Opinion
No. 85-00759F
January 11, 1991
Reorganization — Property of the Estate — Debtors — Postpetition Earnings. — In a Chapter 11 case involving the question of the proper allocation of income from a debtor's postpetition earnings, the debtor carries the burden of going forward with evidence to prove that: 1) he is an individual 2) who performs services 3) which generate earnings 4) postpetition. The objector (here, the trustee) then carries the burden of persuasion as to how much of the earnings are attributable to estate assets and how much to the debtor's personal services. The latter portion is excluded from the estate under Section 541(a)(6). Based on the trustee's proofs regarding this osteopathic medical practice, some $76,000 per year was attributed to earnings from estate property including equipment, supplies and goodwill (all of the latter being taken as business as opposed to personal goodwill). The amount earned by the estate reflected, under one method, a 9.25 percent rate of return on estate assets as previously valued. That amount checked against other methods of approximating the earnings breakdown. In reaching this conclusion on the overall question of how to divide up a Chapter 11 professional's earnings between estate income and personal income, the court (ED Pa.) by agreement followed In re Cooley, CCH Bankr. Dec. ¶ 72,320 (SD Tex. 1988); compare In re Fitzsimmons, CCH Bankr. Dec. ¶ 69,754 (CA-9 1984). The administrative claims owed by this Chapter 11 business for certain tax and trade debts had to be paid by the trustee even though the debtor ran the business. These payments are properly calculated as payable out of gross receipts and belong to the estate.
See Sec. 541(a)(6) at ¶ 9507.
Before me are a number of issues which were heard and taken under advisement. The resolution of most of these disputes will turn upon the answer to one question: What portion of the postpetition earnings of Richard Paolino's medical practice is property of the estate within the meaning of 11 U.S.C. § 541(a)(6). That question arose through an adversary proceeding brought by the debtors against the chapter 11 trustee and Pennsylvania Blue Shield, the resolution of which is now before me. A short discussion of this proceeding's history will put the other disputes in perspective.
I.
Dr. Paolino initiated this litigation by filing an action which requested a determination that postpetition Pennsylvania Blue Cross or Blue Shield payments then held by the trustee were not property of the estate pursuant to § 541. The complaint sought turnover of these funds to the debtor. The trustee's answer included a counterclaim seeking turnover of other and certain postpetition income which he claimed as estate property pursuant to § 541(a)(6).
In preparing for this litigation the trustee served interrogatories upon the plaintiff, as well as request for the production of documents. As explained more fully in In re Paolino, 87 B.R. 366 (Bankr. E.D. Pa. 1988), the debtor did not respond to these requests for discovery, and refused to comply with the various orders I entered compelling the plaintiff to respond. I therefore was constrained to dismiss Dr. Paolino's complaint. Fed.R.Civ.P. 37(b) (incorporated in these proceedings by Bankr. R. 7037). At that time I scheduled the trustee's counterclaim for a hearing, and noted that if discovery as to the counterclaim was not provided by a date certain I would entertain a motion for futher sanctions.
The funds received from Pennsylvania Blue Shield by the trustee, in the approximate amount of $50,000.00, accordingly remained in the trustee's possession.
Dr. Paolino did not, in fact, comply with these discovery requests and the trustee moved for further sanctions, including default judgment on the counterclaim. By unpublished memorandum and order dated August 12, 1988 I entered judgment as to liability on the counterclaim in favor of the defendant trustee pursuant to Fed.R.Civ.P. 37(b)(2)(c) and 55(b). However, I was unable at that time to ascertain the appropriate relief to be granted on the counterclaim. The trustee had requested turnover, pursuant to § 542, of certain postpetition income of Dr. Paolino emanating from two sources: rental income and earnings from his medical practice. See 11 U.S.C. § 541(a)(6). I therefore scheduled a hearing on the scope of relief; that is, to determine the extent of the estate property derived from these two income sources. I noted in that memorandum that since the plaintiff, "by his failure to comply with court ordered discovery, may have frustrated the trustee's ability to prove the relief to which he is entitled, `any doubts about the actual assessment of damages [on the trustee's counterclaim] will be resolved against the' plaintiff." In re Paolino, memorandum at 4, citing Chesa International, Ltd. v. Fashion Associates, Inc., 425 F. Supp. 234, 238 (S.D.N.Y.), aff'd without op., 573 F.2d 1288 (2d Cir. 1977).
The hearing to determine the scope of postpetition estate property was subsequently held, and the determination of the extent of the debtor's liability (on the question of estate property) is now before me for resolution. The resolution of this issue will aid resolution of the related disputes, which involve payment of administrative and priority claims.
Also before me are the trustee's objection to discharge, pursuant to § 727(a), and the debtor's objection to confirmation of the trustee's plan. These issues will be discussed infra.
II. A.
The debtor does not dispute that postpetition revenues generated from various rental properties rightfully are subject to turnover to the chapter 11 trustee. Indeed, at the hearing the debtor stipulated to the admittance of documentary evidence that showed that he had received, through 1987, net postpetition rental income of $11,579.78. (See also debtor's proposed finding of fact, ¶ 32.) What is disputed, then, is the amount of net rental income received by the debtor in 1988.
The trustee had attempted, unsucessfully, to obtain by way of discovery from the debtor the amount of gross revenues and expenses on these properties for calendar year 1988. In the facts of the debtor's non-cooperation, the trustee posits that it is appropriate to arrive at an estimated net income figures for 1988 by basing that income upon the net sums received in previous years. Thus, using an average monthly net rental income figure of $340.58 (which is arrived at by dividing $11,579.78 by 34 months, the length of time over which that sum was earned), the net rental income figure for the period January 1, 1988 through September 30, 1988 is suggested to equal $3,065.22. Trustee's Memorandum at 3.
