Source: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-ca10-94-04017/USCOURTS-ca10-94-04017-0/pdf.json

Nature of Suit Code: 442
Nature of Suit: Civil Rights Employment
Cause of Action: 

---

PUBLISH 

FILED 

UDitecl States Court of Appeals T .. ,..t-. r; ...... =t 

UNITED STATES COURT OF APPEALS SEP 1 n 1995 

TENTH CIRCUIT 

IN RE: DAVIDSON LUMBER SALES, INC.,) 

) 

Debtor, ) 

- - - - - - - - - - - - - - - -- - - - - - - - - - - - - - - - - - - ) 

ZIONS FIRST NATIONAL BANK, N.A., ) 

) 

Appellee, ) 

) 

v. ) 

) 

CHRISTIANSEN BROTHERS, INC., ) 

) 

Appellant, ) 

) 

and ) 

) 

JACOBSEN-ROBBINS CONSTRUCTION. ) 

PATRICK FISHER 

Clerk 

No. 94-4017 

Appeal from the United States District Court 

for the District of Utah 

(D.C. No. 92-CV-843) 

Bryce D. Panzer, of Blackburn & Stoll, LC, Salt Lake City, Utah, 

for Defendant-Appellant. 

J. Randall Call (James A. Beevers and Sally B. McMinimee, of 

Prince, Yeates & Geldzahler, Salt Lake City, Utah, with him on the 

brief), of Prince, Yeates & Geldzahler, Salt Lake City, Utah, for 

Plaintiff-Appellee. 

Before SEYMOUR, Chief Judge, MOORE, Circuit Judge, and SAFFELS,* 

District Judge. 

SEYMOUR, Chief Judge. 

* Honorable Dale E. Saffels, United States Senior District 

Judge for the District of Kansas, sitting by designation. 

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 1 
Zions First National Bank (Zions) brought this adversary 

proceeding against Christiansen Brothers Inc. (Christiansen). 

Zions had a perfected security interest in the accounts receivable 

of debtor Davidson Lumber Sales, Inc. (Davidson) and sought to 

enforce that interest out of accounts receivable Christiansen 

allegedly owed Davidson. The bankruptcy court granted summary 

judgment to Christiansen, ruling that Christiansen owed Davidson 

nothing by virtue of Christiansen's payment of debts that Davidson 

owed to its suppliers, Diehl Lumber Products (Diehl) and Anderson 

Lumber (Anderson) . Zions appealed to the district court which 

reversed, holding that Christiansen's payment of Davidson's debts 

did not relieve Christiansen of its obligation to pay Davidson. 

See Zions First Nat'l Bank, N.A. v. Christiansen Bros. Inc. (In re 

Davidson Lumber Sales, Inc.), 164 B.R. 773 (D. Utah 1993). The 

district court accordingly granted summary judgment for Zions. 

Christiansen appeals, and we reverse. 

I. 

The relevant facts underlying this litigation are undisputed 

and may be briefly stated as follows. Davidson filed a petition 

under Chapter 11 of the Bankruptcy Code on February 6, 1986. The 

case was converted to a Chapter 7 proceeding on April 30, 1987. 

On February 21, 1986, Davidson and Zions entered into a postpetition financing agreement under which Zions obtained a security 

interest in Davidson's accounts receivable. Zions filed a 

-2-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 2 
financing statement in this regard under the Utah provisions of 

the Uniform Commercial Code (UCC) . 

. Christiansen, as the general contractor on a construction 

project, bought goods and materials from Davidson post-petition 

for use on the project. Davidson in turn bought material from 

Diehl and Anderson and resold it to Christiansen for use in the 

project. Christiansen was contractually obligated to the owner of 

the project to deliver the project free of mechanics liens. 

Davidson did not pay Diehl and Anderson for the materials. On 

February 24, 1987, Christiansen issued a joint check to Anderson 

and Davidson as payment for the materials Davidson had purchased 

from Anderson and resold to Christiansen. Davidson's president 

endorsed the check. On February 27, 1987, Diehl filed a notice of 

mechanics lien on the project under state law based on its lack of 

payment. Christiansen and Diehl entered into an agreement on 

March 11, 1987, under which Diehl agreed to release the lien and 

Christiansen agreed to pay Diehl the amounts Davidson owed Diehl 

for the material Diehl sold to Davidson for use on the project. 

Christiansen paid Diehl, and Diehl released the lien. In a letter 

dated March 13, 1987, Davidson wrote to Christiansen stating that 

Zions had a security interest in Davidson's accounts receivable. 

Davidson further stated that it declined to authorize payment of 

these accounts to anyone but the bankruptcy estate. 

-3-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 3 
II. 

In reviewing a bankruptcy court decision, the district court 

accepts fact findings unless clearly erroneous and reviews 

conclusions of law de novo. See Bartmann v. Maverick Tube Corp., 

853 F.2d 1540, 1543 (lOth Cir. 1988). We likewise review a 

bankruptcy court's factual determinations for clear error and its 

legal determinations de novo. Id. We agree with the parties that 

no material fact disputes exist and that we are called upon to 

review only legal issues. 

