Bunch v. J.M. Capital Finance, Ltd. (In Re Hoffinger Industries, Inc.)

MEMORANDUM OPINION AND ORDER

The debtor, Hoffinger Industries, Inc., manufactures aboveground swimming pools and accessories. Its principal manufacturing plant is located in West Helena, Arkansas, and it has facilities in Rancho Cucamonga, California, and offices in Mississippi. The debtor filed its chapter 11 petition on September 13, 2001, in reaction to a personal injury judgment of approximately $13,500,000 in favor of Leesa Bunch [Bunch] rendered August 23, 2001, in Glenn County Superior Court, California. 1 Bunch suffered her injuries in August 1993. The initial notice of litigation to .the debtor and the retailer involved occurred in November 1998. (Pis.’ Ex. 48B.) •

This Court denied confirmation of the debtor’s proposed plan of reorganization in its Opinion dated February 24, 2005, and subsequent Judgment and Order dated March 3, 2005. Throughout this bankruptcy proceeding, the debtor has consistently refused to acknowledge that it has lost the Bunch litigation, both at the trial court and appellate levels. In the plan, Bunch’s claim was simply not addressed as required by the code.

In conjunction with objecting to the debtor’s plan, Bunch initiated this adversary proceeding questioning the claims filed by J.M. Capital Finance, LTD [JM Capital] and Arrowhead Insurance Co. [Arrowhead]. Bunch asserts that these two claims should be disallowed, reconsidered under 11 U.S.C. § 502(j), equitably subordinated under § 510, or reclassified. In addition to contesting Bunch’s assertions, Arrowhead filed its request to have post-petition product liability insurance premiums due from the debtor treated as an administrative claim. By agreement of the parties, the adversary complaint and the administrative claim application were tried together the week of May 2, 2005. The debtor appeared and participated through its counsel and president.

For the reasons stated below, the Court disallows and recharacterizes/reclassifies the JM Capital claim as equity. Also, in the event that it is determined that JM Capital has a claim, the claim is subordinated to the claims of all other creditors of this debtor under the principles of equitable subordination. The administrative application filed by Arrowhead is granted in part, and denied in part.

JURISDICTION

This Court has jurisdiction over this matter under 28 U.S.C. § 1334 and 28 U.S.C. § 157, and it is a core proceeding under 28 U.S.C. §§ 157(b)(2)(A), (B), (K), and (O). The following opinion constitutes findings of fact and conclusions of law in *395 accordance with Federal Rule of Bankruptcy Procedure 7052.

MARTIN HOFFINGER AND THE HOFFINGER FAMILY

Martin Hoffinger, married to Lorraine Hoffinger, is the founder of the entity now known as the debtor and is the patriarch of the Hoffinger family. He acquired his initial interest in the debtor in 1945. It, and the other entities discussed below, have always been closely held by members of the immediate Hoffinger family, their spouses, and children. (Defs.’ Exs. 18, 19, and 20.) Although Martin Hoffinger has divested his ownership interest in the debtor over the years, he has been and remains a director and its CEO. Martin Hoffinger and his family are integral to the transactions described below.

THE CLINTON POOL TRANSACTION

In her adversary proceeding, Bunch comprehensively attacks JM Capital’s approximately $10,000,000 secured claim. The basis of JM Capital’s claim is a purported loan that occurred in 1999 which, as explained below, also involved Arrowhead, the debtor’s product liability insurance carrier. The JM Capital transaction in 1999 can only be understood in its historical context. This requires an understanding of a 1993 $8,250,000 loan to the debtor from Clinton Pool Company, Inc. [CPC].

CPC is owned by eleven Hoffinger family members, either immediate or through marriage, including Ellen Lowe and Candace Caplin, two of Martin and Lorraine Hoffinger’s daughters. (Defs.’ Ex. 54.) CPC is a Nevada corporation that was incorporated on December 9, 1992. Ellen Lowe is the president and Candace Caplin is the treasurer. (Defs.’ Ex. 71.) It maintains an account with check writing privileges through Salomon Smith Barney. (Defs.’ Ex. 19.) CPC elected to become a-subchapter S corporation on November 3, 1993. Its address for IRS purposes is in care of Candace Caplin in North Stamford, Connecticut. (Defs.’ Ex. 54.) CPC does not have offices, other than Ms. Caplin’s home address, and does not appear to conduct any active business activities other than the loan discussed below. Lorraine Hoffinger is the only shareholder of the debtor who is not a CPC shareholder; all CPC shareholders are shareholders of the debtor. 2 (Defs.’ Ex. 18 and 19.)

The debtor borrowed $8,250,000 from CPC in fall 1993. The debtor’s board of directors authorized the CPC transaction in a meeting held August 25,1993. Martin and Lorraine Hoffinger were the only members of the debtor’s board of directors at that time. The appropriate resolution reflected that an $8,250,000 loan would be “offered” to the debtor from CPC. The terms were annual interest payments with the principal to mature on October 1, 2003. (Defs.’ Ex. 15.) In other words, this was a ten year note with no reductions in principal. CPC’s board of directors approved the loan to the debtor at a board meeting held August 27,1993. Candace Caplin and Ellen Lowe, both daughters of Martin and Lorriane Hoffinger, were CPC’s only two directors. (Pis.’ Ex. 18.)

