DOJ Argues Government Did Not Waive 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, Mar. 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 .)

The Justice Department first argues that the First Circuit has jurisdiction because in completely eliminating the government's setoff rights, the bankruptcy court exceeded the proper scope of a stay-lift proceeding, and thereby also made an appealable ruling. The DOJ also contends that the government met the statutory test for stay lifting, noting that under Grella v. Salem Five Cent Savings Bank, 42 F.3d 26 (1st Cir. 1994), lift-stay motions are to be expeditiously granted based on asserted rights that are "colorable." The Justice Department further insists that Fleet failed to overcome the government's demonstration that there was no waiver.

[2] In fact, it is precisely because the Bankruptcy Court completely eliminated the Government's setoff rights that it exceeded the proper scope of a stay-lift proceeding, and thereby also made an appealable ruling. The Bankruptcy Court decision's language is not provisional: "The Court finds that the United States UNEQUIVOCALLY WAIVED its right to assert a setoff." ¹ (JA:0851 (italics added).) "In the alternative, the Court finds that AS A MATTER OF LAW, the bank's security interests in accounts receivable has priority over the right of setoff" under the Massachusetts UCC. (JA:0857 (italics added).)

[3] And the United States, unlike the creditor in Grella, was not able to "wait with the other creditors for the estate's administration." 42 F.2d at 34. Rather, given the Bankruptcy Court's earlier ruling that the stay prohibited freezing payments (BA:12a, 15a n.14), the Government's motion had asked, "[i]n the alternative," if setoff is denied "at this time," that --

the Court require the debtor to provide adequate protection to

[4] The District Court did not view the Bankruptcy Court's decision as provisional (and thus did not dismiss the appeal). Rather, it acknowledged that the Bankruptcy Court exceeded the scope of a lift-stay hearing, but stated that "the parties have been afforded an opportunity for an adversary hearing on the waiver issues in this Court." (BA:26a.) In fact, the appeal was not remotely like an adversary proceeding. It provided neither discovery, nor an opportunity to present evidence to rebut the Bankruptcy Court's factual assumptions. Nevertheless, the District Court viewed the appeal as curing the Bankruptcy Court's error and therefore it affirmed the final judgment.

[5] Fleet's jurisdictional objection relies on In re Henriquez, 261 B.R. 67, 70 (BAP 1st Cir. 2001), urging that this Court "must first determine whether the bankruptcy court's order 'completely resolved all of the issues pertaining to the claim'" underlying the lift-stay motion, in order to determine whether its denial is appealable. (Ans.Br: 1.) Even assuming Henriquez reflects the correct analysis to be applied in determining whether denials of lift-stay motions are appealable, ² the order in this case was final. As noted, the court concluded the Government "unequivocally waived" setoff rights, which were also held inferior "as a matter of law," and it refused to permit GSA to withhold payments (or grant other adequate protection).

[6] Furthermore, Henriquez is distinguishable. There, a creditor moved to lift the stay to foreclose a lien on equipment after the trustee had commenced an adversary proceeding challenging the lien. The bankruptcy court denied the motion expressly without prejudice to the adversary proceeding (261 B.R. at 71 n.6), and the BAP dismissed the creditor's appeal as interlocutory. In the instant case, neither the debtor nor Fleet filed an adversary proceeding "to recover money" from the Government, or to obtain any "equitable relief," or to "subordinate" setoff rights (quoting Rule 7001(1), (7), and (8)). ³ Furthermore, unlike in this case, the movant in Henriquez was not compelled to pay money to a third party outside bankruptcy -- the trustee continued to possess the tangible property at issue.

[7] On the other hand, Fleet's position that the Bankruptcy Court decision decided nothing with finality, if accepted, should mean that the Government may yet bring an action for restitution in a court of competent jurisdiction. Accordingly, if this Court accepts Fleet's jurisdictional argument, it should at least vacate the District Court's decision (for similar lack of jurisdiction), and make clear that the waiver and priority determinations have no res judicata effect if the Government sues Fleet to recover.

II. THE GOVERNMENT MET THE STATUTORY TEST FOR STAY LIFTING

[8] Fleet argues (Ans.Br:18) that the Government "put the cart before the horse" because the Government's lift-stay motion is based on assertedly valid setoff rights, whereas it must first prove a "legally sufficient" basis for setoff. This argument cannot be squared with Grella's holding that lift-stay motions should be expeditiously granted based on asserted rights that are "colorable."

[9] The statute sets forth with clarity what must be shown, after which a court "shall" modify the stay. See In re Montgomery, 262 B.R. 772, 775 (8th Cir. BAP 2001) ("[t]he issues are those identified in the text of the governing statute," citing Grella). It is beyond question that § 362(d)(2)'s standards were met: (A) the debtor lacked equity in its accounts receivable, and (B) the receivables were not necessary to reorganization. The court had already so found. (JA:0642.)

[10] Furthermore, the Government had colorable setoff rights because it owed the debtor contract payments and debtor undisputedly owed the Government taxes. ⁴ Nothing more should have been required, particularly since lifting the stay would, under Grella, have been without prejudice to Fleet's contentions.

[11] There was even a more compelling reason to grant the Government's alternative request since, under § 362(d)(1), consideration must be given to whether a creditor's right will be lost if the stay is not lifted. Here, the status quo was certainly not maintained by denying either setoff or the alternative payment- freeze request.

