IN RE RUSSELL CAVE COMPANY, INC., (Bankr.E.D.Ky. 2001)

WILLIAM S. HOWARD, Judge.

This matter is before the court on defendant Paymentech's Motion for Partial Summary Judgment and the plaintiff's response. Paymentech seeks judgment on the issues of whether and to what extent the plaintiff may recover "chargeback" amounts. Paymentech asserts that there is no genuine issue as to any material fact, and that it is entitled to judgment as a matter of law on these issues. This court has jurisdiction of this matter pursuant to 28 U.S.C. § 1334(b); it is a core proceeding pursuant to 28 U.S.C. § 157(b)(2)(F).

Prior to the filing of its petition in January 1999, the debtor entered into a Credit Card Processing Services Agreement ("the agreement") with First USA Merchant Services, Inc., to collect cash for the credit card purchases of its goods by consumers. (Paymentech states in its memorandum that First USA Merchant Services, Inc. changed its name to Paymentech Merchant Services, Inc. and uses the assumed name Paymentech.) Pursuant to the agreement, Paymentech received funds from the banks that issued credit cards to the consumers, for the debtor's sales of goods to them. From these funds, Paymentech deducted its processing fees and any refunds due customers for returned or other disputed items ("chargebacks"), and then transmitted the remaining amount to the debtor as net proceeds for its credit card transactions. The agreement provided for Paymentech's creation of a reserve account containing funds that were otherwise payable to the debtor for credit card purchases of its merchandise.

Prior to and after the petition date, Paymentech deducted from funds otherwise payable to the debtor for credit card purchases of its merchandise, chargebacks and other adjustments. After the petition date the debtor continued to operate its business as debtor-in-possession and to generate credit card transactions for the purchase of its merchandise by consumers. After the petition date, and without obtaining prior court approval, Paymentech deducted at least $382,754.80 from its reserve account or from other funds otherwise payable to the debtor, in order to process chargebacks.

The plaintiff initiated this proceeding by the filing of its complaint on January 25, 2001, alleging that Paymentech's deductions of chargebacks from funds it held in the reserve account constituted an unauthorized post-petition transfer pursuant to 11 U.S.C. § 549(a); that Paymentech unlawfully converted portions of the debtor's funds in the reserve account to its own use; and that Paymentech willfully violated the automatic stay by exercising control over the funds held in the reserve account. The plaintiff asked the court to enter an order imposing a constructive trust restoring ownership of the funds in the reserve account to the debtor; avoiding the post-petition payment of chargebacks from the reserve account pursuant to § 549; and requiring Paymentech to return the sum of $382,754.80, plus interest, pursuant to § 550(a).

Paymentech filed its answer on March 12, 2001, asserting that the credit card purchases made by the debtor's customers resulted in provisional credits to the debtor, and that reversal of provisional credits was not an unauthorized transfer, conversion, or violation of the automatic stay; that since the credit on each transaction was provisional, the funds against which the chargebacks of post-petition transactions were made were never funds belonging to the debtor; that all chargebacks were in the nature of recoupment and not subject to the automatic stay; that Paymentech had a security interest in all the debtor's assets, as well as a security interest in the reserve account to secure the payment of any and all chargebacks Paymentech received against the debtor's account; and that the debtor's failure to issue credits is a violation of Regulation Z of 12 C.F.R. Part 226.12(e) and other federal law.

Paymentech filed its Motion for Partial Summary Judgment on June 1, 2001. In its memorandum in support, Paymentech contends that the chargebacks are not avoidable pursuant to § 549(a) and do not violate the automatic stay. Section 549(a)(1) provides in pertinent part that"the trustee may avoid a transfer of property of the estate made after the commencement of the case and . . . that is not authorized . . . by the court." Property of the estate is comprised of"all legal or equitable interests of the debtor in property as of the commencement of the case." 11 U.S.C. § 541(a)(1). Property of the estate includes" [p]roceeds, product, offspring, rents, or profits of or from property of the estate . . . [a]nd any interest in property that the estate acquires after the commencement of the case." 11 U.S.C. § 541(a)(6), (a)(7). Paymentech contends that the funds held in the reserve account were not "property of the estate" because the debtor did not exercise control over them.

