As we reach the end of another year, I have a few cases that I meant to blog about, but never quite found the time. Many of these cases are every bit as important as the ones that I did write about. Here are the best of the rest in capsule form. Maybe I will find time to write some more about them next year.
The National Benevolent Association of the Christian Church vs. Weil, Gotshal & Manges, LLP, No. 05-5134 (Bankr. W.D. Tex. 2/6/07). Debtor sued its former attorneys for actions taken during the bankruptcy case. Judge King ruled that where the Court approved the Debtors' motion to sell property free and clear of liens and approved the Debtors' plan of reorganization, res judicata prevented the Debtors from suing their lawyers based on their successful representation of the Debtors. Additionally, failure to disclose the claims in the disclosure statement barred the claims under the doctrine of judicial estoppel. (Note: Although Weil, Gotshal prepared the disclosure statement which did not disclose the claims against it, the Debtors did have a second law firm which could have insisted that the claims be included).
Mahoney v. Washington Mutual, Inc., No. 06-5187 (Bankr. W.D. Tex. 4/23/07). Judge Clark ruled that reporting debt to credit bureau standing alone did not violate the debtor's discharge. Discharge did not make debt go away. Therefore, creditor could continue to report debt as delinquent despite discharge so long as creditor did not steps to try to collect. Excellent discussion on the relationship between sacrificing goats to Mercury and the discharge.
In re Spillman Development Group, Ltd., No. 05-14415 (Bankr. W.D. Tex. 9/20/07). Two determined parties battle intensely. "The parties were in full combat mode sparing no expense." The secured creditor ultimately purchased the property by exercising a credit bid. Did Debtor's counsel achieve a tangible, identifiable benefit which would allow it to be compensated under Pro-Snax? Judge Monroe said yes, although he reduced the fees in some respects. This opinion has an interesting discussion of how the debtor can achieve a positive benefit while acting in opposition to the wishes of the major creditor. The opinion is also full of Judge Monroe's no-holds barred commentary on the no-holds barred tactics of the litigants.
In re Sanders, No. 07-50783 (Bankr. W.D. Tex. 10/18/07). Debtors purchased a new vehicle but could not afford to pay off the old one. Depending on how you analyze the transaction, the negative equity was either financed as part of the new purchase or paid off with a rebate on the new vehicle. Debtor proposed to cram-down the vehicle even though it was purchased 846 days before bankruptcy (which was less than 910 days) and creditor objected. Judge Clark ruled that where the deficiency from the prior vehicle was included in the amount financed, that the loan did not qualify as a PMSI loan which was protected from cram-down under Sec. 1325(a)(*). Judge Clark ruled that PMSI status was an all or nothing proposition so that the entire debt was subject to cram-down even though the majority of the debt was purchase money in character.
Friday, December 21, 2007
Update on Deductibility of 401k Loan Payments Under Means Test
This blog previously reported on Judge Larry Kelly's decision in In re Otero which allowed payments on 401k loans to be deducted under the chapter 7 means test. http://stevesathersbankruptcynews.blogspot.com/2006_11_01_archive.html. That decision was subsequently reversed on appeal by the U.S. District Court. McVay vs. Otero, 371 B.R. 190 (W.D. Tex. 4/26/07). The District Court looked at the same language as Judge Kelly and concluded that a loan against a 401k plan was NOT a debt, so that it could not be a secured debt deductible under the means test. In making this ruling,the District Court followed the majority position.
The Debtors did not further appeal the District Court ruling. Instead,they converted to Chapter 13 and proposed a plan which allowed them to deduct the 401k payments from disposable income. The Debtor's plan was confirmed on November 19, 2007. Under the confirmed plan, the Debtors will pay $99 a month for 36 months and unsecured creditors will receive approximately 3% on their claims. Thus, while the U.S. Trustee was successful in its legal argument, the practical effect to creditors in the specific case appears to be negligible.
This is a subject which merits further discussion. The majority position followed by the District Court seems to be inconsistent with the treatment of 401k loans elsewhere under BAPCPA. Under Sec. 523(a)(18), a debt owed to a 401k plan is not dischargeable. Similarly, Sec. 362(b)(19) has an exception to the automatic stay relating to a "loan" from a tax qualified retirement plan. If Congress considered a loan owed to a 401k plan to be a "debt" for purposes of Sec. 523(a)(18) and created an exception for payments on a "loan" under Sec. 362(b)(19), why would payments owed to a tax qualified retirement plan not be considered to be debts under the means test? This seems to be a case where the majority has the weaker side of the argument.
