Thursday, June 25, 2015

Sale Watch: WBH Energy, Ltd.

This is a new feature on A Texas Bankruptcy Lawyers Blog.   Whenever I hear about Section 363 sales in Texas, I will mention them here to try to get the word out.   Please feel free to send me any sales you are involved in or happen to hear about.

Case No. 15-10003; WBH Energy, Ltd.; Western District of Texas, Austin Division

Bidding Procedures Order:    Dkt. #361; 5/11/15

Assets to be Sold:   Oil and gas interests in the Barnett Combo Play of the Fort Worth Basin

Minimum Bid:   $17.5 million

Bid Deadline:  August 7, 2015, 4:00 p.m.

Auction Date:  August 18, 2015, 10:00 a.m.

 Debtor's Counsel:

 William A. Wood, III

Committee Counsel:

Berry Spears

Friday, June 05, 2015

Fifth Circuit Report: April-May 2015

At the same time that the Supreme Court was busy ruling upon its bankruptcy cases for the term, the Fifth Circuit was active as well.  There were so many cases in April, that it took me two months to summarize them.    Over the course of April and May, the Court decided no less than sixteen cases with bankruptcy implications.   These include cases relating to civil contempt, post-judgment remedies being granted pre-judgment, the conclusion of the BPRE case and important opinions on property of the estate, attorney’s fees, discharge and dischargeability.  There are also four cases involving disputes between homeowners and lenders, including two where the homeowner’s claim was revived on appeal.   There is enough substance here, including in the unpublished opinions, to keep a lot of lawyers and judges reading for a long time.

This case involved a request for mandamus with regard to a civil contempt order for failure to comply with a turnover order.    The SEC obtained an order approving an ex parte temporary restraining order and a receivership order.   The receivership order required the debtor to turn over all of his assets to the receiver along with an accounting. 
Upon investigation, the receiver found that $500,000 had been delivered to the debtor in cash in a Dillard’s bag.  The funds were never deposited into the business account or in any other account.  The District Court entered a turnover order requiring the debtor to turn over the funds and issued an order to show cause in the event that he did not do so.   “Ramirez declined to turn over the asset or reveal where it had gone, and he has continued to do so to this day.”    The District Court held the debtor in contempt then held a second evidentiary hearing to allow the debtor to purge his contempt.   

On the writ of mandamus, the Court found that the contempt was supported by clear and convincing evidence.    The Court also rejected the argument that the debtor was being punished for exercising his Fifth Amendment right not to incriminate himself.    However, the Court noted that:
(H)e is not being punished for his refusal to answer questions; he is being punished for refusing to turn over $500,000, thereby violating the turnover order. A defendant in a contempt hearing bears the burden of production to show that he is presently unable to comply with the underlying order. (citation omitted). He bears this burden even if he claims that his own testimony regarding inability to comply would incriminate him. (citation omitted).   Moreover, as the district court repeatedly noted, Ramirez did not need to testify to show that it would be impossible to turn over the $500,000; he could call other witnesses to testify as to how he spent the money.  
Opinion, pp. 7-8.

This case involved a defendant who was ordered to provide discovery with regard to assets and to refrain from transferring funds other than to pay bills in the ordinary course of business without permission from the Court.   The defendant filed a writ of mandamus, which the Court treated as a request for interlocutory appeal.   

This case involved a hospital which used its own billing codes to allow neighboring clinics which did not have Texas hospital licenses to illicitly bill insurance companies.   The insurance company sued for money had and received, fraud, negligent misrepresentation, unjust enrichment and civil conspiracy.  The District Court granted a “partial judgment” in the amount of $8.4 million on the money had and received claim.    The hospital, which was then under the control of a receiver, filed for chapter 11 relief.   The District Court withdrew the reference and lifted the automatic stay.    The insurance company asked for post-judgment discovery which the District Court granted without a hearing.   At a later hearing, the District Court heard allegations that 2920 ER, LLC had been transferring funds to a third party.   The District Court “essentially ordered an asset freeze from the bench.”   This order was later reflected in a written order.

The Fifth Circuit held that mandamus was not proper because the remedy of an interlocutory appeal was available.   However, the Court proceeded to treat the request for mandamus as an interlocutory appeal.    It found that the request for mandamus placed the insurance company on adequate notice of its claims.    The Fifth Circuit found that a creditor is generally not entitled to post-judgment remedies prior to judgment, relying on the Supreme Court decision in Grupo Mexicano de Desarrollo SA v. Alliance Bond Fund, Inc., 527 U.S. 308 (1999).   The Court of Appeals found that the asset freeze was not available prior to entry of a final judgment unless the Plaintiff complied with Rule 65 which was not done.   The Court vacated the District Court’s orders except to the extent that the discovery was necessary to investigate pending claims.

The take-away here is straightforward.   Post-judgment remedies are generally not available pre-judgment.   If a creditor wants injunctive relief, it must follow the procedures set out in Fed.R.Civ.P. 65.

This is the coda to the second of the Fifth Circuit’s now superseded cases finding that consent was not available in Stern cases.   The Debtor filed an adversary proceeding in bankruptcy court.   After receiving a take-nothing judgment, it contended that the bankruptcy court lacked authority to enter a final judgment.   The Fifth Circuit agreed and remanded the case.   The District Court treated the Bankruptcy Court’s findings and conclusions as a report and recommendation which it adopted.    On appeal, the Debtor contended that the Bankruptcy Court should have allowed a jury trial despite the fact that its request was untimely under the local rules of the bankruptcy court.   The Fifth Circuit ruled that the right to a jury trial may be waived due to inadvertence.   It stated that “we are not convinced that BPRE’s failure to timely comply with the rule resulted from anything other than ‘mere inadvertence.’”    The Fifth Circuit also found that the evidence received in the trial before the bankruptcy court amply supported a take nothing judgment.   Thus, in this case as in Frazin, the right to request a do-over in the District Court did not change the result. 