[12] As stated in Montgomery, the court has "discretion" to consider whether a movant's interest "is potentially vulnerable to avoidance" but that "discretion is bound in by the requirement that requests for the determination of [lien priority], or for the recovery of property, are to be made via adversary proceeding." 262 B.R. at 775 (citing Grella). Too much reliance on defenses to a claim risks having the determination "[i]n result if not form . . . come close to a decision on the merits," which "would counter the legislative intent." Id. n.5. The stay should be lifted where "'the creditor's claim is sufficiently plausible to allow its prosecution elsewhere,' subject to defenses or counterclaims there." Id. (quoting Grella, 42 F.3d at 34).

III. FLEET FAILS TO OVERCOME THE GOVERNMENT'S DEMONSTRATION THAT

[14] Fleet argues (Ans.Br:7 n.2) that service of the June 2, 1995 financing motion on the United States Attorney was adequate because GSA's proof of claim, which it mistakenly concludes was filed "a month later," specified that the Assistant U.S. Attorney represented "the United States of America." As the District Court observed (BA:7a-8a), the GSA claim was not filed until February 1, 1996, ⁵ and the United States Attorney was served only because the SBA had a $110,000 lien (BC:Dkt 55, Sched. D). But the IRS should have been served and sent notice of the hearing, even if its rights were not directly impacted. Bankruptcy Rule 2002(a)(3) and (j)(3) required that notice of the proposal to use the debtor's property to secure financing be mailed to the "District Director of Internal Revenue." None of the subsequent motions or stipulations to continue the financing orders were sent to the IRS (e.g. JA:0093), even after it was scheduled as a creditor. ⁶ And, the April 26, 1996 stipulation was the first one served on IRS counsel. ⁷ (JA:0498, 0501.)

[15] Moreover, to subordinate setoff rights, an adversary proceeding would have been required (see Rule 7001(8)), calling for service on the IRS pursuant to Rule 7004(b)(5). Indeed, subordinating an interest without targeted notice sufficient to apprize the holder that its rights would be affected would violate due process. In re Blumer, 66 B.R. 109, 114 (9th Cir. BAP 1986), aff'd 826 F.2d 1069 (9th Cir. 1987)(Table). At all events, the financing orders did not subordinate setoff rights, and therefore it was unnecessary for the Government to object to them.

[16] Fleet insists (Ans.Br:7-8) the Government knew of Fleet's lien on debtor's accounts receivable. Preliminarily, there is no evidence of such knowledge prior to April 1996. Moreover, the relevant inquiry for waiver is whether the Government knew of its setoff rights. Unless it knew of those rights, there could not have been a "purposeful relinquishment of an appreciated right." Irons v. F.B.I., 811 F.2d 681, 686 (1st Cir. 1987). Fleet offers no evidence that the IRS knew, prior to June 1996, of any postpetition receivables due from the Government. ⁸

(2) FLEET'S LIFT-STAY MOTION

[17] Fleet parrots (Ans.Br:21) the Bankruptcy Court's faulting the Government for "failing to object to the Bank's Lift Stay Motion." But the Government's opening brief (at 48) demonstrated that it could not have asserted a valid objection, since Fleet was entitled to have the stay lifted, regardless of the Government's setoff rights. And, Fleet's lift-stay motion did not mention or purport to have any impact on setoff rights.

(3) & (4) THE GOVERNMENT'S PREPETITION AND POSTPETITION

[19] To attempt to support the implication that the Government "expressly disclaimed any right of setoff," Fleet first states (Ans.Br:8-9) that the IRS requests for administrative tax payments under § 503 did not "mention" setoff, but Fleet fails to point to any evidence of the advertised "express disclaimer" of POSTPETITION setoff rights. Fleet never explains why the § 503 requests were required to mention setoffs at all. Nor does Fleet explain why the IRS should have been expected to assert postpetition setoff rights before they even existed.

[20] Fleet next (Ans.Br:9) quotes the IRS claims for PREPETITION taxes, emphasizing the statement that "This claim is not subject to any setoff or counterclaim." That is a statement that the debtor has no defensive setoff to the tax claim. In light of § 106(c)'s mandatory language that "there shall be offset against a claim or interest of a governmental unit any claim against such governmental unit that is property of the estate," the statement in the claim merely confirms that the IRS was unaware of any prepetition government contract payables.

[21] Moreover, Fleet leaves out that the debtor had already (on June 9, 1995) filed schedules indicating it was neither owed money by, nor doing business with, any government agency. Schedule E, exhibit E-2 (BC:Dkt 55) lists the IRS as an "unsecured" priority creditor (for $246,448). Under § 506(a), if the debtor knew the Government owed it money, it should have listed the IRS as secured. Schedule G, exhibit G-1 (ibid.) represents that debtor had no executory contracts with any government agency. The IRS is entitled, in preparing its claim, to rely on the debtor's representations that the debtor was NOT owed money by, and NOT currently doing business with, the Government. ⁹ The IRS should not be required, in order to avoid waiving setoff rights, to expend its limited resources surveying every federal agency, just to be sure the debtor's schedules were accurate.

[22] The other statement Fleet quotes (Ans.Br:9) from the prepetition tax claims is that the "claimant has deducted all amounts that claimant owes to debtor." But since the claimant is identified on the claim as the "Department of the Treasury -- Internal Revenue Service" (JA:0101), all this indicates is that there were no tax overpayments. The sums payable through GSA were owed by the Department of Defense. (See also Opn.Br:49.)