The Debtors did not further appeal the District Court ruling. Instead,they converted to Chapter 13 and proposed a plan which allowed them to deduct the 401k payments from disposable income. The Debtor's plan was confirmed on November 19, 2007. Under the confirmed plan, the Debtors will pay $99 a month for 36 months and unsecured creditors will receive approximately 3% on their claims. Thus, while the U.S. Trustee was successful in its legal argument, the practical effect to creditors in the specific case appears to be negligible.
This is a subject which merits further discussion. The majority position followed by the District Court seems to be inconsistent with the treatment of 401k loans elsewhere under BAPCPA. Under Sec. 523(a)(18), a debt owed to a 401k plan is not dischargeable. Similarly, Sec. 362(b)(19) has an exception to the automatic stay relating to a "loan" from a tax qualified retirement plan. If Congress considered a loan owed to a 401k plan to be a "debt" for purposes of Sec. 523(a)(18) and created an exception for payments on a "loan" under Sec. 362(b)(19), why would payments owed to a tax qualified retirement plan not be considered to be debts under the means test? This seems to be a case where the majority has the weaker side of the argument.
Gadzooks Update
This blog previously reported on an opinion by Judge Harlin Hale of the Northern District of Texas which limited the effect of the Fifth Circuit's opinion in Matter of Pro-Snax Distributors, Inc., 157 F.3d 414 (5th Cir. 1998). http://stevesathersbankruptcynews.blogspot.com/2006_10_01_archive.html. U.S. District Judge Jane Boyle has now reversed the Bankruptcy Court opinion. William Kaye vs. Hughes & Luce, LLP, No. 3:06-CV-01863-B (N.D. Tex. 7/13/07).
Judge Boyle found that although the Fifth Circuit's Pro-Snax discussion of the correct standard to apply in awarding attorney's fees under Sec. 330 was dicta, that it was judicial dicta rather than obiter dicta. Judical dicta is defined as an opinion on an issue which was directly briefed and argued by the parties, but which was not essential to the decision. Judge Boyle found that judicial dicta should not be lightly disregarded. The Court also questioned whether the Circuit's instructions on the test to be applied on remand was really dicta at all.
The District Court engaged in a curious discussion of whether Pro-Snax was inconsistent with the language of Sec. 330. On the one hand, the District Court noted that it was bound to apply Pro-Snax regardless of whether it was correct. It also noted that many courts had disagreed with its logic. It then engaged in a rather tortured analysis of how Pro-Snax could be reconciled with the language of Sec. 330. Thus, the District Court fulfilled its obligation to follow binding precedent and did so with a straight face.
Finally, the District Court rejected the Bankruptcy Court's attempt to limit Pro-Snax to its original context of awarding fees to debtor's counsel. The District Court found that the language of Sec. 330 did not distinguish between different types of professionals.
The District Court ruling has been appealed to the Fifth Circuit. This may set the stage for the en banc Fifth Circuit to reconsider Pro-Snax.
Judge Boyle found that although the Fifth Circuit's Pro-Snax discussion of the correct standard to apply in awarding attorney's fees under Sec. 330 was dicta, that it was judicial dicta rather than obiter dicta. Judical dicta is defined as an opinion on an issue which was directly briefed and argued by the parties, but which was not essential to the decision. Judge Boyle found that judicial dicta should not be lightly disregarded. The Court also questioned whether the Circuit's instructions on the test to be applied on remand was really dicta at all.
The District Court engaged in a curious discussion of whether Pro-Snax was inconsistent with the language of Sec. 330. On the one hand, the District Court noted that it was bound to apply Pro-Snax regardless of whether it was correct. It also noted that many courts had disagreed with its logic. It then engaged in a rather tortured analysis of how Pro-Snax could be reconciled with the language of Sec. 330. Thus, the District Court fulfilled its obligation to follow binding precedent and did so with a straight face.
Finally, the District Court rejected the Bankruptcy Court's attempt to limit Pro-Snax to its original context of awarding fees to debtor's counsel. The District Court found that the language of Sec. 330 did not distinguish between different types of professionals.
The District Court ruling has been appealed to the Fifth Circuit. This may set the stage for the en banc Fifth Circuit to reconsider Pro-Snax.