Debtor made false statements in borrowing base certificates.   He argued that the borrowing base certificates were statements of financial condition such that reasonable reliance was required.   The Court distinguished between general statements of financial condition and “specific falsifications on the ability to repay the lender, misstatements of inventory and denial of other secured creditors with priority--as was true here.”    The Court also found reliance notwithstanding the Debtor’s argument that the bank could have investigated the statements.
This court will not impose on banking officials this requirement. Under all of these circumstances and the customary practice of lending institutions, it is necessary for them to be able to accept what Plaintiff signed as true.
The Court’s ruling with regard to financial statements is probably wrong, although it most likely did not make a difference in the specific case.

In this decision, the en banc Fifth Circuit overruled the Pro-Snax case.  I have previously written about the case here.  

Creditor sought to deny debtors’ discharge.    Husband was liable on debt to bank but wife was not.    Bankruptcy Court denied discharge as to both debtors.   On appeal, the Fifth Circuit held that bank was a creditor of wife and had standing to object to discharge even though she had no personal liability.   The Court concluded that because bank had a “community claim” against the wife by virtue of her interest in community property that it was a creditor and could object to her discharge. 
The Court also held that the Bank could show that the debtors failed to keep sufficient records without seeking discovery from them.   In this case, the Trustee had requested documents from the Debtors which they failed to provide.   Additionally, in connection with their Rule 26 disclosures, the Debtors were required to produce relevant documents.    The failure to provide documents to the Trustee or in connection with the disclosures was sufficient to show failure to keep records under 11 U.S.C. Sec. 727(a)(3).  
The Court’s finding with regard to standing seems surprising.   While the bank was a creditor in a technical sense due to its ability to collect from community property, this hardly seems to be the type of interest sufficient to deny discharge.   In particular, once the wife’s discharge was denied, the bank could not try to collect from her other than out of any community property she might acquire in the future.    This is certainly an argument against couples acquiring community property together.  

This case concerned whether the debtor’s interest in a malpractice claim against his bankruptcy attorney was property of the estate.   The debtor accused his attorney of mishandling his chapter 11 case with the result that confirmation of his plan was denied, the case was converted to chapter 7 and the debtor lost his discharge.   The Fifth Circuit found that at least some of the harm from the attorney’s actions occurred during the chapter 11 proceeding.   As a result, the Court found that all claims against the attorney were property of the estate.

The problem with this case is that it considers all of the different actions which caused harm to constitute a single cause of action rather than multiple claims based upon different omissions and harms.    By holding that even one harm occurring pre-conversion meant that the entire cause of action accrued pre-confirmation, the Court deprived the debtor of claims that should rightly have belonged to him.    The absurdity of the Court’s result is illustrated by the claims that the attorney’s negligence resulted in loss of the discharge.   The estate was not harmed by denial of the debtor’s discharge and the Fifth Circuit has previously held that claims for loss of the discharge belong to the debtor rather than the estate.   Nevertheless, under this opinion, the chapter 7 trustee, who was the same party who sued for denial of the discharge, could now sue the attorney for negligence leading to denial of the discharge.   This is a bizarre result and should be reconsidered.

For another take, you can read what the Weil Blog had to say here.

Disclosure:   I consulted with the Debtor and was designated as an expert witness.

The homeowners sued Bank of America following a foreclosure.   The homeowners had sought to modify their loan under HAMP.    They were initially told that they did not qualify because their loan was not in default.   Subsequently they stopped making the payments and reapplied.   Over the course of three years, they worked on their modification proposal with Bank of America.    Because they were in default, they received periodic default notices.   However, Bank of America agreed to postpone action pending review of their modification proposal.   Eventually the Bank denied the modification and foreclosed.   

The Court of Appeals ruled that the Bank did not waive its right to foreclose by delaying foreclosure multiple times.     They also claimed a violation of the Texas Debt Collection Act, alleging that the Bank had misrepresented that their modification was under review.    The District Court granted summary judgment and the Fifth Circuit affirmed.    Mere delay is not a waiver of the right to foreclose.   A statement with regard to a proposed modification is not a representation about the character, extent or amount of a consumer debt.

This case illustrates how HAMP often causes more harm than good.    On the one hand, the borrower must be in default to apply for the program.   However, the lender has no obligation to grant a modification.   Thus, by defaulting in order to apply for the program, the homeowner places themselves in jeopardy of losing the property.    This is a well-intentioned but terribly designed program.    While chapter 13 has its drawbacks, at least the automatic stay provides some protection to the debtor.

Nicholas and Stacy Barzelis had a home loan with Flagstar Bank.   Nicholas died and Stacy submitted the death certificate to the bank.   Stacy filed chapter 13 and made payments through the trustee.   The bank refused to accept any payments which did not come from Nicholas.   Stacy sent Flagstar two Qualified Written Requests.   The bank stated that it would not provide information to her unless she provided “letters of authority from a probate attorney.” 
When Flagstar began foreclosure proceedings, Stacy sued.    The bank removed the case to federal court.   Stacy amended to allege claims for breach of contract, negligent misrepresentation, violation of the Texas Debt Collection Act and violation of RESPA.   The District Court dismissed all of the state law claims as preempted under the Home Owners Loan Act of 1933 (HOLA) and granted summary judgment on the RESPA claim.

The Fifth Circuit found that the breach of contract claims were preempted to the extent that they relied upon the Texas Property Code, but not to the extent that they relied upon the contractual agreements between the parties.

The Court found that negligent misrepresentation claims based upon inadequacy of disclosures made were preempted by HOLA.