By subsequent resolution in October 1993, the debtor’s board authorized the debtor to pay the accrued interest due CPC. (Defs.’ Ex. 15, Certificate of Passage of Resolution at the Special Meeting of the Board of Directors of Hoffinger Industries, Inc. Held on October 1, 1993.) The notice waiver recites the purpose^ of the special meeting: “To consider and pass upon the ratification and confirmation of the terms of interest payments of loans payable which are due to shareholders by *396 Hoffinger Industries, Inc.” Defs.’ Ex. 15, Waiver of Notice of Spec. Meeting of the Bd. of Dirs. of Hoffinger Indus., Inc., held on October 1, 1993 (emphasis added). In fact, CPC was the lender, not the debtor’s shareholders. CPC has never been a shareholder of the debtor. As discussed below, CPC did not actually fund the loan until November 1993, if at all. Thus, the above corporate book entry is significant in two respects. First, the debtor treated this transaction as being effective as of a date earlier than its actual funding. Second, it recognizes the real purpose of the CPC transaction was not to incur typical business debt, or even to incur debt to distribute shareholder earnings, but to effectuate a method for paying shareholders interest on their accumulated equity.

The ostensive purpose of the CPC loan was to enable the debtor to make a distribution from the debtor’s AAA account representing shareholder equity. It is not unusual for closely held corporations to borrow money to fund distributions for subchapter S purposes, be they tax related or to distribute earnings. However, as will be set forth below, CPC funded the entire loan from the concomitant shareholder’s distribution. In other words, the debtor used CPC, an otherwise inactive corporation controlled by Hoffinger family members, to allow the shareholder distribution to fund the distribution to shareholders. This circle invites further scrutiny.

Martin Hoffinger testified that in 1993 the debtor’s shareholders, his family, were demanding a distribution of their accumulate equity. On receipt of their $8,250,000 distribution, they loaned the full amount to CPC, which in turned loaned the money to the debtor to make the distribution. No documents were introduced supporting this loan from the debtor’s shareholders to CPC. No loan agreements, promissory notes, bank statements, shareholder agreements, cancelled checks, or other supporting documents appear to exist purporting to show how, and in what proportions, the $8,250,000 was distributed to the debtor’s shareholders, or how it was in turn transferred or loaned to CPC.

Nor could Mr. Hoffinger explain why the debtor immediately borrowed back (to make the distribution) the $8,250,000 distribution utilizing CPC, other than to state that the end purpose of the transaction was to pay interest to shareholders on their equity in the debtor. The debtor’s CFO could find no record of the debtor ever, in 1993 or at any other time, actually distributing the $8,250,000 to the shareholders other than the AAA account being reduced by that amount. 3 This issue bears examination because, as explained below, at some point CPC funded the loan with a check to the debtor. However, the sole source of that funding to CPC through its bank account was, according to witness testimony on behalf of the debtor and JM Capital, the debtor’s distribution to its shareholders. During the trial Martin Hoffinger agreed with a statement Ellen Lowe, his daughter, made earlier that the approximate $8,250,000 deposited into CPC’s account came from a check drawn on an account belonging to the debtor.

However, no evidence of a real money transfer exists. While “real” money is not necessary to counterbalancing book en *397 tries, it is when a bank account, with commensurate deposits and withdrawals, is used to effect the transaction. 4 The debt- or’s CFO postulated (but offered no proof, and stated he could not find any record of a distribution) that the debtor had enough cash to make the distribution; Martin Hof-finger alternatively suggested a short term bank loan might have been involved. 5 In either case, no supporting records or documents could be produced, which should have been relatively simple. Plus, both scenarios leave unanswered the question of why the debtor would fund its own borrowing. Both the debtor’s CFO and Martin Hoffinger acknowledged that the real purpose was to pay interest on equity. Martin Hoffinger, in response to the Court’s questions regarding why the shareholders would lend the money back to the debtor through CPC, stated, “[wjhile it was in the AAA account it was not bearing interest and this way, if they were going to keep their money in there, they were getting interest on it and they did that through CPC.” Part. Tr. Transcr., Test, of Martin Hoffinger vol. 2, 138:22-25 (May 4, 2005).

Michael French, the debtor’s outside auditor, testified regarding the original CPC transaction as follows:

The impact was somewhat significant for shareholders. They now had an eight point two five million loan to the company earning interest and getting paid currently every year the interest element on a loan. So while it was in the sub-chapter S earnings category it was— they weren’t getting paid anything; while it was in the loan category, there were getting paid annually some, I don’t know, whatever their interest rate is times the balance, probably some six hundred, seven hundred thousand dollars a year.

Part. Tr. Transcr., Test, of Michael French vol. 1, 26:4-12 (May 5, 2005).

The CPC loan was booked on the debt- or’s fiscal year end balance sheet dated June 30, 1993. This balance sheet reflected a remaining stockholders’ equity of $10,172,501. Originally, the distribution of subchapter S earnings was to be supported by a note payable to the stockholders, but subsequent to year-end, the debtor signed a note payable to CPC. When the distribution and loan were booked effective June 30, 1993, 6 the debtor was being sued for $10,000,000 related to a personal injury suit, sometimes referred to as the Fleck II case. On August 27, 1993, after the 1993 fiscal year end, a Federal District Court entered summary judgment in favor of the debtor. (Defs.’ Ex. 27.)