Thursday, December 20, 2007
Dallas Judge Investigates Mortgage Rescue Scam; Urges Debtor's Bar to Warn Clients
Dallas Judge Stacey Jernigan recently issued an opinion concerning a mortgage protection scheme which the court found to prey upon both desperate debtors and mortgage lenders seeking to protect their legal rights. In re Michael White, No. 06-32324 (Bankr. N.D. Tex. 12/7/07). The Court ultimately concluded that the debtors were naive victims of a shady operation designed to fraudulently delay enforcement of mortgage liens. In addition to ordering the perpetrators to appear and show cause, the Court made a referral for a possible bankruptcy crime violation and urged the consumer debtor's bar to warn their clients about similar schemes.
Desperate Debtors
The debtors in this case filed chapter 13 to save their homestead. Unfortunately, they were not able to make the post-petition payments required. This led to an order conditioning the stay, which the debtors defaulted upon as well. With the stay lifted, the stage was set for the debtors to receive a barrage of solicitations (eight to twelve per day) from "foreclosure specialists" offering to legally save the house. The debtors responded to one of these offers from an operation calling itself "North American Foreclosure." According to North American Foreclosure, the debtors could delay foreclosure for years if they were to deed a 1% interest in their home to a company which would file bankruptcy and invoke a new automatic stay. In return for this service, the debtors would pay $650 per month to buy back the interest they had deeded over for as long as they needed the service. North American Foreclosure assured the debtors that everything was legitimate because: (a) the document transferring the 1% interest would be notarized; and (b) the transaction would be disclosed to the new bankruptcy court.
Although North American Foreclosure was apparently located in California, they arranged for a local agent named David Curtis, whose business card identified him as working for Jireh Capital Services, LLC to visit the debtor's home. This local agent had the debtors sign several contracts which required that payment be made in cash only. The Debtors were then given a backdated deed to sign. The deed was executed in the name of "C**** C****" who the debtors were assured was an agent of the company. On the eve of foreclosure, the mortage company's servicer received an anonymous fax containing a copy of the deed to C**** C**** and a copy of C**** C****'s bankruptcy petition which had been filed in the Central District of California the previous month.
The Lender Shows Good Sense
The mortgage servicer acted with remarkable restraint. As noted by the Court: "In any event, despite the questionable validity and effect of the Warranty Deed document, and despite the mysterious manner of its delivery (from anonymous senders), HomEq did what one might hope any prudent creditor would do: it took no further action with regard to its collection efforts as to the Homestead (i.e., it did not record the substitute trustee's deed reflecting the foreclosure sale that had already occurred earlier in the day) out of concern over the implications of the C**** C**** bankruptcy case and the automatic stay as to her alleged 1% interest." Memorandum Opinion and Order, p. 5.
HomEq's restraint was commendable in that this was not the first time they had received a notice involving conveyance of a fractional interest to a bankruptcy filer. According to HomEq, this was something which happened several times a month. As a result, they filed a Motion Requesting Show Cause Order. The Court ordered that both sets of debtors appear and show cause. The debtors in both the Northern District of Texas and the Central District of California showed remarkably good judgment by cooperating with Judge Jernigan's Show Cause Order. The Texas debtors testified and produced copies of their documents with North American Foreclosure. It turned out that the California debtor had filed a pro se petition and had nothing to do with the scheme. Instead, North American Foreclosure obtained the name of a random pro se debtor who had recently filed bankruptcy in the Central District of California and arranged for the deed to be executed in the name of an innocent third party.
Judge Jernigan accepted the Debtors' testimony. She concluded that, "This court is satisfied that the Whites have been naively duped in this matter and have not themselves knowingly or fraudulently participated in acts that might be described as a bankruptcy crime. (citation omitted). At worst, they appear to be 'bit characters' in a scheme to defraud borrowers and lenders alike who are in the midst of foreclosure proceedings." Memorandum Opinion and Order, p. 13.
A Cottage Industry of Bottom Feeders
Judge Jernigan had much greater concern for the perpetrators of the scheme. In a section of her opinion entitled "A New Cottage Industry of Bottom Feeders: For Every Action (i.e., Foreclosure Crisis) there is an Opposite Reaction (i.e., Folks Trying to Make a Buck)," she detailed other instances in which similar shenanigans had surfaced.
Judge Jernigan ordered North American Foreclosure, LLP (the instigator of the scheme), David Curtis (the local agent who signed the debtors up and took their money) and Jireh Capital Services, LLC (Curtis's company) to appear and show cause why they should not be found to have violated the automatic stay and be held liable for damages. The Court ominously noted that David Curtis might come to regret the fact that he had accepted a check from the debtors (despite the contract's cash only requirement), which created a paper trail.