B. FLEET'S SUPPLEMENTAL GROUNDS FOR WAIVER

[23] In addition to the alleged bases for finding a waiver relied on by the courts below, Fleet asserts (Ans.Br:10) that the February 20, March 4, and March 7, 1996 disclosure statements were "served on the Government," and implies that the Government's failure to object to them somehow reflects a knowing relinquishment of an appreciated right. In fact, the February 20 and March 4 versions were sent only to the IRS, and not to government counsel (JA:0256; 0332), despite the fact that the GSA claim directed that the Assistant U.S. Attorney also be served. And the March 7 version, while served on the Assistant U.S. Attorney, was accompanied by an order stating that it had already been approved. (JA:0410.) The disclosure statements, each a half inch thick and including almost 30 fine-print single-spaced pages plus extensive exhibits, include a single sentence in the middle of a paragraph, stating that debtor "INTENDS to continue to develop its government contract business and currently has several BIDS OUTSTANDING for additional government work." (E.g., JA:0337 (emphasis added).) The extensive attachments list no government agencies or receivables.

[24] Moreover, a disclosure statement's only function is to aid creditors in evaluating a plan (§ 1125), as the disclosure statements confirm (JA:0334), and the Government DID object to the plan. Having determined that the plan on its face was objectionable, there was no reason to pore through the already-approved disclosure statement (and there is no evidence that any Government official did so).

[25] Fleet misreads the record in asserting (Ans.Br:10) that the Government's plan objection failed to contain "any reference to potential setoffs." Quite the opposite, the plan objection expressly asserted the Government's prepetition "offset" rights in three places (JA:0434, 0438, 0439), and further objected that the plan did not properly provide for the Government's "secured claim" (ibid.). ¹⁰ While the objection did not identify POSTPETITION setoff rights, there is nothing in the record to suggest that the Government was aware of any, or even that there WERE in fact any, postpetition contract payments owed by the Government when it filed the plan objection. Also, the plan's promised payment of postpetition taxes made it less crucial for the Government to preserve postpetition setoffs. The Government may accept a plan's promise of an alternative method of fully satisfying a tax claim, without losing its setoff rights if the plan is rejected and a lienholder demands contract payments from the Government outside bankruptcy, and the taxes will NEVER be paid.

[26] Fleet asserts (Ans.Br:12) the Government "failed to disclose" its letter instructions to GSA to freeze payments; but a "failure" assumes a duty. There simply was none. The letter confirmed part of a confidential telephone conversation among a government officer and government attorneys. (JA:0650.) It advised the agency to search for obligations, freeze any found due, and promptly notify counsel so counsel could "ask the United States Bankruptcy Court for permission to effectuate an offset" (ibid.), consistent with § 362(d). The agency had just advised counsel it could find no such obligations (JA:1055), and there was therefore no assurance that any would be found. And, assuming Fleet was relying on being able to collect gross contract payments free of any setoff rights, government counsel surely had no reason to deduce that fact. ¹¹ But even if there was a duty of disclosure, there is no evidence that Fleet's position worsened between June 13, 1996, and June 28, when Fleet admits it learned of the Government's intentions (JA:0649), especially since the then-frozen funds were released before the Government filed its lift-stay motion. And even assuming the letter violated the stay, that cannot be a basis for eliminating the Government's setoff rights. See In re Rush-Hampton Industries, Inc., 98 F.3d 614, 617 (11th Cir. 1996).

C. FLEET'S "ANALOGOUS" CASES ARE NOT ANALOGOUS

[27] Fleet mistakenly urges (Ans.Br:22) that In re Lykes Bros. Steamship Co., 217 B.R. 304 (Bankr.M.D.Fla. 1997), is "closely analogous." In Lykes, the Commodity Credit Corp. asserted a setoff long after the bar date for amending claims, and after confirmation of a plan that expressly prohibited setoff. The court held that § 553 is trumped by res judicata in view of § 1141's binding effect of a plan confirmation order. In alternative dictum, the court, observing that setoffs may be denied where they may interfere with a successful reorganization, held the setoff was waived, partly because the debtor's plan detrimentally relied on the lack of a setoff. Id. at 313.

[28] In the instant case, the bar date for amending claims did not expire, and the IRS therefore could have amended its claim to assert a setoff, just as it was able to do in In re Sound Emporium, 48 B.R. 1 (Bankr. W.D. Tex. 1984), aff'd 70 B.R. 22 (W.D. Tex. 1985). Also, unlike in Lykes, here the Government timely asserted setoff in objecting to the plan. See In re Krause, 261 B.R. 218, 223 (8th Cir. BAP 2001) (setoff is not waived by omission from a claim where raised in plan objection).

[29] Fleet's reliance (Ans.Br:22) on In re Apex Int'l Management Services, Inc., 155 B.R. 591 (Bankr. M.D. Fla. 1993), aff'd 1996 WL 172210 (M.D.Fla. 1996), is similarly misplaced. The finding that the IRS waived its setoff rights came in an adversary proceeding (not a summary lift-stay proceeding). Before postpetition taxes accrued, the lender, in a proceeding in which the IRS participated, was granted an adequate protection lien covering the debtor's claim against the Air Force in order to finance litigation on that claim. Id. at 593, 595-96. The lender spent two years and $143,000 in attorney fees pursuing debtor's claims against the Air Force, creating the $15,000 settlement fund that the IRS belatedly stepped in to claim. Id. at 595. The district court affirmance is based almost exclusively on this gross inequity, which justified equitable subordination, regardless of waiver.