Paymentech argues that the terms of the agreement prevented the debtor from having any interest in funds in the reserve account until funds were paid to it. The agreement defines the reserve account at ¶ 2 as an account that we may establish on our records for our accounting requirements and benefit pledged by you to secure payment to us of any and all amounts which may be due from you to us and for the benefit of your CARDHOLDER customers. Any and all funds credited to the RESERVE ACCOUNT may be comingled (sic) with our general funds, and will be subject to disbursement only by us. You have no interest in the reserve amount until your receipt thereof. The reserve amount shall secure our PROCESSING FEES and any other sums as may be due to us, CHARGEBACKs, and CREDIT NET AMOUNTs and the claims of CARDHOLDERs arising from CARD SALEs, and you hereby grant to us a security interest in all funds in our possession at any time.

The agreement deals with the reserve account at ¶ 21 which provides:

In the event of the occurrence or threat of a material, adverse change in your financial condition or of another event as the result of which we, in our sole discretion, deem ourselves insecure or have reasonable grounds to believe that we may be liable to third parties for credit extended to you or that you may be liable to your customers for any reason whatsoever, we shall have the right (a) to immediately place payments due you in the RESERVE ACCOUNT and/or stop processing transactions for you until such time as the extent of your obligation to us, our liability to third parties and your liability to your customers is known and we no longer deem ourselves insecure and (b) to demand from you an amount that our experience dictates to assure payment of such liability. Your failure to pay such amount shall allow us to terminate this AGREEMENT immediately and without notice.

Terms in favor of Paymentech notwithstanding, case law supports the conclusion that the funds referred to in the agreement constituted an"interest of the debtor in property."

The issue of whether funds in a reserve or escrow account were property of the estate was considered by the court in World Communications, Inc. v. Direct Mktg. Guar. Trust (In re World Communications, Inc.), 72 B.R. 498, 500-01 (D.Utah 1987). There the court stated:

Pertinent case law demonstrates that even rights of redemption, accounts receivable, reserve accounts, and other similar kinds of interests are considered property of the estate under § 541(a)(1). (Footnotes omitted). Trusts and escrows are less obvious, however, and must be considered individually with respect to the circumstances of each.

Escrow accounts are more difficult to diagnose. Factors that are relevant, although not necessarily determinative, include whether the debtor initiated and/or agreed to the creation of the escrow, what if any control the debtor exercises over it, the incipient source of it, the nature of the funds put into it, the recipient of its remainder (if any), the target of its benefits, and the purpose for its creation. (Footnote omitted).

In applying these elements to the case before it the court went on to conclude that the escrow account in question constitutes property of the estate. The reasons for this are as follows. First of all, on the face of the written contract between the parties . . . there are a number of indications that the escrow funds are incipiently, or at least ultimately, assets of WCI. Page two of the contract defines`escrow account' as an account to be`set up in (WCI's) name for the benefit of (WCI's) customers.' Paragraph 18 states that the account will be made up of`payments due (WCI).'

Secondly, the evidence . . . indicates that DMGT created the escrow account by withholding funds that otherwise would have been transmitted to WCI as proceeds from the sale of its products. In substance, therefore, the escrow account constitutes a form of conduit for WCI's proceeds. These proceeds are temporarily within the control of DMGT for the purpose of processing chargebacks, but are clearly distinguishable from actual earnings or profits of DMGT.

Id. This court quotes this case at length because it is instructive here.