The debtor's response is that this approach "fails to consider the fact that substantial assets which formed the basis of the trustee's estimation of asset value, which is turn is used as a base figure to determine rental income from those assets, were foreclosed upon and removed from the debtor's estate during 1988. The net result of these foreclosures was a substantial loss of property which heretofore had generated rental income." Debtor's Memorandum, at 3-4. The debtor argues that the amount of actual revenue generated, and net income received, was substantially less in 1988 than in previous years, and thus is substantially less than $3,065.22. Therefore, the debtor asks that I award the trustee no turnover of rental income for 1988. (Specifically, the debtor argues that I "ought to enter judgment in the amount of at most $11,579.78, since this is the maximum figure to which the Trustee has shown entitlement." Id., at 4.)
As I stated in my memorandum of August 12, 1988, the plaintiff's failure to comply with court ordered discovery hampered the trustee's presentation. Therefore, to the extent the trustee has the burden on a particular issue, I will look favorably upon the trustee's evidence in meeting that burden, resolving doubts about the assessment of damages against the plaintiff. Thus, I cannot accept the debtor's argument that the trustee has shown no entitlement to funds received in 1988. The trustee did attempt to get information about the properties from sources other than the debtor. He subpoenaed bank records and mortgages, and he examined information received from the appraiser. N.T. at 64. The debtor implicitly is arguing that it is unreasonable for the trustee to suggest a figure of $3,065.22, when the trustee is aware of loss of assets from the estate that had generated this income. From this, he posits that no other money should be subject to turnover. However, the debtor does not make it clear to me which assets were foreclosed upon and removed from the property. The record also shows that the debtor possibly purchased other properties, from which he earns rental property. N.T. at 67-68. The debtor had the opportunity to present testimony on this question, but refused to present figures or other evidence relating to the rental income earned in 1988. As the debtor leaves the basis of his objection to speculation, and as the trustee presented a reasonable estimation for 1988 net income, I shall accept the figure offered and enter judgment ordering turnover of net rental income in the amount of $14,645.00, as requested by the trustee.
The above analysis admittedly looks with favor upon the trustee's evidence and arguments, for the reasons cited. I find further support for this aproach from the provisions of the Bankruptcy code that set forth the duties of a debtor in bankruptcy, 11 U.S.C. § 521. Subsections 521(3) and (4) require the debtor to "cooperate with the trustee as necessary to enable the trustee to perform the trustee's duties under this title," and to "surrender to the trustee all property of the estate and any recorded information, including books, documents, records, and papers relating to property of the estate. . . ." See, e.g., In re Neuman, 88 B.R. 30 (S.D.N.Y. 1988); In re Kent, 92 B.R. 540 (Bankr. S.D. Fla. 1988). The debtors in the instant bankruptcy case repeatedly have refused to cooperate with the trustee, and their antagonism has made it difficult for the trustee to perform his duties (including, but not limited to, determining the extent of estate property). The debtors' failure to fully comply with § 521 renders appropriate an analytical approach which favors the trustee's presentation of his case.
This section is made applicable in chapter 11 bankruptcy cases by virtue of 11 U.S.C. § 103(a).
The trustee, in the current litigation, is required to reconstruct to the best of his abilities the debtors' income from rental property and the medical practice. It is appropriate for the trustee to use any reasonable means for determining these amounts, where the debtors have failed to supply this information and refuse to make available books and records which would reveal the information. Accord, e.g., Goodmon v. Commissioner, 761 F.2d 1522 (11th Cir. 1985) (Internal Revenue Service entitled to determine deficiency in taxes due by any method it deems appropriate when taxpayer's books and records are incomplete or otherwise inadequate); Moore v. Commissioner, 722 F.2d 193 (5th Cir. 1984) (IRS may use any reasonable means to reconstruct taxpayer's income when taxpayer has failed to file a return); Denison v. Commissioner, 689 F.2d 771 (8th Cir. 1982) (same).
B.
The other income source, the debtor's osteopathic medical practice, is certainly the more problematic of the two. Where, as here, an individual debtor reorganizes through a chapter 11 plan, the postpetition earnings of that debtor are not property of the estate. Section 541(a)(6) provides that estate property includes the "proceeds, product, offspring, rents, or profits of or from property of the estate, except such as are earnings from services performed by an individual debtor after the commencement of the case." Compare 11 U.S.C. § 1306(a)(2). Thus, the parties agree that I must determine what portion of the postpetition earnings of the debtor's medical practice is attributable to the services of Dr. Paolino, and what portion remains property of the Paolino's bankruptcy estate. The amount earned "from services performed by [Dr. Paolino]" is not estate property; the balance is estate property, however, and must be turned over to the bankruptcy trustee.
