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In re FRG Inc.

UNITED STATES COURT OF APPEALS FOR THE THIRD CIRCUIT


argued: October 10, 1990.

IN RE FRG, INC., FRP LIMITED PARTNERSHIP A/K/A FRANKLIN REALTY PARTNERS,
v.
BRUCE MANLEY, APPELLANT

On appeal from the United States District Court for the Eastern District of Pennsylvania; Civil Action No. 89-8377.

Higginbotham, Chief Judge, and Greenberg and Hutchinson, Circuit Judges.

Author: Greenberg

Opinion OF THE COURT

GREENBERG, Circuit Judge

Debtors, FRG, Inc. and FRP Limited Partnership a/k/a Franklin Realty Partners, agreed to pay Bruce Manley $100,000 in settlement of a lawsuit brought by Manley against them in the United States District Court for the Eastern District of Pennsylvania, for the recovery of commissions and benefits due him by reason of his former employment with the debtors. The $100,000 debt was evidenced by an installment promissory note which included a confession of judgment clause. After the debtors filed Chapter 11 bankruptcy proceedings, Manley sought relief from the automatic stay of the Bankruptcy Code so that he could pursue the collection of the unpaid debt in proceedings in the Pennsylvania state courts. He alleged that he was a secured creditor, as he had confessed judgment on the note for $80,000 and had attached one of the debtors' bank accounts at Fidelity Bank with sufficient funds to secure the entire debt. He further alleged that the debtors had no interest in the funds. At the conclusion of Manley's case at an evidentiary hearing on his motion, the debtors moved for and obtained a directed verdict. Manley appealed to the district court pursuant to 28 U.S.C. § 158(a), but that court affirmed the bankruptcy court order. Manley then filed this appeal under 28 U.S.C. § 158(d).*fn1 We find that the bankruptcy court and district court erred in concluding that, on the record before the bankruptcy court at the end of Manley's case, he was not entitled to relief. We will therefore reverse the order of the district court and will remand this case to it, so that it may be further remanded to the bankruptcy court to complete the proceedings on Manley's application.

I. BACKGROUND

The basic facts are not in dispute.*fn2 In June, 1987, Manley, a former employee of the debtors, sued them in the underlying district court action. In August, 1988, Manley and the debtors, each represented by counsel, entered into a settlement agreement providing for the debtors to pay Manley $100,000 in six installments.*fn3 The debtors executed a note for the $100,000 which provided that:

Should payment not be received. . .on the tenth day following delivery of the notice [of default], then [FRG and FRP] hereby authorize[ ] irrevocably, the Prothonotary, Clerk of Court, or any Attorney of any Court of Record to appear for [FRG and FRP] in such Court, in term, time, or vacation, at any time before or after maturity and confess a judgment without process in favor of Manley, holder of this Note, with or without the filing of an Averment or Declaration of Default, for the unpaid balance thereon, together with costs and attorney's fees.

App. at 24.

The debtors' counsel specifically agreed to this confession of judgment provision and helped draft it.

The debtors paid the first two installments of $10,000 but did not make a $15,000 payment due on October 16, 1988. After the debtors failed to cure this default, Manley confessed judgment against them in the Court of Common Pleas of Philadelphia County on November 9, 1988, for the remaining $80,000 due on the settlement. Manley then attached FRG's account at Fidelity Bank in Philadelphia and served a Writ of Execution for $80,000.*fn4 At the time of the attachment, there were sufficient funds in the Fidelity account to satisfy the remaining debt.

On November 29, 1988, the debtors filed a motion in the common pleas court to open or strike the judgment and on that day that court entered an order staying Manley from executing on the Fidelity account. By an order of January 13, 1989, the common pleas court opened the confessed judgment but did not strike it. Its opinion stated, in pertinent part:

Pennsylvania law requires that the language of a confession of judgment clause be strictly construed. . . . This Court must narrowly interpret the terms of the subject confession clause, specifically, the ability to make due all future payments.