It is clear from the face of the agreement between Paymentech and the debtor here that funds withheld and placed in the reserve account were funds generated by credit card sales of the debtor's merchandise. Further they were funds which otherwise would have been transmitted to the debtor as proceeds of such sales. The definition of reserve account includes the statement that the account may be set up"for the benefit of your CARDHOLDER customers." Absent its contractual relationship with the debtor, Paymentech would have no claim on these funds. It, like the processing entity in World Communications, is a conduit which had the debtor's proceeds temporarily in its control. Paymentech has argued that the reserve account funds were not property of the estate because the debtor did not control them pursuant to the terms of the agreement. Control is an element to be considered in regard to the application of the"earmarking" doctrine, the second prong of Paymentech's argument. Paymentech cites Musso v. Brooklyn Navy Yard Dev. Corp. (In re Westchester Tank Fabricators, Ltd.), 207 B.R. 391 (Bankr.E.D.N.Y. 1997) in support of its position in regard to this issue.

There, after the filing of the Chapter 11 case, the principal of the debtor prevailed upon an entity owned by his family to pay $100,000.00 which the debtor owed to the defendant. A check for this amount was made payable directly to the defendant and hand-delivered. In addition to this payment, five monthly payments for post-petition use and occupancy were made to the defendant from the debtor's DIP account. The trustee sought to avoid all these transfers pursuant to § 549. The defendant argued that the earmarking doctrine constituted a defense to unauthorized post-petition transfers in both instances. The court explained that

[t]he earmarking doctrine . . . provides that the transfer of funds by a third party for the specific purpose of paying the debtor's obligation to an existing creditor is . . . not preferential where the third party is merely substituted as creditor, and the debtor's assets and net obligations otherwise remain the same (citations omitted). Funds transferred under these circumstances are deemed to be`earmarked,' and not a component of the debtor's overall assets, as their transfer did not diminish the amount available for distribution to creditors (citations omitted).

Id.at 397. The court held that the transfers from the DIP checking account were of property of the estate and that the earmarking doctrine did not apply. The court agreed with the defendant, however, that the earmarking doctrine applied to the $100,000.00 post-petition transfer.

The court found that the debtor never had any control over the disbursement of the funds in question as payment to any other creditor but the defendant:

Here, the Debtor had truly no control over the disbursement of the . . . check because only one creditor, the Defendant, could have received the proceeds. The funds were`earmarked' for use in satisfaction of the obligation to a specific creditor and never part of the estate available for distribution to all creditors. Accordingly, the transfer was not of property of the estate and not avoidable.

Id. at 398. Paymentech maintains that exactly the same elements are present here. The court disagrees. Here there was no transfer by a third party of funds or assets specifically designated to satisfy debts to particular creditors of the debtor. Paymentech took control of funds generated by credit card sales of the debtor's merchandise, funds in which the debtor had an interest and which would otherwise have been available for distribution to all creditors. These were not earmarked funds.

Paymentech also contends that it was authorized to set off the reserve account pursuant to 11 U.S.C. § 553(a). That subsection recognizes a creditor's right"to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case . . ." Both debts must arise before the commencement of the case and be truly mutual. Davidovich v. Welton (In re Davidovich), 901 F.2d 1533, 1537 (10th Cir. 1990). Paymentech maintains that the mutuality of debt requirement is met because the responsibilities of the parties to each other were set out in the agreement before the commencement of the case. Paymentech concedes, however, that if the funds were property of the estate it was obliged to seek relief from the automatic stay before exercising any right of set-off. 11 U.S.C. § 362(d). See Shugrue v. Chemical Bank, Inc. (In re Ionosphere Clubs, Inc.), 177 B.R. 198 (Bankr.S.D.N.Y. 1995). The court has already determined the funds were property of the estate, and Paymentech may not rely on setoff as a defense without having obtained relief from the stay.