The trustee suggests that the decision In re Cooley, 87 B.R. 432 (Bankr. S.D. Tex. 1988) should guide the attribution question. There, a physician filed for relief under chapter 11 with the intention of liquidating his assets. The Cooley court noted that the § 541(a)(6) earnings exception should be applied consistently, regardless of whether the individual debtor was liquidating or reorganizing. Therefore, that court read with disfavor the Court of Appeals decision of In re FitzSimmons, 725 F.2d 1208 (9th Cir. 1984), stating that the Ninth Circuit relied heavily on the fact that the debtor before it contemplated reorganization rather than liquidation. The bankruptcy court in Cooley was of the opinion that the application and interpretation of section 541(a)(6) should not vary because of an individual's choice to reorganize or liquidate under Chapter 11, and therefore the Ninth Circuit's reliance on reorganization principles to interpret narrowly the earnings exception omitted consideration of the effect of liquidation and the right to a fresh start on the scope of the exception. In re Cooley, 87 B.R. at 440. The court therefore rejected the Ninth Circuit's approach to the extent "that it requires a valuation of an individual's personal or `hands-on' services." Id., at 441. Instead, the court formed a different analytic approach, one which it believed would not construe the earnings exception too narrowly in the context of liquidation, and one which "seems best to guard against the potential conflict with the prohibition against involuntary servitude and to ensure protection of an individual's fresh start," as well as remain faithful to the plain meaning of section 541(a)(6). Id.
The Cooley approach probably represents a less favorable interpretation of § 541(a)(6) for a trustee than does the approach of In re FitzSimmons, 725 F.2d 1208 (9th Cir. 1984). As the trustee supports the Cooley reasoning, I will not attempt to decide whether Cooley or FitzSimmons is the more persuasive.
The Cooley court did agree with the approach taken in FitzSimmons which identified § 541(a)(1) property interests which in turn generated the subsection (a)(6) postpetition "profits," such as the business invested capital, accounts receivable, goodwill, and employment contracts. In re Cooley, 87 B.R. at 441. Where the two approaches essentially differ is on the application of the burden of proof. Under FitzSimmons, the debtor may exclude from the estate only the postpetition income that debtor demonstrates is derived from his or her individual efforts, with the residue viewed as estate property. Under Cooley, the trustee must demonstrate the postpetition proceeds derived from the estate's assets with the residue viewed as the result of the debtor's personal services.
Under Cooley, the burden of production rests with the debtor to show that, under the earnings exception, the debtor is 1) an individual, 2) who performs services, 3) which generates earnings, 4) postpetition. Upon proving these elements the burden of persuasion then falls upon the trustee to show that the purported earnings are actually the proceeds, product, offspring, rents or profits derived from § 541(a)(1) estate property or assets (such as business invested capital, accounts receivable, goodwill, and employment contracts). Id. As the trustee implicitly urges that I adopt this approach, tempering my analysis with the recognition that the debtor hindered the trustee's ability to present its case, and as the debtor does not urge otherwise, I shall accept the parties' recommendation. That is, as liability has been established and the debtor has met his initial burden of production, the trustee must show that Dr. Paolino's earnings are actually derived from estate property. I shall view the trustee's evidence in a favorable light. See Chesa International, Ltd. v. Fashion Associates, Inc., 425 F. Supp at 238 ("The well-known and ancient doctrine [states] that when a party frustrates proof of damages, either by withholding facts or through inaccurate recordkeeping, any doubts about the actual assessment of damages will be resolved against that party," citing, inter alia, Westinghouse Elec. Mfg. v. Wagner Elec. Mfg. Co., 225 U.S. 604 (1912)). Accord, Louis Vuitton S.A. v. Spencer Handbags Corp., 765 F.2d 966, 973 (2d Cir. 1985); Polo Fashions, Inc. v. Rabanne, 661 F. Supp. 89, 97 (S.D. Fla. 1986).
In order to meet his burden, the trustee must first establish the scope of section 541(a)(1) assets or property interests, and then prove the extent to which these assets contribute to the postpetition income stream of Dr. Paolino's medical practice. In re Cooley, 87 B.R. at 441. The trustee chose to accept the valuation of the medical practice, as offered by the debtors in their schedules of assets and liabilities, in their initial determination of estate property. The debtors' schedule B-2 values the medical practice as a business, on the date of filing, at $648,000.00; the value of surgical, x-ray and other medical equipment is listed at $180,619.00. See Ex. T-1; N.T. at 14-15. The trustee's acceptances of these figures as the valuation of this business assumes that the former figure was arrived at by the common practice of valuating a service business by establishing a multiple of income, to which fixed assets (minus any liabilities on those assets) are added. N.T. at 15-16. The debtor disputes the use of these figures, stating that the witness, "an allegedly trained Certified Public Account," Plaintiff's Memorandum at 6, should have known that it would be error to base an analysis on figures "which he could neither substantiate nor verify." Id. See also N.T. at 26-27. The debtor thus argues that his own initial estimate of assets is fatally flawed, and it cannot provide a basis for deriving any rate of return on estate assets, as it renders the trustee's income claim meaningless.
I find, however, that the inclusion of the debtors' valuations in their schedules should be viewed as an admission, at least for the purpose of resolving this dispute. Certainly, as intimated by the debtor, this "subjective" valuation might be inflated. The coverage is just as possible, however, as the debtors conceivably may have attempted, early in these involuntary proceedings, to minimize their reported assets. As noted above, the trustee did attempt to glean information about the medical practice assets from the debtor, which information could have assisted him in arriving at, perhaps, a more realistic value of these assets. These attempts at discovery were repeatedly ignored by the debtor. Thus, the debtor's argument that the trustee did not "in any fashion whatsoever attempt to derive a realistic value for the assets subject to and available for independent inspection" is disingenuous. I shall accept the figure of $828,619.00 as representing the value of the property surrounding the medical practice that adhered to the estate on the date the order for relief was entered.
