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May 13, 1966

In the Matter of ELKINS-DELL MANUFACTURING COMPANY, Inc., Bankrupt. In the Matter of DORSET STEEL EQUIPMENT CO., Inc., Bankrupt

The opinion of the court was delivered by: LORD, III

 These cases involve a narrow but important question of bankruptcy law and administration: May and, if so, should a referee in bankruptcy refuse to enforce a security agreement between a creditor and the bankrupt which the referee finds unconscionable?


 The factual setting of both cases is similar. In Elkins-Dell, the bankrupt and Fidelity America Financial Corporation entered into a loan agreement in October, 1959. Fidelity was to advance money to the bankrupt against an assignment of accounts receivable. In January, 1960, an involuntary bankruptcy petition was filed, and after an unsuccessful attempt at an arrangement, Elkins-Dell was adjudicated a bankrupt in May, 1960.

 The agreement was, to say the least, somewhat one-sided. Fidelity was to advance 75% of the value of accounts assigned to it, but was obligated to take only "such Accounts of [Elkins-Dell] which, in the sole and unlimited discretion of [Fidelity], may be acceptable to [Fidelity] and to pay therefor." The bankrupt, on the other hand, promised that it would neither "negotiate for nor borrow any form of money whatsoever from any source other than [Fidelity] without the written consent of [Fidelity] first obtained" and that it would neither "sell or assign any accounts to any person, firm or corporation other than [Fidelity]; nor sell, dispose of, or in any way, hypothecate any assets, without the written consent of [Fidelity] first obtained." The bankrupt, in other words, had the obligation to finance only through Fidelity, but Fidelity had the power to refuse to supply the bankrupt with funds. This arrangement, the referee concluded, "spelled ruin to the bankrupt * * *." Record, Elkins-Dell, p. 24.

 Fidelity also reserved the power to direct the Post Office to deliver all the bankrupt's mail to it, to receive and open such mail and "to dispose of all mail addressed to [the bankrupt]." The bankrupt promised not to "request an extension from or a composition with creditors" or to "file a Voluntary Petition in Bankruptcy, or for an Arrangement or Reorganization or the appointment of a Receiver or make an Assignment for the Benefit of Creditors; without the written consent of [Fidelity] first obtained." Fidelity got the power to veto a suspension of the bankrupt's business, for that, too, required Fidelity's prior "written consent." It had the unilateral power to change the terms of the contract merely by giving notice of the change by certified mail. Such a change could be vetoed by the bankrupt if it expressed its disagreement in writing within five days, and there is no evidence of any attempts to change any of the terms.

 The interest rate was 1/23 of 1% per day (more than 15.8% per year) on the total unpaid balance of any amount loaned, but in any event a minimum of $500. per month, plus 5/23 of 1% on check collections. The interest rate would have been usurious, except for the Pennsylvania statute which precludes a corporation from raising the defense of usury. 15 P.S. ยง 2852-313.

 Pursuant to the agreement, substantial advances of money were made to the bankrupt, and during October, November and December, 1959, substantial collections were made by Fidelity on the accounts assigned. At the end of December, Fidelity was still owed about $28,536 (cents omitted throughout). No loans were made thereafter. By the date the involuntary petition was filed, collections on accounts had reduced the balance due to about $14,061. By January 26, 1960, the advances had been paid off, and about $2,082 stood to the credit of the bankrupt. By May 25, 1960, the credit balance was $10,678.

 In March, 1961, the trustee demanded an accounting from Fidelity. In April, an accounting was rendered, to which exceptions were filed in June. On June 27, 1961, a special hearing on the exceptions was held. Decision was reserved, and because of delay by the parties, a decision was not rendered by the referee until July 22, 1965. The referee found the contract unconscionable and ordered Fidelity to pay the costs of the proceedings and to turn over to the estate the money collected on the accounts after the petition was filed; the $5,000 minimum interest fee charged in November, 1959, for the remaining ten months of the agreement; and the difference between the more than 15% annual interest collected from October to December, 1959, and the legal rate of 6%. Of that order Fidelity seeks review.

 In Dorset Steel, the contract provisions were essentially the same, except that the interest rate was 1/20 of 1% per month (more than 18.2% per year) and the minimum interest was $250 per month. Dorset was originally a partnership. It incorporated shortly before the agreement was entered into, but the trustee concedes that he has no standing to contest the incorporation or the circumstances surrounding it, or otherwise to raise the defense of usury. *fn1"

 The major difference between the two cases is the manner in which the issue arises. In Dorset Steel, unlike Elkins-Dell, a secured claim was filed by Fidelity against the estate. The cash balance owing to it was $11,423. Finding the contract unconscionable, the referee ordered Fidelity to pay the trustee all interest collected in excess of 6% per annum, plus interest on the amounts so due, as well as the costs of the proceedings. He further disallowed the secured claim of $11,423 but allowed it as an unsecured claim in the same amount. Fidelity duly petitioned for review of that order.


 The referee concluded, to use his language in Elkins-Dell, that each of these agreements "is so one-sided in favor of Fidelity, drives so hard a bargain and is so overreaching as to be unenforceable in a court of conscience." Record, Elkins-Dell, p. 31. He relied largely on Campbell Soup Co. v. Wentz, 172 F.2d 80 (C.A. 3, 1948), which held that equity would not enforce an unconscionable contract. Campbell Soup had succeeded in obtaining an agreement with a carrot grower which included a provision excusing Campbell from accepting carrots under certain circumstances, but did not permit the grower to sell rejected carrots anywhere else. When Campbell sued for specific performance, the court found that "the sum total of its provisions drives too hard a bargain for a court of conscience to assist." 172 F.2d at 84. In the instant contracts, there is a provision comparable to the one which the court found in Campbell to be "the hardest." Id. at 83. That is the provision allowing Fidelity to pick and choose what accounts it would accept but precluding the bankrupts from going elsewhere to find funds. There are, in addition, other provisions, outlined above, which the referee found onerous and oppressive.

 In reviewing his orders, we start from the premise that "courts of bankruptcy are essentially courts of equity, and their proceedings inherently proceedings in equity." Local Loan Co. v. Hunt, 292 U.S. 234, 240, 54 S. Ct. 695, 697, 78 L. Ed. 1230 (1934). That, naturally, is not a panacea. But the equity powers of the bankruptcy court extend not merely to the issuance of orders and the granting of relief "to secure or preserve the fruits and advantages of a judgment or decree rendered therein," id. at 239, 54 S. Ct. at 697, and not just to the rigorous scrutiny that it gives the conduct and dealings of the bankrupt, e.g., Acme Distrib. Co. v. Collins, 247 F.2d 607 (C.A. 9, 1957), but also to the examination it makes of the claims of creditors, Pepper v. Litton, 308 U.S. 295, 60 S. Ct. 238, 84 L. Ed. 281 (1939). For "the bankruptcy court in passing on allowance of claims sits as a court of equity. * * * In the exercise of ...

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