## Facts

- M. Paolella & Sons, Inc. operated as a wholesale distributor of tobacco products, purchasing inventory from major tobacco companies on credit.
- MNC Commercial Corp. provided Paolella a revolving line of credit secured by a blanket lien on substantially all assets, including inventory.
- By mid-1985, MNC became concerned about Paolella’s financial condition and worked with Paolella toward an orderly liquidation by early 1986, increasing monitoring of operations and collateral.
- In December 1985, the tobacco companies offered a special buying program, and Paolella received roughly $2 million more inventory than usual in January 1986 while MNC continued to monitor the inbound goods under its lending arrangement.
- At the end of January 1986, MNC stopped advancing funds to cover Paolella’s checks, declared a default, and demanded possession of its collateral, including inventory delivered during January.
- The tobacco companies filed an involuntary bankruptcy petition and asserted reclamation rights in goods delivered shortly before the filing.
- The bankruptcy court (i) equitably subordinated MNC’s secured claim to the tobacco companies’ claims, (ii) entered judgments for the tobacco companies on reclamation claims against MNC, and (iii) entered a preference judgment for the Chapter 7 trustee against MNC based on improvement in position during the 90-day period.
- MNC appealed the equitable subordination and reclamation rulings; the trustee cross-appealed seeking a larger preference recovery.

## Issues

1. Whether an arm’s-length institutional lender’s monitoring, liquidation planning, and exercise of contractual remedies constituted inequitable conduct warranting equitable subordination under 11 U.S.C. § 510(c).
2. Whether a secured lender with a prior, perfected blanket lien qualified as a good-faith purchaser such that the sellers’ reclamation rights under U.C.C. § 2-702 and 11 U.S.C. § 546(c) were cut off.
3. Whether the bankruptcy court correctly found and measured an avoidable preference based on the lender’s improvement in position under 11 U.S.C. § 547(c)(5).

## Decision

- The district court reversed equitable subordination of MNC’s secured claim.
- The district court reversed the reclamation judgments against MNC, holding the sellers’ reclamation rights were subordinate to MNC’s rights.
- The district court affirmed the preference judgment for the trustee based on MNC’s improvement in position during the 90-day prepetition period.
- The district court rejected the trustee’s cross-appeal for a larger preference recovery.

## Legal Principles

- Equitable subordination of a non-insider, arm’s-length lender requires proof of gross or egregious misconduct; strict monitoring and enforcement of contractual rights, without dishonesty or misleading conduct, is insufficient.
- Reclamation rights under U.C.C. § 2-702 and 11 U.S.C. § 546(c) are subordinate to the rights of a good-faith purchaser; a secured creditor with a prior, continuously perfected security interest in inventory may qualify as a good-faith purchaser absent a lack of “honesty in fact.”
- A floating-lien creditor’s preference exposure under 11 U.S.C. § 547(c)(5) turns on whether its secured position improved during the 90-day prepetition period; appellate review defers to the bankruptcy court’s valuation and methodology absent clear error, including aggregation of related-entity collateral when consistent with the secured transaction structure.

## Conclusion

The district court held that the lender’s conduct, though aggressive, did not meet the misconduct threshold for equitable subordination and did not defeat its good-faith purchaser status for purposes of cutting off reclamation; however, the lender remained liable for a preference to the extent its floating-lien position improved during the 90-day period before bankruptcy.


In re M. Paolella & Sons, Inc., 161 B.R. 107 (E.D. Pa. 1993)