Court Opinion

ID: 9452252
Source: CourtListenerOpinion
Date Created: 2023-08-04 17:34:45.477237+00
Date Added: 2024-06-11T17:33:08.354042
License: Public Domain

GEWIN, Circuit Judge
(dissenting):
The majority opinion is anchored to two premises which I conceive to be misconceptions of the law, and therefore I respectfully dissent.
The misconceptions mentioned are expressed in the following language:
(a) “The difficulty here is that this is not simply a case of an attempt to create a.debt relationship between the sole stockholders and their corporation, nor is it simply a case of a debenture being subordinated to other creditors. It is both of these things.”
(b) “It is plain, as the government points out, that the holders of the ‘debentures’ are practically helpless if the Snyder Bros. Company should decide, for any reason, not to pay interest when due or the principal on its maturity date.”
The cases on this subject are myriad, and it is readily admitted that the question presented is difficult. In many cases of this nature the pertinent inquiry relates to whether the parties intended to create a debt or to make a capital investment. For example in Rowan v. United States (5 Cir. 1955) 219 F.2d 51 at 54 we stated:
“But it is said that whether an advance is a loan or is capital depends on the intent of the parties, and this intent is to be ascertained from all relevant facts and circumstances. In stating this proposition, the brief for the United States cites two cases decided by this Court, Arnold v. Phillips, 5 Cir., 117 F.2d 497 and United States v. South Georgia Ry. Co., 5 Cir., 107 F.2d
3. This is undoubtedly the law * * * ”
*988This issue is not present in this case, however, because in its reply brief the Government states that intent is not an issue to be resolved but that the only question is whether the debentures on their face constitute an “indebtedness.”1
It is the Government’s position that the debentures are not an “indebtedness” because there is, in effect, no fixed date at which the obligation of the taxpayer to pay principal and interest can be enforced by the holders. It arrives at this conclusion through the following rather tortuous exegesis of the terms of the securities themselves. The debentures state that upon failure to pay either principal or interest, all superior creditors “shall be entitled to receive payment in full” before the debenture holders “shall be entitled to receive any payment * * * ” The Government construes this language to mean that all superior creditors must be paid in full before the debenture holders can enforce their rights. Thus, payment on the securities can be indefinitely postponed by the failure (through collusion or complacency) of any single superior creditor to demand his money; and the corporation can extort an infinite number of extensions on the debentures by simply threatening a default which would give rise to such a situation.
It is quite clear that subordination standing alone does not destroy “indebtedness.” 2 Commissioner v. O.P.P. Holding Corp., 76 F.2d 11, 12 (2 Cir. 1935). See also John Kelley Co. v. Commissioner, 326 U.S. 521 (1946); Kraft Foods v. Commissioner, 232 F.2d 118, 125-126 (2 Cir. 1956).
I find the following language from the Second Circuit in Commissioner v. O.P.P. Holding Corp., supra, at page 12 to be the most pertinent expression available on the nature of an “indebtedness” as distinguished from an equity investment:
“We do not think it fatal to the debenture holder’s status as a creditor that his claim is subordinated to those of general creditors. The fact that ultimately he must be paid a definite sum at a fixed time marks his relationship to the corporation as that of creditor rather than shareholder. The final criterion between creditor and shareholder we believe to be the contingency of payment. The shareholder is entitled to nothing, prior to liquidation, except out of earnings. Even on liquidation, at least in New York, arrears of cumulative dividends are confined to earnings. Michael v. Cayey-Caguaa Tobacco Co., 190 App.Div. 618, 180 N.Y.S. 532. These debenture bondholders were not so limited. The interest could be deferred, but it was not lost, though the company had no earnings; it could be collected, together with the principal, in 1954, from the *989corpus of the debtor’s property, regardless of whether there should be a surplus. See Warren v. King, 108 U.S. 389, 399, 2 S.Ct. 789, 27 L.Ed. 769. This distinction marks the vital difference between the shareholder and the creditor. The shareholder is an adventurer in the corporate business; he takes the risk, and profits from success. The creditor, in compensation for not sharing the profits, is to be paid independently of the risk of success, and gets a right to dip into the capital when the payment date arrives.” (Emphasis added)
See also Rowan v. United States, supra. In the present case, there is an expressed obligation to pay principal and interest at fixed dates. Therefore, the ultimate question is whether, as the Government contends, the debentures are so worded that payment can be postponed or extended indefinitely so as to avoid payment as a matter of law.
While it is true that the debentures provide that superior creditors shall be paid in full before the holders can receive any payment, they also expressly reserve to the holders all other rights available at law. The law of Georgia controls the remedies of the debenture holders as against the corporate taxpayer. Notwithstanding the subordination provision, they also clearly and unequivocally provide that nothing shall impair the unconditional and absolute obligation of the company (taxpayer) to pay to the holders of the debentures the principal and interest, or diminish the legal remedies of the holders upon default.
The majority seems to admit that the creation of a debt between the debenture holders and the corporation in the circumstances here present would not be objectionable. Likewise, it is admitted that subordination is not fatal to the taxpayer’s position. But the majority will not tolerate both. I cannot agree. Such reasoning will allow a debt but never subordination. Subordination is not condemned but is an approved business practice. The taxpayer usually gets in trouble when the facts show a “thin incorporation” where the ratio of capital to debt financing reflects a gross imbalance; where there is an absence of business purpose in the transaction; or when the value of the property transferred to create the debt is less than the amount of the debt created. The facts and circumstances of this case clearly show an absence of any of these condemned practices. There is not present any capital and debt inbalance; there is a valid business purpose; and no one has questioned the value of the assets transferred.
I construe these provisions simply to mean that whenever there is default on the debentures, all other indebtedness becomes due and all superior creditors are to be given a preference in payment over the debenture holders. I discern nothing therein which would prevent a debenture holder from obtaining payment, either from earnings or surplus, once the superior indebtedness is paid.3 Nor is there any reason why the holders could not sue to enforce the obligations, even if the superior creditors fail to demand payment.
The majority is simply in error when it agreed with the Government that the debenture holders “aré'practically helpless” if the taxpayer refuses to pay principal or interest when due, “for any reason”. The law of Georgia is clearly to the contrary. A recent Georgia case so holds. Commercial M & F Corp. v. North American Investors, 111 Ga.App. *990355, 141 S.E.2d 768 (1965).4 In Georgia, an obligee can sue on an instrument containing a subordination clause and obtain a judgment. Unless there is a provision in the subordination agreement which precludes suit on the instrument, the cited Georgia case holds that it is immaterial in a suit seeking judgment that there are any outstanding claims of general creditors of the maker on the date payment is due on the note. In the event judgment is recovered, the provisions of the subordination agreement might affect the enforcement and collection of the judgment, but would not constitute a bar to obtaining judgment. Only other creditors can then raise the subordination provision as an obstacle to the enforcement of the judgment. In short, the taxpayer here has a definite legal obligation to pay principal and interest at a fixed date, and the debentures on their face constitute a valid indebtedness. The majority opinion fails to consider this important case in the Georgia jurisprudence. The judgment of the District Court should be affirmed.