It was noted at the trial on the damage component that this figure, based upon unknown factors or calculations, may or may not contain an element of "goodwill," whether that goodwill be denominated personal or business. N.T. at 58-59. This is significant, because the debtor concedes that the trustee is entitled to receive "a reasonable investment return" to the extent the income is generated by the estate's business goodwill, as opposed to Dr. Paolino's personal goodwill. The trustee conceded at trial that some part of the valuation figure "probably is attributable to personal goodwill." N.T. at 59. He argues that the frustration of his attempts at discovery should yield a lenient view towards his burden of providing this component.
It is not readily apparent, however, that the law of the Commonwealth of Pennsylvania distinguishes between personal and business goodwill. See Ullom v. Ullom, 384 Pa. Super. 514, 559 A.2d 555 (1989); Beasley v. Beasley, 359 Pa. Super. 20, 518 A.2d 545 (1986), app. denied, 516 Pa. 631, 533 A.2d 90 (1987). Compare In re Cooley, 87 B.R. at 442 (distinguishing personal goodwill from business goodwill, citing Geesbreght v. Geesbreght, 570 S.W.2d 427, 435 (Tex.Civ.App. Ft. Worth 1978, writ dism'd) (difference exists, under Texas state law, between personal goodwill of an individual and the goodwill of a business)). Under Butner v. United States, 440 U.S. 48 (1979), state law defines the property interests which make up the debtor's bankruptcy estate.
Where the Cooley court found it "difficult to view the goodwill attributable to the medical practice as anything but the personal goodwill of Dr. Cooley. . .," In re Cooley, 87 B.R. at 443, I here find it difficult to attribute the goodwill component of Dr. Paolino's medical practice as anything other than business goodwill. Dr. Cooley was described in that opinion as an internationally recognized heart surgeon, whose reputation and "personal referral network on a local, national, and international level among cardiologists and other physicians" created personal goodwill. Id., at 435. Dr. Paolino, on the other hand, conducts a local osteopathic medical practice. There was no evidence presented to suggest that the debtor's skills and reputation as a medical practitioner were such that would generate referrals-from other physicians either locally or from a larger area. Dr. Paolino presented no basis upon which I could conclude that he has created a medical practice that exists in any measure due to his personal goodwill. Further, it is not at all clear that such a component is even recognized by applicable state law. Therefore, I conclude that the goodwill component of the debtor's medical practice, whatever that amounts to, shall be considered strictly business goodwill, which is property of the estate generating estate property. In re FitzSimmons, 725 F.2d at 1211.
The trustee's position is that the estate is entitled to receive a reasonable investment return on the value of the estate's interest in the medical practice and the office equipment, furnishings and supplies during the duration of the bankruptcy. To determine this return the trustee looked to the total valuation of the medical practice as offered by the debtor in his schedules, and determined that an investor purchasing this business could reasonably expect a rate of return on the business of 9.25% per year. This rate of return yields an annual income stream of $76,647.26 from the assets. Therefore, the trustee suggests that the debtor pay to him $76,600.00 per year for each year of the medical practice's operation over the life of the bankruptcy.
This rate of return figure was arrived at by averaging the returns on investments from money market accounts, one year certificates of deposit and 30 month certificates as of a certain date. N.T. at 16. The debtor objects to the utilization of the return on short term liquid investments as representing the return of an investor on an on-going medical practice. In his memorandum the debtor states that this rate of return is applied inappropriately, where it "completely ignore[s] the actual values of the medical practice, its track record and history, and a host of economic factors which specifically influence the rate of return on assets which Dr. Paolino's practice may actually have yield. . ." Id., at 6. Again, however, the debtor's refusal to cooperate in discovery vitiates his argument. The rate of return suggested is not unreasonable on its face. Furthermore, in chapter 11 cases it is understood that, in determining present value, market factors such as the ones relied on by the trustee are to be utilized to determine the appropriate rate of return. See generally 5 Collier on Bankruptcy § 1129.03 at 1129-81-85 (15th ed. 1990).
This approach makes sense if one considers that the trustee arguably could have sold the entire medical practice (with supplies and equipment) as assets of the estate, thereby receiving certain funds into the estate. These monies would then have been available for distribution to creditors. By allowing the debtor to continue, undisturbed, with his medical practice, thereby continuing uninterrupred his ability to earn a living, the trustee argues the estate should not be penalized by not receiving any income from these estate assets, but should be receiving a reasonable rate of return.
I emphasize that this "reasonable rate of return" is a figure that allows Dr. Paolino to continue receiving a substantial income from the profits generated by the medical practice. This is illustrated by the second approach utilized by the trustee to corroborate the result reached by the first approach. Under this other analysis the trustee attempted to value the personal services of Dr. Paolino utilizing a publication of an entity known as Robert Morris Associates. N.T. at 18. This annual publication is a compilation of the financial statements of various industries as reported to that entity. The "statement studies" for physicians with total assets of less than one million dollars revealed that a physician's median salary (specificially, the salary of an "officer" physician of a medical practice) in 1985 was 35.3% of the practice's gross receipts, and 32.9% of receipts in 1986. Id., at 20. As the trustee had access to financial statements from Dr. Paolino's medical practice accountants for the years 1985 and 1986, N.T at 21, he was able to arrive at an estimate of the net amount earned by Dr. Paolino for the years 1985 and 1986. These amounts were compared with the "reasonable salary" as reported by Robert Morris Associates, revealing that Dr. Paolino received an excess of approximately $60,000.00 in 1985 and $76,000.00 in 1986 over the normative salary. N.T. at 23-24. The trustee asserts that these figures are close enough to the rate of return figure ($76,600.00) to lend that sum credibility.
