In re Montgomery

N. Eddie Montgomery was the sole owner of Southland Escrow Services, Inc. (collectively, Montgomery) (debtor), a firm that engaged in real estate closings. In 1987, Montgomery opened several bank accounts with Third National Bank (Third National) (creditor) as part of a cash-management system for Montgomery’s business. The cash-management system entailed a main funding account, which held the receipts from real estate closings, and a zero-balance account, from which checks were drawn. The system allowed Montgomery to have immediate access to the funds in the main funding account and was intended to transfer funds into the zero-balance account each day to cover whatever checks were presented for payment that day. The system did not operate in a timely manner, which resulted in checks being initially recorded as overdrafts. In turn, a bank employee would debit the main funding account the following day to balance out the accounts. However, the main funding account often did not contain enough funds to cover the checks that were being drawn. By March 1988, Third National suspected that Montgomery was running a check-kiting scheme across several different banks. By this time, the overdraft balance at Third National had increased significantly to over $2 million. In early April 1988, Third National called Montgomery to a meeting to discuss the mechanics of reducing the overdraft balance. Montgomery agreed to do so. Deposits continued being made into the main funding account, but Montgomery stopped writing checks from the zero-balance account. As a result, Montgomery’s negative balance at Third National was reduced to zero. Despite resolving the overdraft issue with Third National, Montgomery’s check-kiting activities continued at other banks. On June 3, 1988, involuntary-bankruptcy proceedings were initiated against Montgomery. Subsequently, the trustee in bankruptcy demanded that Third National return approximately $2 million in preferential transfers. Third National refused. In an adversary proceeding, the bankruptcy court ruled that the transfers were preferential under the Bankruptcy Code and thus voidable. The district court affirmed the bankruptcy court’s decision, and Third National appealed.