The Court annulled the automatic stay to allow HomEq to record its substitute trustee's deed. This was more in the nature of a comfort order, since it appears unlikely that there was ever a new automatic stay arising from the C**** C**** bankruptcy.
The Court gave notice to the U.S. Attorney that a possible bankruptcy crime had taken place.
Plea to the Debtor's Bar
Finally, the Court issued a "Plea to the Consumer Debtor Bankruptcy Bar," stating:
"The court urges attorneys representing consumer debtors to warn their clients of the apparent schemes being solicited to debtors such as the Whites. while this court is of teh view in this matter that the Whites were naive 'bit characters' who did not fully understand the consequences of their actions and did not set out to defraud HomEq, this may not always be the case. The Whites have lost $1,300 and have not saved their home. This court suspects other debtors have lost even more. The court hopes that it will become a standard part of consumer debtor representation in this district to warn debtors of the hazards of dealing with some of the non-attorney Bankruptcy Services that are offering the illusion of relief from foreclosure for a steep fee."
Memorandum Opinion and Order, pp. 21-22. So, there you have it. Warn your clients. If something seems to be too easy, it is probably a scam. Also, please tell your clients that if you, as a trained bankruptcy professional cannot help them, that they should not expect that a non-lawyer who sends them a slick brochure and expects to be paid in cash can do any better.
Desperate Debtors
The debtors in this case filed chapter 13 to save their homestead. Unfortunately, they were not able to make the post-petition payments required. This led to an order conditioning the stay, which the debtors defaulted upon as well. With the stay lifted, the stage was set for the debtors to receive a barrage of solicitations (eight to twelve per day) from "foreclosure specialists" offering to legally save the house. The debtors responded to one of these offers from an operation calling itself "North American Foreclosure." According to North American Foreclosure, the debtors could delay foreclosure for years if they were to deed a 1% interest in their home to a company which would file bankruptcy and invoke a new automatic stay. In return for this service, the debtors would pay $650 per month to buy back the interest they had deeded over for as long as they needed the service. North American Foreclosure assured the debtors that everything was legitimate because: (a) the document transferring the 1% interest would be notarized; and (b) the transaction would be disclosed to the new bankruptcy court.
Although North American Foreclosure was apparently located in California, they arranged for a local agent named David Curtis, whose business card identified him as working for Jireh Capital Services, LLC to visit the debtor's home. This local agent had the debtors sign several contracts which required that payment be made in cash only. The Debtors were then given a backdated deed to sign. The deed was executed in the name of "C**** C****" who the debtors were assured was an agent of the company. On the eve of foreclosure, the mortage company's servicer received an anonymous fax containing a copy of the deed to C**** C**** and a copy of C**** C****'s bankruptcy petition which had been filed in the Central District of California the previous month.
The Lender Shows Good Sense
The mortgage servicer acted with remarkable restraint. As noted by the Court: "In any event, despite the questionable validity and effect of the Warranty Deed document, and despite the mysterious manner of its delivery (from anonymous senders), HomEq did what one might hope any prudent creditor would do: it took no further action with regard to its collection efforts as to the Homestead (i.e., it did not record the substitute trustee's deed reflecting the foreclosure sale that had already occurred earlier in the day) out of concern over the implications of the C**** C**** bankruptcy case and the automatic stay as to her alleged 1% interest." Memorandum Opinion and Order, p. 5.
HomEq's restraint was commendable in that this was not the first time they had received a notice involving conveyance of a fractional interest to a bankruptcy filer. According to HomEq, this was something which happened several times a month. As a result, they filed a Motion Requesting Show Cause Order. The Court ordered that both sets of debtors appear and show cause. The debtors in both the Northern District of Texas and the Central District of California showed remarkably good judgment by cooperating with Judge Jernigan's Show Cause Order. The Texas debtors testified and produced copies of their documents with North American Foreclosure. It turned out that the California debtor had filed a pro se petition and had nothing to do with the scheme. Instead, North American Foreclosure obtained the name of a random pro se debtor who had recently filed bankruptcy in the Central District of California and arranged for the deed to be executed in the name of an innocent third party.
