Case Name: In re: GARDEN RIDGE CORPORATION, et al., Debtor, Daniel Ferguson, Appellant
Court: United States Court of Appeals for the Third Circuit
Jurisdiction: United States
Decision Date: 2010-07-09
Citations: 386 F. App'x 41
Docket Number: No. 09-1261
Parties: In re: GARDEN RIDGE CORPORATION, et al., Debtor, Daniel Ferguson, Appellant.
Judges: 
Reporter: West's Bankruptcy Reporter
Volume: 439
Pages: 41–47

Head Matter:
In re: GARDEN RIDGE CORPORATION, et al., Debtor, Daniel Ferguson, Appellant.
No. 09-1261.
United States Court of Appeals, Third Circuit.
Argued on Nov. 9, 2009.
Opinion filed: July 9, 2010.
William D. Sullivan, Esquire (Argued), Sullivan, Hazeltine, Allinson, LLC, Wilmington, DE, for Appellant Daniel Ferguson.
Pauline K. Morgan, Esquire, Joseph M. Barry, Esquire (Argued), Sean T. Greedier, Esquire, Ian S. Fredericks, Esquire, Skadden, Arps, Slate, Meagher & Flom, David B. Stratton, Esquire, Pepper Hamilton, Wilmington, DE, for Appellee Garden Ridge Corporation.
Christian M. Thompson, Esquire, Connolly, Bove, Lodge & Hutz, Wilmington, DE, for Appellee Concord Mall, LTD Partnership.
James C. Carignan, Esquire, David M. Fournier, Esquire, Pepper Hamilton, Wilmington, DE, for Appellee Official Committee of Unsecured Creditors.
David M. Klauder, Esquire, United States Department of Justice, Office of the Trustee, Wilmington, DE, for Appellee United States Trustee.

Opinion:
OPINION
ROTH, Circuit Judge:
Daniel Ferguson, a creditor of the Garden Ridge debtors, appeals the District Court's denial of his setoff claim under sections 362(d) and 553(a) of the United States Bankruptcy Code. We will affirm.
I. Background
Because we write primarily for the parties, we only briefly recite the facts. In 2001, Garden Ridge Management, Inc., hired Ferguson as an executive employee. Ferguson's employment contract included severance pay of $250,000 and reimbursement of $60,000 in relocation expenses. Upon commencing employment, Ferguson borrowed $250,000 from Garden Ridge, L.P., under the terms of a written promissory note. In 2003, Garden Ridge Management, Inc., terminated Ferguson's em ployment. Ferguson filed a state law contract claim for damages of $310,000 (severance pay of $250,000 and relocation expenses of $60,000). Garden Ridge, L.P., later filed an action against Ferguson in federal court for collection on the $250,000 promissory note.
In 2004, Garden Ridge Management, Inc., and six related corporate entities filed for bankruptcy protection under Chapter 11. On March 29, 2005, the debtors filed a proposed reorganization plan including a request for substantive consolidation. Substantive consolidation "treats separate legal entities as if they were merged into a single survivor left with all the cumulative assets and liabilities." In re Owens Corning, 419 F.3d 195, 205 (3d Cir.2005). The proposed plan allowed the debtors to reserve all legal and equitable defenses, but deemed the assets and liabilities of all Garden Ridge debtors merged with the assets and liabilities of Garden Ridge, L.P. (A-473.) On April 28, 2005, the Bankruptcy Court confirmed the proposed substantive consolidation in the plan because the debtors, in effect, functioned as a single entity. (A-591 to-592.)
Ferguson, whose state law action was automatically stayed by the bankruptcy filing under 11 U.S.C. § 362, asserted a claim against the bankruptcy estate for $310,000. Claiming the existence of mutual debts — ie., Ferguson's debt of $250,000 and Garden Ridge's debt of $310,000— Ferguson brought a setoff claim under state law, which would place him in the position of an unsecured creditor for $60,000 ($310,000 less $250,000). (Bankr. D.I.1518, Apr. 13, 2005); see 11 U.S.C. § 553(a). Garden Ridge objected to Ferguson's setoff claim for lack of mutuality because the transactions involved two separate Garden Ridge entities. Ferguson's breach of contract claim related solely to his employment by Garden Ridge Management, Inc., an entity that employed all of Garden Ridge's staff. Ferguson's promissory note was held by Garden Ridge, L.P., an entity that operated Garden Ridge's stores and paid Garden Ridge Management, Inc., a fee for use of its employees.