The Promissory Note to CPC is dated October 1, 1993, well after the loan was booked as of June 30, 1993, and interest started to accrue. (See Defs.’ Ex. 15, authorizing on October 1, 1993, payment of interest already accrued.) It is an interest only note payable annually on October 1, commencing October 1994 and maturing on October 1, 2003. Martin Hoffinger executed the note on behalf of the debtor. The interest rate is tied to “the published prime rate .... ” Defs.’ Ex. 30. CPC took as collateral real (Defs.’ Ex. 31; Pis.’ Ex. 25) and personal property (Pis.’ Ex. 24) *398 constituting most, if not all, of the debtor’s assets. 7

The principle reason for all of this was to pay interest to stockholders on accumulated earnings. A secondary effect was to collateralize this relationship and thus create a preferred secured creditor on debt that moments before had been stockholder equity. This effectively rendered the debtor judgment-proof from collection efforts by any unrelated third party, an expectation the debtor had given the status of the Fleck II litigation, which was still extant at the June 1993 fiscal year end effective date. No real distribution occurred. The distribution funded the loan; the loan funded the distribution.

The original $8,250,000 loan was funded by CPC signing a counter check dated November 3, 1993. (Defs.’ Ex. 37.) No witness, including Martin Hoffinger, could explain how CPC obtained $8,250,000 to fund this check. The circular testimony was that the loan was for the purpose of distributing shareholder earnings of $8,250,000. The assertion was the debtor did not have that amount in cash and accordingly had to borrow from CPC. However, CPC, as previously discussed, was owned exclusively by shareholders of the debtor. Further, CPC apparently did not conduct any business or have any assets; basically, its sole purpose was to loan money to the debtor. No one, including Martin Hoffinger who was intimately involved in the transaction, could clarify how CPC obtained money from its shareholders to loan to the debtor when the debtor’s loan was the source of the distribution to the shareholders, which they in turn used to fund the loan to CPC. The contention that this was merely a paper transaction falls apart when a bank is involved and a counter check drawn on that bank was issued in the amount of $8,250,000. Corporate entities can do paper entries. Banks, in the absence of real money in a real account, cannot. No one could explain how CPC obtained the $8,250,000 to loan to the debtor. In fact, the check from CPC to the debtor is dated November 3, 1993; the deposit to cover it was not made until November 5,1993. The only testimony regarding the source of the deposit is that it somehow came from the debtor.

Thereafter, the debtor paid CPC interest on the loan with no reductions of principal until the JM Capital transaction in August 1999. In 1995, the debtor paid $497,438 on accrued interest due and owing to CPC in the amount of $686,780. (Defs.’ Ex. 27, Fin. State, July 31,1995, n. 6.) It is difficult to quantify exactly the interest amounts paid in 1993 and subsequent years because the CPC note and other related party obligations are not always differentiated in the audited financial statements. The July 31, 1997 and 1998, Financial Statement reflects interest payments to CPC of $808,791 and $741,904. The debtor’s auditor suggested the interest payments were approximately six to seven hundred thousand dollars a year. On at least one occasion, the debtor rolled over interest into principle and paid additional interest. (Defs.’ Ex. 39: $580,900 in July 1995.)

JM Capital’s $10,000,000 proof of claim directly relates to the original CPC transaction. In the debtor’s audited July 31, 2000 and 1999, Financial Statement, the CPC $8,250,000 1999 line item debit disappears and reemerges as the $10,000,000 JM Capital year 2000 line item. Ostensibly, the JM Capital loan paid off CPC and permitted an additional $1,750,000 distribution to the debtor’s shareholders. The *399 circumstances of this transaction will be discussed in more detail below. The debt- or paid $742,500 in interest in 1999 and $878,400 in 2000. (Defs.’ Ex. 27, Fin. State. July 31, 2000 and 1999.) No explanation is given as to why the JM Capital transaction occurred in 1999, other than that the CPC loan was then coming due. This assertion is patently incorrect given the October 2003 CPC maturity date.

When this change occurred in 1999, no original CPC note marked “paid” was ever requested, provided, or documented. It appears that some or all of CPC’s collateral filings or recordings were never released. The auditors for the debtor simply accepted a written confirmation of the zero balance from Ellen Lowe on behalf of CPC. The confirmation letter originated from Jennifer Dunn, the debtor’s CFO at that time, and was countersigned by Ellen Lowe. As mentioned above, Ms. Lowe is one of Martin and Lorraine Hoffinger’s daughters. The auditor’s confirmation letter confirming the new JM Capital debt was from Ms. Dunn to Peter Caplin, Ms. Lowe’s brother-in-law.

ARROWHEAD INSURANCE COMPANY

Prior to examining in detail the transition of the CPC credit to JM Capital, it is necessary to understand the role that Arrowhead, the debtor’s product liability insurer, played with respect to the debtor. The issue of Arrowhead’s administrative claim will be examined in another section of this opinion.