The bankruptcy court based its decision on its conclusion 

that, under Utah law, Christiansen's payments as a general 

contractor to suppliers who had not been paid by Davidson, the 

subcontractor, created a defense to Christiansen's obligation to 

pay Davidson. The district court disagreed, concluding that 

nothing in applicable Utah statutes allows a general contractor to 

extinguish its obligation to a subcontractor by paying directly 

the subcontractor's creditors. Accordingly, we turn first to Utah 

law. 

Utah recognizes the principle of setoff,l under which a 

defendant may assert a counterclaim against a plaintiff "to be 

1 The parties and the district court have addressed to varying 

degrees whether the facts in this case give rise to a claim of 

setoff or of recoupment. See Zions First Nat'l Bank, N.A. v. 

Christiansen Bros., Inc. (In re Davidson Lumber Sales, Inc.), 164 

B.R. 773 n.2 (D. Utah 1993). The Bankruptcy Code distinguishes 

between setoff and recoupment, imposing more impediments to the 

availability of setoff. See Davidovich v. Welton (In re 

Davidovich), 901 F.2d 1533, 1536-37 (lOth Cir. 1990). We do not 

resolve this issue. Instead, in concluding that Christiansen is 

not obligated to Zions, we assume that we are dealing with the 

issue of setoff, the assumption less favorable to Christiansen. 

-4-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 4 
used in full or partial satisfaction of whatever is owed." Mark 

VII Fin. Consultants Co~. v. Smedley, 792 P.2d 130, 133 (Utah Ct. 

App. 1990). The court in Mark VII held that as a general rule 

setoff is only warranted when the demands between the parties are 

mutual. Id. at 133 (citing 80 C.J.S. Set-Off and Counterclaim § 

48a(2) (1953); 20 Am. Jur. 2d Counterclaim, Recoupment, and Setoff 

§ 74 (1965)). As support for that proposition, the court cited 

authorities which also recognize that a court in equity may permit 

setoff even when the debts are not mutual in order to effect 

equity and prevent injustice. See 80 C.J.S. Set-Off and 

Counterclaim at§ 48(b), 20 Am. Jur. 2d Counterclaim, Recoupment. 

and Setoff at § 75.2 Although we have found no decision of the 

Utah courts addressing whether setoff is available under the 

circumstances here, we have found no indication in Utah law that 

setoff would be barred in these circumstances. 

Moreover, the Utah courts recognize that the.statutes 

providing for mechanics liens and payment bonds are remedial in 

nature and are designed to protect suppliers from the contract 

privity requirement. See Cox Rock Prods. v. Walker Pipeline 

Constr., 754 P.2d 672, 673-74 (Utah Ct. App. 1988). To achieve 

2 Although we believe the Utah courts would allow setoff absent 

mutuality when equitable considerations are present, we note in 

addition that several well-defined exceptions exist to a strict 

construction of the mutuality requirement, including the setoff of 

creditor claims under the doctrine of subrogation. See J.A. Clark 

Mechanics. Inc. v. Case W. Reserve Univ. (In re J.A. Clark Mech .. 

Inc.), 80 B.R. 430, 432 (Bankr. N.D. Ohio 1987) (citing cases). 

"'Mutuality is evident because the surety's claim for 

reimbursement and the debtor's debt are owing between the same 

parties.'" Id. (quoting 4 Collier on Bankruptcy ,I 553.04 (5) (15th 

ed. 19 87) ) . 

-5-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 5 
the protective purposes of these statutes, the Utah courts 

construe them broadly. See Richards v. Security Pac. Nat'l Bank, 

849 ·P.2d 606, 610 (Utah Ct. App.), cert. denied, 859 P.2d 585 

(Utah 1993). Accordingly, the courts have held as a matter of 

policy that as between a commercial lender and a lienholder, 

[g]iven the legislature's creation of a specific 

statutory preference for mechanics' lienholders, if the 

question is framed as a choice between which party 

should receive a windfall, we believe it should be the 

mechanics' lienholder .... Given the statutory 

protection granted mechanics' lienholders, it is much 

more appropriate to have commercial lenders bear the 

burden of protecting themselves. 

Id. at 612. Although the specific holdings in these cases arose 

out of fact situations distinguishable from those at issue here, 

absent otherwise controlling Utah authority the policy in the 

cases favoring lienholders at the expense of commercial lenders 

inform our determination of the way in which the Utah courts would 

resolve the issues before us.3 In keeping with the concern of the 

Utah courts and legislature that lienholders recover payment for 

material they have supplied, we conclude that Utah would permit a 

general contractor who pays a supplier in order to prevent or to 

3 An additional indication of the concern in Utah that the law 

provide for the payment of laborers and suppliers is found in Ron 

Case Roofing & Asphalt Paving. Inc. v. Blomquist, 773 P.2d 1382 

(Utah 1989). There the court held that when two parties reach a 

contractual agreement that one party will pay debts arising from 

the furnishing of labor or materials, the suppliers are third 

party beneficiaries of that contract with an enforceable right to 

payment against the contracting party assuming the payment 

obligation. See id. at 1385-87. 