D. RELIANCE IS RELEVANT TO ESTOPPEL, NOT WAIVER

[30] Fleet insists (Ans.Br:25) that detrimental reliance is relevant to whether a waiver has occurred. Although reliance is relevant to estoppel, it has no bearing on whether a party has made a "purposeful relinquishment of an appreciated right" -- the crux of a waiver. Irons, 811 F.2d at 686. Accord Rose v. Regan, 344 Mass. 223, 229, 181 N.E.2d 796 (1962). ¹²

[31] The relationship between waiver and detrimental reliance is best revealed in In re Metropolitan Int'l, Inc., 616 F.2d 83 (3d Cir. 1980), where the Third Circuit stated the two issues "are whether the appellant possessed the requisite intent for a valid waiver, and if so, did the [bankruptcy] receiver detrimentally rely upon the waiver, thereby ESTOPPING a recission" of the waiver. 616 F.2d at 86 (emphasis added). The Court then affirmed the bankruptcy court's determination that the creditor had waived setoff, but reversed the reliance finding, "hold[ing] that the bankruptcy court erred in failing to hold a hearing" to ascertain whether there was really detrimental reliance. ¹³ Id.

[32] At all events, Fleet's arguments (Ans.Br:27, 28) that it "relied" on the statements or omissions in the various tax claim forms are belied by the record. Fleet's counsel objected at the hearing to being deemed to have notice of the setoff assertions in the GSA claim form, explaining that the bank generally does not review other creditors' proofs of claim. (JA:0732.) Indeed, Fleet did not argue in the Bankruptcy Court that it relied on the claim forms -- the court raised that assumption sua sponte.

[33] Also, Fleet does not dispute that, although the stipulated financing orders use language suggesting Fleet was making new loans to finance a reorganization, as a practical matter, the "arrangement allowed debtor to continue receiving cash payments due on its accounts while the bank's interest in debtor's accounts receivable would 'roll-over' to future accounts receivable." (BA:6a n.5.) This undermines any claim of "detriment" resulting from any conceivable reliance on any act or omission by the Government, since Fleet, notwithstanding its unproven assertions, did not introduce any EVIDENCE that if the Government had asserted setoff rights at any given moment during the case, Fleet's exposure would have been any less. In contrast, the IRS was involuntarily financing the debtor's operations through the debtor's continuous diversion of trust fund taxes.

E. IMPUTED KNOWLEDGE IS ANTITHETICAL TO A KNOWING WAIVER

[34] Fleet argues (Ans.Br:29 n.16) that "[i]t 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 government agencies," quoting Apex, 155 B.R. at 595 (bracketed words supplied by Fleet). This argument cannot withstand scrutiny. The United States has both a common-law and statutory right to offset debts and claims between different agencies. There are over a hundred federal agencies and thousands of offices spanning fifty States and, as the Second Circuit observed, the contention that one government official must be charged with another's knowledge "can be disposed of on a 'reducto ad absurdum' basis." United States v. Quinn, 445 F.2d 940, 944 (2d Cir. 1971), cert. denied, 404 U.S. 850, 945 (1971). See Fansteel Metallurgical Corp. v. U.S., 145 Ct.Cl. 496, 501 (1959) ("one branch of the Government cannot be attributed with knowledge which reposes in files of other department units").

[35] Moreover, the imputed knowledge approach cannot be squared with the rule that a waiver is the knowing relinquishment of an appreciated right. Thus, in Sound Emporium, 48 B.R. at 2, the bankruptcy court determined that the tax claim form's disavowal of setoff rights should not control, because the IRS had lacked knowledge of Army's obligation to debtor. See also In re South Park Care Assoc., Inc., 203 B.R. 445, 448 (Bankr. W.D.Mo. 1996) (Government did not knowingly waive setoff by failing to object to plan modification because "the right was unknown to HCFA at the time of the Third Modification" and "HCFA could not have knowingly or intentionally waived an unknown right").

F. EQUITY CANNOT IGNORE THE LAW

[36] The Government's opening brief demonstrates (at 23-24) that setoff is a common law and/or statutory right which, outside bankruptcy, requires no judicial assistance. Fleet responds first by arguing (Ans.Br:31-32) that under Darr v. Muratore, 8 F.3d 854 (1st Cir. 1993), setoff in the bankruptcy context may result in an inequitable "preference" and therefore "is not automatic." Using that as a springboard, Fleet relies on decisions by some other courts that have asserted they may "invoke equity to bend the rules" or to "override a creditor's satisfaction of technical statutory requirements" for setoff. (Ans.Br:33 & n.19 (quoting cases).)

[37] Darr's comment that setoff in bankruptcy may result in a "preference" and is therefore "not automatic" must be read in the context of what immediately follows it -- the explanation that debts must be "mutual" for a setoff to be appropriate. 8 F.3d at 860. Since, § 506(a) accords secured status to claimants with setoff rights, it is untenable to view proper setoffs of MUTUAL debts as resulting in a preference, and Darr does not suggest otherwise. Moreover, Darr recognizes that setoff is a "common law right," id., and does not remotely endorse the view that courts may override legally valid setoffs based on amorphous evaluations of general fairness.

[38] Fleet (Ans.Br:31-33) does cite some cases holding that setoff is an "equitable remedy" subject to broad judicial defeasance. We submit that this view is traceable to a misreading of Cumberland Glass Co. v. DeWitt, 237 U.S. 447 (1915). The Supreme Court was construing § 68a of the old Bankruptcy Act of 1898 and held that "the provision is permissive" only in the sense that "the language of the act indicates the necessity of action by the court for the statute provides that 'the account shall be stated.'" Id. at 455. Thus, the statement that "the matter is placed within the control of the bankruptcy court, which exercises its discretion in these cases upon the general principles of equity," must be read in conjunction with the Supreme Court's further statements that setoff is a right "established in common law," while subject to "equitable procedure," and that it does not matter that setoff "has the effect to pay one creditor more than another" because it is a "generally recognized right of mutual debtors" and, when properly invoked, "should be enforced by the court." Id.