The Robert Morris Associates publication did not provide an industry classification for osteopaths. The category of "physician" was chosen as the one most closely approximating the debtor's business. I do not agree with the debtor's implicit argument that I should disregard this analysis because the trustee did not utilize surveys which specifically address the practice of a physician engaged in osteopathic medicine. Memorandum, at 7.
That is, in 1985 net earnings of Dr. Paolino from the medical practice were in the approximate amount of $250,000.00; the RMA study revealed a reasonable salary for that year in the amount of $190,000.00. For 1986 the respective figures were $256,000.00 and $180,000.00. N.T. at 24-25. The difference between the net earnings and RMA salary figures were $60,000.00 in 1985 and $76,000.00 in 1986. (Gross receipts from Dr. Paolino's practice in 1985 equalled $548,000.00; 35.3% of that figure yields, precisely, $189,914.00. Gross receipts for 1986 were $547,000.00, yielding a median salary of $179,963.00.)
Considering the amount of gross receipts received annually by this medical practice and considering the ample annual salary determined to be "earned" by the debtor, the trustee's request for an annual return to the estate of $76,600.00 is a relatively modest one.
Given the other facts of record regarding this particular medical practice, I do find that the rate of return/"overage" figures reasonably represent that portion of the income stream not "earned" by Dr. Paolino. I accepted the value of the medical equipment (clearly estate property, see, e.g., In re Cooley, 87 B.R. at 442) at $180,619.00. It seems reasonable to expect that this equipment could annually generate approximately 12% of its value in income, or an amount of about $21,674.00. See In re Cooley, 87 B.R. at 442 (12% accepted as fair rate of return on the investment of fixed assets).
It is true, as the debtor fairly points out, that the trustee's analysis does not consider depreciation on this equipment. Indeed, it is possible that the equipment is no longer in use by the debtor, as it could have been repossessed, or sold. The debtor presented no evidence on these points, however. I shall assume for this discussion that the equipment remains in the debtor's control, and remains in use. I shall also not be concerned with factoring into the analysis any depreciation, as it is equally possible that the debtor upgrades this equipment with some frequency.
Additionally, Dr. Paolino was paying other doctors from between $10,000.00 and $20,000.00 annually for services provided to his own patients. I find it reasonable to assume that Dr. Paolino was able to earn from these doctors' services twice the amount paid to these employees. The debtor asserts that, because the trustee was unable to show what these other doctors generated in terms of gross revenue for the estate, the trustee should be prohibited from receiving any amount that the estate "earned" by virtue of the doctors' employment by the debtor. I disagree. Again, the debtor could have produced evidence of the billing or receipts for services rendered by these physicians, but chose to not reveal that information. It does not seem unreasonable to decide that the medical practice received in gross revenues a figure double the amount paid to these doctors for their services. Thus, it appears that the medical practice was receiving between $20,000.00 and $40,000.00 annually for services clearly provided by persons other than the debtor. These two factors alone (the return on the equipment and the return from services provided by the other physicians), when viewed in a light most favorable to the trustee, reveal an income stream of up to $61,674.00 annually that was not "earned" by Dr. Paolino. While this sum is $14,926.00 less than that requested by the trustee, I find this difference relatively insignificant when compared with the medical practice's gross receipts, net earnings, amount claimed as estate property and the debtor's annual "salary." As Dr. Paolino prohibited the trustee from investigating with any precision his medical practice, I easily conclude that the slightly larger figure appropriately is assessed.
Again, the argument could be raised that Dr. Paolino alone operated the medical equipment at issue, and thus "earned" this income generation. As the other physicians were working at this medical practice, which likely employed nurses and possibly other personnel qualified to operate this machinery, and given the debtor's lack of evidence on this point, I conclude that the above described sum is reasonable.
I appreciate the fact that I am imposing upon the debtor the necessity of paying a fixed sum annually to the trustee without knowing in advance the future earnings of the medical practice. I also appreciate the concern underlying the section 541(a)(6) earnings exception to estate property, which is gleaned from the policy concerns Congress expressed with respect to chapter 13 bankruptcy cases. Congress expressly avoided the potential conflict with the Thirteenth Amendment's prohibition against involuntary servitude by requiring that chapter 13 be strictly voluntary. This result is necessary since the chapter 13 debtor's postpetition earnings are included as property of the estate. 11 U.S.C. § 1306(a)(2). That concern is likewise reflected in the earnings exception of § 541(a)(6). Thus, Congress acted "to protect against creditors impressing an individual debtor to work for the estate, as well as to protect an individual Chapter 11 debtor's right to a fresh start." In re Cooley, 87 B.R. at 438, citing Powell v. United States Cartridge Co., 339 U.S. 497 (1950); Local Loan Co. v. Hunt, 292 U.S. 234 (1934). See also In re Noonan, 17 B.R. 793, 800 (Bankr. S.D.N.Y. 1982).
Here, it is evident that some funds generated by the medical practice (which is estate property) constitute estate property and not the debtor's postpetition earnings. Again, the debtor's resistance to discovery makes quantifying this sum problematic. It would be burdensome to the estate to require the trustee to prove to the best of his abilities, every year this case continues in bankruptcy, the extent of the medical practice's gross earnings, net earnings, and "overage" due the estate. Given the debtor's reluctance to assist, it is conceivable that the trustee in future years would have no better information available than he has received to date.