-6-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 6 
discharge a lien to set that payment off against amounts it owes 

to the defaulting subcontractor.4 

. Zions argues that even if Christiansen had a right to setoff, 

that right was subordinate to Zions' perfected security interest 

in Davidson's accounts receivable. We disagree. Section 9-104(i) 

of the Utah version of the UCC, Utah Code Ann. § 70A-9-104(i),5 

states that Article 9 does not apply to any right to setoff. See 

Insley Mfg. Corp. v. Draper Bank & Trust, 717 P.2d 1341, 1344 

(Utah 1986) . Utah has joined the majority of jurisdictions 

construing this provision by holding that a creditor may have a 

right to setoff without complying with the security agreement and 

filing provisions of Article 9, although the priority of such a 

4 Zions argues that the Utah provisions relevant to the payment 

of construction funds undercut Christiansen's right to setoff. 

See Utah Code Ann. §§ 58-55-602, -603 (Supp. 1994). These 

statutes provide that a contractor must pay his suppliers "within 

30 consecutive days after receiving construction funds from . . . another contractor . . . or after the last day payment is due 

under the terms of the billing, whichever is later." Id. 58-55-

603(2). Zions argues that because Christiansen never paid 

Davidson, Davidson's duty to pay Diehl and Anderson never arose. 

However, all the participants in the underlying events, including 

Davidson and Zions, have agreed throughout this litigation that 

Davidson owed the money to these suppliers. Moreover, with 

respect to construction contracts, the general rule is that such 

pay-when-paid provisions do not operate as conditions precedent 

under which the duty to pay is contingent upon receipt of funds 

from a third party. See Ritz-Craft Corp. v. Stanford Management 

Group, 800 F. Supp. 1312, 1317-18 (D. Md. 1992) (citing cases). 

To the contrary, these provisions are viewed as only postponing 

payment for a reasonable time and merely establishing a convenient 

time for payment. Id. 

5 All further references herein to Uniform Commercial Code 

sections are contained in Utah Code Ann. tit. 70A. 

-7-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 7 
setoff is to be determined under that Article's priority 

provisions. Id. at 1344-45.6 

· The relative rights of account debtors and assignees of 

accounts receivable are set out in section 9-318 of the ucc. 

Under that provision the rights of the assignee, here Zions, are 

subject to "any . . . defense or claim of the account debtor [here 

Christiansen] against the assignor [here Davidson] which accrues 

before the account debtor receives notification of the 

assignment." Utah Code Ann. § 70A-9-318(1) (b). Contrary to 

Zions' assertion, Zions as assignee bears the burden of proving 

that Christiansen received notice of the assignments so as to cut 

off Christiansen's right to set off those payments against the 

account debt. See 4447 Assocs. v. First Sec. Fin., 889 P.2d 467, 

470-71 (Utah Ct. App. 1995) (citing cases). Also contrary to 

6 Zions' reliance upon Insley Mfg. Corp. is thus misplaced. As 

set out in text, Insley holds that although section 9-104(i) 

removes a setoff from the security and filing provisions otherwise 

imposed by Article 9, the priority provisions of that Article are 

to be used in determining the priority of a right to setoff vis-avis the claims of other creditors. See Insley, 717 P.2d at 1344-

45. In that case, the court followed its holding in resolving the 

priority conflict between a creditor's perfected purchase money 

security interest in inventory and identifiable cash proceeds and 

a creditor's right to setoff against those proceeds. It is in 

this context that the court noted the importance of the 

constructive notice given by the filing of a financing statement, 

and stated that Article 9 has no provision suggesting that a 

perfected security interest [in inventory and proceeds] is 

subordinate to a right of setoff. Id. at 1345. 

In the instant case, as distinguished from Insley, we must 

look to Article 9 to resolve a priority conflict between a 

creditor's right to setoff and another creditor's perfected 

security interest in accounts receivable, an issue resolved 

directly by UCC section 9-318. 

-8-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 8 
Zions' assertion, filing a financing statement does not provide 

the actual notice required under section 9-318 . 

. While filing a financing statement is constructive 

notice that is effective for other purposes under 

Article 9, see Utah Code Ann. § ?OA-9-312(5) (a) (1990) 

(establishing priority among multiple security interests 

by date of filing), it does not suffice for the actual 

notice required under section ?OA-9-318. A financing 

statement only offers notice that a security interest 

may exist, and requires potential creditors to make 

further inquiry to confirm the existence of specific 

details of the transaction. See Sannerud v. First Nat'l 

Bank, 708 P.2d 1236, 1241 (Wyo. 1985); U.C.C. § 9-402 

cmt. 2 {1989). An account debtor, unlike a potential 

creditor, is not obligated to check the UCC recordings 

continually to ascertain whether the debt has been 

assigned, and the filed financing statement offers no 

actual notice of the assignment's existence that would 

affect an account debtor's right to assert subsequent 

claims and defenses. See Utah Code Ann. § ?OA-9-

318{1) {b) {1990); Chase Manhattan Bank v. State, 40 

N.Y.2d 590, 388 N.Y.S.2d 896, 898-99, 357 N.E.2d 366, 

369 {1976) (financing statement not actual notice that 

would bar account debtor from asserting setoff) . 

Id. at 473 n.9 (emphasis added). 

The only evidence in this record relevant to the notice issue 

is the letter from Davidson to Christiansen dated March 13, 1987. 

Even assuming that this letter would constitute sufficient notice 

under section 9-318(1) {b), see 4447 Assocs., 889 P.2d at 472-75, 

the letter was dated after Christiansen's agreement to pay Diehl 

and after Christiansen issued the joint check to Anderson and 

Davidson. Because Christiansen's claim for setoff arose before it 

received the notice, if any, provided by the March 13 letter, 

Zions' rights as assignee are subject to that claim.? 