The Court found that the claims under the TDCA were not preempted.   It wrote:
We agree with the consensus, concluding that similar state consumer-protection laws—those “that establish the basic norms that undergird commercial transactions”—do not have more than an incidental effect on lending and thus escape preemption. The essential purpose of the TDCA is to limit coercive and abusive behavior by all those seeking to collect debts, something that does not burden lending in the same way as would a specific mandate on interest rates. Instead, it more closely resembles a generally applicable law against deceptive trade practices, governing behavior at the margins of banking and lending. Additionally, the law is consistent with “the safe and sound operation of federal savings associations.” Section 560.2(a). As a result, the statute overcomes the presumption, and the claims are not preempted under HOLA.
Opinion, pp. 8-9.

 The Court also reversed the summary judgment under RESPA.   The District Court had found that Flagstar was not required to respond because Stacy was not the borrower and had not provided proof that she was acting as representative of her husband’s estate.   However, the Fifth Circuit found that “under Texas law, Stacy, as the survivor to her husband’s interest in the property subject to their community debt, was the successor-debtor on the Note and was the legal borrower.”   As a result, Flagstar was required to respond to her QWR.

This is a rare case in the Court did not affirm dismissal of the borrower’s claims against a home lender.  As a result, it is worth reading.

The homeowners contended that the statute of limitations barred a foreclosure.    The Bank accelerated the debt in 2004.    However, it accepted payments from the homeowners in 2006.   It accelerated for a second time in 2010 and foreclosed in 2013.   The Court held that the Bank abandoned its acceleration when it subsequently accepted payments and that the foreclosure was within the four year statute of limitations. 
This is a rare case interpreting the effect of section 1111(b) in the context of a sale.    Baker Hughes and other creditors filed an involuntary petition against the debtor.   The case was converted to chapter 11.   Scott Oils filed a plan of reorganization which allowed it to purchase 90 mineral leases and several wells for $3.4 million.   Baker Hughes claimed liens on four of the leases and one of the wells.   Four other creditors had mineral liens in the same well.
Baker Hughes attempted to make a section 1111(b) election in order to treat its claim as fully secured.   Baker Hughes did not object to confirmation, appear at the confirmation hearing or appeal the confirmation order.   Apparently the sale occurred subsequent to confirmation and Baker Hughes appealed the sale order.
Baker Hughes contended that it was entitled to submit a credit bid on the properties in which it claimed a lien and that by virtue of the section 1111(b) election, it could treat its claim as fully secured.    The Fifth Circuit found that a section 1111(b) election was not available on a sale pursuant to a plan.   Additionally, the plan provided that the right to credit bid was preserved but Baker Hughes failed to show that it actually submitted a credit bid.
Judge Edith Jones submitted a concurrence to address the unusual position of Baker Hughes.   Judge Jones found that Baker Hughes waived its section 1111(b) election by failing to pursue it at the confirmation hearing.    She concurred to question the majority’s conclusion that the plan had actually preserved the right to credit bid.    She questioned whether a private bulk sale of assets burdened by multiple liens could actually protect a secured creditor’s right to credit bid regardless of whether the orders said that it did.   She went further and stated that a creditor would be entitled to make a section 1111(b) election even though the property was being sold pursuant to a plan if the sales procedures did not preserve the right to credit bid.   However, because the creditor did not pursue its section 1111(b) election at confirmation, it lost the right to protest.   Additionally, Judge Jones noted that given the other liens on the property, the creditor would have been required to satisfy the other lienholders to make a credit bid which would have rendered it impractical.  
The bottom line seems to be that Judge Jones believes that a sale pursuant to a plan which does not expressly provide for a credit bid could be subject to a section 1111(b) election.   In this case, failure to pursue the right argument at the right time waived it.   Otherwise, it could have been an interesting mess.
This is the almost a Ponzi scheme case.   Templeton invested in partnerships organized by American Housing Foundation (AHF).  The trustee sought to equitably subordinate his claims, to recover voidable preferences and to recover fraudulent transfers.    The Bankruptcy Court granted equitable subordination and preference recovery but denied the fraudulent transfer claim.   Both parties cross-appealed.
The Fifth Circuit affirmed the equitable subordination ruling.    It found that Templeton’s claims arose from the purchase of securities of AHF’s affiliates and were subject to equitable subordination.
The Bankruptcy Court rejected Templeton’s ordinary course defense on the basis that AHF was a Ponzi scheme and that payments from a Ponzi scheme are not in the ordinary course of business. 