Martin Hoffinger testified that the debt- or has always needed product liability insurance. In addition to the protection it affords the debtor, both the debtor’s lenders and its retailers expected the debtor to carry an adequate policy. Mr. Hoffinger explained that the debtor experienced difficulty in obtaining coverage in the 1980s because of pool industry litigation losses. By 1987, the debtor was unprotected.

Initially, the debtor self-insured using an entity it created — Products Quality Assurance Group, Inc. [PQA]. The debtor contracted with PQA to manage its product liability cases for a fee equal to 5% of net sales. (Pis.’ Ex. 17.) The fee covered management and indemnification to the debtor for all costs incurred with respect to any claim over $50,000, up to $500,000 a claim, not to exceed $3,000,000 per annum. (Defs.’ Ex. 15.) It appears in late 1992 or early 1993, PQA took the unusual step of pledging its assets to collateralize industrial revenue bonds benefitting the debtor. (Defs.’ Ex. 15, Consent of the Dirs. of the Bd. of Dirs. of Hoffinger Indus., Inc. dated Dec. 21, 1992.) PQA was formed by the debtor and served in an administrative role and not as an independent insurer.

For significant periods of time since October 1987, and as of June 30, 1993, the debtor had elected not to purchase liability insurance. (Defs.’ Ex. 27, Fin. State. June 30, 1993, n. 7.) According to the debtor’s auditors, in 1993 the debtor’s managers evaluated the cost benefits of purchasing such insurance. A year later, in June 1994, Arrowhead was formed as a Cayman Islands entity (Pis.’ Ex. 33) and the debtor paid premiums for fiscal year 1994 in the amount of $1,496,000 (Defs.’ Ex. 27, Fin. State. June 30, 1994, n. 9). The initial directors were The Director Ltd. (resigned approximately one month after appointment), Martin Hoffinger (also Chairman), and Ellen Hoffinger Lowe. 8 Ms. Lowe served as its secretary, with Terry Burke serving as its assistant secretary and noted as an “Insurance Manager/Accountant.” Mr. Burke became a director in 2003, at the same time Ms. Lowe *400 resigned her position. A Cayman Islands entity managed Arrowhead. (Defs.’ Ex. 16.) Arrowhead’s sole customer and source of income was the debtor, and it conducted no other business activities, insurance or otherwise.

Arrowhead is owned by Chief Enterprises, Ltd. [Chief], an entity owned in five equal parts by Hoffinger family members, including Lorraine Hoffinger, Candace Caplin, and Ellen Lowe. (Defs.’ Ex. 20.) All five shareholders are shareholders of the debtor. (Defs.’ Ex. 18.) Arrowhead, in turn, wholly owns JM Capital. Arrowhead in many ways acts similar to PQA. The policy was an indemnity policy that reimbursed the debtor for its fees, costs, and expenses, as well as any judgment amount, up to $500,000 per claim after a $50,000 deductible. Other than Mr. Burke acting as an insurance manager/accountant, it had no employees. The indemnity amount did not inure to the benefit of injured third parties. In referring to fifteen pending personal injury lawsuits, the debtor stated, “[w]e control our own litigation.” Defs.’ Ex. 15, Mins, of Bd. Meeting of Hoffinger Indus., Inc., May 21, 1996 at the Holiday Crown Inn in New York City. In addition to its role as the debtor’s insurance company, Arrowhead also played a part in the 1999 JM Capital, CPC, and debtor transaction.

THE JM CAPITAL TRANSACTION

In 1999, the debtor incurred $10,000,000 in debt to JM Capital. This transaction forms the basis for JM Capital’s secured claim filed in this bankruptcy proceeding. The debtor has never questioned the validity of this debt, and the debtor’s proposed plan of reorganization contemplated paying JM Capital in full, including principle and interest.

By a Loan Agreement dated August 4, 1999, the debtor borrowed $10,000,000 from JM Capital. (Defs.’ Ex. 33.) It is JM Capital’s and the debtor’s contention that the proceeds were used to pay the $8,250,000 debt to CPC, with the $1,750,000 balance distributed as equity to the debtor’s shareholders. (Defs.’ Ex. 36.) Several pertinent facts emerge from the August 4, 1999, Loan Agreement. The interest rate is not stated on the agreement. The agreement calls for the transfer of $5,000,000 in cash directly to the debtor. Simultaneously with that transfer, JM Capital was to execute five $1,000,000 notes in favor of the debtor. 9 The first note was to have a maturity date of October 1, 2000, with the remaining notes to mature on October 1, 2001, 2002, 2003, and 2004. Finally, the agreement acknowledges that part of the proceeds are to be used to pay CPC. This would involve the debtor paying cash and securities to CPC and assigning to CPC the five $1,000,000 promissory notes.

