KSB

Judge Somers

12-06043 Redmond, Trustee v. NCMIC Finance Corporation (Doc. # 25)

Redmond, Trustee v. NCMIC Finance Corporation, 12-06043 (Bankr. D. Kan. Jan. 15, 2013) Doc. # 25

PDFClick here for the pdf document.


SO ORDERED.
SIGNED this 15th day of January, 2013.

 

 

Designated for print publication
IN THE UNITED STATES BANKRUPTCY COURT
FOR THE DISTRICT OF KANSAS


In Re:

BROOKE CORPORATION,
DEBTOR.

CHRISTOPHER J. REDMOND,
Chapter 7 Trustee of Brooke
Corporation, Brooke Capital
Corporation (f/k/a Brooke Franchise
Corporation), and Brooke Investments,
Inc.;

PLAINTIFF,

v.
NCMIC FINANCE CORPORATION,

DEFENDANT.

CASE NO. 08-22786
CHAPTER 7

ADV. NO. 12-6043

MEMORANDUM OPINION AND ORDER GRANTING IN PART
THE PLAINTIFF’S MOTION TO DISMISS COUNTERCLAIM COMPLAINT


Plaintiff Christopher J. Redmond, Chapter 7 Trustee (Trustee) of Debtors Brooke

Case 12-06043 Doc# 25 Filed 01/15/13 Page 1 of 30


Corporation, Brooke Capital Corporation, and Brooke Investments, Inc., moves under
Federal Rule of Civil Procedure 12(b)(6) and (c), made applicable to this proceeding by
Federal Rule of Bankruptcy Procedure 7012(b), to dismiss the counterclaims asserted by
Defendant NCMIC Finance Corporation (NCMIC or Defendant). The motion presents
the question whether a creditor’s claims for damages allegedly caused by the tortious acts
of a custodian, who was superseded by the filing of a petition under Chapter 11 and the
appointment of a Chapter 11 Trustee, are entitled to administrative priority under 11

U.S.C. § 503(b)(1)(A) or (b)(3)(E).1 After carefully considering the pleadings and the
oral arguments of counsel,2 the Court finds that only the claims arising from postpetition
conduct are eligible for administrative expense status, but that, except for the one claim
that was asserted in NCMIC’s proof of claim, administrative expense status for those
claims is barred by a prior order of the Court. As to NCMIC’s prayer that the
counterclaims defeat the Trustee’s fraudulent conveyance claims against it, the Court
finds that only the counterclaims arising from postpetition conduct are eligible for offset
under § 553 and that recoupment is not available for any of the counterclaims. Based on
these rulings, the Trustee’s motion is granted in part.
BACKGROUND FACTS.

The Brooke group of companies was involved in many aspects of insurance and

1 Future references to Title 11 in the text shall be to the section number only.
2 The Trustee appears by Michael D. Fielding of Husch Blackwell LLP. NCMIC appears by Paul


D. Sinclair of Polsinelli Shughart PC.
2
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insurance-related businesses, including a network of insurance franchisees and agents.
The parent company was Debtor Brooke Corporation (Brooke Corp.). Debtor Brooke
Capital Corporation (Brooke Capital), a majority-owned subsidiary of Brooke Corp.,
owned 100% of Brooke Capital Advisors, Inc. (BCA), which has not filed bankruptcy but
was involved in events relevant to this proceeding. Brooke Capital also owned 100% of
Debtor Brooke Investments, Inc. The three Brooke Debtors will be referred to
collectively as Debtors.3 Another relevant majority-owned subsidiary of Brooke Corp.
was Brooke Credit Corporation, d/b/a Aleritas Capital Corporation (Aleritas), which has
not filed bankruptcy. Aleritas was engaged in lending money to Brooke franchisees and
other insurance agents.

Defendant NCMIC, which began its relationship with Brooke in 1998, initially
fulfilled a “warehouse” financing role for Brooke agency franchise loans, holding the
loans until they were securitized or sold to community banks. Later, NCMIC provided
insurance premium financing and merchant credit card processing services to Brooke
agents/franchisees. In addition, NCMIC purchased various participation interests in loans
which Aleritas made to Brooke agents.

Brooke’s business did not flourish. The Trustee alleges that the Brooke business
model was unsustainable. On September 11, 2008, the Bank of New York Mellon, as
trustee, filed an Emergency Motion for the Appointment of a Receiver with the United

3 The bankruptcies of the three Debtors are being jointly administered. In re Brooke Corp., Case
no. 08-22786, is the lead case.

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States District Court for the District of Kansas.4 The Brooke defendants opposed the
motion and sought the appointment of a Special Master instead. A hearing was held, and
the parties agreed the District Court should enter a Consent Order Appointing a Special
Master. Pursuant to that order, Albert A. Riederer (Riederer) was appointed Special
Master of the “Special Master Entities,” defined to be Brooke Capital, Brooke Corp., and
BCA. The Special Master had authority to administer and manage the Special Master
Estate, including the following power and authority:

to take custody, control and possession of all records, assets,
funds, bank accounts, brokerage accounts, premises and other
materials of any kind in the possession of or under the direct
or indirect control of the Special Master Entities related to the
Special Master Estate, and to direct the application thereof as
set forth in the agreements of the Special Master Entities and
their subsidiaries governing the same.5

Brooke Corp. and Brooke Capital filed voluntary Chapter 11 petitions on October 28,
2008, and Brooke Investments, Inc., filed a voluntary petition under Chapter 11 on
November 3, 2008. Riederer was appointed as Chapter 11 Trustee of the three Debtors.
On June 29, 2009, the Chapter 11 proceedings were converted to Chapter 7. Riederer
initially served as Chapter 7 Trustee. On November 3, 2011, Plaintiff Christopher J.
Redmond was appointed as successor Chapter 7 Trustee.