C.
While the debtors and the trustee have ably addressed the factually difficult issue of the computation of the postpetition earnings of the husband debtor which represents estate property, neither discusses the conceptually difficult question of the length of time which such payments must be made. It is this issue which lurks underneath the question of confirmation, annual payments to the trustee, and even the allowance of postpetition claims. The difficulty may be described thusly:
If annual payments of $76,600.00 represent a return to the trustee, (and so to unsecured creditors), of the debtors' use of estate property to generate income, do these annual payments continue for as long as the debtor continues with his medical practice? If so, there could be a lifetime of payments made by virtue of an involuntary chapter 11 petition, since there is no limit in chapter 11, (unlike chapter 13), on the length of a plan. Is it possible that 11 U.S.C. § 303, in authorizing involuntary chapter 11 petitions, could obligate a self-employed professional debtor to tender payments to creditors for the balance of his professional life? If the answer is no, and that an end date must be established for the plan, how is it fixed? Depreciation of the estate assets is one possibility, but some assets, such as real estate and goodwill may not depreciate. Limiting the recovery of all unsecured creditors to the percentage of value their total claims had to the total value of uncollateralized assets as of the inception of the case — that is, unsecured creditors receive only that which they would have received in a chapter 7 liquidation, accord 11 U.S.C. § 1129(a)(7)(A)(ii) — seems upon initial reflection the conceptually correct answer in an involuntary chapter 11 case, but is impossible to realize unless one does not discount to present value the unsecured claims, or one uses a discount less than the 9.25% granted to the trustee here.
If I am reading Ex. T-1 correctly, the debtors initially scheduled $987,518.20 in unsecured claims and $828,619.00 in unencumbered assets. If so, and if these figures are accurate, then in a chapter 7 liquidation, unsecured creditors of these debtors would not be entitled to postpetition interest by virtue of 11 U.S.C. § 726(a). E.g. In re Kentucky Lumber Co., 860 F.2d 674 (6th Cir. 1988) (unless the debtor is solvent, unsecured creditors do not receive postpetition interest). Therefore, assuming that these debtors were insolvent as of the order for relief, and that the amount unsecured creditors would receive in a chapter 7 case is the ceiling as well as the floor which a true chapter 11 reorganization plan proposal by a nondebtor party in an involuntary case can provide, the trustee would be entitled to receive his annual payment for a period not greater than that necessary to repay all unsecured creditors the amount of the — nondiscounted value of unencumbered assets. As the parties do not address this important issue, I do not fix the length of any plan proposed by the trustee. I am content to have any of these assumptions challenged at a later date by any party in interest. However, it is important for the parties to focus upon this issue.
The debtors also listed approximately $400,000.00 in cash held by court appointed custodians. I assume that such cash was collateral for certain creditors and was not reachable by unsecured creditors. Accord In re Aspen Data Graphics, Inc., 109 B.R. 677, 682 (Bankr. E.D.Pa. 1990).
As mentioned above, the trustee has utilized the asset value figures for purposes of this dispute. It therefore is appropriate to also use them to determine the length of the chapter 11 plan.
III.
Having determined that portion of the medical practice's income which is to be designated as estate property as opposed to income generated by the debtor's services, I may now turn to resolving the next set of issues. Various creditors have filed administrative or priority claims against the estate, which are opposed by the trustee. Essentially, the trustee objects to these proofs of claim, all of which involve postpetition taxes goods and services provided postpetition to the medical practice, on the basis that these claims are rightfully held against Dr. Paolino personally, and not against the bankruptcy estate. That is, the trustee would now have me hold that, because Dr. Paolino operated the medical practice and generated these bills, he should be responsible for their payment.
The trustee's approach to determining the "earnings exception" assumed that the debts of the medical practice were paid before distribution was made to Dr. Paolino or the estate. That is, by equating the "rate of return" sum to the amount of money generated by services not performed by Dr. Paolino, the trustee attempted to determine the medical practice's "earnings overage." In verifying that figure, the trustee utilized the net amount garnered by the practice, offset by a reasonable annual draw by Dr. Paolino. Thus, the trustee must assume that the expenses incurred by the medical practice will be paid from the gross receipts of that business, before the profits (to either the estate or the debtor) are calculated.
Consistent with this, I find that the various claims that are asserted must be paid from estate funds and not by Dr. Paolino personally. Although I discuss the individual claims in more detail below, I find that each of the claims are rightfully asserted against the estate and are to be paid in the amounts claimed.
Actually, the dispute between the debtors and the trustee over postpetition claims only has meaning if these expenses are classified as estate expenses and if such a classification does not extend the total of annual payments due from Dr. Paolino. In other words, the issue of who is responsible for payment of these services, the debtors or the trustee, is irrelevant if the trustee can pass on their cost to Dr. Paolino through longer plan payments. In discussing the payments due to unsecured creditors and the length of the plan, I did not consider the issue of administrative creditors. I will address this issue in the context of any dispute over the terms of a proposed plan.
The following claims have been objected to by the chapter 11 trustee:
Proof of Claim No. Claimant Amount Claimed
19 Leaseservice $8,947.04 21 General Electric Co. $7,992.40 25 IRS $112,092.31 42 Commonwealth of PA $32,081.59 45 IRS $92,088.63 40 National Health $15,230.90 Laboratories, Inc.
I shall discuss the three non-governmental claims first.