With one exception, there is no credible evidence that the five $1,000,000 promissory notes were ever drafted, executed, or assigned. At trial, JM Capital suggested that there did not need to be an assignment as the note relationship could have been directly between JM Capital and CPC. In the first instance, no evidence was presented that this alternative scenario ever occurred. Second, that scenario is inconsistent with the actual wording of the JM Capital/debtor Loan Agreement. Third, in her memo of June 2, 1999, Jennifer Dunn characterized the transaction as one involving an assignment of five $1,000,000 “notes receivable from J.M. Capital Finance _” Pis.’ Ex. 55. Fourth, Martin Hoffinger’s memo of June 18, 1999, (Pis.’ Ex. 57) also characterized *401 the five $1,000,000 notes as “negotiable,” which would be transferred from the debt- or to CPC. Fifth, unaudited JM Capital financial statements refer to the notes as having been “issued,” (Pis.’ Ex. 75) but again no evidence was presented reflecting their actual existence. Further, the sole $1,000,000 note in existence (Pis.’ Ex. 91) has JM Capital as the maker and the debtor as lender/payee. This sole promissory note, dated August 2, 1999, has a prime rate tied to Citibank of New York. No one produced a copy or an original of the other four notes, nor could any witness unequivocally and credibly state that they had ever seen or handled the other four notes. The Court finds that these notes simply do not exist.

The Loan Agreement calls for mortgages on property located in California and Arkansas, as well as financing statements on all the debtor’s personal property. It does not appear that the mortgages were properly recorded. Additionally, as reflected in the debtor’s cash collateral motion, the validity of JM Capital’s UCC financing statements are questionable. The liens purport to be a blanket lien on all the debtor’s personalty.

The debtor also executed a $10,000,000 Promissory Note on August 4, 1999, to JM Capital. It is an interest only note, payable annually on October 1, commencing October 1, 1999, with the entire unpaid principal balance plus accrued interest due and payable on August 4, 2009. It is a ten year note carrying no reductions in principal until maturity. Interest is tied to the “published prime rate.” Defs.’ Ex. 32. The attendant Loan Agreement with JM Capital does not clarify the interest rate. “Prime Rate” is meant to be a defined term correlated to a published bank rate, but the specific bank designation is blank. (Defs.’ Ex. 33.) The sole existing one million dollar note does refer to Citibank of New York.

The JM Capital money to make this loan came from Arrowhead. Specifically, Arrowhead held a board meeting to consider this matter on July 20, 1999. JM Capital was a wholly-owned subsidiary of Arrowhead formed in the Cayman Islands on either July 20, 1999, (Defs.’ Ex. 17) or July 14, 1999, (Defs.’ Ex. 62). JM Capital’s principle activity was to provide financing to the debtor. (Defs.’ Ex. 62, Arrowhead Ins. Co. Consolidated Fin. State. June 20, 2001 and 2000, n. 1.) In fact, no evidence exists that it had any other purpose or ever engaged in any other business activity. Arrowhead capitalized JM Capital in the amount of $50,000. Also, Arrowhead authorized the transfer of $5,000,000 in cash investments held at the Bank of Bermuda to the debtor’s account at Salomon Smith Barney to occur on or about August 2, 1999. According to the debtor’s documents, JM Capital was to purchase $10,000,000 of the debtor’s' notes payable (actually only $8,250,000 as a note payable to CPC, plus $1,750,000 as a distribution to shareholders) by the payment of $5,000,000 in cash and five notes payable of $1,000,000 each. (Defs.’ Ex. 16; Pis.’ Ex. 38.) Arrowhead did not take a note back from JM Capital. Adequate documentation explaining or quantifying the relationship between JM Capital and Arrowhead does not exit. The two entities do prepare consolidated financial statements.

Arrowhead was JM Capital’s sole source of financing. The debtor was Arrowhead’s only customer and was its sole source of income. This was recognized by Mr. Hof-finger, on behalf of the debtor, who explained to Arrowhead’s Cayman Islands manager, Ron Sulisz, that “[t]he annual payment of the balance of the purchase of the notes will be less than the amount received annually from premiums. There *402 by allowing Arrowhead to continue to grow its equity.” Defs.’ Ex. 36, letter dated May 11, 1999, from Martin Hoffinger to Ron Sulisz. According to a post-petition auditor report, from June 1988 through July 2002 the debtor had paid Arrowhead premiums of approximately $20,000,000. 10 (Defs.’ Ex. 58.) Despite this large financial outlay, no one on behalf of the debtor had ever compared premiums paid to indemnity claims made and received.

Martin Hoffinger, a director of both the debtor and Arrowhead, 11 apparently concluded that Arrowhead could afford this investment of its premium income. Mr. Hoffinger suggested this transaction would increase Arrowhead’s yield via its wholly-owned subsidiary by 40%. Further, Mr. Hoffinger stated:

The costs to Arrowhead for claims paid, from the inception of Arrowhead, has been minimal. We do not expect claims of any substance to originate in the immediate foreseeable future. There are only three claims now open. All three are expected to be settled under the self insurance reserve of the insured.

Defs.’ Ex. 36, letter dated May 11, 1999, from Martin Hoffinger to Ron Sulisz.