The Trustee filed this adversary proceeding against NCMIC on May 5, 2012. His
Complaint alleges five counts: Count I for avoidance of a security interest; Counts II and

4 Bank of New York Mellon v. Aleritas Capital Corp., D. Kan. Case no. 2:08-cv-02424-JWL.
5 Case no. 2:08-cv-02424-JWL, Dkt. 23 at 4.
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III for recovery of allegedly preferential transfers; and Counts IV and V for recovery of
allegedly constructively fraudulent transfers.6 Counts I, II, and III were dismissed by
consent, after NCMIC filed a motion for summary judgment.7 Defendant describes the
Trustee’s pending claims to avoid fraudulent transfers8 as seeking recovery of the
following: (1) $5.6 million in loan payments made by Aleritas on loans to franchisees
that were assigned to NCMIC; (2) $17 million in loan payments to other lenders which
allegedly benefitted NCMIC; and (3) $22.3 million in franchisees’ operating expenses
that were paid to third parties, such as landlords and utility companies, which allegedly
benefitted NCMIC.9 NCMIC responded to the Complaint with an answer denying the
allegations and asserting its “Counterclaim for Purposes of Recoupment, Offset and/or
Administrative Claim” (the Counterclaim Complaint).10 Under various tort theories,
NCMIC seeks compensation for multi-million dollar losses allegedly relating to the
following described activities engaged in during the period that the Special Master was in
charge of the Debtors’ estates, plus limited claims for the conduct of Riederer as Chapter
11 Trustee.

Some of the claims asserted by NCMIC arise from NCMIC’s relationship with

6 Adv. no. 12-6043, Dkt. 1.
7 Dkt. 8.
8 The claims are asserted under 11 U.S.C. §§ 544, 548(a)(1)(B), and 550 and K.S.A. 33-204(a)(2),


33-205(a), and 33-207. Dkt. 1.

9 Dkt. 9 at 2-3.

10 Dkt. 5.

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CJD & Associates, LLC (CJD), a limited liability company which was a wholly-owned
subsidiary of Brooke Brokerage Corporation, which, in turn, was wholly owned by
Brooke Corp. On September 13, 2005, NCMIC purchased a 74.803% interest in a $2.525
million loan from Aleritas to CJD. In the spring of 2008, NCMIC loaned $2.5 million to
Brooke Corp., secured by an assignment of Brooke Brokerage’s 100% interest in CJD.
NCMIC alleges that on September 17, 2008, the first day Riederer served as Special
Master, unbeknownst to CJD and NCMIC, $1.38 million was transferred from CJD’s
bank account to Brooke Corp., and that an additional $428,000 was transferred from CJD
to Brooke on the following day. CJD’s financial condition deteriorated, and Brooke
Corp. defaulted on the CJD loan. On December 22, 2008, after Brooke Corp. filed for
bankruptcy relief, Riederer, as Trustee, filed an emergency motion requesting permission
to abandon the stock of CJD to NCMIC. The motion was granted. Thereafter, NCMIC
entered into an “Agreement to Accept Collateral in Satisfaction of Obligations” and, in
accord with that agreement, made two $25,000 payments to the Trustee and became the
owner of CJD. In an effort to prop up CJD, NCMIC alleges it incurred obligations of
approximately $2.94 million and also paid $25,000 to acquire the remaining 25.197%
participation interest in the loan from Aleritas to CJD.

Some elements of NCMIC’s counterclaim arise out its longstanding relationship in
providing commercial insurance premium financing to Brooke Capital, Brooke
franchisees, and insureds who dealt with Brooke franchisees. Under this arrangement,
NCMIC advanced funds for premium payments, and the insureds assigned to NCMIC as

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security all unearned premiums and dividends which became payable under the financed
policies. If financed policies were cancelled, NCMIC was entitled to the return of any
unearned premiums and commissions. NCMIC claims that Riederer as Special Master
wrongfully retained $178,541.20 in unearned premiums and $17,517.85 in unearned
commissions. NCMIC also seeks to recover $170,724.86 as amounts which it advanced
to Brooke for financed premiums but which it alleges Brooke failed to remit to the
insurance carriers. In addition, NCMIC financed Brooke Capital’s purchase of errors and
omissions policies for its franchisees. Despite Brooke Capital’s failure to make timely
payment of the funds due to NCMIC under this arrangement, on September 25, 2008,
upon receipt of partial payment, NCMIC alleges it honored Trustee Riederer’s request not
to cancel the policies and continued to make payments that allowed the policies to stay in
effect until December 2008. NCMIC asserts a loss of $126,000 stemming from its
financing of the E&O policies.

NCMIC also seeks to recover various payments made to Riederer as Special
Master and as Chapter 11 Trustee. These include payments related to FTI Consulting,
which was utilized by Riederer with respect to Brooke Corp. issues, and Silverman
Consulting, which was utilized by Riederer with respect to Aleritas issues. In addition,
NCMIC asserts a claim based upon its purchase of 100% participation interests in one
loan from Aleritas to Midwest Funeral Real Estate Management Company and another to
RKC Financial Corporation, a Brooke franchisee. As to the RKC loan, it is alleged that
Riederer defaulted by failing to appear for an arbitration scheduled for October 21, 2008,

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thereby precluding NCMIC’s collection from RKC based upon its participation interest.

The Trustee responded to the Counterclaim Complaint with a motion to dismiss,
the matter which is the subject of this opinion. The Trustee’s motion and supporting
memorandum includes the following chart of NCMIC’s counterclaims, which the Court
has edited to remove notes commenting about the claims. The columns are self-
explanatory, except for column three, labeled “counts.” It identifies the legal theories of
recovery for each claim using numbers defined as: (1) breach of fiduciary duty;