7 Zions argues that Christiansen, as Diehl's subrogee, should 

be charged with Diehl's notice of the assignment, citing the 

Colorado case of Union Ins. Co. v. RCA Corp., 724 P.2d 80 {Colo. 

Ct. App. 1986). That case is irrelevant both because it construed 

-9-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 9 
III. 

Zions further argues that allowing setoff here would violate 

several provisions of the Bankruptcy Code, specifically those 

pertaining to post-petition financing, use of cash collateral, 

setoff, and the automatic stay. We begin our consideration of 

these claims by turning to a long line of cases addressing these 

and similar arguments in the context of the construction industry. 

This authority provides a framework for evaluating Zions 

assertions and supports our determination that the Utah courts 

would allow setoff in this situation. 

The court in Selby v. Ford Motor Co., 590 F.2d 642 (6th Cir. 

1979), discussed at length the special problems that arise with 

respect to payment down the line in the construction industry. 

The court pointed out that the Michigan trust fund statute at 

issue there was 

designed to remedy problems in the construction 

industry. Like the law merchant of an earlier day, the 

building trades have gradually created a set of 

commercial expectations as the result of the customs and 

practices of the industry. The nature of the industry 

is such that the commercial expectations of the parties 

are defeated when a building contractor or subcontractor 

does not use accounts paid to him on a job to pay 

subcontractors or materialmen. Unless the parties see 

that construction funds are properly applied down the 

line, the liabilities of the parties up the line are 

affected. The unpaid workers must undertake the lengthy 

and wasteful process of filing, perfecting and 

Colorado law and because it was not concerned with the particular 

notice requirements of section 9-318. The Utah courts have made 

it clear that section 9-318 requires actual notice to the account 

debtor, Christiansen. See 4447 Assocs., 859 P.2d at 473 n.9. In 

these circumstances, Diehl's notice is not notice to Christiansen. 

-10-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 10 
foreclosing on their mechanics liens. The owner's 

property and the construction lender's security are 

encumbered. 

Id. -at 647. The court observed that to preserve the economic 

viability of the multi-tier payment system used in the 

construction industry, 

courts and legislatures have increasingly found that the 

parties have an independent legal duty arising from 

reasonable commercial expectations to see to the proper 

application of construction funds. In the absence of 

statute, courts have declared that construction funds in 

the hands of a contractor are held subject to a 

constructive trust or an equitable assignment or an 

equitable lien. Even in the absence of a state builders 

trust statute, federal bankruptcy courts in a variety of 

situations have refused to apply the property, 

preference and statutory liens sections of the 

Bankruptcy Act to favor unsecured creditors over the 

equitable claims of subcontractors and materialmen to 

the proceeds of a construction project in the hands of a 

bankrupt contractor. 

Id. at 648 (footnotes omitted) .a 

One of the earliest cases in this area arose out of a factual 

setting very similar to that before us. The court was required to 

determine "whether direct payments by the bankrupt's debtor (a 

general contractor) to the bankrupt's creditor (a supplier to the 

bankrupt), made under obligation of California law, were invalid 

as setoffs" under the prior Bankruptcy Act. Bel Marin Driwall, 

Inc. v. Grover (In reBel Marin Driwall, Inc.), 470 F.2d 932, 933 

(9th Cir. 1972). Under the California law applicable at the time, 

"a general contractor and his surety were subject to judgment in 

8 We realize that the funds at issue here were in the hands of 

the general contractor, Christiansen, rather than held by the 

bankrupt subcontractor, Davidson. We are also aware that Zions is 

a secured creditor. Nonetheless, the general concerns underlying 

the discussion in Selby are relevant to the instant circumstance. 

-11-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 11 
favor of unpaid materialmen and suppliers." Id. at 935. The 

court pointed out that the general contractor thus paid the 

suppliers pursuant to a mandatory obligation imposed by statute 

which existed independently of any duty which the bankrupt 

subcontractor owed to those suppliers to pay for materials 

furnished to him. Id. The court held that when payment is made 

pursuant to such an independent legal obligation, setoff is 

proper. Id. at 935-36. 

In Scherer Hardware & Supply. Inc. v. Charles H. Eichelkraut 

& Son. Inc. (In re Scherer Hardware & Supply. Inc.), 9 B.R. 125 

(Bankr. N.D. Ill. 1981), the court also addressed whether a 

general contractor who pays a bankrupt subcontractor's supplier 

pursuant to an independent legal duty may set this payment off 

against the debt owed to the subcontractor. The court recognized 

that according to the holding in Bel Marin, "where a debtor of the 

bankrupt paid a claim of one of the bankrupt's creditors, a setoff 

should be allowed if the claim had been acquired as the result of 

a direct or independent legal obligation." In re Scherer, 9 B.R. 

at 129. The court further held that under Bel Marin, the 

requisite independent legal obligation can come from the general 

contractor's direct legal duty, "whether contractual or statutory, 

to pay all claims for labor and materials, regardless of the 

claimant's privity of contract with the general contractor." Id. 