However, the Court found that AHF was not a Ponzi scheme.   Although it engaged in some fraudulent and Ponzi-like transactions, it “engaged in substantial legitimate business.”    The Court ruled that it was improper to expand the rule against treating Ponzi scheme distributions as not in the ordinary course “to cover legitimate businesses in which there were some fraudulent or Ponzi-like transactions.”     As a result, it reversed and remanded for the Court to consider Templeton’s defense.
On the other hand, the Bankruptcy Court rejected the fraudulent transfer allegations on the basis that Templeton gave value and acted in good faith under 11 U.S.C. Sec. 548(c).    The Court found that the Bankruptcy Court’s findings on value were insufficient because they did not show that AHF appropriated Templeton’s investments in the limited partnerships.   It also found that the Bankruptcy Court applied the wrong test in determining whether Templeton acted in good faith.   The Bankruptcy Court found that Templeton acted in good faith because his transactions did not defraud other creditors.   However, this was the wrong standard.   Instead, the test is whether the claimant was “on notice of the debtor’s insolvency or the fraudulent nature of the transaction.”
As a result, the Fifth Circuit affirmed the equitable subordination but remanded the other claims for further consideration.
Jett sued American home Mortgage Servicing for negligently and willfully failing to update her credit information.    Jett became delinquent on her home mortgage and filed for chapter 13 relief.  After she completed her plan, her credit report “erroneously showed the mortgage as discharged in bankruptcy with a $0 balance.”    Jett disputed the listing and Experian sent an automatic credit dispute verification form to American Home.    American Home attempted to reply back that the loan was current with a balance of $35,000.    However, her credit report was not updated over a period of two and a half years.    
Jett sued claiming that she was denied refinancing because American Home failed to update her credit.   Apparently American Home left a field on the form blank which signaled that Experian should continue to report the original information.   The District Court granted summary judgment on Jett’s claims finding that she had not produced evidence as to American Home’s policies and procedures and that therefore she had failed to show that American Home knew that it was supposed to conform to those policies. 
The Fair Credit Reporting Act creates a private cause of action for both negligent and willful reporting of erroneous information.    The Court found that “regardless of the policies and procedures used to investigate the dispute, the plain language of (FCRA) makes clear that a furnisher is liable if it negligently reports the results of its investigation to the CRA.”   Thus, the fact that American Home knew that the credit was being erroneously reported and failed to correct it was sufficient to create a fact issue for purposes of summary judgment.
This was the companion case to Cantu v. Schmidt.   It involved malpractice claims against the debtor’s accountant, who was the husband of the attorney sued in the other case.   The Court found that all of the injuries occurred prior to conversion and that the creditor body was damaged.   As a result, it found that the claims belonged to the estate.
This is an important dischargeability case.   I have recently written about it in depth here.
This case involved a suit brought against a chapter 7 trustee.    (This is the third of three cases involving Michael B. Schmidt discussed in this post.   He prevailed in all three cases).   BFG Investments, Inc. filed bankruptcy and Schmidt was appointed as Trustee.    His final report was approved in 2009 and no appeal was taken.   Four years later, BFG and its president filed suit in U.S. District Court against Schmidt alleging gross negligence and breach of fiduciary duty.   The District Court dismissed the suit because the plaintiffs had failed to obtain leave from the Bankruptcy Court before filing suit against the Trustee.
The Supreme Court has held that “before suit is brought against a receiver leave of the court by which he was appointed must be obtained.”   Barton v. Barbour, 104 U.S. 126, 128 (1881).   This principle applies to bankruptcy trustees as well. 
The Plaintiffs argued that Stern v. Marshall created an exception to this rule because the Bankruptcy Court would lack authority to enter a final judgment.    Based on Executive Benefits Insurance Agency v. Arkison, the Court found that Stern does not “decide how bankruptcy or district courts should proceed when a ‘Stern’ claim is identified.”    It went on to state that:
We are not called upon in this case to provide all the details regarding how a party should, post-Stern, proceed under Barton. We hold only that a party must continue to file with the relevant bankruptcy court for permission to proceed with a claim against the trustee. If a bankruptcy court concludes that the claim against a trustee is one that the court would not itself be able to resolve under Stern, that court can make the initial decision on the procedure to follow. Once a bankruptcy court makes such a determination, this court can review the utilized procedure.
 Opinion, p. 4. 
The Court also rejected the argument that Barton is satisfied by filing suit in the District Court.
Thus, it seems clear that a suit against a trustee must originate in the Bankruptcy Court.

Those are all of the cases that I could find for April and May 2015.   I am exhausted.   How about you?

Tuesday, June 02, 2015

Supreme Court Extends Dewsnup But Suggests They Really Don't Care for the Decision

The Supreme Court extended the holding of Dewsnup v. Timm, 502 U.S. 410 (1992) to a fully unsecured junior lien in a chapter 7 case.    However, the Court suggested in a footnote that they are ready to reconsider the underlying precedent.    This suggests that the Petitioners may have lost because they were not bold enough in challenging Dewsnup.   Bank of America v. Caulkett, No. 13-1421 (6/1/15). 

What Happened

Both debtors in these consolidated cases owned a home with a senior mortgage and a fully unsecured second mortgage.   They each filed chapter 7 and tried to strip off the junior mortgage under 11 U.S.C. Sec. 502(d).    In each case, the Bankruptcy Court, the District Court and the Eleventh Circuit approved the "strip off" of the junior liens with the result that they were voided.   The Eleventh Circuit decisions were unreported, which suggests that the Court of Appeals did not find them remarkable.  The Supreme Court granted cert but did not mention a conflict in circuits.   

The Ruling

In a 9-0 decision written by Justice Thomas, the Supreme Court reversed the Eleventh Circuit, finding that the result was compelled by Dewsnup v. Timm.    Under 11 U.S.C. Sec. 506(d), a lien that secures a claim against the debtor that is not an "allowed secured claim" is void.   The Court suggested that the debtors' argument made sense under the statutory language.
The Code suggests that the Bank’s claims are not secured.  Section 506(a)(1) provides that “[a]n allowed claim of a creditor secured by a lien on property . . . is a secured claim to the extent of the value of such creditor’s interest in . . . such property,” and “an unsecured claim to the extent that the value of such creditor’s interest . . . is less than the amount of such allowed claim.” (Emphasis added.)In other words, if the value of a creditor’s interest in the property is zero—as is the case here—his claim cannot be a “secured claim” within the meaning of §506(a). And given that these identical words are later used in the same section of the same Act—§506(d)—one would think this“presents a classic case for application of the normal rule of statutory construction that identical words used indifferent parts of the same act are intended to have the same meaning.” (citation omitted). Under that straightforward reading of the statute, the debtors would be able to void the Bank’s claims. (emphasis added).  
Opinion, p. 3.   While seeming to help the debtors, the Court quickly followed with the statement that:
Unfortunately for the debtors, this Court has already adopted a construction of the term “secured claim” in §506(d) that forecloses this textual analysis.
Id.     Showing some disdain for its own precedent, the Court explained Dewsnup as follows:
Rather than apply the statutory definition of “secured claim” in §506(a), the Court reasoned that the term “secured” in §506(d) contained an ambiguity because the self-interested parties before it disagreed over the term’s meaning. (citation omitted). Relying on policy considerations and its understanding of pre-Code practice, the Court concluded that if a claim “has been ‘allowed’ pursuant to §502 of the Code and is secured by a lien with recourse to the underlying collateral, it does not come within the scope of §506(d).” (citation omitted). It therefore held that the debtor could not strip down the creditors’ lien to the value of the property under §506(d) “because [the creditors’] claim [wa]s secured by a lien and ha[d] been fully allowed pursuant to §502.” (citation omitted).   In other words, Dewsnup defined the term “secured claim” in §506(d) to mean a claim supported by a security interest in property, regardless of whether the value of that property would be sufficient to cover the claim. Under this definition, §506(d)’s function is reduced to “voiding a lien whenever a claim secured by the lien itself has not been allowed.”
Opinion, p. 4.    Relying on Dewsnup, the Court found that:
Because the Bank’s claims here are both secured by liens and allowed under §502, they cannot be voided under the definition given to the term “allowed secured claim” by Dewsnup.
Id.    The court rejected several arguments as to why Dewsnup could be limited without being overruled.    Among other things, it found that it made little sense to treat a claim secured by $1 of value differently than a claim which was completely underwater.   While the Court noted that there are some instances where a dollar makes a difference, such as under the means test, there was nothing to indicate that underwater mortgages should be treated differently than completely unsecured ones.