(2) conversion; (3) fraudulent transfer; (4) negligence; (5) money had and received; and
(6) unjust enrichment. The paragraph numbers in the “Description” column refer to
paragraphs in the Counterclaim Complaint.
Claim Amount Counts Description
CJD Loan Losses $3,314,000.00 1, 4 Pre-petition debt obligation due to pre-petition loans made
to CJD. See ¶¶ 29-36.
CJD Capital Infusions $2,949,000.00 1, 4 Monies which NCMIC infused into CJD after NCMIC
acquired the CJD stock from Brooke Brokerage. See ¶ 59.
Note: NCMIC has not alleged in its Counterclaims that
any of these moneies when to or for the benefit of the
Debtors’ estates.
CJD Consideration
Payments
$ 50,000.00 1, 4 Monies transferred by NCMIC to the Debtors post-
petition. See ¶ 44.
CJD Farmers Payment $ 25,000.00 1,4 Monies paid by NCMIC to Farmers and Merchants Bank
of Hill City (“Farmers”) to acquire the participated loan
interest on which CJD was obligated. See ¶ 54. The
Farmers participation interest related to a November 2003
loan. See ¶ 30.
CJD Transfers $3,895,784.00 3 Pre-petition debt obligation stemming from the alleged
transfer of funds from CJD to Brooke. See ¶ 58, 65, 164.
Wrongfully Withheld
Unearned Premiums
$ 178,541.20 1, 2, 4 Pre-petition debt obligation stemming from Brooke’s
alleged failure to remit or turnover unearned premiums it
had allegedly received from cancelled policies where
NCMIC had provided premium financing. See ¶¶ 79-80.

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Wrongfully Withheld
Unearned
Commissions
$ 17,517.85 1, 2, 4 Pre-petition debt obligation stemming from Brooke’s
alleged retention of unearned commissions due to
unearned premiums that had been returned to NCMIC.
See ¶¶ 86-87.
Wrongfully Withheld
Financed Amounts
$ 170,724.86 1, 2, 4 Pre-petition debt obligation stemming from Brooke’s
receipt of financed premium which Brooke allegedly
failed to remit to the appropriate carrier or general agent.
See ¶¶ 93-94.
Unearned Premium
E&O Loss
$ 126,000.00 5, 6 Pre-petition debt obligation stemming from an E&O
policy which was financed pre-petition. See ¶¶ 101-109;
111-113; 117.
FTI Related Payment $ 150,000.00 5, 6 Pre-petition debt obligation due to NFC’s wire transfer of
$150,000 to Brooke on October 10, 2008, with the monies
being intended to begin winding down Brooke. See
¶¶ 110; 119-120.
Silverman Related
Payment
$ 40,435.00 5, 6 Monies transferred on November 5, 2008, due to a request
for funds “to keep Aleritas alive after the Debtors filed for
bankruptcy.” ¶ 122; see also ¶ 123.
Silverman Related
Retention
$ 114,577.00 5, 6 Amounts allegedly owed by Aleritas to NCMIC for loan
payments. See ¶¶ 124-125.
Midwest Funeral
Proceeds
$ 105,511.89 2, 4 Amounts allegedly owed by Aleritas to NCMIC on a loan
in which NCMIC held a participated interest, and on
which Aleritas allegedly foreclosed and obtained gross
sales proceeds in October 2008. See ¶¶ 127-131.
RKC Loss $1,146,508.00 1, 4 Pre-petition debt obligation due to a 100% participated
loan interest which NCMIC owned where the Brooke
franchisee (i.e., the borrower) filed an arbitration
proceeding against Brooke Corp., Aleritas (f/k/a Brooke
Credit Corp.) and BASC and others, and obtained an
arbitration award on October 21, 2008. See ¶¶ 133-146.
Merchant Fee Loss $ 42,555.00 1, 2, 4 Pre-petition debt obligation which occurred in October
2008 due to fees and losses which Brooke was allegedly
responsible to pay NCMIC due to rejected ACH
transactions. See ¶¶ 148-156.

ANALYSIS.

A. NCMIC’s counterclaims are for the purposes of recoupment, offset,
and/or administrative expense status.
NCMIC asserts its counterclaims only for the purposes of recoupment, offset,

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and/or administrative expense status11 as a means to defeat recovery on the Trustee’s
fraudulent transfer claims alleged in the Complaint. The Trustee’s motion to dismiss is
therefore directed at these purposes — the Trustee’s primary position is not that the tort
claims fail to state claims for which relief may be granted; rather, it is that NCMIC’s tort
claims are not entitled to administrative expense status, and further, that neither
recoupment nor offset apply. The Trustee’s motion to dismiss under Rule 12(b)(6) tests
the legal sufficiency of NCMIC’s allegations.

B. Whether any of NCMIC’s counterclaims may be entitled to administrative
expense status.12
1. Applicable Code provisions.
Allowance of administrative expenses is addressed by § 503. Subsections
(b)(1)(A) and (b)(3)(E) are relied upon by NCMIC. They provide in relevant part as
follows:

(b) After notice and a hearing, there shall be allowed
administrative expenses . . . , including —

(1)(A) the actual, necessary costs and expenses of

preserving the estate . . . [and]

. . .

(3) the actual, necessary expenses . . . incurred by —
. . .
11 Dkt. 5.

12As an alternative to the position that none of the counterclaims are administrative expenses of
the Debtors’ estates, the Trustee argues that certain claims, identified as third-parry claims, fail to state
claims against the estates. The counterclaims included in this category are: CJD Capital Infusions; CJD
Farmers Payment; Silverman Related Payment; Silverman Related Retention; and Midwest Funeral
Proceeds. The Court does not address this issue because doing so would be mere dicta, in light of the
Court’s resolution of the other issues.

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 (E) a custodian superseded under section 543 of this
title, and compensation for the services of such
custodian.
Under §§ 507(a)(1)(C) and (a)(2) and 726(a)(1), administrative expenses are entitled to
priority. “Statutory priorities are to be narrowly construed ‘[b]ecause the presumption in
bankruptcy cases is that the debtor’s limited resources will be equally distributed among
his creditors.’”13 The question here is whether any of the tort claims alleged in the
Counterclaim Complaint satisfy the foregoing definitions of administrative expenses.