[39] The leading bankruptcy treatise and better reasoned cases agree that where the legal elements for setoff are met, bankruptcy courts may not abrogate the right except as empowered by a specific provision of the Bankruptcy Code. Collier on Bankruptcy ¶ 552.02[3] at 553-11 (revised 15th ed., 1996); In re Applied Logic Corp., 576 F.2d 952, 957-58 (2d Cir. 1978) (Friendly, J.); In re Krause, 261 B.R. at 223 (8th Cir. BAP 2001). At the very least, "compelling circumstances" are required to abrogate a right of setoff. In re Bennett Funding Group, 146 F.3d 136, 139 (2d Cir. 1998); In re Medina, 205 B.R. 216, 223 (9th Cir. BAP 1996); In re Whimsy, Inc., 221 B.R. 69, 74 (S.D.N.Y. 1998).

[40] Further, bankruptcy courts have only those powers conferred by Congress. Their remedial powers arise under § 105, which does not authorize "bend[ing] the rules" of law. As this Court has observed:

A bankruptcy court may invoke section 105(a) only if the

[41] Assuming bankruptcy courts have discretion to abrogate legally valid setoff rights, it was error to do so here. Even those courts which maintain they have discretion to nullify setoff rights have generally limited denial to creditors "who engaged in illegal or fraudulent conduct," In re Blanton, 105 B.R. 321, 337- 338 (Bankr. E.D.Va. 1989)(listing cases), or acted "tortiously or in bad faith." Rush-Hampton Industries, 98 F.3d at 617. ¹⁴ Furthermore, eliminating a legal right based on alleged inequity plainly requires an adversary proceeding. Rule 7001(7).

IV. THE STAY AFFECTS ONLY PREPETITION SETOFF RIGHTS

[42] Our opening brief (at 42) reveals that the District Court misread cases as involving the applicability of the stay to postpetition setoffs when they only involved prepetition setoff rights. Fleet multiplies this error. It argues (Ans.Br:38) that the Government has twice lost the argument that the stay is inapplicable to postpetition setoff rights, citing Okwukwu v. IRS, 210 B.R. 194 (Bankr. N.D.Ala. 1997), and Hudson v. IRS, 168 B.R. 449 (Bankr. S.D.Ga. 1994).

[43] But both cases involve only PREPETITION tax overpayments and PREPETITION tax claims. Similarly, Braniff Airways Inc. v. Exxon Corp., 814 F.2d 1030 (5th Cir. 1987), involved wholly PREPETITION- accrued setoff rights. And, Pruett v. American Income Life Ins., 220 B.R. 625 (Bankr. E.D.Ark. 1997), involved a recoupment issue (not setoff) with a PREPETITION claim on one side of the transaction. Among Fleet's citations, only one case is on point, and its entire analysis consists of the following conclusory assertion: "However, 11 U.S.C. § 362(a)(3) is not limited in its application to prepetition claims or events. Therefore, even if we conclude that § 362(a)(7) is inapplicable, the automatic stay arises by reason of § 362(a)(3)." In re 222 Liberty Associates, 110 B.R. 196, 200 (Bankr.E.D.Pa. 1990). The case pre- dates Citizens Bank of Md. v. Strumpf, 516 U.S. 16 (1995), which undermines this view by confirming that freezing an account -- even one normally subject to a unilateral ability to withdraw -- does not control anything belonging to the person demanding payment.

[44] Fleet asks (Ans.Br:40-43) this Court to read Strumpf narrowly and ignore its reasoning that refusing to pay a debt based on a right of setoff does not control any property of the person demanding payment. But that is the basis for Strumpf's conclusion that withholding payment cannot violate § 363(a)(3). ¹⁵ In this regard, Fleet mischaracterizes our argument as being that the "accounts receivable" were not property of the estate. The debtor's CLAIMS against the Government, which the accounts receivable represented, were undoubtedly property of the estate (at least until Fleet foreclosed on them). But claims may be subject to defenses, including setoff. The Fifth Circuit recently reached an analogous conclusion, holding that, although "a debtor's claim to a tax refund is property of the estate," the tax overpayment did not become estate property where it was subject to setoff, and therefore could not be claimed as exempt property. In re Luongo, 259 F.3d 323, 335 (5th Cir. 2001).

[45] Fleet mistakenly infers (Ans.Br:46) a Government "argument that post-petition setoffs are not subject to review by the bankruptcy court." No such argument is advanced. We only argue that the stay does not enjoin setoff of mutual postpetition debts. This is the plain meaning of § 362(a)(7), which would be entirely superfluous if § 362(a)(3) barred setoffs. If a debtor feels a setoff has been improperly taken, it may file an adversary proceeding to recover on a postpetition debt. This maintains a level playing field among reorganizing debtors and their competitors (whose invoices are subject to setoff without court assistance).