Dewsnup Is Not Dead Yet But It's Not Very Healthy

Probably the most interesting part of the opinion is its lone footnote.   The footnote does not even have a number.   It is simply indicated by a cross.   After stating that the debtors did not ask the Court to overrule Dewsnup, Justice Thomas wrote:
†From its inception, Dewsnup v. Timm, 502 U. S. 410 (1992), has been the target of criticism. See, e.g., id., at 420–436 (SCALIA, J., dissenting); In re Woolsey, 696 F. 3d 1266, 1273–1274, 1278 (CA10 2012); In re Dever, 164 B. R. 132, 138, 145 (Bkrtcy. Ct. CD Cal. 1994);Carlson, Bifurcation of Undersecured Claims in Bankruptcy, 70 Am. Bankr. L. J. 1, 12–20 (1996); Ponoroff & Knippenberg, The Immovable Object Versus the Irresistible Force: Rethinking the Relationship Between Secured Credit and Bankruptcy Policy, 95 Mich. L. Rev. 2234,2305–2307 (1997); see also Bank of America Nat. Trust and Sav. Assn. v. 203 North LaSalle Street Partnership, 526 U. S. 434, 463, and n. 3 (1999) (THOMAS, J., concurring in judgment) (collecting cases and observing that “[t]he methodological confusion created by Dewsnup has enshrouded both the Courts of Appeals and . . . Bankruptcy Courts”). Despite this criticism, the debtors have repeatedly insisted that they are not asking us to overrule Dewsnup.
Justices Kennedy, Breyer and Sotomayor expressly joined in all of the opinion except for the footnote.

This opinion reminds me of the He Is Not Dead Yet song in Spamalot.   In this opinion, the Justices are saying that Dewsnup is not dead yet.   However, like the person dragging the still protesting man out to the dead body collector, they seem willing to give it a whack and speed it on its way.    Given the pointed comments made about Dewsnup in this opinion, it appears that there may be as many as six justices who are willing to kick it to the curb if given the opportunity.

Thursday, May 28, 2015

Fifth Circuit Narrows Fraud Dischargeability Claims

Rejecting a Seventh Circuit precedent, the Fifth Circuit has ruled that a non-dischargeability claim under section 523(a)(2)(A) must be based upon a false representation.    While bad conduct that does not involve a misrepresentation may be actionable under other sections of the Code, it will not constitute actual fraud under Sec. 523(a)(2)(A).   Husky International Electronics, Incorporated v. Ritz (Matter of Ritz), No. 14-20526 (5th Cir. 5/22/15).  

What Happened

Over the course of four years, Husky sold electronic components to Chrysalis Manufacturing Corp.     Chrysalis failed to pay for $163,999.38 in product.    Ritz controlled the finances of Chrysalis and was a director and 30% shareholder.  At the same time that Chrysalis was failing to pay Husky, it paid out over a million dollars to entities controlled by Ritz.   These transfers were made without reasonably equivalent consideration while Chrysalis was insolvent.

Although Ritz had not guaranteed the debt, Husky sued him in an attempt to pierce the corporate veil.  Ritz filed bankruptcy before the case could go to trial.  Husky brought a dischargeability complaint under sections 523(a)(2) and (a)(6) based on the fraudulent transfers.     

When the case went to trial, the Bankruptcy Court found that Ritz was not a credible witness.   Nevertheless, it found that Husky had failed to prove that Ritz had perpetrated an actual fraud in order to pierce the corporate veil.  It also found that because Ritz had not made a false representation to Husky that there was not a valid claim under section 523(a)(2) and that Husky had failed to prove up its claim for willful and malicious injury under section 523(a)(6).

On appeal, the District Court found that Husky had proven actual fraud under the Texas Business Organizations Code so that Husky had a claim against Ritz, but that it had not established either ground for non-dischargeability.    

In an opinion written by Judge Carolyn King, the Fifth Circuit ruled that lack of a representation doomed the fraud claim and that proving fraudulent transfers without more did not satisfy the requirements for a willful and malicious injury.

The Ruling

Most of the opinion was devoted to whether "actual fraud" under section 523(a)(2)(A) required a representation.    McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000) had held that actual fraud was broader than false representations and encompassed the full spectrum of conduct by which men may take advantage of one another.    The Court rejected this reasoning on multiple grounds.   