2. With minor exceptions, NCMIC’s claims are not administrative expenses
under § 503(b)(1)(A).
Generally, administrative expense priority under § 503(b)(1)(A) is given to claims
that “satisfy two elements: (1) the claim resulted from a post-petition transaction, and

(2) the claimant supplied consideration which was beneficial to the debtor-in-possession
(or trustee) in the operation of the company’s business.”14 “Thus at first blush, it would
appear that postpetition tort claims could never gain administrative status because it is
difficult to envision a tort ‘benefiting’ the bankruptcy estate.”15 However, in Reading,16 a
1968 case decided under the Bankruptcy Act, the United States Supreme Court held that
13 Isaac v. Temex Energy, Inc., (In re Amarex, Inc.), 853 F.2d 1526, 1530 (10th Cir. 1988)
(quoting Trustees of Amalgamated Ins. Fund v. McFarlin’s, 789 F.2d 98, 100 (2d Cir. 1986)).
14 Peters v. Pikes Peak Musicians Ass’n (In re Colorado Springs Symphony Orchestra Ass’n), 462
F.3d 1265, 1268 (10th Cir. 2006).
15 3 William L. Norton, Jr., and William L. Norton III, Norton Bankruptcy L. & Prac. 3d, § 49:25
at 49-169 (Thompson Reuters/West 2012).
16 Reading Co. v. Brown, 391 U.S. 471 (1968).
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damages resulting from the negligence of a receiver appointed under Chapter XI acting

within the scope of his authority as receiver gave rise to actual and necessary costs of

administration in a Chapter XI arrangement, entitling the claim to priority. The Court

reasoned as follows:

Petitioner [the tort claimant whose property was destroyed by
fire] suffered grave financial injury from what is here agreed
to have been the negligence of the receiver and a workman. It
is conceded that, in principle, petitioner has a right to recover
for that injury from their ‘employer,’ the business under
arrangement, upon the rule of respondeat superior.

. . . .

. . . The ‘master,’ liable for the negligence of the ‘servant’ in

this case was the business operating under a Chapter XI

arrangement for the benefit of creditors and with the hope of

rehabilitation. That benefit and that rehabilitation are worthy

objectives. But it would be inconsistent both with the

principle of respondeat superior and with the rule of fairness

in bankruptcy to seek these objectives at the cost of excluding

tort creditors of the arrangement from its assets, or totally

subordinating the claims of those on whom the arrangement is

imposed to the claims of those for whose benefit it is

instituted.17

“Although Reading involved interpretation of § 64a of the Bankruptcy Act, subsequent

decisions have recognized that Reading’s analysis carries over to Code § 503(b).”18

The Reading rationale has been expanded to apply to statutory penalties incurred

postpetition, in addition to tortious damages incurred postpetition.19 But the Tenth Circuit

17 Id. at 477-79.

18 3 Norton Bankruptcy L. & Prac. 3d, § 49:25 at 49-171.

19 In re CF&I Fabricators of Utah, Inc., 150 F.3d 1293, 1298 (10th Cir. 1998).

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has held that it does not extend to such claims when they arise from prepetition conduct.
In CF&I Fabricators, the debtors sponsored a pension plan subject to the standards of the
Internal Revenue Code and ERISA, but failed to meet their funding obligations before
filing under Chapter 11. The Pension Benefit Guarantee Corporation asserted claims
against the estate and sought priority status for them as tax claims or, alternatively, as
administrative expenses. After rejecting the assertion that the claims were tax claims, the
Tenth Circuit considered and rejected the position that the claims were entitled to
administrative priority under the Reading rationale. “Even if we were to assume the
contributions were statutory in nature [so that the Reading rationale applied], the Reading
line of cases only allows administrative priority for post-petition expenses.”20 Because
the claims were derived from pension credits relating to work performed prepetition, the
postpetition requirement was not satisfied; for purposes of Reading, liabilities are not
incurred postpetition simply because they become due postpetition. Other circuit courts
of appeal also limit the Reading rationale to expenses arising from postpetition conduct.21

To summarize, administrative expense status under § 503(b)(1)(A) is generally
limited to claims which result from postpetition transactions which benefitted the debtor-
in-possession (or trustee) in the operation of the company’s business. Under Reading,

20 Id. at 1299.

21 E.g., In re Hemingway Transport, Inc., 954 F.2d 1, 6-7 (1st Cir. 1992); Pension Benefit
Guaranty Corp. v. Sunarhauserman, Inc. (In re Sunarhauserman, Inc.), 126 F.3d 811. 817 (6th Cir.
1997); In re Jartran, Inc., 732 F.2d 584, 588-90 (7th Cir. 1984); In re Abercrombie, 139 F.3d 755, 758
(9th Cir. 1998).

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which may be viewed as an exception to the benefit rule for purposes of § 503(b)(1)(A),
the scope of § 503(b)(1)(A) is expanded to encompass tort claims arising from
postpetition conduct undertaken in the operation of the estate’s business.

Under these standards, as a matter of law, most of NCMIC’s claims are not
administrative expenses under § 503(b)(1)(A). The only claims which relate to
postpetition conduct are those seeking recovery of: (1) a postpetition payment to the
Brooke estates of $50,000 as CJD-acquisition consideration, alleged to be damages for
the Trustee’s breach of fiduciary duty and negligence22; (2) the postpetition portion
(which the Trustee contends is $16,772.99) of NCMIC’s $178,541.20 claim for allegedly
Wrongfully Withheld Unearned Premiums, as damages for the Trustee’s breach of
fiduciary duty, conversion, and negligence; and (3) the postpetition portion (which the
Trustee contends is $913.59) of NCMIC’s $17,517.85 claim for Wrongfully Withheld
Premiums, as damages for the Trustee’s breach of fiduciary duty, conversion, and
negligence. All of the other claims are excluded from § 503(b)(1)(A) as a matter of law
because they relate solely to prepetition conduct.

3. NCMIC’s claims which relate to Riederer’s prepetition conduct as Special
Master are not entitled to administrative expense status under § 503(b)(3)(E).
NCMIC’s primary argument for administrative expense priority for the damages

22 The Court does not address the Trustee’s contention that to allow the counterclaim to recover
$50,000 paid to the Debtors’ estates postpetition would result in NCMIC receiving a double recovery at
the expense of other creditors. The motion to dismiss can be resolved without addressing this fact-based
question.