Subsequent cases have similarly held in the bankruptcy context 

that where a general contractor pays suppliers pursuant to an 

independent legal obligation imposed either by statute or by 

-12-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 12 
contract, the general contractor may set that debt off against 

amounts owing to the subcontractor. See, ~' Stoebner v. 

Horizon Fabricators. Inc., 153 B.R. 840 (D. Minn.); In re E. & D. 

Elec. Co., Inc., 68 B.R. 3 (Bankr. S.D. Miss. 1986); In re 

Flanagan Bros .. Inc., 47 B.R. 299 (Bankr. D. N.J. 1985). 

Equally significant to our consideration of Zions' arguments 

are those cases holding that when a general contractor pays a 

supplier on the basis of an independent legal obligation, those 

payments do not become part of the bankruptcy estate. See ~, 

Crocker v. Braid Elec. Co. (In re Arnold), 908 F.2d 52, 56 (6th 

Cir. 1990); Shaw Indus .. Inc. v. Gill (In re Flooring Concepts, 

Inc.), 37 B.R. 957, 961 (Bankr. 9th Cir. 1984); Rieser v. Bruck 

Plastics Co. (In re Trinity Plastics. Inc.), 138 B.R. 203, 207 

(Bankr. S.D. Ohio 1992). The case of Georgia Pacific Corp. v. 

Sigma Service Corp., 712 F.2d 962 (5th Cir. 1983), upon which both 

the district court and Zions rely, is distinguishable in 

significant respects and therefore does not compel a different 

result. In Sigma, the court considered whether a constructive 

trust existed under the applicable state law in funds owed to a 

general contractor in favor of that contractor's unpaid suppliers. 

The court held that even if a trust existed, because the debtor 

had legal title to the funds they became part of the estate 

subject to the suppliers' equitable interest under 11 U.S.C. § 

541(a), (d). See Sigma, 712 F.2d at 964-68. But see Begier v. 

I.R.S., 496 U.S. 53, 59 (1990) ("Because the debtor does not own 

an equitable interest in property he holds in trust for another, 

-13-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 13 
that interest is not 'property of the estate.'"). The court in 

Sigma further held that no constructive trust arose under state 

law .in any event. Significantly, the court's discussion was 

directed only to the argument that the funds were not part of the 

estate because they were subject to a constructive trust. The 

court did not address the line of cases holding that payments made 

by a debtor's debtor to that debtor's creditor under an 

independent obligation are not part of the bankruptcy estate.9 

Considering Zions' arguments in light of the above authority, 

we first note that Christiansen paid Diehl and Anderson as the 

result of an independent legal duty imposed by the contract 

between Christiansen and the project owner. It is undisputed that 

this contract obligated Christiansen to deliver the project free 

from liens, an obligation that required Christiansen to pay the 

suppliers in the event Davidson did not so as to prevent the 

suppliers from filing liens. The Utah courts have held that a 

contract provision materially similar to this one renders the 

suppliers third party beneficiaries with a right to claim directly 

9 At least two courts have held that when a subcontractor is 

obligated by a contract with the general contractor to supply 

materials and fails to pay his suppliers, he has breached his 

contract and the general contractor is no longer contractually 

obligated to pay the defaulting subcontractor. See Tri-City Serv. 

Dist. v. Pacific Marine Dredging & Constr. (In re Pacific Marine 

Dredging & Constr.), 79 B.R. 924, 929 (Bankr. D. Or. 1987); 

Business Fin. Servs. v. Butler & Booth Dev. Co., 711 P.2d 649, 

651-52 (Ariz. Ct. App. 1985). Under these holdings, the 

subcontractor has no legal or equitable interest in funds held by 

the general contractor. See In re Pacific Marine, 79 B.R. at 929. 

Accordingly, such funds are not part of the bankruptcy estate and 

the security interest of the subcontractor's creditor cannot 

attach to them. Id. 

-14-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 14 
against the contract obligor. See Ron Case Roofing & Asphalt 

Paving. Inc. v. Blomquist, 773 P.2d 1382, 1385-87 (Utah 1989). 

Consequently, the payments made by Christiansen to the suppliers 

are generally considered by the authorities cited above to be 

available for setoff against the debt Christiansen owed the 

bankrupt, and are not considered part of the bankruptcy estate.10 

With the above principles in mind, we turn to Zions' argument 

that Christiansen violated 11 U.S.C. § 363(c) (2) by using the cash 

collateral attributable to the accounts receivable it owed 

Davidson to pay the suppliers without the consent of Zions or the 

bankruptcy court. Section 363(c) (2) provides that "[t]he trustee 

may not use, sell, or lease cash collateral under paragraph (1) of 

this subsection unless--(A) each entity that has an interest in 

such cash collateral consents; or (B) the court, after notice and 

a hearing, authorizes such use, sale, or lease in accordance with 

the provisions of this section." Cash collateral is defined as 

10 The funds paid by Christiansen to Anderson by joint check are 

also excluded from the bankruptcy estate under the doctrine of 

earmarking. 

It is generally recognized that where the payee controls 

the application of the funds by requiring dual 

endorsement before the check can be negotiated, the 

funds are claimed to be earmarked funds on the specific 

condition that a joint payee shall receive the proceeds, 

the Debtor who is already a named payee is merely deemed 

to be a conduit for those funds, which did not become 

the property of the Debtor's estate. 