Judge King relied heavily on the reasoning of Field v. Mans, 516 U.S. 59 (1995).    Field was based on how the term actual fraud was interpreted under the common law in effect when the term was added to the Code in 1978.  It cited  the Restatement (Second) of Torts and Prosser on Torts to establish that justifiable reliance was the appropriate standard of intent to establish actual fraud.    The same authorities defined actual fraud as based on a misrepresentation.    The Supreme Court also "appeared to assume" that a false representation was part of the cause of action.    While nondischargeable fraud claims are based on the common law, the law of fraudulent transfer is a creature of statute.   

Multiple Fifth Circuit decisions have defined fraud under section 523(a)(2) as involving a a false representation,  e.g., Matter of Acosta, 406 F.3d 367 (5th Cir. 2005).   No Fifth Circuit case had expanded section 523(a)(2) beyond a representation and no other circuit had followed McClellan.

The Court rejected application of the canon of statutory construction that every word in a statute should be given effect.    The Court noted that canons of construction are used to help determine Congressional intent, "not to lead courts to interpret the law contrary to that intent."    The Court cited a treatise by Justice Scalia and Bryan Garner which pointed out that the canon against surplusage cannot always be dispositive because it is not invariably true.   In other words, sometimes words in a statute really are duplicative of each other.    In this case, the Court found that the term "actual fraud" was intended to reflect the common law and referred to "actual or positive fraud rather than fraud implied by law."     

As an additional ground, the Court found that transfers made with intent to hinder, delay or defraud a creditor were actionable under section 727(a)(2)(A).  Judge King stated that ""(i)t would appear odd at the very least for Congress to have intended that the 'actual fraud' provision cover fraudulent transfers when there is another provision directly addressing such transfers."

As the final brick in her statutory construction, Judge King relied upon the rule that exceptions to discharge be construed in favor of debtors.

Thus, fraudulent transfers unaccompanied by false representations cannot constitute actual fraud under section 523(a)(2)(A).

The Court also affirmed denial of the claim under section 523(a)(6).    The Court based its ruling on the Supreme Court holding in Kawaahua v. Geiger, 523 U.S. 57 (1998) that willful and malicious injury requires more than an intentional action which results in harm.   There must be either subjective intent to harm or a substantial objective certainty of harm.   Because the creditor apparently did not prove anything beyond the fact of the fraudulent transfers, it did not meet its burden of proof.

What It Means

This is an important decision because it limits what can be alleged under section 523(a)(2)(A).   Claims which do not allege a false representation can be disposed of under Rule 12(b)(6) without the need for a trial.     Bad acts which do not rely upon a representation must be grounded elsewhere in the Code.   Larceny and embezzlement are nondischargeable under section 523(a)(4).   Conversion is actionable under section 523(a)(6).   Most importantly for this case, transfers of property made with intent to hinder, delay or defraud a creditor may result in denial of discharge under section 727(a)(2)(A).    

Had the creditor sought to deny discharge rather than to determine dischargeablility, it would have been a closer case.   However, in order to have standing to pursue the claim, it would have needed to establish that it was a creditor.   This would have required piercing the corporate veil. The District Court found that Husky could have pierced the corporate veil while the Fifth Circuit declined to reach this question.    

A secondary lesson is that claims under sections 523 and 727 are narrow technical claims.  It is not enough to prove that the debtor did bad things and was not a credible witness.   Proving that the debtor was evasive and slippery is not a substitute for proving up the statutory elements.    

Tuesday, May 26, 2015

Wellness Case Brings Healing for Bankruptcy Court Authority

Resolving an issue left open by two prior decisions, the Supreme Court ruled that the right to entry of a final judgment by an Article III court, like the right to trial by jury, is a personal right which can be waived or consented away (subject to supervision by an Article III Court).    The decision left Chief Justice Roberts, whose broad language in Stern v. Marshall spawned a plethora law review articles, in the minority, while Justice Sotomayor wrote for the six justices in the majority.   Wellness International Network, Ltd. v. Sharif, No. 13-935 (5/26/15).    

The Stern Problem

Article III of the Constitution states that the judicial power is vested in courts created under that Article, which is to say, judges appointed by the President, confirmed by the Senate and enjoying life tenure.    Over the years, Congress created many other judges, such as U.S. Magistrate Judges, Administrative Law Judges and Bankruptcy Judges, to help with the workload of the federal courts.   These judges were not appointed by the President or confirmed by the Senate and did not enjoy life tenure.    While they were under the supervision of Article III Judges, some of these legislatively created judges enjoyed great levels of independence.   

In Stern v. Marshall, 564 U.S. ___, 131 S.Ct. 2594 (2011), the Court said that Congress did not have unlimited power to create adjuncts to assist the Article III judges.   Specifically, the Court said that the Bankruptcy Court did not have the power to enter a final judgment on a state law counterclaim brought by a debtor against a creditor.    Judges, practitioners and academics alike wondered whether the system of independent Article I Bankruptcy Judges could survive this ruling.    This uncertainty was engendered by the narrow scope of the actual issue decided and the sweeping language used by Chief Justice Roberts to support it.   Taken to its fullest extent as suggested by the dissenting justices in that case, it could have meant that Bankruptcy Court's lacked the power to decide anything that could have been decided by courts of law in 1789 and parties lacked the authority to consent to a different result.   

 Life After Stern

The sky did not fall following Stern and the Bankruptcy Courts continued to operate.   However, there was a split of authority as to whether parties could consent to entry of a final judgment by a Bankruptcy Court in a Stern case.    Last year, in Executive Benefits Ins. Agency v. Arkison, 134 S.Ct. 2165 (2014), the Court ducked the consent issue.   Instead, it found that regardless of the Bankruptcy Court's authority to enter a final judgment, it could hear cases within its jurisdiction and submit a report and recommendation to the District Court which could review it on a de novo basis. This was important because the Bankruptcy Court decision was a summary judgment which the District Court was bound to review on a de novo basis in any event.   As a result, even if the Bankruptcy Court lacked authority to enter a final judgment, the District Court's ruling on appeal was the functional equivalent of entry of a final judgment by that court.  