Judge Jernigan accepted the Debtors' testimony. She concluded that, "This court is satisfied that the Whites have been naively duped in this matter and have not themselves knowingly or fraudulently participated in acts that might be described as a bankruptcy crime. (citation omitted). At worst, they appear to be 'bit characters' in a scheme to defraud borrowers and lenders alike who are in the midst of foreclosure proceedings." Memorandum Opinion and Order, p. 13.
A Cottage Industry of Bottom Feeders
Judge Jernigan had much greater concern for the perpetrators of the scheme. In a section of her opinion entitled "A New Cottage Industry of Bottom Feeders: For Every Action (i.e., Foreclosure Crisis) there is an Opposite Reaction (i.e., Folks Trying to Make a Buck)," she detailed other instances in which similar shenanigans had surfaced.
Judge Jernigan ordered North American Foreclosure, LLP (the instigator of the scheme), David Curtis (the local agent who signed the debtors up and took their money) and Jireh Capital Services, LLC (Curtis's company) to appear and show cause why they should not be found to have violated the automatic stay and be held liable for damages. The Court ominously noted that David Curtis might come to regret the fact that he had accepted a check from the debtors (despite the contract's cash only requirement), which created a paper trail.
The Court annulled the automatic stay to allow HomEq to record its substitute trustee's deed. This was more in the nature of a comfort order, since it appears unlikely that there was ever a new automatic stay arising from the C**** C**** bankruptcy.
The Court gave notice to the U.S. Attorney that a possible bankruptcy crime had taken place.
Plea to the Debtor's Bar
Finally, the Court issued a "Plea to the Consumer Debtor Bankruptcy Bar," stating:
"The court urges attorneys representing consumer debtors to warn their clients of the apparent schemes being solicited to debtors such as the Whites. while this court is of teh view in this matter that the Whites were naive 'bit characters' who did not fully understand the consequences of their actions and did not set out to defraud HomEq, this may not always be the case. The Whites have lost $1,300 and have not saved their home. This court suspects other debtors have lost even more. The court hopes that it will become a standard part of consumer debtor representation in this district to warn debtors of the hazards of dealing with some of the non-attorney Bankruptcy Services that are offering the illusion of relief from foreclosure for a steep fee."
Memorandum Opinion and Order, pp. 21-22. So, there you have it. Warn your clients. If something seems to be too easy, it is probably a scam. Also, please tell your clients that if you, as a trained bankruptcy professional cannot help them, that they should not expect that a non-lawyer who sends them a slick brochure and expects to be paid in cash can do any better.
Tuesday, November 06, 2007
Pakistani Lawyers Risk Lives for Rule of Law
In Pakistan, thousands of lawyers dressed in black suits and ties took to the street to protest the dissolution of the supreme court and the suspension of the constitution. It is estimated that 500-700 were arrested. "Bush criticizes Musharraf," Austin American Statesman, November 6, 2007, p. A1. Meanwhile, in the United States, 37,000 dissidents gathered (in cyberspace) around a slogan implicitly advocating overthrow of the government ... and set a one-day fundraising record for Republicans. "YouTube video, Guy Fawkes motto help Paul collect $4.2 million in 1 day," Austin American Statesman, November 6, 2007, p. A6.
What do these two stories have in common? The connection is arguably tenuous, but the common link seems to be fear or the lack thereof.
In Pakistan, the president feared the power of an independent judicial branch and the rule of law which it represented. When the Supreme Court questioned his right to seek another term, Gen. Musharraf chose to impose emergency rule. Curiously, the General dissolved the supreme court but left parliament in place. This seems to suggest that a cowed legislative branch is less of a threat to absolute power than an independent judiciary. In a system where the rule of law is subordinate to the rule of power, lawyers are reduced from independent actors to government functionaries. Thus, the lawyers correctly perceived that they were under attack and took to the streets.
The story about Ron Paul's fundraising is not grim. Indeed, it is humorous in its cheekiness. Ron Paul is the Texas Congressman running a longshot campaign for the Republican nomination for president. The Paul campaign organized a one-day internet fundraiser around the slogan "Remember, remember the 5th of November." This is the first line from a poem recalling the attempt by Guy Fawkes to blow up parliament and assasinate King James I. It also featured prominently in the recent movie "V for Vendetta" in which a masked vigilante leads a mob of citizens to overthrow an oppressive British government. Ron Paul and his band of followers fancy themselves as modern day revolutionaries. They oppose most everything government does from social security to the war in Iraq. However, when they openly use the language of revolution to advance their cause, it evokes at best a chuckle or a yawn, but not fear.