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alleged to have been caused by the torts of Riederer as Special Master23 relies upon
§ 503(b)(3)(E), quoted above. That provision defines administrative expenses to include
the actual and necessary expenses incurred by a custodian superseded under § 543,24
thereby including some claims arising from prepetition conduct within the definition of
administrative expenses. But, as examined below, one requirement for such expenses is
that they provided a benefit to the bankruptcy estate. The Court concludes that NCMIC’S
claims based upon the allegedly tortious conduct of the Special Master fail to satisfy this
requirement.

The concept of using estate funds to compensate a superseded custodian but
limiting such expenses to those benefitting the estate has its origins in Randolph &
Randolph v. Scruggs,25 a 1903 decision of the Supreme Court, which allowed a
bankruptcy claim for compensation for services rendered by a superseded assignee for the
benefit of creditors which were beneficial to the bankruptcy estate. The Supreme Court
stated:

23 As to the liability of the estate for the torts of the Special Master, NCMIC relies on McNulta v.
Lochridge, 141 U.S. 327 (1891), which allowed, under nonbankruptcy law, a claim for negligence against
the current receiver of a railroad when the wrong had occurred while the railroad was in the possession of
a former receiver. When moving to dismiss the Counterclaim Complaint, the Trustee does not challenge
the position that the Brooke estates have liability for wrongs of the Special Master.

24 The Trustee does not challenge NCMIC’s position that Riederer is a superseded custodian
under the Code. “Custodian” is defined by § 101(11) to include a “receiver or trustee for any of the
property of the debtor, appointed in a case or proceeding not under this title.” Although the Trustee
points out that Riederer was appointed as a special master under the authority of Federal Rule of Civil
Procedure 53(a)(1)(A) and not as a receiver under the authority of Federal Rule of Civil Procedure 66, he
fails to identify any limitation on the Special Master’s authority which would remove him from the
Code’s definition of custodian.

25 190 U.S. 533 (1903).

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We are not prepared to go further than to allow
compensation for services which were beneficial to the estate.
Beyond that point we must throw the risk of his conduct on
the assignee, as he was chargeable with the knowledge of
what might happen.26

The legislative history of § 503(b)(3)(E) reflects an intent to codify Randolph by giving
administrative expense status only “to the extent such services actually benefit the
estate.”27

Courts generally require a benefit to the estate when finding that expenses of a
superseded custodian are entitled to administrative expense status.28 In addition to the
legislative history, this construction is supported by the use of the phrase “actual,
necessary expenses” in § 503(b)(3)(E). The general administrative expense provision,
§ 503(b)(1)(A), uses the similar phrase “actual, necessary costs and expenses.” The
Tenth Circuit construes § 503(b)(1)(A) to require that the consideration supplied by the
claimant was “‘beneficial to the debtor-in-possession in the operation of the business.’”29
As the Fifth Circuit has found, the benefit requirement is “‘merely a way of testing
whether a particular expense was truly “necessary” to the estate: If it was of no “benefit,”

26 Id. at 539.

27 In re Kenval Marketing Corp., 84 B.R. 32, 34 (Bankr. E.D. Pa. 1988) (quoting 124 Cong. Rec.
H 11094-95 (daily ed. Sept. 28,1978) (remarks of Rep. Edwards); S 17411 (daily ed., Oct. 6, 1978)
(remarks of Sen. DeConcini)).

28 4 Collier on Bankruptcy ¶ 503.10[6] (Alan N. Resnick & Henry J. Sommer, eds.-in-chief, 16th
ed. 2012).

29 Amarex, 853 F.2d at 1530(quoting Trustees of Amalgamated Ins. Fund v. McFarlin’s, 789 F.2d
98, 101 (2d Cir.1986), which was quoting In re Mammoth Mart, Inc., 536 F.2d 950, 954 (1st Cir.1976)).

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it cannot have been “necessary.”’”30 NCMIC’s tort claims based upon alleged
misconduct by the Special Master are not typical of claims arising from actions which
benefitted the estate.

Nevertheless, according to NCMIC, such claims are “actual and necessary
expenses” for purposes of § 503(b)(3)(E) under Reading, discussed above. Alternatively,
NCMIC argues that the custodianship estate and, ultimately, the bankruptcy estate
benefitted from the conduct at issue. The Court rejects these rationales for finding that
damages allegedly caused by the tortious acts of the special master are eligible for
administrative expense treatment.

The parties agree, and this Court’s research has confirmed, that there are no cases
applying Reading to allow administrative expense status to tort claims which arose
prepetition. As discussed above, courts applying Reading for purposes of § 503(b)(1)(A)
restrict administrative expense treatment to claims based upon postpetition conduct.
Further, contrary to NCMIC’s arguments, the Court finds the rationale of Reading does
not support the expansion of administrative expense status to tort claims arising from
prepetition conduct of a superseded custodian. The primary rationale of Reading was
recognition of the benefit to creditors from reorganization and the unfairness of
subordinating the claims of those injured as a result of the operation of a debtor’s
business to the claims of creditors for whose benefit the reorganization was instituted.

30 Szwak v. Earwood (In re Bodenheimer, Jones, Szwak, & Winchell, L.L.P.), 592 F.3d 664, 672
(5th Cir. 2009) (quoting In re H.L.S. Energy Co., 151 F.3d 434, 437 (5th Cir. 1998)).

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Therefore, under Reading, “[i]n order for a tort damage or other similar claim to be
accorded administrative priority, it should arise from the operation of the debtor’s
business.”31 But NCMIC’s tort claims alleged against the Special Master did not arise
from the operation of Brooke’s business under the protection of Chapter 11. There is no
unfairness in giving NCMIC’s claims for tort damages the same status as other prepetition
claims. To argue benefit to the estate based upon the operation of Brooke’s business by
the Special Master would move the line of demarcation created by the filing of a Chapter
11 proceeding from the date of filing to the date of the appointment of the superseded
custodian. If this is to be the law, Congress, not a court, would be the proper body to so
provide, and Congress has not done so.