This ruling preserved the ability of Bankruptcy Courts to hear disputes in the first instance.   However, it left open the question of whether Bankruptcy Courts could issue final orders in all matters with consent or by waiver.   The consent issue had enormous practical significance.    If parties could not give valid consent, they could have an advisory trial in the Bankruptcy Court and then request a do-over in the District Court if they didn't like the result.    There was also the possibility (although I am not aware of this actually happening) of a party agreeing to litigate in Bankruptcy Court and ignoring the result on the basis that it had never been approved by the District Court.    

The issue split the circuit courts.   The Fifth, Sixth and Seventh Circuits nixed consent while the Ninth Circuit permitted it.   Today's decision resolved that split and established that parties can consent to entry of a final judgment by a Bankruptcy Judge.   The decision also acknowledges the practical reality that without legislatively created courts, "the work of the federal court system would grind nearly to a halt."   Opinion, p. 2.   In a footnote, the Court noted that the 349 Bankruptcy Judges hear twice as many cases as all of the District and Circuit judges combined.    

What Happened

Sharif was a distributor for Wellness International Network, a manufacturer of health and nutrition products.    Sharif sued Wellness but wound up owing $650,000 in attorneys' fees after he failed to comply with discovery and other litigation obligations.    When Sharif filed bankruptcy, Wellness wanted to know about the $5 million in assets he had listed on a loan application in 2002.   Sharif glibly admitted that he had lied about owning the assets and said that they really belonged to a trust which he administered for his mother and sister.    

Wellness filed an adversary proceeding against Sharif seeking to deny his discharge and establish that the trust was an alter ego.   Sharif answered and conceded that these claims were core proceedings.   Once again, Sharif failed to provide responsive discovery answers.   As a result, the Bankruptcy Court entered default judgment against him and denied his discharge.   The Bankruptcy Court also found that the trust was his alter ego because the Debtor "treats [the Trust's] assets as his own property."    

Sharif appealed to the District Court.   While his case was pending, the Stern decision came out.   He asked to supplement his briefing to assert that the District Court should treat the Bankruptcy Court's ruling as a report and recommendation.   The District Court denied the request for additional briefing as untimely and affirmed the Bankruptcy Court.

The Seventh Circuit affirmed in part and reversed in part.  It upheld denial of the discharge as something that the Bankruptcy Court had the authority to grant.   However, it reversed the ruling on the alter ego claim.   It held that not only did the Bankruptcy Court lack authority to enter a final judgment, but that it might have lacked authority to even hear the case in the first place.   (The latter ruling was based on the fact that 28 U.S.C. Sec. 157 did not authorize Bankruptcy Courts to issue reports and recommendations in core proceedings.   In Executive Benefits, the Supreme Court clarified that Bankruptcy Courts could issue a report and recommendation in any case in which it could not issue a final judgment, thereby eliminating the so-called statutory gap).

The Majority Ruling

Justice Sotomayor began her discussion of consent by stating, "(a)djudication by consent is nothing new."    Opinion, p. 8.    After discussing cases, the Court held that the right to an Article III tribunal is both a personal one which may be waived and a structural one that must be respected.  Justice Sotomayor wrote:
The entitlement to an Article III adjudicator is “a personal right” and thus ordinarily “subject to waiver,” (citation omitted). Article III also serves a structural purpose, “barring congressional attempts ‘to transfer jurisdiction [to non-Article III tribunals] for the purpose of emasculating’ constitutional courts and thereby prevent[ing] ‘the encroachment or aggrandizement of one branch at the expense of the other.’” Id., at 850 (citations omitted). But allowing Article I adjudicators to decide claims submitted to them by consent does not offend the separation of powers so long as Article III courts retain supervisory authority over the process.
Opinion, pp. 11-12.    In reaching this formulation, Justice Sotomayor resolved a question which had been dividing commentators for years:   was the right to an Article III Court personal and thus waivable or was it structural and therefore immutable?   Although the Court answered "both," it did so in a way that set a low bar for satisfying the structural concerns of the Constitution.   So long as the Article III judiciary retained "supervisory authority" over the legislatively created courts, separation of powers was not violated.    Stated another way, Congress can create judicial helpers for the Article III Courts but cannot create an entire independent system out of whole cloth.

Under this standard, it is clear that Bankruptcy Courts are under the supervisory authority of the Article III Courts.   Bankruptcy Judges are appointed by Article III judges and may be removed by them.   They are a unit of the District Court and enjoy their authority by virtue of an order of reference from the District Courts.   The District Courts also have the power to withdraw that reference.   Indeed, if a District Court wished to do so, it could revoke the order of reference completely and decide all bankruptcy matters.    Decisions of Bankruptcy Courts are reviewed by either the District Courts or by Bankruptcy Appellate Panels (with consent).   However, Bankruptcy Appellate Panels only exist if created by the Court of Appeals.   

The Court further noted that the Bankruptcy Courts do not possess "free-floating authority to decide claims traditionally heard by the Article III Courts" but instead may hear "a narrow class of common law claims" which are incidental to their primary bankruptcy powers.   Finally, the Court noted that Bankruptcy Courts were not created by Congress "to aggrandize itself or humble the Judiciary."   Instead, the Court noted the practical benefit to the Article III Judiciary from having Bankruptcy Courts:
Congress could choose to rest the full share of the Judiciary’s labor on the shoulders of Article III judges. But doing so would require a substantial increase in the number of district judgeships. Instead, Congress has supplemented the capacity of district courts through the able  assistance of bankruptcy judges. So long as those judges are subject to control by the Article III courts, their work poses no threat to the separation of powers.
Opinion, pp. 14-15.    