Paymentech was required to seek relief from the automatic stay before effecting any post-petition transfer. A creditor may not" tak[e] any action to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate" once the bankruptcy petition is filed. 11 U.S.C. § 362(a)(3). A creditor may not pursue"any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case. . . ." Id. at § 362(a)(6). As set out in Martino v. First Nat'l Bank of Harvey (Matter of Garofalo's Finer Foods, Inc.), 186 B.R. 414, 435-36 (N.D.Ill. 1995):

The automatic stay has dual purposes. It protects the debtor from its pre-petition creditors by stopping`all collection efforts, all harassment, and all foreclosure actions' while permitting the debtor`to attempt a repayment or reorganization plan . . .' (Citation omitted). It similarly protects all creditors by ensuring that the estate will be preserved against attempts by other creditors to gain an unfair advantage with respect to the payment of claims (citations omitted). The purpose of the stay is thus not confined to pre-petition debts . . . Rather, it protects and preserves the value of a chapter 11 estate against post-petition creditors who, without court approval, seek to take the property of the estate in satisfaction of their post-petition claims (footnote omitted).

Paymentech then goes on to argue, however, that the chargebacks were also in the nature of recoupment not subject to the automatic stay. The court in In re Ruiz, 146 B.R. 877, 880 (Bankr.S.D.Fla. 1992), set out the basics of recoupment:

While setoff under § 553 is limited to instances involving mutuality of obligation, the doctrine of recoupment simply requires the claims to arise from the same transaction, and that the amounts recouped not exceed the amount of the original sum owed. (Citation omitted.)

The doctrine of recoupment, as it survives in bankruptcy, only applies if a debtor's pre-petition work product produces post-petition revenue which is not dependent upon the debtor's post-petition efforts. A defendant may not, . . ., withhold that which is due a debtor for post-petition efforts to satisfy a pre-petition debt. In re Sherman, 627 F.2d 594 (2nd Cir. 1980); Waldschmidt v. CBS, Inc., 14 B.R. 309 (M.D.Tn. 1981). A debtor's future earnings or earnings earned post-petition are protected to provide the debtor's fresh start. Local Loan Co. v. Hunt, 292 U.S. 234, 54 S.Ct. 695, 78 L.Ed. 1230 (1934).

Several bankruptcy decisions have applied the doctrine of recoupment. In the Waldschmidt case, Singer George Jones made several records for CBS corporation. CBS had advanced Jones royalties prior to the bankruptcy filing in anticipation of future earnings from his albums. The district court held that the post-petition royalties which resulted from Jones' pre-petition work product could be withheld by CBS, until the full advancement had been recovered. The court determined that the post-petition royalties did not relate to any post-petition effort by Jones. The royalties were based exclusively on the pre-petition work product which he had created. Waldschmidt v. CBS, Inc., 14 B.R. at 314-315.

While there may be merit in Paymentech's contention that its deduction of funds from the reserve account arose from the same transaction as the debtor's claim to the funds, i.e., the contract embodied in the agreement, Paymentech has not demonstrated that it advanced funds to the debtor pre-petition which it then recouped post-petition. In fact, setoff rather than recoupment is applicable where a creditor appropriates funds for chargebacks. See In re Ionosphere Clubs, 177 B.R. at 206. As set out above, however, Paymentech is foreclosed from setoff for present purposes as it failed to get relief from the stay.

Paymentech's final argument is that the debtor violated the provisions of the Federal Trade Commission Act, 15 U.S.C. § 45(a)(1), Regulation Z, 12 C.F.R. Part 226(e), and the Mail and Telephone Order Merchandising Rule found at 16 C.F.R. Part 435, in failing to timely issue credits and engaging in transactions causing chargebacks to occur. As Paymentech states, these are consumer protection provisions. Paymentech was not a consumer of the debtor's merchandise, and this court doubts that Paymentech has standing to assert these provisions. Further, Paymentech makes only a vague, unsupported argument that chargebacks should be allowed if only to prevent the plaintiff from benefitting from the debtor's"illegal" conduct. The court dismisses this argument out of hand.

In consideration of all of the foregoing, it is the opinion of this court that Paymentech's Motion for Partial Summary Judgment on the issue of whether, and to what extent, it may recover chargeback amounts should be overruled.

An order in conformity with this opinion will be entered separately.