Jensen v. Pen Air Conditioning. Inc. (In re Winsco Builders. 

Inc.), 156 B.R. 98, 100-01 (Bankr. M.D. Fla. 1993); see also 

Rieser v. Bruck Plastics Co. (In re Trinity Plastics. Inc.), 138 

B.R. 204, 206-07 & n.1; see generally McCuskey v. National Bank of 

Waterloo (In re Bohlen Enters., Ltd.J, 859 F.2d 561, 565 (8th Cir. 

1988). 

-15-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 15 
"cash, negotiable instruments, documents of title, securities, 

deposit accounts, or other cash equivalents whenever acquired in 

which the estate and an entity other than the estate have an 

interest and includes the proceeds, products, offspring, rents, or 

profits of property subject to a security interest." 11 U.S.C. § 

363(a) (emphasis added). As emphasized in the quoted definition, 

this section is not applicable unless the debtor has an interest 

in the property. As we have discussed, when a general contractor 

makes a payment to ~ supplier under an independent legal 

obligation, that payment is not part of the bankruptcy estate and 

the debtor therefore has no interest in it. See In re Arnold, 908 

F.2d at 55-56. Accordingly, Christiansen's payment did not 

violate section 363(c) {2) .11 

Zions also argues that allowing setoff here would violate the 

automatic stay provisions of 11 U.S.C. § 362(a) (3) and (4). Under 

those provisions, the filing of a bankruptcy petition operates to 

stay "any act to obtain possession of property of the estate or of 

property from the estate or to exercise control over property of 

the estate," 11 U.S.C. § 362(a) (3), and to stay "any act to 

11 Even if we assume that the payments made here could 

constitute property of the estate, section 363(c) {2) is directed 

only to the trustee's use of cash collateral. Zions has cited no 

authority for its assertion that this section also applies to 

parties other than the trustee. We believe that Zions' attempt to 

invoke section 363(c) (2) is actually a variation on its arguments 

with respect to other provisions of the Bankruptcy Code dealing 

with setoff and the automatic stay which we address below. 

-16-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 16 
create, perfect, or enforce any lien against property of the 

estate, n id. § 362 (a) (4) .12 

- Zions' security interest, Christiansen's debt to Davidson, 

Davidson's debt to the suppliers, and Christiansen's payments to 

those suppliers all arose after Davidson filed its Chapter 11 

petition. We are thus concerned here only with the availability 

of setoff with respect to post-petition obligations. The 

Bankruptcy Code does not address setoff in these circumstances. 

Section 553, which governs the availability of setoff, is directed 

to mutual debts that arose before the commencement of the 

bankruptcy proceeding. See 11 U.S.C. § 553(a). The automatic 

stay section deals with setoff specifically, but it is likewise 

addressed only to a debt owed the debtor that arose before the 

case was filed. See 11 U.S.C. § 362(a) (7) .13 

Despite the Bankruptcy Code's failure to address the 

situation, courts generally recognize that in appropriate 

circumstances mutual post-petition debts may be set off. See 

~'Mohawk Indus. v. United States (In re Mohawk Indus.), 82 

B.R. 174, 178-79 (Bankr. D. Mass. 1987); Paris v. Transamerica 

12 We do not see the relevance of section 362(a) (4). It is 

clear that Diehl filed a lien against the property. Although this 

lien precipitated Christiansen's payment to Diehl due to the 

independent legal obligation imposed upon Christiansen by 

contract, the lien itself did not attach to property of the 

debtor. Accordingly, we address Zions' argument only with respect 

to section 362(a) (3). 

13 The district court therefore erred in holding that the setoff 

here was barred by 11 U.S.C. § 362(a) (7). See In re Davidson 

Lumber Sales, Inc., 164 B.R. at 776 n.2. That provision by its 

terms only applies when the debt to the debtor arose before 

commencement of the bankruptcy proceeding. 

-17-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 17 
Ins. Group (In re Buckley & Assocs. Ins., Inc.), 78 B.R. 155, 158 

(E.D. Tenn. 1987); Dery v. General Motors CokQ. (In re Fordson 

Eng'.g CokQ.), 25 B.R. 506, 511 (Bankr. E.D. Mich. 1982); In re 

Shoppers Paradise, Inc., 8 B.R. 271, 277-78 (Bankr. S.D.N.Y. 

1980). In considering the availability of setoff, the above-cited 

cases do not address whether the setoff would be subject to the 

stay imposed by section 362(a) (3) on acts to obtain possession of 

property of the estate or to exercise control over such property. 

Even if we assume that section 362(a) (3) could apply to the 

setoff of mutual post-petition obligations, we do not believe 

Zions may invoke its protection here. The primary function of 

section 362(a) (7), which as we have observed applies by its terms 

to the setoff of a prepetition debt, "is to permit rehabilitation 

of Chapter 11 debtors." Row Steel, Inc. v. Asphalt & Sealers 

Equip. Mfg. (In re Row Steel, Inc), 33 B.R. 20, 22 (Bankr. 