In fact, Arrowhead has profited handsomely from the debtor, its sole customer. In May 1999, Arrowhead had assets in excess of $8,000,000 and would soon be receiving additional premiums in excess of $1,500,000 from the debtor. Martin Hof-finger assured Arrowhead’s manager that this favorable premium relationship benefiting Arrowhead would continue until the JM Capital note was paid in full. (Defs.’ Ex. 36, letter dated May 26, 1999, from Martin Hoffinger to Ron Sulisz, and Martin Hoffinger memo: Revised 6/18/99.) Also: “Arrow[head] will continue to finance/capitalize JM from continuing premiums.” Defs.’ Ex. 36, Martin Hoffinger memo: Revised 6/18/99. Even after the $10,000,000 loan “[t]he Arrowhead equity balances in the Cayman Banks should be more than adequate to cover the exposure of any claims that may arise.” Defs.’ Ex. 36, letter dated June 22, 1999, from Martin Hoffinger to Ron Sulisz. In short, the debtor was once again financing its own borrowing.

Further, while in the process of scrutinizing the proposed transaction, the Cayman Islands management company confirmed that by entering into the proposed arrangement,

the directors of Arrowhead are indicating that the investment in JM is being made out of assets surplus to Arrowhead’s requirements for (a) paying its insurance and other liabilities and (b) maintaining net worth sufficient to support the business which Arrowhead will continue to write.

Defs.’ Ex. 36, HSBC Insurance Management memo dated May 26, 1999, from Ron Sulisz to Martin Hoffinger. The Cayman Islands Monetary Authority approved the transaction by its letter of June 1, 1999. In that letter, the authority expressed its requirement that all reported claims had to be fully secured with both short-term funds and bonds. (Defs.’ Ex. 36, letter dated June 1, 1999, from Gordon Rowell to Ron Sulisz.)

JM Capital was to take a security interest in all of the debtor’s assets, “including everything that’s not nailed down.” Defs.’ Ex. 36, the debtor’s internal memo dated May 19, 1999. As stated above, this goal *403 was not fully achieved. This raises the obvious question of whether the debtor adequately performed its duty to examine the JM Capital transaction and outstanding issues of validity, perfection, and priority at arm’s length. The debtor did not. In fact, through its cash collateral efforts and the proposed plan of reorganization, the debtor has consistently attempted to treat JM Capital’s debt as fully secured and payable not only by its terms, but on an accelerated basis.

Michael Monchick, a lawyer and a member of the debtor’s board of directors, candidly set forth his concerns in his post-petition letter of October 3, 2001, to Robert Breakstone, another board member. Mr. Monchick expressed frustration over the failure of the debtor’s counsel, with the assistance, or lack thereof, of Jennifer Dunn, to ensure that the JM Capital perfection documents were adequately recorded. He posits the following rhetorical, but very telling, question: “Why weren’t all assets protected? A good question? People responsible did not do their job.” Pis.’ Ex. 77.

Mr. Monchick, a member of the debtor’s board of directors, is more concerned about the creditor’s perfection than the debtor’s best interest. If unperfected, and as a result either unsecured or only partially secured, it would be in the debtor’s best interest to treat JM Capital as such and propose a more limited payout under any proposed plan of reorganization. The debtor’s plan of reorganization proposed a 30% payout to unsecured creditors with payment in full to JM Capital. Again, no explanation is given as to why Mr. Mon-chick is more interested in protecting JM Capital than in furthering the debtor’s best interests in the context of its chapter 11 bankruptcy proceeding. The only valid resulting inference is that the secondary purpose of this transaction, like the earlier CPC loan, was to judgment-proof the debt- or.

Martin Hoffinger shed some light on the debtor’s attitude concerning this corollary benefit of the JM Capital transaction when he testified at the cash collateral hearing as follows:

Q. Who is a Director of Arrowhead?

A. I am.

Q. You are?

A. Yes.

Q. Who has control over whether Arrowhead pays money out on a claim or not?

A. I probably do.

Q. Anyone else?

A. We have-Terry Burke is Manager of the Britannia Insurance Management Company, and they are the managers of that account.

Q. Okay. What family members own Chief, which is the holding company for Arrowhead, which owns JM.?

A. To the best of my knowledge, my wife and four daughters.

Q. Okay. You’re not an owner?

A. No, I’m not.

Q. And JM Capital loaned $10 million to Hoffinger Industries and refinanced the CPC note in about 1999?

A. That’s correct.

Q. And this was to avoid people who have judgments from coming in and taking the assets of the company; correct?

A. It was just good business.

Q. Does good business include protecting your assets from judgment creditors?

A. Whatever is good business is what we practice.

Q. Could you please answer my questions, sir?

A. Please rephrase your question.

*404 Q. Does good business include protecting your assets from judgment creditors?

A. Yes.

Defs.’ Ex. 3 at 47.

At a board of directors meeting held March 22, 2001, JM Capital authorized its two directors, Martin Hoffinger and his son-in-law, Peter Caplin, to open a bank account at the Bank of Butterfield, located in the Cayman Islands. The account was opened by Martin Hoffinger executing the new account signature card on May 18, 2001, with an initial deposit of $1,000,000. (Defs.’ Ex. 17.) Apparently, this is the first time JM Capital ever had a checking account. At trial Martin Hoffinger was not aware that JM Capital even had a checking account.