After careful review of the Note's confession provision, we find that the Note fails to clearly and unequivocally provide for acceleration of all future payments upon default. This Court is persuaded that a strict interpretation of the confession clause would limit judgment to the unpaid portion of the overdue payment.

Manley v. FRG, Inc., November Term, 1988 Civ. No. 606 (Ct. Common Pleas, Philadelphia County, Jan. 13, 1989) (omitting citations).

Manley and the debtors both appealed to the Superior Court of Pennsylvania from the order of January 13, 1989, but while the appeals were pending the debtors paid Manley the overdue $15,000, without prejudice to the rights of the parties in the litigation. Thereafter, on May 17, 1989, the debtors filed voluntary petitions pursuant to Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York. Under 11 U.S.C. § 362, prosecution of the appeals from the order of the common pleas court opening the judgment was automatically stayed; thus Manley has been effectively blocked from making a recovery in the state court proceedings.*fn5 The bankruptcy proceedings were later transferred to the United States Bankruptcy Court for the Eastern District of Pennsylvania, where they are ongoing.

On September 20, 1989, Manley filed a motion for relief from the automatic stay pursuant to section 362(d) of the Bankruptcy Code so that he could pursue the state court proceedings. The hearing on his application leading to this appeal was held in the bankruptcy court on October 18, 1989.*fn6 When the bankruptcy court granted the debtors' motion for a directed verdict it entered an order providing as follows:

AND NOW, this 18th day of Oct., 1989, upon consideration of the Motion of Bruce Manley for relief from the bankruptcy court stay, after a lengthy hearing of this date, it is hereby ORDERED that the Motion be denied. The only basis for the Movant's contention that his claim is secured is a confessed judgment which has been opened by the state court. After review of the state court judge's Opinion and in light of our holding in In re Souders, 75 Bankr. 427 (Bankr.E.D.Pa. 1987), we find that the Movant's security interest is of sufficiently doubtful validity that we do not believe it justifies compelling the Debtor to be relegated to state court to defend the Movant's claim there.

In re FRG, INC., Ch. 11 Case No. 89-12766-S (Bankr. E.D. Pa. Oct. 18, 1989); In re FRP, Ch. 11 Case No. 89-12768-S (Bankr. E.D. Pa. Oct. 18, 1989).

The district court on Manley's appeal reviewed the bankruptcy court order under an abuse of discretion standard and found that it had not abused its discretion under either section 362(d)(1) or section 362(d)(2) of the Bankruptcy Code. In re FRG, INC., 114 Bankr. 75 (E.D. Pa. Apr. 27, 1989). The district court reasoned that the bankruptcy court had not abused its discretion when it determined that Manley's security interest was of doubtful validity because it was questionable whether the debt could be accelerated upon default, as the note did not include an express acceleration clause. Furthermore, it concluded that the "very existence" of In re Souders, 75 Bankr. 427 (Bank. E.D. Pa. 1987), cited by the bankruptcy court, which held the Pennsylvania confession of judgment procedures unconstitutional, put the validity of Manley's interest in issue as "quite apart from the merits of Souders " "to date [it] has not been overruled." In addition, the district court concluded that "the bankruptcy court did not abuse its discretion in finding that the balance of hardships did not tip essentially in [Manley's] favor." This appeal followed.