Further, the Court rejects NCMIC’s alternative contention that benefit to the estate
for purposes of § 503(b)(3)(E) is present based upon the specific Special Master
transactions which are the basis for the tort claims. For example, NCMIC argues that the
Special Master estate, and therefore the bankruptcy estate, benefitted when the Special
Master allegedly tortiously transferred funds from CJD to Brooke. It is true that the estate
allegedly received the funds, but NCMIC’s focus is misdirected. Under § 503(b)(1)(A),
administrative expense status requires that the consideration supporting the claimant’s
right to payment must have been beneficial to the trustee or debtor-in-possession.32

31 Daniel Morman, The Legacy of Reading Co. v. Brown[:] Claims Arising from Trustee or DIP
Misconduct, 23 Am. Bankr. Inst. J. 1, 40 (2004).
32 In re Amarex, 853 F.2d at 1530.
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Similarly, under § 503(b)(3)(E), the claimant must have benefitted the estate. Here
NCMIC is not claiming that it conferred a benefit on the estate; it is alleging the Special
Master’s wrongful acts benefitted the estate. NCMIC is claiming it was injured, and is
attempting to recover from the Trustee the losses that it alleges it suffered because of the
acts of the Special Master. Whether those acts benefitted the Special Master estate or
ultimately the bankruptcy estate is not the issue.

For the foregoing reasons, the Court finds that the claims asserted by NCMIC
against the estate are not entitled to administrative expense status under § 503(b)(3)(E).
There is no precedent extending the Reading rule allowing administrative expense status
under § 503(b)(1)(A) for damage claims for torts committed by a bankruptcy trustee
during the operation of the debtor’s business to § 503(b)(3)(E) for expenses incurred by a
superseded custodian. Further, apart from Reading, NCMIC has not shown that its claims
arise from its own, in contrast to the Special Master’s, prepetition activities which
conferred a benefit on the estate, as required for administrative expense status under
§ 503(b)(3)(E).

4. Administrative expense status of NCMIC’s Counterclaims is barred by a
prior order of the Court.
Alternatively, the Trustee argues that even if NCMIC’s claims were viable
administrative expense claims, NCMIC would not be entitled to judgment for any
administrative expense claims against the Debtors’ estates because NCMIC’s purported
administrative expense claims have been barred and discharged by a prior order of the

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Court. On October 13, 2009, an order was entered in the main bankruptcy case

establishing November 30, 2009, as the bar date for all holders of any Chapter 11

administrative expense claims.33 The order provided in part:

Any person or entity that is required, but fails, to file an
Administrative Expense Request for its Chapter 11
Administrative Expense in accordance with the procedures set
forth in this Order on or before the Administrative Bar Date

(a) shall be forever barred, estopped, and enjoined form
asserting any Chapter 11 Administrative Expense against the
Debtors and the Debtors shall be forever discharged from any
and all indebtedness or liability with respect to such Chapter
11 Administrative Expenses, and (b) shall not be permitted to
receive payment from the Debtors’ estates or participate in
any distribution in the Debtors’ Chapter 7 cases on account of
such Chapter 11 Administrative Expense.34
On October 16, 2009, a Notice of Deadline to File Administrative Expense Requests was

filed.35 It is undisputed that NCMIC received both the October 13, 2009, order and the

October 16, 2009, notice. NCMIC did not file an administrative expense claim in

accordance with the orders by the November 30, 2009, bar date. The administrative

claims were asserted in the Counterclaim Complaint filled on June 25, 2012. The Trustee

contends the estates are therefore discharged from any liability for the administrative

claims asserted by NCMIC.

33 Case no. 08-22786, Dkt. 831, Order (I) Establishing Administrative Bar Date and Procedures
for Filing Administrative Expense Requests and (II) Approving Form and Manner of Notice of the Bar
Date.

34 Id. at ¶ 10.

35 Case no. 08-22786, Dkt. 854.

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NCMIC responds that the argument fails because: (1) the claims arising from
Riederer’s acts or omissions as Special Master are viable because Riederer as a
superseded custodian has not filed a § 543 accounting; (2) there are numerous exceptions
to claim bar dates and proofs of claim may be amended; and (3) the administrative bar
date does not apply. Of course, the Trustee argues none of NCMIC’s positions are valid.

Section 543 imposes three duties upon a custodian with knowledge of the
commencement of a bankruptcy case: (1) not to take any action in the administration of
the property of the debtor; (2) to deliver the property to the trustee; and (3) to file an
accounting of any property of the debtor. Bankruptcy Rule 6002(a) provides that the
custodian shall “promptly” file a report and account, and transmit it to the United States
Trustee. Subsection (b) provides that after the report and account is filed and an
examination has been made into the superseded administration, “after notice and a
hearing, the court shall determine the propriety of the administration, including the
reasonableness of all disbursements.”

The only authority provided by NCMIC in support of its position that Riederer’s
failure to promptly file an accounting renders the administrative claim bar date ineffective
is American Bridge Products.36 The court in that case held that under state law, the
statute of limitations did not begin to run on a bankruptcy trustee’s claims to impose
personal liability on the debtor’s prebankruptcy state court receiver for negligence and

36 Riley v. Decoulos (In re American Bridge Products, Inc.), 599 F.3d 1 (1st Cir. 2010).
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breach of duty until the receiver had rendered a final accounting or been discharged in
either state or federal court. But American Bridge Products does not address a bar date
established by the bankruptcy court; it is concerned with tolling of the state law limitation
period on state law causes of action asserted by a bankruptcy trustee. Likewise, neither
the Code nor bankruptcy rules provide any basis for finding that a failure to promptly file
an accounting affects the enforcement of a bar date for claiming administrative expense
status for claims against a bankruptcy estate as the successor to the official-capacity
liability of a superseded custodian.