The JM Capital transaction was slated to occur on or about August 2, 1999. The $10,000,000 promissory note between the debtor and JM Capital is dated August 4, 1999. It is an interest only note for ten years, with interest payable annually commencing October 1, 1999, with the unpaid principal balance together with accrued interest to mature on August 4, 2009. (Pis.’ Ex. 67.) The JM Capital UCC filing in Phillips County, Arkansas, occurred on August 25,1999, (Pis.’ Ex. 69) and with the Arkansas Secretary of State on September 13, 1999. The mortgage on real property in Phillips County, Arkansas, does not appear to have been filed of record. (Pis.’ Ex. 71; see also Pis.’ Ex. 79, memo dated November 20, 2003, from Martin Hoffinger to Michael Monchick.)

How this transaction actually occurred is very confusing and was not satisfactorily explained by the witnesses. It appears that almost every entity involved had an account with Salomon Smith Barney. It is unclear if the transfers in fact tracked from each account in turn or if certain entities bypassed a particular account and transferred consideration directly to the end beneficiary. (See Defs.’ Ex. 50.) Were this transaction normal and at arm’s length, there should have been first an executed $10,000,000 loan agreement and note between the debtor as borrower and JM Capital as lender. Either before or at execution of the JM Capital/debtor loan documents, Arrowhead would have capitalized or loaned JM Capital cash and securities equaling $5,000,000 (plus an additional $583,039 of which $524,271 was used to cover accrued interest due CPC as of August 2, 1999 (Defs.’ Ex. 49.)). JM Capital would then have paid $3,250,000 directly to CPC (plus the additional amount to cover accrued interest (Defs.’ Ex. 49.)). At the same time, JM Capital should have transferred $1,750,000, an amount representing the balance of the $5,000,000 in cash and securities, to the debtor for the debtor’s stockholders as a distribution of their AAA accounts as of July 31, 1998. The debtor’s records would have reflected the proportional distributions. JM Capital would also have executed the five $1,000,000 notes to the debtor, which the debtor would have then, in turn, assigned to CPC. CPC would have accepted the $3,500,000 in cash and securities (plus the additional amount to cover accrued interest (Defs.’ Ex. 49.)) and the assignment of the five $1,000,000 notes in satisfaction of the original $8,250,000 loan. Subject to the non-recourse issue addressed below, CPC would have accordingly released its mortgages and UCC filings and JM Capital would have then taken its place by filing its own mortgages and UCC filings.

Most of this did not occur as suggested. It appears more likely that the debtor, utilizing Midland Bank, engaged in a series of transfers through various Salomon Smith Barney accounts with Arrowhead transferring cash and securities directly to the debtor, bypassing JM Capital, and the *405 debtor directly transferring cash and securities to CPC. (Defs.’ Ex. 50; Defs.’ Ex. 36, memo dated June 24, 1999, from Martin Hoffinger to Norman Moss.) It also appears that by letter dated July 22, 1999, Peter Caplin, on behalf of JM Capital, instructed Arrowhead to skip transferring the $5,000,000 amount in cash and securities to JM Capital, but rather transfer that amount directly to the debtor’s Salomon Smith Barney accounts on or about August 2, 1999. (Pis.’ Ex. 63.) Likewise, at the direction of Martin Hoffinger, the cash and securities seem to have been transferred directly to the debtor’s Salomon Smith Barney account from Arrowhead’s account at the Bank of Bermuda. (Pis.’ Ex. 72.)

The Court is not offended by, and surely the law does not preclude, instances where parties efficiently move money to effect a legitimate commercial transaction. However, in this instance there are legal consequences resulting from the total lack of any credible witness on behalf of JM Capital or the debtor having the ability to explain even remotely how either the CPC or JM Capital transactions actually occurred. This extends to the reasons for the transactions, the movement of money, the execution of documents, the existence of documents, the release or not of collateral, the taking or perfection of collateral, the continuation of perfection, and whose money was used when and directed to whom. In a normal, typical, arm’s length transaction, all of these factors are clear and susceptible to easy reconstruction in a court of law. Accounting is accounting and math is math. When math, accounting, and financial transactions are married clarity — not confusion, dissimulation, or obfuscation — is the result.

This lack of clarity permeates both the CPC and the JM Capital transactions. CPC’s Salomon Smith Barney account statements were directed to the attention of Ellen Lowe in Houston, Texas. (Defs.’ Ex. 44.) JM Capital’s Salomon Smith Barney account statements were directed to the identical address. (Defs.’ Ex. 46.) Despite this unitary interest, Ms. Lowe did not appear and no one else could explain how the transfers actually occurred. As previously stated, only one of the necessary five $1,000,000 notes was ever produced. Not a single witness could testify unequivocally that they had ever seen the other four notes or any assignment or endorsement of the five notes to CPC. There is evidence that the debtor made interest payments on its debt to JM Capital, which apparently, through the Salomon Smith Barney accounts, was paid to CPC. In the year preceding its chapter 11 filing, the debtor paid JM Capital $797,671 in interest. (Pis.’ Ex. 9, Sch. 3(b).) There is also evidence that at least two notes, of which only one was represented by an actual written promissory note, were paid in two $1,000,000 increments. (Defs.’ Ex. 53, Sum. of Evid. of Payment Toward the 5 $1M Notes.) The other three nonexistent notes were never paid.