Having ruled that consent was possible, the Court ruled that it need not be express. 
Nothing in the Constitution requires that consent to adjudication by a bankruptcy court be express. Nor does the relevant statute . . . mandate express consent; it states only that a bankruptcy court must obtain“the consent”—consent simpliciter—“of all parties to the proceeding” before hearing and determining a non-core claim.
Opinion, p. 18.    

Thus, the Court remanded the case to the Seventh Circuit to decide the question of whether consent had indeed been given.    

The majority opinion was joined in by Justices Kennedy, Ginsberg, Breyer and Kagan. Justice Alito concurred in the judgment with the demurrer that he would not have reached the issue of whether consent could be implied.   

The Chief Justice and Justices Scalia and Thomas dissented.

The Dissents

At thirty-nine pages, the dissents are nearly twice as long as the majority opinion.    The dissenting justices (each of whom was in the majority in Stern) did not agree that supervisory authority satisfied separation of powers.   The Chief Justice expressed his preference that the Court would have once more avoided deciding the consent issue.   He warned that by deciding the larger issue, the Court was descending a slippery slope.
By reserving the judicial power to judges with life tenure and salary protection, Article III constitutes “an inseparable element of the constitutional system of checks and balances”—a structural safeguard that must “be jealously guarded.”(citation omitted).

Today the Court lets down its guard. Despite our precedent directing that “parties cannot by consent cure” an Article III violation implicating the structural separation of powers, (citation omitted), the majority authorizes litigants to do just that. The Court justifies its decision largely on pragmatic grounds. I would not yield so fully to functionalism. The Framers adopted the formal protections of Article III for good reasons, and “the fact that a given law or procedure is efficient, convenient, and useful in facilitating functions of government, standing alone,will not save it if it is contrary to the Constitution.” (citation omitted).

The impact of today’s decision may seem limited, but the Court’s acceptance of an Article III violation is not likely to go unnoticed. The next time Congress takes judicial power from Article III courts, the encroachment may not be so modest—and we will no longer hold the high ground of principle. The majority’s acquiescence in the erosion of our constitutional power sets a precedent that I fear we will regret. I respectfully dissent.
Roberts, C.J., Dissenting, pp. 1-2.    The Chief went on to quote significant amounts of his opinion from Stern.  He effectively established that despite his protestations to the contrary, he never intended for Stern to be a narrow ruling.   Instead, he sought to interpose the Article III Judiciary as a bulwark against Congressional interference in the bankruptcy arena no matter how difficult or impractical this might be.   His dire sermon concluded with an allusion to the Bible.
Ultimately, however, the structural protections of Article III are only as strong as this Court’s will to enforce them. In Madison’s words, the “great security against a gradual concentration of the several powers in the same department consists in giving to those who administer each department the necessary constitutional means and personal motives to resist encroachments of the others.”The Federalist No. 51, at 321–322 (J. Madison). The Court today declines to resist encroachment by the Legislature.  Instead it holds that a single federal judge, for reasons adequate to him, may assign away our hard-won constitutional birthright so long as two private parties agree. I hope I will be wrong about the consequences of this decision for the independence of the Judicial Branch. But for now, another literary passage comes to mind: It profits the Court nothing to give its soul for the whole world . . . but to avoid Stern claims?
 Roberts, C.J., Dissenting, p. 20.    

Justice Thomas complained that both the majority and the Chief Justice had failed to answer the question of "whether a violation of the Constitution has actually occurred."    Justice Thomas does not appear to answer this question either.   Instead, he appears to conclude that the parties did not brief the proper issues and that those issues "merit closer attention by this Court."   As a result, Justice Thomas would have decided the case on the narrow ground of whether an alter ego claim is in fact a Stern claim.  

What It Means

This case has two main impacts:  the practical and the political.    

On a practical level, Wellness has brought healing to the uncertainty wreaked by Stern.   We now have a pretty solid flow chart for knowing what Bankruptcy Courts should do with matters brought before them.
  1. Is there jurisdiction under 28 U.S.C. Sec. 1334?   If yes, proceed to #2.   If no, stop.
  2. Has the District Court withdrawn the reference?  If yes, stop.  If no, proceed to #3.
  3. Must or should the Court abstain?  If yes, stop.   If no, proceed to hear the matter.
  4.  Is the claim one which could have been heard by the courts of law in England in 1789?  If no, proceed to enter a final judgment.  If yes, proceed to #5.
  5. Have the parties consented to entry of a final judgment, either expressly or implicitly?  If yes, proceed to enter a final judgment.   If no, enter a report and recommendation
While I may be oversimplifying this, I think it captures the general idea of where we are today.

On a political level, Justices Breyer, Ginsberg, Sotomayor and Kagan have made the journey from  the dissent in Stern to the majority in Wellness.   They were able to make this transition because Justices Alito and Kennedy changed positions.  While this is rank speculation, it is entirely possible that Justices Alito and Kennedy could see the harm in giving the Bankruptcy Courts unlimited power to rule on state law counterclaims and therefore joined the majority in Stern, but did not want to jeopardize the authority of U.S. Magistrates or other consent-based mechanisms.   If the Chief  had gotten his way, the magistrate system, which operates on referral and consent, could well have fallen.

An older definition of conservative is to conserve, to observe respect for existing institutions.    In his desire to assert the dignity of the Article III Judiciary, the Chief Justice could have torn down decades of smoothly functioning institutions, jeopardizing not only Bankruptcy Judges but Magistrate Judges and possibly arbitrators as well.    Thus, Justices Alito and Kennedy could have joined both majorities out of a sense of conservatism.