Southern District Judge Gets Judicial Estoppel Right

Judicial estoppel is intended to protect the integrity of the bankruptcy system by encouraging parties to play straight with the court. Parties who successfully convince the court to take one position can not come back later with an inconsistent position. While the doctrine is intended to preserve the integrity of the court, it is frequently used by litigants as a get out of court free card. In a recent opinion by Judge Wesley Steen of the Southern District (and current president of the American Bankrutpcy Institute), the court declined to enforce judicial estoppel against the bankruptcy trustee based on the debtor's failure to disclose an asset.

A Common Fact Pattern

In James Lewellyn Miller, II (Case No. 04-31214 Bankr. S.D. Tex. 8/7/06), the debtor filed for chapter 7 and failed to disclose a cause of action against Merck relating to the drug Vioxx. The Trustee issued a no asset notice after the creditors' meeting. Subsequently, the debtor remembered that he had a claim and filed suit in state court. The vigilant trustee, upon learning that his asset was being hijacked by the debtor, asked the court to re-open the case. Merck did not want to be sued, so it asked Judge Steen to reconsider his order re-opening the case. Merck argued that it would be futile to re-open the case because judicial estoppel would prevent the trustee from pursuing the case. Thus, while this was ostensibly about whether to re-open a case, the underlying issue was whether judicial estoppel would apply. However, it was not Merck's day.

Standing?

First, Judge Steen questioned whether Merck even had standing to question the re-opening. Judge Steen pointed out that Merck was not a creditor and had not participated in the case prior to it being closed originally. He rejected the notion that being sued gave Merck standing.

"The Court understands that Merck is a party to a state court lawsuit. Merck has cited no authority that being a defendant in a lawsuit brought by the Trustee, without more, makes Merck a party in interest that has a right to be heard on bankruptcy case administration. Estates are administered for the benefit of creditors and the debtor(s), not for the benefit of entities who may owe money to the estate.

* * *

"Giving Merck a voice in whether the chapter 7 trustee can sue Merck is a very strange idea, a little like putting the fox in charge of the hen house. The Court sees no authority for that in the Bankruptcy Code. Merck is not a party in interest merely on showing that the Trustee will sue Merck."

Slip op. at 4.

Juducial Estoppel

However, the Court did not stop there. It proceeded to analyze the merits of Merck's judicial estoppel arguments and found them wanting. Thus, Merck got the worst of both worlds. The court rejected its standing to appear in bankruptcy court but also ruled on the merits of the argument that it didn't have standing to make in the first place. (However, as explained later, the Court did limit the extent of its ruling).

There are three elements to judicial estoppel:

1. The party took a clearly inconsistent position.
2. The court accepted that position.
3. The party took the prior position intentionally and not inadvertently.

The Court did not get past the first element in finding that judicial estoppel would not apply, since the Trustee did not take an inconsistent position.

"It is not clear what 'contrary position' Merck asserts as the operative 'contrary position' that might judicially estop the Trustee. Possibly Merck contends that Debtor's failure to list the claim against Merck is a 'contrary position.' If that is Merck's contention, then judicial estoppel might apply to the Debtor. but the party seeking to reopen this bankruptcy case is the Trustee, and the Trustee did not make the statement about which Merck complains. The Trustee did not file the schedules. The Trustee is not judicially estopped from reopening the case by a 'contrary position' taken by the Debtor."

Slip Op. at 6.

The Court rejected Merck's argument that the Debtor and the Trustee were essentially the same party, stating:

"Merck asserts ... that ... the distinction between Debtor and the Trustee is a distinction without a difference. But there is a vast difference between a trustee in a chapter 7 case and a debtor in a chapter 7 case. The trustee acts as representative of creditors. The debtor represents no one but himself."

Slip Op. at 9.

The Court contrasted its case with In re Walker, 323 B.R. 188 (Bankr. S.D. Tex. 2005), an opinion by his colleague Judge Bohm. In Walker, it was the Debtor who sought to reopen the case and the Trustee was nowhere to be found. In that case, the Court was concerned that the Trustee would simply abandon the asset back to the Debtor and noted that the result would likely be different if the Trustee were likely to pursue the claim. In Miller, on the other hand, it was the Trustee who sought to reopen the case and who was already taking steps to pursue the asset.

The Court makes a very important distinction here. The Trustee and the Debtor are different parties who serve different roles. Indeed, in the case of Debtor misconduct or failure to perform his duties, the Trustee is an adverse party to the Debtor. Thus, it is particularly insidious to suggest that the creditors (who are the Trustee's constituency) should be punished for the Debtor's failure to file an accurate set of schedules. This is a case where the integrity of the system demands that the cause of action be disclosed to the Trustee so that it may be pursued for the benefit of the creditor body. To say that judicial estoppel should apply against the Trustee (and by extension the creditors) in order to preserve the integrity of the bankruptcy system is a bit like burning down a village in order to save it.

Judge Steen also addressed the possibility that Merck was contending that the Trustee took an inconsistent position by filing the no-asset report. The Court pointed out that since the Trustee did not know about the lawsuit at the time he filed the no-asset report, it would not count as an intentional inconsistent position so that judicial estoppel would not apply.

After having addressed judicial estoppel at some length, the Court clarified the scope of its ruling. The Court stated that it was merely determining that the Trustee was not judicially estopped from reopening the case and that Merck could assert judicial estoppel in response to a suit brought by the Trustee. While the Court prudentially saved the ultimate issue for another day (and perhaps another court), the logic would seem to apply equally to the merits as to the procedural issue determined here.

Practice Tip

The best way to avoid judicial estoppel claims is to make sure that potential claims and causes of action are properly scheduled in the first place. Of course, the next best thing is to amend the schedules when the issue first arises (and preferably well before any state court action is filed). However, assuming that the issue doesn't surface until way down the road, there is likely to be a race to the courthouse between the debtor-plaintiff and the defendant. If the plaintiff is willing to fall on his sword and surrender the cause of action to the trustee and the trustee is willing to pursue that cause of action for the benefit of the creditors, then judicial estoppel should not apply. The Debtor may still be able to benefit from the Trustee's pursuit of the claim if a portion of the claim is exempt, if there are excess proceeds or if part of the claim arose post-petition and is not property of the estate. On the other hand, if the defendant is able to raise the issue before the debtor realizes that the claim is in peril, then the defendant may prevail. Once the trustee is involved, the defendant would be well served by trying to settle directly with the trustee rather than pursuing a scorched earth policy. If the state court lawsuit is large and the claims in the bankruptcy case are small, then the trustee might be willing to settle for an amount which will pay the claims.