[46] Even if the stay applies to postpetition setoffs, the Bankruptcy Court nevertheless erred in refusing to lift it. As noted (pp.5-7 supra), the Government met the § 362(d)'s standards, and stay-lifting would have been without prejudice to Fleet's contentions. Also, the policy behind staying setoffs does not extend to protecting a secured creditor. Thus, in In re Davidson Lumber Sales, Inc., 66 F.3d 1560 (10th Cir. 1995), the court held that "mutual postpetition debts may be set off" and, without deciding whether § 362(a)(3) would otherwise apply, held that a creditor collecting the debtor's accounts receivable under a security interest could not invoke any stay against such setoffs. It reasoned that, since § 362(a)(7)'s stay of prepetition setoffs was intended to promote rehabilitation of debtors and not to grant windfalls to secured creditors, any application of § 362(a)(3) to postpetition setoffs should be similarly limited. Id. at 1569. And, "[t]he result should be controlled by the law that would control outside of bankruptcy." Id. at 1570. The Tenth Circuit's refusal to allow a lienholder to invoke § 362(a)(3), which protects "property of the estate," is consistent with the rule that only a trustee (or debtor in possession) has standing to represent the estate. § 323; Rule 6009. Thus, Fleet lacked standing to defend against stay-lifting based on § 362(a)(3) (and the debtor, stripped of all its assets by Fleet's foreclosure, had no economic stake).

V. FLEET'S PRIORITY ARGUMENTS

[48] At the end of its brief, Fleet argues that the Anti- Assignment Act is inapplicable to its lien authorized by § 364. Fleet observes that transfers by "operation of law" are not subject to the Anti-Assignment Act, and that this includes a transfer to an "assignee in bankruptcy." The operation-of-law exception applies to transfers to bankruptcy trustees and to "general assignments for the benefit of creditors . . . by analogy" United States v. Shannon, 342 U.S. 288, 292 (1952). But it generally does not apply to benefit individual creditors. See Patterson v. United States, 354 F.2d 327, 330-32 (Ct.Cl. 1965) (receiver for single creditor does not meet operation-of-law exception). Moreover, § 364 merely permits the court to "authorize the obtaining of credit" by the trustee or debtor in possession "secured by a lien on property of the estate." It is questionable whether this empowers a bankruptcy court to relieve a debtor of the need to comply with the Anti-Assignment Act. Cf. St. Paul & D. R. Co., 112 U.S. 733, 735-37 (1885) (court approval of voluntary assignment does not fit operation-of-law exception).

[49] More fundamentally, Fleet's argument misses the mark because, even if the procedural requirements of the Anti-Assignment Act do not apply, that does not mean the assignee can gain greater rights against the Government than the assignor. Assuming arguendo that § 364 enables Fleet's lien to attach to rights to payment from the Government, it is clear that the lien attaches only to the net debt (after accounting for setoff defenses).

[50] Outside bankruptcy, it cannot be doubted that Fleet's lien could not have affected the Government's setoff rights. See Malman v. United States, 207 F.2d 897, 898 (2d Cir. 1953) ("claims against the United States are always subject to set-off"); Applied Companies v. United States, 144 F.3d 1470, 1476 (Fed. Cir. 1998) ("it is well settled that the government retains its setoff right unless there is some explicit statutory or contractual provision that bars its exercise").

[51] Any suggestion that § 364 can alter this result is belied by § 106(a)(4). That provision specifies that the enforcement of any bankruptcy court judgment against the United States shall be paid as if rendered by a district court in a nonbankruptcy case. Such judgments are subject to the Judgment Setoff Act, 31 U.S.C. § 3728(a), providing that the Government "shall withhold paying that part of a judgment against" it "that is equal to a debt the plaintiff owes the Government." (See Opn.Br:54-55.) And, § 106(c) mandates that a debtor's claims against the Government be setoff against the Government's claims. ¹⁶ Thus, had Fleet (or the debtor) brought an adversary proceeding "to recover money" from the Government, see Rule 7001(1), the Government's setoff rights would have been superior. Surely Fleet cannot circumvent that result by opposing a lift-stay motion.

[52] Further, Fleet admitted to the Bankruptcy Court that the financing orders do not mention, let alone expressly subordinate, setoff rights. (JA:0748.) In this regard, although Fleet's brief repeatedly claims it was granted a "superpriority security interest" or "superpriority lien," nowhere in the financing orders does the word "superpriority" modify "lien" or "security interest." The financing orders do not cite § 364(d)'s provision for granting a senior lien, but rather cite § 364(c)(2) and (3), and expressly provide that liens granted Fleet "are junior liens." (JA:0042; 0066.)

[53] "Superpriority" refers to unsecured claims for administrative expenses granted priority under § 507. Section 507(b) permits such superpriority where a postpetition lender's collateral becomes insufficient and it must look to the scheme for distribution of the estate's funds available for distribution. This is recognized in paragraph 7 of each of the financing orders. (JA:0043; 0067.) This kind of administrative superpriority with respect to distribution of property of the estate has no impact on a right of setoff, which limits the funds that reach the estate in the first place. As Strumpf teaches, the estate does not own funds of an account debtor that are subject to a right of setoff. ¹⁷ 516 U.S. at 21. See In re Calderone, 166 B.R. 825, 830 (Bankr. W.D.Pa. 1994) (one asserting setoff "is NOT requesting distribution from the bankruptcy estate res") (emphasis in original). Moreover, in every Bankruptcy Code chapter, "secured claims," which include not just liens but also setoff rights under § 506(a), trump even superpriority unsecured administrative claims. See 11 U.S.C. §§ 725, 1129(b)(2)(A), 1325(a)(5). Thus, "[a]dministrative expenses . . . do not have priority over secured claims." Hartford Underwriters Ins. Co. v. Union Planters Bank, 530 U.S. 1, 5 (2000). Stated another way, even subordinated claims can be used for setoffs, before funds reach the estate. Rochelle v. United States, 521 F.2d 824, 855 (5th Cir. 1975) (old Act), amended on reh'g, 526 F.2d 405 (1976), cert. denied, 426 U.S. 948 (1976); In re Alliance Health of Ft. Worth, Inc., 240 B.R. 699, 704 (N.D.Tex. 1999), aff'd (Table) 200 F.3d 816 (5th Cir. 1999). Thus, it matters not whether the financing orders subordinated all other administrative claims to Fleet's right to repayment of postpetition loans, because the superpriority rules apply only to ESTATE funds to be distributed by a trustee (or pursuant to a reorganization plan).

