (In re Reposa), 186 B.R. 775, 780 (D. R.I. 1995) (citing Darr v. Muratore and denying setoff claim); United States v. Arkinson (In re Cascade Roads, Inc.), 34 F.3d 756, 763 (9th Cir. 1994) (collecting cases holding that setoff is permissive, not mandatory); In re Lykes Bros. Steamship Co., Inc., 217 B.R. at 312 (bankruptcy court has discretion to prohibit Government's exercise of setoff); In re Holder, 182 B.R. at 776 ("the application of setoff is permissible, not mandatory, and lies within the equitable discretion of the court"); In re Lincoln, 144 B.R. 498, 501 (D. Mont. 1992) ("the right of setoff is neither automatic or self-executing, nor is it mandatory . . .; [w]hether a setoff is allowed or disallowed ultimately rests on the sound discretion of the Bankruptcy Court") (citations omitted). These numerous cases, among others, establish that bankruptcy courts unquestionably have authority to deny setoff rights. Additional discussion and case citations regarding the bankruptcy court's discretion to deny setoff rights appear in section I(A), supra, on pages 20-21.

¹⁹ See also The Official Committee of Unsecured Creditors v. Manufacturers and Traders Trust Company (In re Bennett Funding Group), 212 B.R. 206, 211 (2d Cir. BAP 1997) ("the court may 'invoke equity to bend the rules,' if required, to avert injustice") (citations omitted); Shugrue v. Fischer (In re Ionosphere Clubs, Inc.), 164 B.R. at 841 (quoting In re Lakeside Community Hospital: "[T]he bankruptcy judge must scrutinize the right to setoff in light of the Bankruptcy Code's goals and objectives. These goals include . . . equitable treatment of all creditors."); In re Lincoln, 144 B.R. at 502 (finding that equities required denial of setoff because of adverse effect setoff would have on secured creditor and on debtor's effort to reorganize).

²⁰ The Government at least implies that it should not even have been required to move for relief from the automatic stay. Rather, it seems to take the position that it acted appropriately when it unilaterally and without notice to the Bankruptcy Court or the secured lender froze payments owed to the Debtor. Such a bold stance is not countenanced by Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995) as the Government argues. On the contrary, the Supreme Court's holding in Strumpf that a temporary withholding of payment DURING THE PENDENCY OF A MOTION FOR RELIEF FROM STAY presupposes bankruptcy court approval before the exercise of setoff rights. Lower courts addressing analogous situations both before and since Strumpf confirm that bankruptcy court approval is a prerequisite to exercising setoff rights, including those accruing post-petition. See, e.g., Aetna Casualty v. LTV Steel Co. (In re Chateaugay Corp), 94 F.3d 772, 781 (2nd Cir. 1996) ("the IRS cannot conduct its setoff procedures without the permission of the bankruptcy court"). See also cases cited in section III, infra, at pages 39-40.

²¹ See also Shugrue v. Fischer (In re Ionosphere Clubs, Inc.), 164 B.R. at 844 (upholding the bankruptcy court's denial of the Government's setoff rights in the context of a motion for relief from stay); United States v. Arkinson (In re Cascade Roads, Inc.), 34 F.3d at 766 (upholding the bankruptcy court's decision to continue the stay after finding that the Government, which sought relief from the stay, had acted in bad faith).

²² See also Melamed v. Lake County National Bank, 727 F.2d at 1404 (court's decision regarding setoff "will not be set aside unless found to be a clear abuse of discretion"); The Official Committee of Unsecured Creditors v. Manufacturers and Traders Trust Company (In re Bennett Funding Group), 212 B.R. at 211 ("The decision of whether to lift the automatic stay is 'committed to the sound discretion of the Bankruptcy Judge'. . . . As such, the Bankruptcy Judge's decision may be overturned 'only upon a showing of abuse of discretion.'") (citations omitted).

²³ See Okwukwu v. Internal Revenue Service, 210 B.R. 194, 196 (N.D. Ala. 1997); Hudson v. United States (Internal Revenue Service), 168 B.R. 449, 452 (S.D. Ga. 1994). In Hudson, the court found that the Government's actions in withholding a refund prior to seeking relief from stay were willful thus mandating the award of actual damages and attorneys' fees for violating the stay.

²⁴ The Government criticizes the District Court's reliance on In re J.A.G., Inc. because the holding in that case did not concern the automatic stay, but rather denied setoff due to a lack of mutuality; and because the relevant legislative history concerned section 553 of the Bankruptcy Code. These distinctions do not detract from the Court's broad and unequivocal statement that the automatic stay applies to both post and pre-petition setoffs.

²⁵ While not specifically addressing issues regarding the automatic stay, additional courts have recognized that the post- petition setoff right is subject to the Bankruptcy Code. See, e.g., In re CDM Management Services, 226 B.R. 195, 196 (S.D. Ind. 1997) (recognizing the availability of post-petition setoff under the Bankruptcy Code); In the Matter of Aquasport, Inc., 155 B.R. 245, 248-49 (S.D. Fla. 1992), aff'd 985 F.2d 579 (11th Cir. 1993) (rejecting argument that the Bankruptcy Code only applies to pre- petition setoffs); Paris v. Transamerica Insurance Group (In re Buckley & Associates Insurance, Inc.), 78 B.R. 155, 158 (E.D. Tenn. 1987) (rejecting post-petition setoff claim as inequitable under Bankruptcy Code).