Ferguson argues that, even if Garden Ridge Management, Inc., and Garden Ridge, L.P., were separate entities when he transacted with them, the Bankruptcy Court's confirmation of substantive consolidation effectively merged the entities, thereby creating mutuality for setoff purposes.
II. Discussion
The District Court had jurisdiction pursuant to 28 U.S.C. § 158(a)(1) over the appeal from the Bankruptcy Court, which had jurisdiction pursuant to 28 U.S.C. § 157(b). We have jurisdiction over this appeal pursuant to 28 U.S.C. § 1291 and 158(d). The District Court's determinations are subject to plenary review. In re Prof'l Ins. Mgmt., 285 F.3d 268, 282-83 (3d Cir.2002). The Bankruptcy Court's factual determinations are reviewed for clear error and its legal determinations are reviewed de novo. Id.
Setoff rights arise under the common law of equity and "allow [] entities that owe each other money to apply their mutual debts against each other, thereby avoiding the absurdity of making A pay B when B owes A." Citizens Bank v. Strumpf, 516 U.S. 16, 19, 116 S.Ct. 286, 133 L.Ed.2d 258 (1995) (internal quotation marks omitted). To perfect a setoff claim, the party asserting setoff rights must prove the debts between the creditor and debtor are mutual. See In re APF Co., 264 B.R. 344, 354 (Bankr.D.Del.2001); see also In re Czyzk, 297 B.R. 406, 409 (Bankr.D.N.J.2003).
The question presented is whether substantive consolidation created mutuality for setoff purposes even though, absent substantive consolidation, the element of mutuality would not have otherwise been satisfied. The debts of Ferguson and Garden Ridge, Inc., would only be mutual if Garden Ridge, Inc., and Garden Ridge, L.P., had disregarded their entity separateness, a question the Bankruptcy Court did not decide when it confirmed the reorganization plan because the then-prevailing standard for substantive consolidation did not require such a finding. This Court's subsequent decision in Owens Coming, which held that substantive consolidation is appropriate when debtors disregard their entity separateness, 419 F.3d at 211, does not operate as an ex post facto finding that the Garden Ridge entities disregarded the entity separation. Whether the Garden Ridge entities lost their mutuality defense because they disregarded entity separateness when dealing with Ferguson is a factual question not resolved at the time of substantive consolidation and raised for the first time in this adversarial proceeding.
The element of mutuality is not satisfied for two related reasons. First, as the Bankruptcy Court found, the record does not support Ferguson's claim that, when he dealt with Garden Ridge Management, Inc., and Garden Ridge, L.P., he believed they were alter egos because they had acted in disregard of their corporate separateness. Second, the Bankruptcy Court's factual determination that Ferguson was employed by Garden Ridge Management, Inc., and not Garden Ridge, L.P., has support in the record and is not clearly erroneous. Ferguson was an executive of Garden Ridge and understood its business operations. His debt to Garden Ridge, L.P., cannot be setoff against his claim against Garden Ridge Management, Inc., because those debts are not mutual.
Although substantively consolidated with the other Garden Ridge entities, Garden Ridge, L.P., preserved its defense to Ferguson's setoff claim on grounds of lack of mutuality. In the reorganization proceeding, the Bankruptcy Court approved a substantive consolidation provision allowing the Garden Ridge debtors to retain all "legal or equitable defense[s] that the Debtors had immediately prior to the Petition Date." (A-483 (Reorganization Plan, Art. VIII(F), p. 36).) The controversy between Ferguson and the Garden Ridge entities was live at the time of the Chapter 11 proceeding, so the Garden Ridge entities must have consented to the substantive consolidation provision confirmed by the Bankruptcy Court with the mutuality defense in mind. Had Oivens Coming been precedent when the Garden Ridge entities were substantively consolidated on April 28, 2005, the Bankruptcy Court might have considered other factors in determining the appropriateness of that relief. But because Owens Coming was not decided until August 15, 2005, the Bankruptcy Court's prior confirmation of substantive consolidation should not defeat the mutuality defense preserved here.
III. Conclusion
For the reasons stated above, we will affirm the judgments of the Bankruptcy Court and District Court.
. On the date of confirmation, Ferguson's claim for damages against Garden Ridge Management, Inc., and his loan with Garden Ridge, L.P., were at issue between the parties.