Second, NCMIC points out that its proof of claim, claim number 1073, was filed
on November 2, 2009, before the administrative claim bar date. It included a claim for
$178,541.20 for conversion of Wrongfully Withheld Unearned Premiums, and a
statement that a portion of this claim might be entitled to administrative expense priority.
NCMIC argues that creditors may amend proofs of claim and those amendments
generally relate back so they are deemed timely filed. Contemporaneously with filing its
objection to the Trustee’s motion to dismiss, NCMIC filed an amended proof of claim
which includes a priority claim of $8,430,370.80, comprised of all the claims alleged in
the Counterclaim Complaint. It therefore asserts its administrative claims were timely
filed.37

But NCMIC’s argument overlooks § 503(a), which provides: “An entity may

37 The Court at this time does not address whether the amended proof of claim relates back for
purposes other than the filing of administrative claims.

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timely file a request for payment of an administrative expense, or may tardily file such
request if permitted by the court for cause.” NCMIC has failed to show cause for its
untimely filing. Although the Court does not doubt that NCMIC did not seriously
evaluate the possibility it might have claims against the estate until after it was sued by
the Trustee on May 5, 2012, this circumstance does not constitute cause for allowing an
untimely filing of an administrative claim.

Finally, NCMIC argues that the administrative bar date order is ineffective to
discharge the estate’s liability for NCMIC’s claims because the definition of an
administrative expense included in the October 16, 2009, notice of the October 13, 2009,
order relates only to those claims arising from the date of filing to the date of conversion
to Chapter 7. The only claims which the Court has found not to be precluded from
administrative expense status as a matter of law arose during the defined period and are
therefore included within the scope of the order. As discussed above, the remaining
claims, those arising from allegedly wrongful acts of the Special Master, even though
arguably outside of the time frame to which the order applies, are nevertheless barred
from administrative expense status as a matter of law.

The only counterclaim arising postpetition which is not excluded from
administrative expense status by the prior order is the postpetition portion of the claim for
Wrongfully Withheld Unearned Premiums.

C. Most of NCMIC’s Counterclaims are not eligible to be offset against the
Trustee’s claims.
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1. NCMIC’s counterclaims which arose prepetition may not be offset against
the Trustee’s claims against NCMIC.
NCMIC’s Counterclaim Complaint seeks a judicial determination that it has the
right to offset the amount of its alleged injuries against any monies that the Trustee may
recover from it. The Trustee argues this relief must be denied because under § 553, the
Code section addressing offset, NCMIC’s prepetition claims may not be offset against the
Trustee’s postpetition claims.

The parties agree that under § 553, four elements are generally required for offset:

(1) the creditor holds a claim against the debtor that arose before the commencement of
the case; (2) the creditor owes a debt to the debtor that also arose before the
commencement of the case; (3) the claim and the debt are mutual; and (4) the claim and
the debt are each valid and enforceable.38 For debts to be mutual, “[t]he parties must owe
the debts to one another in the same capacities or relationships and the debts must be of
the same character.”39 The controversy in this case is about the second and third
elements. The Trustee asserts mutuality is lacking because NCMIC’s claims (its
counterclaims) are prepetition and its debts (the Trustee’s Uniform Fraudulent Transfer
Act (UFTA) claims40) are postpetition. NCMIC responds that since the Trustee is
asserting fraudulent conveyance claims under state law by stepping into the shoes of
38 5 Collier on Bankruptcy at ¶ 553.01[1].
39 4 Norton Bankruptcy L. & Prac. 3d, § 73:5 at 73-35 to 73-36.
40 These claims are asserted under 11 U.S.C. §§ 544(b) and 550, and K.S.A. 33-204(a)(2), 33


205(a), and 33-207.
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prepetition creditors of NCMIC, the Trustee’s claims arose prepetition.

Courts generally hold that a prepetition claim against the debtor may not be set off
against a trustee’s preferential transfer or fraudulent transfer claim.41 With respect to
preferential transfer claims, the Fifth Circuit Court of Appeals in a 1924 case stated:

The reason is, to permit this to be done would defeat the right
to recover the preference and render the statute futile. In such
a case the transaction is single, and results in a depletion of
the fund that would otherwise have gone to creditors to the
extent of the preferential payments. Allowing the creditor to
set off the debt due him against the payments received by him
would leave the preference unremedied. In this class of cases,
the right to offset is denied, because the estate has been
depleted to the detriment of creditors of like class, and to
allow the right of set-off would perpetuate the depletion.42

It applied the same reasoning to a claim of fraudulent transfer under the 1898 Bankruptcy
Act.43 In 1991, the Ninth Circuit Court of Appeals agreed the rule applied to a fraudulent
conveyance claim under § 548 of the Code,44 and in 1994, applied it to a fraudulent
conveyance claim under state law.45

Nevertheless, NCMIC asserts it may offset its prepetition claims against any
recovery on the Trustee’s UFTA claims. NCMIC would have this Court rule that,

41 5 Collier on Bankruptcy at ¶ 553.03[3][e][v]; 4 Norton Bankruptcy L. & Prac. 3d, § 73:4 at 7331
to 73-33.
42 Walker v. Wilkinson, 296 F. 850, 852 (5th Cir. 1924).
43 Mack v. Newton, 737 F.2d 1343, 1366 (5th Cir. 1984).
44 Wyle v. C.H. Rider & Family (In re United Energy Corp.), 944 F.2d 589, 597 (9th Cir. 1991).
45 Acequia, Inc., v. Clinton (In re Acequia, Inc.), 34 F.3d 800, 817 (9th Cir. 1994).
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although preferential transfer claims under § 547 and fraudulent transfer claims under
§ 548 arise postpetition for purposes of § 553, state law fraudulent conveyance claims
asserted under § 544(b) do not.46 According to NCMIC, this is so because the state law
UFTA claims arose entirely separately and independently of the bankruptcy and, under
§ 544, the Trustee steps into the shoes of an actual creditor who, prepetition, could have
brought the alleged fraudulent transfer claim against NCMIC.