Once the debtor filed its chapter 11 petition and Arrowhead’s income stream ceased, JM Capital was no longer able to make payments to CPC. Three $1,000,000 notes have become due and owing from JM Capital to CPC. Despite this fact, CPC has never made a demand or pursued collection from JM Capital, or made a claim against the debtor. Again, in a normal transaction it would be rare for the initial lender to accept third party notes (or, as in this case, non-existent third party notes) in full satisfaction of a debt, or without some recourse against the original maker, in this instance the debtor. Conversely, if the initial lender took the notes without recourse, the reasonable expectation is that someone on behalf of either CPC, JM Capital, or the debtor could explain the under *406 lying logic, reason, or consideration. No one could in this instance.

Further, a setoff question presents itself. Specifically, Arrowhead claims it is owed approximately $5,000,000 in premiums from the debtor. The five $1,000,000 notes technically should be from JM Capital as maker to the debtor as lender/payee. JM Capital is Arrowhead’s wholly-owned subsidiary and its sole source of funding, with Arrowhead’s sole source of funding being the debtor. This stream was to continue, according to the debtor, as long as the JM Capital debt remained outstanding. In fact, the debtor would be obligated to prepay the JM Capital debt if it changed insurance carriers. (Pis.’ Ex. 52.) Were this a true arm’s length transaction, Arrowhead and JM Capital would simply assert a setoff of the outstanding obligations due under the balance of the five $1,000,000 promissory notes. This would result in an offset of $3,000,000, which it would simply refuse to pay to the debtor, or its alleged assignee, CPC. Neither Arrowhead or JM Capital has attempted to do so.

Further, no documents or credible testimony exist that would explain the relationship between JM Capital and CPC regarding the balance of the note obligations. JM Capital has missed three of the $1,000,000 payments, but CPC has not sued or even made demand on either JM Capital or the debtor. The debtor has made some of its interest payments to JM Capital post-petition by signing new promissory notes rolling the interest into the principle and paying interest accordingly. (See, e.g., Pis.’ Ex. 93.) According to its auditor, its CFO, and its president, the debtor is absolutely confident that CPC is paid in full as per its confirmation letter. That should not prevent JM Capital from asserting its right of setoff and leaving CPC apparently, but inexplicable, without recourse rights. Simply put, no one in this transaction seems to be operating in their own best interest. Also, no one seems capable of explaining either how the transaction actually took place or the parties’ post-default actions, or lack thereof. Nor have they, with the exception of accounting entries, historically treated these as real debt obligations. Rather, each seems to be acting in a manner consistent with a unitary identity of interest; that is, paying the debtor’s shareholders interest on them equity, with the secondary benefit of tying up the debtor’s assets as collateral.

CASH COLLATERAL HEARING

On April 5, 2002, JM Capital filed its proof of claim in the amount of $10,557,808. No supporting documents are attached to the proof of claim. JM Capital asserts that it has a fully secured claim. The debtor has consistently treated JM Capital as fully secured during the course of this bankruptcy. This non-critical favoritism began as early as the debt- or’s initial post-petition efforts to obtain financing.

On October 10, 2001, shortly after the September 13, 2001, petition filing date, the debtor filed its Motion for Authority to Use Cash Collateral and Incur Secured Debt [the Cash Collateral Motion], (Defs.’ Ex. 1.) The Cash Collateral Motion envisioned a $10,000,000 line of credit from C.M.A. Corporation [CMA] with JM Capital agreeing to subordinate its August 4, 1999, $10,000,000 loan contingent upon adequate protection payments and a superp-riority administrative expense claim. The Cash Collateral Motion discloses that there may be infirmities in JM Capital’s perfection of its collateral, including a potential preference action. Throughout, the debtor has never taken any action to dispute or otherwise question JM Capital’s fully secured status. In addition to seeking superpriority status for JM Capital, *407 the Cash Collateral Motion sought replacement liens and cross collateralization of prepetition indebtedness by those hens, as such would “preserve[ ] the collateral position of JM.” Defs.’ Ex. 1, Cash Collateral Mot. ¶ 13.

The Cash Collateral Motion does not contain any representations reflecting the ownership of JM Capital. Nor does it disclose JM Capital’s relationship to Arrowhead or the absence of certain promissory notes essential to the credit relationship between the debtor, CPC, and JM Capital. In fact, the proposed cash collateral loan agreement involving CMA, JM Capital, and the debtor has the debtor waiving every claim, cause of action, or defense it might have against JM Capital. (Defs.’ Ex. 1, Cash Collateral Mot. Ex. 1 § 3.15.) 12 This is especially egregious given the unwinding of the realities of the JM Capital transaction discussed in this opinion. It is almost impossible to fathom any valid or appropriate reason for the debtor to treat JM Capital as some disinterested arm’s length third party insisting on a superpriority status in return for subordinating its already subordinated, and inadequately documented and perfected, debt.

The debtor’s complicity, if not leadership, in this regard has been consistent throughout this bankruptcy proceeding, beginning with the Cash Collateral Motion, continuing through its first proposed plan, and now with its position at the trial of this matter. As is evident from the facts, the debtor and JM Capital — under the direction of Martin Hoffinger — have acted with a unity of