B. STATE LAW ALSO ACCORDS PRIORITY TO THE GOVERNMENT'S SETOFF

[55] Fleet's reliance on § 506(a) to argue that a setoff is a "security interest" falling under UCC 9-312 is misplaced. Section 506(a) merely grants "secured claim" status to claims "subject to setoff"; it does not state that a setoff is a "security interest." Bankruptcy Code § 101(51) defines a "security interest" as a "lien created by an agreement." This does not encompass a setoff. Also, § 506(a) applies only to prepetition claims and § 553 would prevent § 506 from altering State-law rules for determining the priority of a prepetition right of setoff. Under State law, UCC 9-104(I) flatly precludes treating setoffs as a "security interest." In re Thompson Boat Co., 230 B.R. 815, 826 (Bankr.E.D.Mich. 1995).

[56] Fleet's argument (Ans.Br:51-53) that it prevails under UCC 9-318 has two fatal flaws. First, contrary to Fleet's arguments, the notification of an assignment referred to under that UCC provision is not notice of a security interest, but rather notification that the lender is collecting the borrower's accounts, consistent with UCC 9-502. (See Opn.Br: 59-60.) Thus, the first notification was August 8, 1996, when Fleet reported its foreclosure to the court or, at the earliest, June 17, 1996, when the stay was lifted to allow Fleet to enforce its security interest by collecting. By then, the postpetition taxes had fully accrued. Even if notification of assignment refers to a mere security interest, the postpetition taxes accrued before the Government received ACTUAL notification of any security interest, and certainly before it learned of a security interest in GOVERNMENT contract obligations. In this regard, UCC 9- 318(3) requires that the notification must identify the particular accounts assigned.

[57] Second, Fleet ignores that UCC 9-318 applies only to an "account debtor," which is defined by UCC 9-105(1)(a) as one who is already "obligated on an account." Thus, notification is not effective against a party who has not yet received goods or services (such as debtor's trucking services, JA:0336) under a contract that only requires payment for goods delivered or services performed. Where an offsetting claim arises BEFORE the contract is performed, the account debtor never owes more than the net indebtedness. ¹⁸ "[H]e who hath not cannot give." Commerce Bank, 244 F.3d at 783. "THIS IS A FUNDAMENTAL RULE OF LAW, and no resort to the complexities of the Uniform Commercial Code can render it impotent in this action." Id. at 784 (italics in original). See Taylor v. Barton-Child Co., 228 Mass. 126, 129, 117 N.E. 43 (1917) ("[a] man cannot grant or charge that which he hath not").

CONCLUSION

[58] The judgments of courts below should be reversed.

Respectfully submitted,

[59] I certify that this reply brief complies with the type volume limitation set forth in Rule 32(a)(7) of the Federal Rules of Appellate Procedure (as modified by Court order). The body of this brief contains 7,955 words.

PETER SKLAREW

[60] It is hereby certified that service of this reply brief has been made upon counsel for the appellee on this 7th day of November, 2001, by delivery of two copies, and one computer readable disk copy, to Federal Express for delivery to them within 3 calendar days, properly addressed as follows:

Debra K. Mayfield, Esquire

² Several courts have concluded that orders denying relief from the stay are generally final and appealable, being analogous to the refusal to modify an injunction. In re Delta Resources, Inc., 54 F.3d 722, 726 (11th Cir. 1995), cert. denied, 516 U.S. 980 (1995); RTC v. Swedeland Dev. Group, Inc. (In re Swedeland Dev. Group, Inc.), 16 F.3d 552, 559 n.4 (3d Cir. 1994); In re Chateaugay Corp., 880 F.2d 1509, 1511 (2d Cir. 1989); Matter of Boomgarden, 780 F.2d 657, 660-61 (7th Cir. 1985); In re American Mariner Industries, 734 F.2d 426, 429 (9th Cir.1984).

³ Since a setoff is normally a defense to an action on a debt, it was not the Government's responsibility to file an adversary proceeding. And once the Government paid the debt (as required by the Bankruptcy Court's denial of even the alternative request to freeze payments), the Government could not, as a practical matter, obtain relief in an adversary proceeding. An adversary proceeding AGAINST THE DEBTOR would be useless -- by the time of the Bankruptcy Court's decision, the debtor was an empty shell, and the Government's money was going to Fleet. (JA:0777-831.) An adversary proceeding AGAINST FLEET would thereafter have served no bankruptcy purpose, thereby raising a serious jurisdictional issue. Except for dischargeability determinations implicating a debtor's fresh start, a dispute is outside bankruptcy jurisdiction unless the outcome can affect the administration of the bankruptcy estate. Celotex v. Edwards, 514 U.S. 300, 309 n.6 (1995). A suit by the Government against Fleet to recover money could not affect the bankruptcy estate's administration. Accordingly, such a suit would need to be brought outside bankruptcy, in the district court pursuant to 28 U.S.C. § 1345. But that nonbankruptcy recourse cannot possibly be a basis to consider the BANKRUPTCY COURT ORDER interlocutory.