E.D.N.C. 1983). "[I]f the right to set-off will not substantially 

interfere with the debtor's reorganization effort and has been 

obtained in good faith, equitable considerations favor lifting the 

automatic stay to allow set-off." Id. at 23. The automatic stay 

is thus intended to promote the purposes of the Bankruptcy Code in 

rehabilitating Chapter 11 debtors. Presumably the same 

considerations would apply to the application of section 362(a) (3) 

to post-petition setoff. "Property acquired by the debtor postbankrtupcy must be used for the benefit of all unsecured creditors 

or for the debtor's benefit in reorganizing or for the debtor's 

fresh start." USBI Co. v. Otha C. Jean & Assocs., Inc. (In re 

-18-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 18 
Otha C. Jean & Assocs.), 152 B.R. 219, 221 (Bankr. E.D. Tenn. 

1993) . 

. The court in Otha C. Jean refused to allow a bank to invoke 

the provisions of section 553 to prevent a setoff when allowing 

setoff would not "violate the reasons behind the rules expressed 

or implied" by that section. Id. at 222; see also Flanagan Bros .. 

Inc., 47 B.R. at 303 (refusing to bar setoff under section 553 

when bar would be contrary to intent behind that section). Here, 

as in Otha C. Jean, denying the right to setoff would not increase 

the funds available to pay unsecured claims or give the debtor the 

use of the money for reorganization or for a fresh start. The 

setoff would at most only affect an asset, the accounts receivable 

assigned to the bank, which would otherwise not be available for 

any of the purposes underlying the automatic stay. Here, too, 

denying setoff on the basis of the automatic stay "will give 

[Zions] an advantage based on bankruptcy law for ~o reason related 

to the bankruptcy case. [Zions] should not get a windfall because 

[Davidson] happened to file bankruptcy. The result should be 

controlled by the law that would control outside of bankruptcy." 

Otha C. Jean, 152 B.R. at 222. 

As we discussed in part I supra, Zions did not avail itself 

of the state law protection provided in section 9-318 of the 

U.C.C. by giving timely notice of the assignment to Christiansen. 

Zions' rights in the accounts receivable are therefore subject to 

Christiansen's right to setoff. We are not inclined to allow 

Zions, a sophisticated commercial lender, to invoke the provisions 

-19-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 19 
of the automatic stay simply to obtain relief from its failure to 

act in a commercially prudent manner. It is not appropriate to 

apply provisions of the Bankruptcy Code to override priorities 

established by state law and to contravene state public policy 

when to do so would not further the purposes of the Code 

provisions at issue. 

The above discussion is also dispositive of Zions' argument 

that it should prevail on the basis of 11 U.S.C. § 348(d). Under 

that provision, when a bankruptcy case is converted from a Chapter 

11 proceeding to one under Chapter 7, a claim "against the estate 

or the debtor that arises after the order for relief but before 

conversion . . . shall be treated for all purposes as if such 

claim had arisen immediately before the date of the filing of the 

petition." This provision is significant in the context of a 

claim to setoff because "[a] creditor is not permitted to setoff 

the debtor's prepetition obligation to him against his obligation 

to the debtor which arose postpetition, because the two 

obligations lack mutuality." In re Mohawk Indus., 82 B.R. at 176. 

The purpose of section 348(d), as with "any bankruptcy law is to 

provide a discharge of debts in order to grant the debtor a fresh 

start. To permit the set off of prepetition debts owed by the 

debtor against independent postpetition debts owed to the debtor 

would be a complete frustration of any fresh start." Id. at 177. 

Here, however, enforcement of section 348(d) would not further its 

underlying purpose of providing the debtor with funds for a fresh 

-20-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 20 
start or for reorganization; it would merely provide Zions with a 

priority to which it is not entitled under state law . 

. Moreover, the decision upon which Zions relies is of doubtful 

authority in any event. Zions points to the case of Still v. 

United Pipe & Supply Co. (In re W.L. Jackson Mfg. Co.), 50 B.R. 

498 (Bankr. E.D. Tenn. 1985). There the court applied section 

348(d) to prevent a setoff, although in so doing the court 

"realize[d] that this result could affect the rehabilitation of 

debtors under Chapter 11" by discouraging potential creditors from 

dealing with a Chapter 11 trustee or debtor in possession. Id. at 

504-05. In a subsequent case, the same court refused to apply 

section 348(d), pointing out that "the law as set out in§ 348 is 

far from clear as to how postbankruptcy debts are to be treated 

when a Chapter 11 case converts to Chapter 7 after partial 

performance of a confirmed plan." Paris v. Transamerica Ins. 

Group (In re Buckley & Assocs. Ins., Inc.), 67 B.R. 331, 335 

(Bankr. E.D. Tenn. 1986). The court believed that in refusing to 

apply section 348(d) it "reached a result that is not only legally 

correct but is just as to [the creditor seeking setoff] and the 

debtor's other creditors." Id. at 335. Upon appeal of this 

decision, the district court reached a different outcome but 

likewise refused to apply section 348(d), holding that "the 

appropriate analogy is to cases involving set-off during a Chapter 

11, ignoring the conversion to Chapter 7 in this case." Paris v. 

Transamerica Ins. Group (In re Buckley & Assocs. Ins .. Inc.), 78 

B.R. 155, 158 (E.D. Tenn. 1987). The court further observed that 

-21-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 21 
"[s]et-off is permissible in Chapter 11 ... where it does not 

undermine the debtor's ability to reorganize," and that "[t]he 

decision to grant or deny set-off is also guided by equity." Id. 