II. DISCUSSION

The district court used the wrong standard of review. The order of the bankruptcy court recites that the motion for the directed verdict was granted because the court concluded that Manley's security interest was of doubtful validity. Accordingly, Manley could not establish that FRG did not have an equity in the bank account and he was not entitled to relief from the stay. See 11 U.S.C. § 362(d)(2)(A). Inasmuch as that was a legal conclusion, the bankruptcy court did not exercise its discretion in finding Manley's security interest to be of doubtful validity. Furthermore, the bankruptcy court never made a finding that a balancing of the hardships indicated that Manley should be denied relief. Indeed, in view of the finding that the bankruptcy court did make, it had no reason to consider the balance of hardships. Therefore, the district court should not have used an abuse of discretion standard of review.*fn7

The bankruptcy court order cites two considerations for finding that the security interest was of doubtful validity -- the opinion of the common pleas court when it opened the judgment and the opinion of the bankruptcy court itself in In re Souders, 75 Bankr. 427. We will consider the legal sufficiency of these reasons, exercising direct plenary review.*fn8

A. THE COMMON PLEAS COURT OPINION

There are two possible bases for the determination by the bankruptcy court that the opinion of the common pleas court undermined the validity of Manley's security interest and we reject both. First, the bankruptcy court may have been relying on the fact that the judgment was opened, without regard for the reasoning underlying the opinion. If so it erred, for under Pennsylvania law an attachment or execution process issued on a judgment remains valid even if the judgment is opened. Thus, while striking a judgment annuls the lien, opening a judgment does not. Pa. R. Civ. P. 2959(f). See Rochester Machine Corp. v. Mulach Steel Corp., 287 Pa. Super. 270, , 430 A.2d 280, 286-87 (1981) ("Thus, the judgment does remain effective even after it has been opened unless it is struck by order of court."), rev'd on other grounds, 498 Pa. 545, 449 A.2d 1366 (1982). Accordingly, Manley's security interest was not invalidated by the opening of the judgment.

Second, the bankruptcy court may have considered the substantive reasoning of the common pleas court in opening the judgment, i.e., that the note did not include an explicit acceleration clause. In its opinion, the common pleas court found that the note permitted confession of judgment only for accrued unpaid payments, not the remaining debt in full, noting that Pennsylvania strictly construes confession of judgment clauses in favor of the debtor in cases of ambiguity. See Parliament Industries, Inc. v. William H. Vaughan & Co., 501 Pa. 1, , 459 A.2d 720, 726 (1983); Housing Mortgage Corp. v. Tower Development & Investment Corp., 402 Pa. 388, , 167 A.2d 146, 147 (1961).

It seems to us, however, that notwithstanding the opinion of the common pleas court, the bankruptcy court was not justified in holding the security interest to be of doubtful validity because the order of the common pleas court left the attachment of the funds unimpaired. If the bankruptcy court relied on the substantive reason for the opinion of the common pleas court, it incorrectly considered only a portion of Pennsylvania law because it disregarded the law concerning enforcement of opened judgments.

We also point out that it is questionable whether the note was ambiguous. We observe that although the note made continuous reference to "payments," unmistakably meaning the six installments, it ultimately provided that in the case of an uncured default, judgment may be confessed "in favor of Manley, holder of this note, with or without the filing of an Averment or Declaration of Default for the unpaid balance thereon, together with costs and attorney's fees." [Emphasis added.] As a matter of language syntax, the term "unpaid balance thereon" appears to relate back to the phrase "holder of the note" so that the parties contemplated that the confession clause applied to the remaining debt, not just the overdue payment or payments. If so, it is difficult to understand why the drafters of the note would have included a statement that upon an uncured default the obligation to satisfy the debt would be accelerated. We, however, do not undertake to make a definitive determination of the meaning of the note, as the consequence of our decision will simply be that the proceedings in the bankruptcy court on Manley's application will resume. If Manley obtains relief from the automatic stay, then the definitive meaning of the note can be determined in the proceedings which follow.

B. IN RE SOUDERS

The second basis for the bankruptcy court's order denying relief from the stay was its prior decision in In re Souders, 75 Bankr. 427, in which it found the Pennsylvania confession of judgment procedures facially unconstitutional.*fn9 This reliance on Souders was misplaced.

