Mechanics' and Metals Nat. Bank of City of New York v. Ernst

Background

A bank made a $400,000 clearance loan and credited it to a brokerage firm’s deposit account that already held about $36,239.47. The bank certified and paid large checks that morning, then the cashier, hearing troubling rumors about the brokers, ordered all payments stopped and went to the brokers’ office. The brokers’ representative gave some securities after being asked for additional collateral. Later that day the brokers announced they could not meet obligations and an involuntary bankruptcy petition was filed. The suit seeks the proceeds of securities the bank sold and a later deposit of $54,048.08.

Reasoning

The Court examined whether the bank had reasonable grounds to treat the brokers as insolvent and whether the bank’s actions created an unlawful preference under the Bankruptcy Act. The Court accepted the lower courts’ findings that the firm was insolvent, that it knew it, and that the bank’s conduct amounted to a preference. The Court also held that a general promise to give security on demand does not put a creditor in a better position. The $54,048.08 paid in after the cashier’s order to stop payments was treated as a payment and therefore a preference. The bank was not allowed a set-off.

Real world impact

The decision confirms that banks that take or keep funds and securities after clear signs of a debtor’s insolvency can lose those sums as avoidable preferences. It limits banks’ ability to rely on vague promises to get extra collateral and enforces returning preferential payments to the bankruptcy estate.