Finally, we consider Zions' policy argument. Zions has 

argued throughout these proceedings that unless it prevails, 

"lenders simply will not provide post-petition financing to 

Chapter 11 debtors, and the underlying policy of Chapter 11 to 

help failing businesses rehabilitate themselves will be 

frustrated." Br. of Aplee. at 10. In so doing, Zions simply 

fails to acknowledge the critical fact that commercial lenders 

such as Zions have a readily available means of protecting their 

security interest in the accounts receivable of a Chapter 11 

debtor against the claim of a party such as Christiansen. They 

need only give notice under U.C.C. section 9-318 in one of two 

ways. See 4447 Assocs., 889 P.2d at 472 & n.8; see also id. at 

470 n.S. Mere notice of the assignment under section 9-318(1) (b) 

would have cut off Christiansen's ability to setoff its claim 

against amounts due Davidson, while notice and demand for payment 

under section 9-318(3) would have required Christiansen to pay the 

amounts due Davidson directly to Zions. Zions could thus have 

given notice under section 9-318(1) (b) so as to obtain protection 

against setoff without impeding Davidson's ability to reorganize 

by requiring Christiansen to pay the funds to Zions rather than 

Davidson. 

Although Zions is harshly critical of Christiansen's alleged 

failure to take action to protect itself, in our view the 

-22-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 22 
magnitude of Zions' failure leaves it in no position to point the 

finger of blame elsewhere. Zions, as a sophisticated commercial 

lender extending post-petition financing to a debtor in 

possession, failed to act in a commercially prudent manner when it 

did not avail itself of the protection provided under state law. 

We do not believe the result we reach here will affect the 

availability of post-petition financing generally because we are 

convinced that commercial lenders as a rule do not overlook the 

state law protection that Zions failed to use in this case. 

Accordingly, we REVERSE and REMAND with directions to enter 

judgment in favor of Christiansen. 

-23-

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 23 
Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 24 
SAFFELS, Senior District Judge, Dissenting. 

Because I find the district court's reasoning persuasive and 

its result correct, I cannot support the majority's decision to 

reverse. I, therefore, dissent. 

The facts have been well-stated and will not be repeated 

here. Suffice it to say that the crux of the matter is whether 

Christiansen, the general contractor, had the right under Utah 

law to pay Diehl, the lien claimant, the amount claiming to be 

owed to release the lien, and by doing so create a defense to 

Christiansen's obligation to pay Davidson, the bankrupt 

subcontractor. 

The district court found that under Utah law Christiansen 

had no legal duty to the supplier, Diehl, and had no legal right 

to pay Diehl directly. The court further found that such payment 

did not release Christiansen from its obligation to pay Davidson. 

Diehl, of course, had every right to protect itself by 

filing a mechanic's lien against the project owner. The mere 

filing of this lien in no way legally obligated Christiansen. 

Christiansen's decision to bypass payment to Davidson and pay 

Diehl was merely to protect itself from the project owner with 

whom Christiansen had contracted to deliver a lien-free project. 

As the district court noted: 

the mechanic's lien statute is to protect those who 

have added directly to the value of real property by 

performing labor or furnishing material. This statute 

was intended and designed to prevent the owner of land 

from taking benefit of improvements placed on his 

property without paying for the labor or material that 

went into them. In Re Davidson Lumber Sales, Inc., 167 

B.R. 773, 776(D. Utah, C.D. 1993). 

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 25 
The statute applies to the owner because it is the owner's 

real property to which the lien attaches. Nothing in the statute 

indicates it applies to the general contractor in the same way. 

Id. The project owner wisely had protected itself through the 

contract with Christiansen. Christiansen, once Diehl filed the 

lien, faced the dilemma of whether to: (1) satisfy its 

contractual obligation to the project owner by paying Diehl to 

insure the release of the lien; (2) pay Davidson and satisfy that 

contractual obligation; or (3) pay both Diehl and Davidson at a 

substantial monetary loss. Christiansen chose option 2 and 

thereby fulfilled its contractual obligation to the project 

owner. 

The district court provided a succinct and accurate synopsis 

of the protective actions of the parties in this matter: 

Christiansen voluntarily contracted with the 

owner to keep the property clear of any 

mechanic's lien and Christiansen could have 

imposed the obligation on Davidson, but it 

did not. Diehl protected itself by filing a 

mechanic's lien; Zions protected itself with 

its super-priority post-petition lien on 

Davidson's inventory and accounts receivable; 

and the owner protected itself with its 

contract with Christiansen. 

Davidson, 167 B.R. at 778. 

It is clear to me that all parties except Christiansen 

protected their interests in this project. Christiansen, 

presumably a seasoned general contractor, failed to adequately 

protect its interests when it could easily have done so. It 

should not now be rewarded and allowed to breach its contractual 

obligations to Davidson. The result of such an action is that 

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 26 
Zions, a party which did protect itself, suffers a unjustifiable 

loss. 

The district court correctly concluded that there was 

nothing under Utah law which gave Christiansen the right to pay 

Diehl and not pay Davidson as required under the contract. 

Because I would affirm the district court's decision, I, 

respectfully, dissent. 

Appellate Case: 94-4017 Document: 01019277232 Date Filed: 09/19/1995 Page: 27