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In re All Phase Steel Works, LLC

United States District Court, D. Connecticut

October 24, 2016



          Jeffrey Alker Meyer United States District Judge

         This bankruptcy appeal involves the right of setoff for a general contractor who has been called upon to pay the debts of a breaching subcontractor against remaining amounts owed by that general contractor to the subcontractor. On June 1, 2016, the debtor-in-possession, All Phase Steel Works, LLC, appealed from an order of the bankruptcy court, Manning, C.J., granting unsecured creditor PAC Group, LLC's motion for relief from stay to assert its right of setoff pursuant to 11 U.S.C. § 553(a). See 11 U.S.C. § 362(d)(1). For the reasons set forth below, the bankruptcy court's decision is affirmed.


         All Phase fabricates and installs steel for commercial construction projects, and PAC is the general contractor for two such projects: the Central Connecticut State University Dining Facility project (CCSU project) and the Mandell Jewish Community Center Project (JCC project). PAC hired All Phase as its steel subcontractor for both projects, and All Phase, in turn, hired its own sub-subcontractors to provide labor and/or materials for each project. Doc. #6-1 at 78 (CCSU); Doc. #6-1 at 94 (JCC). The relevant portions of both contracts are identical: All Phase was obligated to pay its sub-subcontractors or suppliers no later than 30 days after it received payment from PAC for the work of those sub-subcontractors or suppliers. Doc. #6-1 at 74 (CCSU); Doc. #6-1 at 98 (JCC). The contracts further granted PAC a right of setoff in the event that All Phase failed to pay its sub-subcontractors:

If the Subcontractor . . . fails to pay for labor and/or materials for which it has received payment from PAC, or fails in any respect to prosecute any covenant on its part to be performed, then, PAC shall have the right after delivery of three days written notice to the Subcontractor, and, without prejudice to any other remedy it may have, to make good such deficiencies and may deduct the cost thereof from the payments then or thereafter due the Subcontractor . . . .

Doc. #6-1 at 69 (CCSU); Doc. #6-1 at 95 (JCC).

         In connection with the CCSU project, PAC obtained bonds from a surety, requiring PAC to “promptly pay for all materials furnished and labor supplied or performed in the prosecution of the work included in and under the aforesaid contract, ” and “execute all the terms, conditions and stipulations” of the CCSU project or else “indemnify and reimburse the [State of Connecticut] for any loss that it may suffer through the failure of [PAC] to faithfully observe and perform each and every obligation and duty imposed . . . .” Doc. #6-1 at 103, 105.

         All Phase failed to pay several of its sub-subcontractors on the CCSU job. On February 18, 2016, PAC gave three days' notice of intent to exercise its contractual right to set off the damages caused by several of All Phase's contractual breaches totaling $105, 478.80, against amounts PAC owed to All Phase on the JCC project in the amount of $52, 169.29. Doc. #6-1 at 81. PAC listed one of All Phase's defaults as the failure to “Pay all vendors.” Doc. #6-1 at 81.

         Rather than cure the default, All Phase filed for Chapter 11 protection in the bankruptcy court on February 23, 2016. In its petition, All Phase listed PAC as an unsecured creditor in the amount stated by PAC in the three days' notice, and All Phase also listed its unpaid sub- subcontractors from the CCSU project as unsecured creditors. All Phase listed the IRS as a secured creditor for hundreds of thousands of dollars and with preexisting liens on accounts receivable, including the receivable from PAC on the JCC project.

         On March 30, 2016, PAC moved for relief from stay in order to exercise its right of setoff under § 553(a), asserting that the $52, 169.29 it owed to All Phase on the JCC project should be offset by $84, 217.86 of claims it had against All Phase for its failure to pay sub-subcontractors on the CCSU project and who might look to PAC for payment. To substantiate its claim against All Phase, PAC attached invoices from the unpaid sub-subcontractors, the contracts between PAC and All Phase authorizing the right of setoff, and the bonds obligating PAC to pay for all labor and materials on the CCSU project. All Phase did not enter any evidence of its own, request an evidentiary hearing, or dispute that it owed its sub-subcontractors the amounts stated.

         On May 19, 2016, Chief Judge Manning granted PAC's motion for relief from stay for cause, allowing PAC to exercise its right to setoff under § 553(a). Section 553(a) provides, in pertinent part: “Except as otherwise provided in this section and in sections 362 and 363 of this title, this title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case . . . .” 11 U.S.C. § 553(a). Chief Judge Manning concluded that PAC had an equitable right of setoff under Connecticut common law in order to “enforce the simple but clear natural equity” in this case, and that there was mutuality of debt as required under § 553(a). See Doc. #5 at 19 (citing OCI Mtg. Corp. v. Marchese, 255 Conn. 448, 463-64 (2001)). All Phase appealed.


         On appeal pursuant to 28 U.S.C. § 158(a)(1), a bankruptcy court's findings of fact are reviewed for clear error, its conclusions of law are reviewed de novo, and its decision to lift the automatic stay to allow exercise of setoff rights is reviewed for abuse of discretion. See In re Bennett Funding Grp., Inc., 146 F.3d 136, 138 (2d Cir. 1998). “A court abuses its discretion when its decision (1) rests on an error of law or a clearly erroneous factual finding; or (2) cannot be found within the range of permissible decisions.” In re Bolin & Co LLC, 527 F. App'x 45, 47 (2d Cir. 2013).

         The law of setoff (or “offset”) is well-established. It “allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding the absurdity of making A pay B when B owes A.” Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18 (1995). Section 553(a) does not create a federal right of setoff, but rather preserves whatever right of setoff exists under applicable nonbankruptcy law, ibid., even if the right of setoff “has the effect of paying one creditor more than another” would otherwise receive through the bankruptcy process. Bohack Corp. v. Borden, Inc., 599 F.2d 1160, 1164-65 (2d Cir. 1979). The Second Circuit favors enforcing the right of setoff, and will not disturb that right unless ‚Äúcompelling circumstances require it. . . . The statutory remedy of set off should ...

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