. In its original brief the Government appeared to raise the question of intent by the following language:
“In the instant case, it is clear that the Snyder brothers intended, to and actually did commit the partnership assets that they transferred to the corporation upon its organization to the risks of the corporate venture.” (Emphasis added)
In its reply brief here, however, the following statement is made:
“On the other hand, in the instant case the intent of the parties is not at issue, for there is no contention that the ‘Debenture’ holders would not seek to enforce the'‘Debentures’ to the extent that the terms of the ‘Debentures’ permitted this. Whether the ‘Debentures’ constituted a capital investment or indebtedness depends not on a determination of anyone’s intent but rather on a characterization of the instrument here involved.” (Emphasis added)

. In effect the Government recognizes this principle by the following statement in its initial brief:
“This is not to say that one advancing funds to a corporation cannot subordinate his claim to certain claims of other creditors and still be a creditor of the corporation. One who is unwilling to commit his funds to the risks of the corporation’s business may still be willing to allow certain of its other obligations to be satisfied out of its assets prior to satisfaction of his own claim, where it appears that there would still be sufficient assets to provide security for his own claim.”

. It is significant to note that factually the business involved was apparently a successful and lucrative one. During the last five years of its existence the partnership earnings ranged from approximately $45,000 to $96,000 per year, and in 4 of the 5 years the annual earnings exceeded $80,000. The taxable income of the corporation for the fiscal years 1959 and 1960 was $78.586 and $38,743 respectively. The accumulated earnings at the end of fiscal 1960 were $84,751.00 and its net worth was $192,461.00. After the corporation was organized and the debentures were issued, its net worth was approximately $108,000.00 based on book values.

. The Court makes incidental reference to the fact that the subordination agreement involved terminated on the due date of the note. The opinion, however, seems to be based on an assumption that collection of the note was subject to the subordination agreement.