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decided: April 25, 1979.


No. 794 April Term, 1978, Appeal from the Order of the Court of Common Pleas of Allegheny County, Civil Division, No. DSB2035 July Term, 1973.


Gerald S. Lesher, Pittsburgh, for appellant.

James H. McConomy, Pittsburgh, and with him John C. Unkovic, Pittsburgh, for appellee.

Cercone, Wieand and Lipez, JJ.

Author: Lipez

[ 265 Pa. Super. Page 561]

This is an appeal from the trial court's judgment in favor of appellee, defendant below, in an action begun by appellant, plaintiff below, by confessing judgment on certain notes executed by appellee.*fn1

Appellee, Cellco, Inc. (Cellco), was incorporated on April 18, 1967. There were six shareholders: Robert E. Lee, Frank Diekneite, Donald Schmuck, Donald Hamilton, Frederick J. O'Reilly, and Phillip Crowley.*fn2 Cellco elected to operate under Subchapter S*fn3 of the Internal Revenue Code. Cellco borrowed money from the Small Business Administration (SBA) in order to purchase a plant in Donora, Pennsylvania. The loan agreement with the SBA required each shareholder of record at the time of any subsequent distribution of profits by Cellco before the loan was repaid to put back into Cellco one-fourth of the amount of such distributions remaining after payment of taxes thereon.

On October 22, 1970, Lee, Diekneite, Schmuck and Crowley entered into an agreement with Cellco (the Buyout Agreement) providing that Cellco would purchase the stock held by the four in exchange for cash payments totaling $550,000. O'Reilly and Hamilton would then be the only stockholders. In order to secure the payment obligation, O'Reilly and Hamilton were required to deposit in escrow all but ten of their combined shares in Cellco. O'Reilly testified that the closing date for the Buyout Agreement was November 1, 1970. This was also the first day of Cellco's fiscal year 1971. In December of 1970, O'Reilly, acting as president,

[ 265 Pa. Super. Page 562]

    caused Cellco to distribute profits totaling approximately $116,000 to himself and Hamilton, as the only shareholders of record on the date of the distribution. O'Reilly's share was approximately $68,000 before taxes. Pursuant to the SBA loan agreement, O'Reilly, as he had after previous distributions, returned to the corporation 25% of the amount of the distribution remaining after paying his personal income taxes. Hamilton likewise returned 25% of his net share of earnings and profits. They took back from Cellco certain instruments, labeled notes, evidencing these advances.

In mid-1972, O'Reilly caused Cellco to hire Hamilton as a vice-president. During his employment (April, 1972 through May, 1973), Hamilton received $28,562.50 from Cellco as salary. On a number of occasions, O'Reilly's son, F. R. O'Reilly, removed from the plant, and sold, scrap metal belonging to Cellco. The purchasers paid F. R. O'Reilly and not Cellco a total of $6,694.92.*fn4

Cellco eventually defaulted on the Buyout Agreement and, on March 20, 1972, a Consent Decree was entered, setting out a revised payment schedule. The Decree also provided that, in the event of further default, the stock held in escrow for the benefit of Crowley and Schmuck was to be transferred to them. Cellco defaulted on the first of the rescheduled payments, and on April 25, 1973, the court below, Wentley, J., order the transfer. This wiped out O'Reilly's stock holdings in Cellco. Crowley thereupon became president, and O'Reilly and Hamilton left Cellco's employ. Shortly thereafter, Hamilton assigned his note to O'Reilly for consideration, and O'Reilly caused judgment to be confessed on all of the instruments. Cellco responded by asking the lower court to strike or open the confessed judgment. The court below, Smith, J., opened the judgment, and the parties proceeded to trial of O'Reilly's claim that the instruments represented corporate debts then due him. The trial court, Watson, J., found that the instruments

[ 265 Pa. Super. Page 563]

    were corporate debt and that O'Reilly was owed $54,701.21,*fn5 subject to certain setoffs. The lower court, sitting en banc, granted Cellco's exceptions and concluded that (1) the instruments represented shareholders' equity rather than debt; (2) the instruments were subordinated to other indebtedness of Cellco; and (3) that setoffs claimed by Cellco and allowed by the court en banc exceeded O'Reilly's claim. O'Reilly then brought his appeal. Although we conclude that the instruments represent corporate ...

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