²⁶ The Government argues that the account receivable it seeks to set off against taxes owed by the Debtor is not "property" of the estate, but rather is simply a "chose in action". (Gov. Brief at 39). On the contrary, the United States Supreme Court has recognized that "property of the estate" includes all types of property "tangible or intangible", including "causes of action." United States v. Whiting Pools, Inc., 462 U.S. 198, 205 n. 9 (1982). See also United States v. Federation of Puerto Rican Organizations of Brownsville, Inc., 155 B.R. 44, 47 (E.D. N.Y. 1993) (discussing Whiting Pools at length, and holding that the IRS's service of levy was not sufficient to divest the debtor of its ownership interest in accounts receivable, or to prevent those accounts receivable from being included as property of the debtor's estate). Consistent with Whiting Pools, this Court and others also have held that a debtor's contractual right to recover an account receivable is property of the bankrupt estate. Ralar Distributors, Inc. v. Rubbermaid, Inc. (In re Ralar Distributors, Inc.), 4 F.3d 62 (1st Cir. 1993). See also In re National Environmental Waste Corp., 191 B.R. 832, 834 (C.D. Cal. 1996) ("it is well established in the Ninth Circuit that the contract rights of a debtor are property of the estate") (citations omitted); In re Phelps, Technologies, Inc., 245 B.R. 858, 864-865 (W.D. Missouri 2000) (debtor's right to receive payments under contract were property of the bankruptcy estate).

²⁷ The Government also cites United States v. Inslaw, 932 F.2d 1467 (D.C. Cir. 1991), and Mountaineer Coal Company v. Liberty Mutual Insurance Co., 247 B.R. 633 (W.D. Va. 2000) as support for its position. That reliance is misplaced, as neither of those cases concerns or even mentions the issue of setoff rights. Inslaw concerns the Government's continued use of a software program developed by the debtor notwithstanding a contract dispute pending between the Government and the debtor; and Mountaineer Coal concerns an insurer's failure to pay a debt which it owed to the estate. In addition to the factual distinctions of these cases, the Mountaineer court recognized that "the policy arguments in favor of finding a violation of the automatic stay when a creditor, without a reasonable basis therefor, refuses to pay over a debt to the bankruptcy estate are weighty." Id. at 644. It also acknowledged that not all courts have interpreted the Bankruptcy Code so strictly: "[T]he Court of Appeals for the Fourth Circuit has demonstrated a willingness to go beyond the strict literal wording of 11 U.S.C. section 362 when necessary to give practical effect to the remedy provided for violations of the automatic stay." Id., citing Budget Service Co. v. Better Homes of Virginia, 804 F.2d 289, 292 (4th Cir. 1986).

²⁸ Section 9-312 provides in relevant part:

(5) . . . Priority between conflicting security interest and the

³⁰ See cases cited on page 58 of Government Brief.

³¹ The Government wrongly asserts that it received notice on August 8, 1996 when it claims the Bank first reported that it was collecting the Debtor's accounts receivable. As more fully discussed in the Statement of facts, supra, on pages 12-13, the Bank first indicated its intent to attempt to collect the receivables in June 1996 (not August) when it filed a motion for relief from stay which the Bankruptcy Court granted after a hearing attended by the Government's counsel. More importantly, however, the relevant notice was of the Bank's secured interest, not of its plan to commence collection efforts. To the extent that the Government is attempting to assert that it did not receive "actual" notice in June 1995 because the notice was served on the Department of Justice and the United States Attorney but not on the Internal Revenue Service, that argument is disingenuous and without merit. As noted in footnote 7, at page 19, the Government cannot take the position that it is one entity in order to satisfy the mutuality requirement of claiming a setoff, and contrarily posit that service on one branch or department of the Government is not service on another. Moreover, as detailed in the Statement of Facts, infra, at pages 7-8, the U.S. Attorney's Office filed a Proof of Claim on behalf of the GSA as early as July 1995 and the IRS itself was served with other related notices and attended numerous hearings between June 1995 and August 1996, each of which were notice to the Government of the Bank's secured interest.

³² See also Kitaeff v. Vappi & Co., Inc. (In re Bay State York Co., Inc.), 140 B.R. at 614 ("the First Circuit has ruled that a creditor's 'setoff rights are governed by Massachusetts' basic common-law setoff doctrines,'" quoting Sisk); Armstrong v. Dakota Bank and Trust Co. (In re Knudson) 959 F.2d 1280,1284 (8th Cir. 1991) (agreeing with Sisk); Griffin v. Continental American Life Insurance Co., 722 F.2d 671 (11th Cir. 1984) (applying state law to conclude that a perfected security interest has priority over a setoff); Tavormina v. ITT Commercial Finance Corp. (In re Aquasport), 115 B.R. 720 (S.D. Fla. 1990), aff'd 155 B.R. 245 (S.D. Fla. 1992), aff'd 985 F.2d 579 (11th Cir. 1993) (setoff rights determined under state law); In re Chestnut Company, Inc., 39 B.R. 519, 521 (D.S.C. 1984) ("the nature, existence, and enforceability of claims sought to be set off are to be determined by applying the law of the state where the operative facts occurred").

³³ The revelant language of Section 106 of the Code, captioned "Waiver of Sovereign Immunity," states:

(a) Notwithstanding an assertion of sovereign immunity,

³⁵ Additional examples of cases in which courts denied the Government's setoff rights appear in Section I(A), supra, at pages 22-23.