The burden of proving these claims for administrative expenses is, of course, on the claimants. E.g., In re Baldwin-United, 43 B.R. 443 (S.D. Ohio 1984); In re Massetti, 95 B.R. 360, 363 (Bankr. ED. Pa. 1989); In re Patch Graphics, Inc., 58 B.R. 743 (Bankr. W.D. Wis. 1986). That burden is met by a preponderance standard. In re Sinclair, 92 B.R. 787 (Bankr. S.D. Ill. 1988). For the claims to be allowed as administrative expenses of the estate under § 503(b) they must represent actual and necessary costs and expenses of preserving the estate.
I find that claimants Leaseservice, General Electric Co. and National Health Laboratories, Inc. have met their burden by showing that the debts arose postpetition, in connection with transactions between the claimants and the debtor, which generated income for the medical practice, and that the claims represent debts incurred in order to benefit the operation of the debtor's business. Accord, In re Airlift International, Inc., 97 B.R. 664 (Bankr. S.D. Fla. 1989), aff'd, 120 B.R. 597 (S.D. Fla. 1990); In re Keegan Utility Contractors, Inc., 70 B.R. 87 (Bankr. W.D.N.Y. 1987). There is no suggestion that these claims arose during the "gap" period of this involuntary case. In re Dakota Lay'd Eggs, 68 B.R. 975 (Bankr. D.N.D. 1987). I also find that these creditors were "induced" by the Dr. Paolino to provide the goods and services.
The thrust of the trustee's objection to these claims is, basically, that it would be unfair to require the estate to bear as administrative expenses the costs of a business that the trustee neither operated nor controlled. This is, admittedly, an unusual situation in that the chapter 11 debtor has continued to operate his business postpetition, as a debtor-in-possession, even though a trustee was appointed by this court to oversee the bankruptcy case. The trustee has allowed the debtor to continue postpetition with the medical practice, unfettered and without supervision. Normally it is the chapter 11 trustee which operates the business. 11 U.S.C. § 1108.
The trustee's decision to not interfere with the medical practice does not absolve the estate of the duty to pay the allowed administrative expenses. The trustee argues that he is "in a role equivalent to a third-party investor or trade creditor" with respect to the estate. Memorandum of Trustee, at 7. That is, the trustee likens his position vis-a-vis the debtor to that of other creditors, in that he too must await payment from the debtor. I do no find this position tenable. The trustee has certain duties to perform, and is to act in the best interests of the estate and creditors. Merely because the trustee decided to not operate the business is no justification for allowing his duties to lapse. The operating costs of this medical practice must be paid, and the estate is required to pay them. Whether the trustee pays these costs from funds of the estate already in his possession, or whether the trustee may take some action against the debtor to require that future gross earnings be applied towards these debts, (see footnote 16 supra) is immaterial to the determination that the estate, and not Dr. or Mrs. Paolino personally, must pay.
Although there was no evidence submitted on this point, I may safely assume that the medical practice, prepetition, incurred debts for similar services from these or other entities. That is, as the trustee's formulation for determining an annual amount of estate property not "earned" by the debtor's services considered that the operating expenses were paid from the gross earnings, I find it consistent and appropriate to order the estate to pay these postpetition administrative expenses.
The Internal Revenue Service (IRS) has filed two proofs of claim in this case; one is for prepetition taxes in the amount of $122,029.31, see Ex. 4, and the other is for postpetition taxes in the amount of $92,088.83. See Ex. B. The sum claimed as priority, prepetition taxes includes sums for taxes owed, penalties and prepetition interest. Of this total, $26,433.28 is claimed as an unsecured priority, and $95,596.03 is claimed as secured. An attachment to Ex. A lists the prepetition dates on which the notice of tax liens assertedly were filed, and the office location where filed.
The trustee did concede at the hearing that notices of lien had been filed, but argued that no evidence was presented regarding what property of the estate, if any, secures these claims. However, the objection to the claim filed by the trustee did not raise this issue as a basis for its objection. Thus, I do not have before me an objection to the secured status of the claims.
The Commonwealth of Pennsylvania's proof of claim No. 42 is in the total amount of $32,081.59. Of this total, $13,787.37 is claimed as secured, statutory lien claims, $1,460.58 is claimed as a priority, and $16,833.64 is claimed as administrative, postpetition taxes. These sums all include interest on the underlying taxes owed.
With regard to the priority tax claims, both state and federal, the trustee argues that any prepetition penalties should be disallowed seventh priority status, as he asserts that no evidence was offered to show that the-penalties are in compensation for actual pecuniary loss. See 11 U.S.C. § 507(a)(7)(G). The trustee posits that since prepetition interest is also claimed, the penalties must be considered punitive in nature (the actual pecuniary loss being recovered by the interest claimed), citing In re New England Carpet Co., 26 B.R. 934 (Bankr. D. Vt. 1983).
Indeed, it has been held that the fact that interest is charged in addition to other penalties may indicate that the penalties are punitive in nature, in the absence of evidence to the contrary, since (as the trustee argues) the pecuniary loss would be compensated by the interest. See, e.g., In re Hinderberg, 108 B.R. 407, 417-18 (Bankr. N.D.N.Y. 1989); In re Standard Johnson Co., 90 B.R. 41 (Bankr. E.D.N.Y. 1988); In re Jackson, 80 B.R. 213 (Bankr. D. Colo. 1987); In re Healis, 49 B.R. 939 (Bankr. M.D. Pa. 1985).