The Court rejects NCMIC’s attempt to distinguish claims under §§ 547 and 548
from claims under § 544. NCMIC cites no case authority and no commentators
supporting its position. The Trustee’s rights under § 544, just like his rights under §§ 547
and 548, did not exist until the bankruptcy was filed. Section 544 “creates a status and
allows applicable nonbankruptcy law to determine the rights that accrue as a result of the
created status.”47 Although generally, § 544(b) confers upon the trustee no greater rights
of avoidance than a creditor would have had if it were asserting invalidity on its own
behalf, there are exceptions.48 For example, the trustee is not denied relief because of the
prepetition wrongful conduct of the debtor.49 Also, the trustee may avoid the entire
transfer for the benefit of the estate, without regard to the size of the claim of the creditor

46 In addition to asserting state law fraudulent conveyance claims under § 544, the Trustee also
cites § 548(a)(1)(B), the Bankruptcy Code’s constructive fraudulent transfer provision, as a statutory basis
for recovery. NCMIC presents no argument that such claims arose prepetition.

47 4 Norton Bankruptcy L. & Prac., ¶ 63:7 at 63-36 to 63-37.

48 5 Collier on Bankruptcy, ¶ 544.06[3].

49 Id.

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whose rights and powers the trustee is asserting.50 And § 502(d) specifically requires
disallowance of any claim of an entity from which property is recoverable under a
Chapter 5 cause of action, including claims under § 544. It would render § 502(d)
meaningless if a setoff of prepetition claims could be effectuated as a defense against
Chapter 5 causes of action.

The Court therefore rejects NCMIC’s contention that its counterclaims which
arose prepetition can be offset against the Trustee’s UFTA claims. The Trustee’s motion
to dismiss should be granted on this issue.

2. NCMIC’s counterclaims which arose postpetition are not as matter of law
precluded from offset.
NCMIC’s only counterclaims which relate to postpetition conduct seek recovery
of: (1) the CJD-consideration payment of $50,000 as damages for the Trustee’s alleged
breach of fiduciary duty and negligence; (2) the postpetition portion (which the Trustee
contends is $16,772.99) of the $178,541.20 claim for allegedly Wrongfully Withheld
Unearned Premiums, as damages for breach of fiduciary duty, conversion, and
negligence; and (3) the postpetition portion (which the Trustee contends is $913.59) of
the $17,517.85 claim for Wrongfully Withheld Premiums, as damages for breach of
fiduciary duty, conversion, and negligence. The Trustee does not argue that these claims
as a matter of law are outside the offset allowed by § 553.

3. NCMIC’s failure to include all of its prepetition claims in its timely filed
50 5 Collier on Bankruptcy, ¶ 544.06[4].
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proof of claim does not preclude offset of the Trustee’s claims against the omitted
claims.

The Trustee argues that most of NCMIC’s prepetition claims are time barred. On
July 20, 2009, the Court entered on order establishing November 9, 2009, as the deadline
for filing claims against the Debtors’ estates. On November 2, 2009, NCMIC filed a
proof of claim, but it included only a small portion of the claims asserted in the
Counterclaim Complaint. In response to the Trustee’s motion to dismiss, NCMIC filed an
amended proof of claim and argues that amendments of claims are freely granted and that
such amendments relate back.

Both parties have overlooked the rule in the Tenth Circuit that “timely filing of a
proof of claim is not a prerequisite to asserting a right of setoff under 11 U.S.C. § 553.”51
This rule is based on the fact that offset is “a universally recognized right grounded in
principles of fairness that [is] not, with a few limited exceptions, affected by the
Bankruptcy Code.”52 The Court therefore finds that NCMIC’s failure to file a timely
proof of claim for all of the damages alleged in the Counterclaim Complaint does not
provide a basis for denial of offset.

D. Recoupment is not a legally valid defense to the Trustee’s claims.
The Counterclaim Complaint seeks a court determination that NCMIC is entitled
to use the doctrine of recoupment to defeat recovery on the Trustee’s claims against it. In

51 Davidovich v. Welton (In re Davidovich), 901 F.2d 1533, 1539 (10th Cir. 1990) (citing Turner

v. United States (In re G.S. Omni Corp.), 835 F.2d. 1317, 1317 (10th Cir. 1987)).
52 Id.
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bankruptcy, the common law doctrine of recoupment is distinct from setoff. For setoff,
the mutual debts need not have arisen out of the same transaction, but for recoupment, the
same transaction requirement does apply.53 When moving to dismiss, the Trustee argues
that none of NCMIC’s counterclaims arise out of the same transactions as the estate’s
claims. When responding to the motion, NCMIC agrees. The Trustee is entitled to
dismissal of NCMIC’s allegation that recoupment is available as a defense to the
Trustee’s claims.

CONCLUSION.

For the foregoing reasons, the Court grants the Trustee’s motion to dismiss in part.
NCMIC’s tort claims which arise from prepetition conduct of the Special Master are not
entitled to administrative expense status under § 503(b)(1)(A) or (b)(3)(E). NCMIC’s
counterclaims which relate to postpetition conduct of the Chapter 11 Trustee are not
precluded from administrative expense status under § 503(b)(1)(A) as a matter of law.
They seek recovery of: (1) the CJD-consideration payment of $50,000 as damages for the
Trustee’s alleged breach of fiduciary duty and negligence; (2) the postpetition portion
(which the Trustee contends is $16,772.99) of the $178,541.20 claim for allegedly
Wrongfully Withheld Unearned Premiums, as damages for breach of fiduciary duty,
conversion, and negligence; and (3) the postpetition portion (which the Trustee contends
is $913.59) of the $17,517.85 claim for Wrongfully Withheld Premiums, as damages for

53 Id. at 1537.
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breach of fiduciary duty, conversion, and negligence. However, except for the
postpetition portion of the claim for Wrongfully Withheld Unearned Premiums,
administrative expense status of these counterclaims is barred by the Court’s
administrative bar date order. As to offset, as a matter of law, none of NCMIC’s
counterclaims, except the three claims which arise from postpetition conduct, as
enumerated above, are eligible to be set off against the Trustee’s claims. Recoupment is
not a valid defense to the Trustee’s claims. In short, the only counterclaims which are not
subject to dismissal under Rule 12(b)(6) and (c) are the ones for offset of the postpetition
counterclaims; as to those claims, administrative expense status is precluded as a matter
of law for all except the one for Wrongfully Withheld Unearned Premiums.

IT IS SO ORDERED.

# # #

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