In Souders, the debtor, who had a limited education, while not represented by an attorney executed a demand note which included a provision for confession of judgment. She testified that she did not understand the wording or significance of the note and was led to believe she would face criminal prosecution if she failed to cooperate with the demands of the obligee as her debt arose from her embezzlements. Id. at 429-30. Analyzing the Supreme Court decisions in Swarb v. Lennox, 405 U.S. 191, 92 S. Ct. 767, 31 L. Ed. 2d 138 (1972), and D. H. Overmyer Co. v. Frick Co., 405 U.S. 174, 92 S. Ct. 775, 31 L. Ed. 2d 124 (1972), the bankruptcy court determined that the debtor did not knowingly and intelligently execute the confession of judgment clause and thus she could not be said to have waived her due process rights to notice and an opportunity for a hearing before judgment was entered by signing the note. 75 B.R. at 436-37.

However, rather than limiting its holding to the facts before it, the bankruptcy court held that the judgment could not be enforced because the Pennsylvania procedures authorizing confession of judgments were facially unconstitutional, a conclusion it based on the absence of statutory provision for a judicial determination of whether a debtor has waived due process rights in executing the confession of judgment provision. Id. The bankruptcy court reasoned that the Supreme Court holding in Swarb that a confession of judgment clause is per se unconstitutional as to a certain class of individuals did not conversely mean that a confession of judgment is constitutional for everyone else. Id. at 435.

We reject this interpretation by the bankruptcy court and overrule Souders to the extent that it held the Pennsylvania confession of judgment procedures facially unconstitutional. In Swarb, the Supreme Court affirmed a district court order holding the Pennsylvania confession of judgment procedures unconstitutional when applied in cases involving individuals with conjugal incomes of less than $10,000 annually. 405 U.S. at 200, 92 S. Ct. at 772.*fn10 The Court, however, did not declare the procedures per se unconstitutional. Rather, it recognized that in some circumstances a knowing debtor could be held to have effectively and legally waived due process rights with respect to notice in litigation which it would otherwise possess absent a confession of judgment clause. Id. at 200, 92 S. Ct. at 772. See also Erie Telecommunications, Inc. v. City of Erie, 853 F.2d 1084, 1094-96 (3d Cir. 1988).

The Supreme Court in Swarb recognized that holding the Pennsylvania confession of judgment statute per se unconstitutional would be inconsistent with its decision in Overmyer. In Overmyer, the Court upheld the use of a confession clause against a corporate debtor and thus in Swarb the court acknowledged that its holding meant that the confession clause was not per se unconstitutional. Furthermore, in Overmyer, the Court recognized a confession of judgment as a proper tool in the commercial context and acknowledged its constitutionality in cases involving intelligent and voluntary waivers of constitutional rights. 405 U.S. at 187-88, 92 S. Ct. at 783. In Overmyer, the debtor was a substantial corporation with principals fully aware of the impact of the confession of judgment clause. Id. at 186, 92 S. Ct. at 782-83.

Accordingly, the bankruptcy court erred when it relied on Souders to find Manley's security interest of doubtful validity.*fn11 While the debtor in Souders may have been entitled to relief, Souders's broad and gratuitous holding that the Pennsylvania confession of judgment procedures are facially unconstitutional was simply wrong.*fn12 This case is much more like Overmyer than Souders, as the debtors here seem to be business entities with sophisticated principals, knowledgeable in business matters. Furthermore, the confession of judgment clause here was negotiated and specifically agreed upon in a commercial context in settlement of major litigation between parties represented by counsel. In sum, therefore, the bankruptcy court erred when it concluded at the end of Manley's case that his security interest was of such sufficient doubtful validity that he could not be granted relief from the automatic stay.

III. CONCLUSION

Our analysis requires that the bankruptcy court complete the hearing on Manley's motion for relief and then determine whether he has satisfied the requirements for relief under section 362(d). The judgment of the district court will be reversed and the case remanded to the district court with directions that it enter an order reversing the judgment of the bankruptcy court and remanding the matter to the bankruptcy court for completion of the hearing on Manley's application.


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