I note that the IRS does not disagree with this position in its posthearing memorandum. Instead, the government only acknowledges that penalties upon its unsecured priority tax claims are to be treated as general, unsecured claims. Indeed, the lack of priority does not alter the propriety of the penalty itself. E.G., In re New England Carpet Co. The IRS does not argue for the propriety of granting a seventh position priority to tax penalties on its apparently secured tax claims, to which interest has been claimed. I find that the penalties claimed are punitive in nature, and may not be granted priority status.
The trustee also argues that the interest claimed on the postpetition, administrative tax claims should be disallowed, citing In re American Internat'l Airways, Inc., 77 B.R. 490 (Bankr. E.D. Pa. 1987). However, since that decision was rendered there has been other judicial consideration of whether postpetition interest should be treated as an administrative expense. See In re Flo-Lizer, Inc., 916 F.2d 363 (6th Cir. 1990); In re Mark Anthony Construction, Inc., 886 F.2d 1101 (9th Cir. 1989); In re Allied Mechanical Services, Inc., 885 F.2d 837 (11th Cir. 1989). See also United States v. Friendship College, Inc., 737 F.2d 430 (4th Cir. 1984). These cases interpreted § 503(b)(1) in a manner consistent with the treatment of § 64(a)(1) of the Bankruptcy Act by Nicholas v. United States, 384 U.S. 678 (1966), and concluded that postpetition interest is rightfully treated as an administrative expense. ("Like § 503(b) of the Code, § 64(a)(1) of the Act did not specify whether post-petition interest qualified for priority treatment as an administrative expense." In re F.A. Potts Co., 114 B.R. 92, 94 n. 3 (Bankr. E.D. Pa.) (Twardowski, Ch.J.), rev'd on other gnds, 115 B.R. 66 (E.D. Pa. 1990)).
Accordingly, it has been recently held in this district that the United States, as a creditor, was entitled to postpetition interest on its claim for administrative expenses. See In re F.A. Potts Co., 114 B.R. at 94. I agree with this conclusion, and find that the interest is properly treated as an administrative expense. Accord Rustolo, Recovery of Interest on Postpetition Taxes Under Section 503 of the Bankruptcy Code, 64 Am.Bank. L.J. 427 (Fall, 1990).
IV.
The remaining issues are the debtors' objection to the trustee's proposed plan of reorganization, and the trustee's objection to the debtors' discharge of bankruptcy, pursuant to 11 U.S.C. § 727(a).
I easily conclude that the plan cannot be confirmed, because it does not provide for administrative expenses to be paid in full on the plan's effective date. 11 U.S.C. § 1129(a)(9). The trustee agreed at the hearing that I cannot confirm his proposed plan; thus, confirmation will be denied.
With respect to the trustee's objection to the debtors' discharge in bankruptcy, pursuant to § 727(a), I conclude that discharge cannot, at this point, be denied pursuant to this subsection of the bankruptcy code. This section is made applicable in chapter 11 proceedings for individuals by virtue of § 1141(d)(3). This subsection states:
(d)(3) The confirmation of a plan does not discharge a debtor if —
(A) the plan provides for the liquidation of all or substantially all of the property of the estate;
(B) the debtor does not engage in business after consummation of the plan; and
(C) the debtor would be denied a discharge under section 727(a) of this title if the case were a case under chapter 7 of this title.
Thus, the trustee argues that the debtors "should be denied a discharge under Sections 727(a) and 1141(d)(3) of the Bankruptcy Code unless the Court confirms a plan under Section 1129 of the Code which (i) does not provide for the liquidation of all or substantially all of the property of the estate and/or (ii) Paolino engages in business after consummation of such plan." Memorandum, at 8-9. This argument acknowledges that the provisions of § 1141(d)(3) are stated in the conjunctive, and therefore all three conditions must be satisfied for the denial of discharge under that subsection. See In re Rich-Morrow Realty Co., Inc., 100 B.R. 893, 895 n. 2 (Bankr. N.D. Ohio 1989). Accord In re Pfliger, 57 B.R. 467 (Bankr. D.N.D. 1985) (as debtor proposed a plan of continuing operations and not of liquidation, creditor may not proceed under § 1141(d)(3)(C).
It has therefore been held that where there is no proposed plan submitted for consideration, the issue of nondischargeability would not be ripe for resolution. Matter of Rich-Narrow Realty Co.; In re Miller, 80 B.R. 270 (Bankr. W.D.N.Y. 1987). This result makes sense where it is the terms of the proposed plan that will determine whether discharge should be denied under § 1141(d)(3). Without knowing the precise terms of a future plan proposed by the trustee or another party in interest, (i.e. liquidation as opposed to reorganization, and whether the debtor intends to remain in business after consummation of the plan) I cannot make a determination of whether the provisions of § 1141(d)(3) are met.
Here, the trustee's proposed plan of reorganization was denied confirmation for failing to provide for payment in full of administrative expenses on the effective date of the plan. The docket reveals that no other proposed plan of reorganization has been filed with this court. Thus, I conclude that the issue is not ripe for resolution. The trustee's motion to deny discharge under the provisions of §§ 1141(d)(3) and 727(a) will be denied without prejudice.
Courts may take judicial notice of the contents of their own dockets. See Fed.R.Evid. 201 (as incorporated by Bankr. R. 9017); In re Digby. 47 B.R. 614, 620 (Bankr. N.D. Ala. 1985); In re Brown. 37 B.R. 516 (Bankr. E.D. Mo. 1984). See also Russell, Bankruptcy Evidence Manual, §§ 201.1 et seq. (1990).
An order consistent with this memorandum shall issue.