⁴ Fleet suggests (Ans.Br:19n.7) that this Court may hold that different federal agencies' debts lack mutuality in bankruptcy cases. This argument has been uniformly rejected (correctly, we submit) by those courts of appeals that have addressed this issue. See, e.g., United States v. Maxwell, 157 F.3d 1099 (7th Cir. 1998); In re Continental Airlines, Inc., 134 F.3d 536 (3d Cir. 1998), cert. denied, 525 U.S. 929 (1998); In re Hal, Inc., 122 F.3d 851 (9th Cir. 1997); In re Chateaugay Corp., 94 F.3d 772 (2d Cir. 1996); In re Turner, 84 F.3d 1294 (10th Cir. 1996). The courts below did not reach this issue.

⁵ Fleet's record citation (JA:0178-81) is to the earlier-dated attachment to the claim form. The claim is file-marked February 1, 1996 (JA:0177).

⁶ The IRS was scheduled as a creditor on June 9, 1995 (BC:Dkt 55, Exhibit E-2), shortly after the final financing motion was served on June 2, 1995.

⁷ Fleet's brief states there was an "entire year of active involvement by the Government" and supports this with an out-of- context quote from Judge Stearns' mandamus decision, saying the court found that counsel for the IRS "receive[d] copies of all pleadings and orders filed in the case." (Ans.Br: 11 & n.6.) But Judge Stearns found only that pleadings and orders served after the IRS attorney was "an attorney of record" were received by him. (JA:1116 n.6.) IRS counsel did not appear until April 1, 1996. (BC:Dkt 474.)

⁸ Fleet asserts (Ans.Br:18) that the "undisputed facts reveal that the Government knew for months" about its setoff rights and "remained silent." Quite the opposite, the record confirms that the Government quickly asserted its PREPETITION setoff rights in the GSA claim and reiterated them in the plan objection. There is no evidence that the Government was aware of POSTPETITION setoff rights before IRS counsel examined the exhibits to debtor's May 31, 1996 § 363-sale motion on the way home from the June 10, 1996 hearing. (JA:1054-55.) Within slightly more than two weeks, the GSA informed debtor of the payment freeze, and Fleet learned of the Government's determination to exercise postpetition setoff rights. (JA:0649.)

⁹ The official instructions for completing Official Form 10 state that "the proof of claim is the creditor's response to the information provided by the debtor in the debtor's schedules."

¹⁰ Fleet incorrectly claims (Ans.Br:28 n.15) that the Government did not properly serve its plan objection. To the contrary, although the certificate of service (JA:0449) does not list Fleet's counsel because Rule 3020 does not require service of plan objections on creditors, IRS counsel nevertheless mailed copies to all creditors including Fleet's counsel. (JA:1047-48.)

¹¹ See also JA:1071-97 (affidavits of two bankruptcy experts -- one by a former United States Trustee for a multi-state region for ten years -- opining, inter alia, that Government counsel had no duty to disclose, and should not have disclosed, the Government's efforts to find and freeze payments before they were actually found).

¹² Fleet (Ans.Br:25) cites In re Brockton Shoe Mfg., 8 F.Supp. 959, 961 (Mass. 1934), for the view that an entity may unintentionally waive setoff rights. The case was decided under the old Act, which used different statutory language, mandating that setoffs be stated in claims (compare old Act § 68a with Code § 553). Moreover, the bank admitted it was aware of its setoff rights and argued only that it misconstrued the law regarding their priority.

¹³ Because the waiver determination was affirmed in Metropolitan, Fleet cites it (Ans.Br:25) for the proposition that waiver can be determined as a matter of law where that is the only reasonable conclusion from undisputed facts. However, in Metropolitan, the creditor had stated on several occasions that it was aware of its setoff rights and would not exercise them.

¹⁴ Fleets argues that In re Cascade Roads, 34 F.3d 756 (9th Cir.1994), supports equitable elimination of setoff rights. The denial there was based on a willful stay violation that caused significant damages, and on conduct considered "highly inequitable," involving an "endless string of meritless defenses and delays [that] held up distribution to Cascade's creditors for nearly a decade." Id. at 766. The Rush-Hampton decision distinguishes Cascade Roads as resting on a finding of "bad faith during litigation." 98 F.3d at 617.

¹⁵ Fleet's reliance (Ans.Br:42) on In re Holden, 236 B.R. 156 (Bankr.Vt. 1999), aff'd, 258 B.R. 323 (D.Vt. 2000), is also misplaced. The court found a violation of § 363(a)(3) by the "indefinite" freeze, without court permission, of a postpetition tax refund for potential setoff against a PREPETITION tax debt. But the court relied heavily on its view that there was really never a right of setoff (postpetition to prepetition) to justify the freeze under Strumpf, and on the fact that the refund greatly exceeded the claim, at least entitling the estate immediately to the surplus. Here, the Government asked to setoff or freeze only enough GSA obligations to cover the taxes. (JA:0676.)

¹⁶ Section 364's silence about setoff rights cannot -- in the face of § 106(a)(4) and (c) -- provide the unambiguous waiver of sovereign immunity required to eliminate the Government's setoff rights. See United States v. Cohen, 389 F.2d 689, 692 (5th Cir. 1967).

¹⁷ Similarly, even if Fleet had been granted a superpriority lien under § 364(d), such a lien, by the terms of § 364(d), encumbers only "property of the estate." (The same applies to the "junior" lien Fleet WAS granted under § 364(c).)

¹⁸ Our opening brief (at 62) demonstrates that the record not only reveals that the postpetition taxes accrued before notification, but also indicates it was before the postpetition contract obligations arose. Fleet has the burden of proof on such issues. See § 362(g).