While the story about Ron Paul is somewhat silly (and in no way compares to the bravery of the Pakistani lawyers), perhaps it makes a point about what we take for granted. Here, we can talk about overthrowing the government because we allow for the potential of overthrowing the government every four years. We know that on January 20, 2009, President Bush will voluntarily leave the White House. There is a good possibility that he will hand over power to the opposing party. On the other hand, the Pakistani lawyers and judges have no assurance that their constitution will prevail and that Gen. Musharraf will cede power to anyone other than a hand-picked successor.
What do these two stories have in common? The connection is arguably tenuous, but the common link seems to be fear or the lack thereof.
In Pakistan, the president feared the power of an independent judicial branch and the rule of law which it represented. When the Supreme Court questioned his right to seek another term, Gen. Musharraf chose to impose emergency rule. Curiously, the General dissolved the supreme court but left parliament in place. This seems to suggest that a cowed legislative branch is less of a threat to absolute power than an independent judiciary. In a system where the rule of law is subordinate to the rule of power, lawyers are reduced from independent actors to government functionaries. Thus, the lawyers correctly perceived that they were under attack and took to the streets.
The story about Ron Paul's fundraising is not grim. Indeed, it is humorous in its cheekiness. Ron Paul is the Texas Congressman running a longshot campaign for the Republican nomination for president. The Paul campaign organized a one-day internet fundraiser around the slogan "Remember, remember the 5th of November." This is the first line from a poem recalling the attempt by Guy Fawkes to blow up parliament and assasinate King James I. It also featured prominently in the recent movie "V for Vendetta" in which a masked vigilante leads a mob of citizens to overthrow an oppressive British government. Ron Paul and his band of followers fancy themselves as modern day revolutionaries. They oppose most everything government does from social security to the war in Iraq. However, when they openly use the language of revolution to advance their cause, it evokes at best a chuckle or a yawn, but not fear.
While the story about Ron Paul is somewhat silly (and in no way compares to the bravery of the Pakistani lawyers), perhaps it makes a point about what we take for granted. Here, we can talk about overthrowing the government because we allow for the potential of overthrowing the government every four years. We know that on January 20, 2009, President Bush will voluntarily leave the White House. There is a good possibility that he will hand over power to the opposing party. On the other hand, the Pakistani lawyers and judges have no assurance that their constitution will prevail and that Gen. Musharraf will cede power to anyone other than a hand-picked successor.
Wednesday, October 24, 2007
Timely Amended Claim Avoids Usury Penalty
After just sixteen days on the bench, Austin Bankruptcy Judge Craig Gargotta has penned his first opinion. In Ingalls vs. Cunningham, Adv. No. 06-1236 (Bankr. W.D. Tex. 10/16/07), Judge Gargotta considered whether a creditor which filed an arguably usurious claim could take advantage of Texas's usury cure provision when it amended the claim to delete the offending charges. Judge Gargotta concluded that it could.
In this case, the creditor filed an initial claim for $89,280 on November 19, 2005. On April 24, 2007, the Trustee sought to amend an existing adversary proceeding to include a claim for usury. Ten days later, the creditor objected to the motion and filed an amended claim for $32,041.66 which eliminated the offending charges. The parties entered an agreed order which allowed the amendment but preserved the defendant's right to challenge the usury claim.
On defendant's motion to dismiss, the court considered whether the creditor's amended claim was sufficiently timely to constitute an allowable cure under the Texas Finance Code. Texas has two separate usury cure provisions. If the creditor discovers the usury violation, Texas Finance Code Sec. 305.103 allows the creditor to correct the violation within 60 days from "the date the creditor actually discovered the violation" by giving notice to the obligor. A second section, Texas Finance Code Sec. 305.006, applies when the obligor discovers the violation. It requires the obligor to give the creditor 60 days notice prior to filing suit or filing a counterclaim. During the 60 day period, the creditor may correct the violation in the same manner as under Sec. 305.103 (that is, by giving notice to the debtor).
In this case, the court found that Sec. 305.006 applied because this case involved a suit by the debtor's chapter 7 trustee. The court found that the trustee's motion for leave to amend constituted notice to the obligor of the usury violation triggering the 60 day period to cure. The court found that amending the proof of claim to exclude the allegedly usurious charges consituted an adequate cure. Because the creditor filed its amended claim well within the 60 day cure period, it was not subject to being sued for usury. As a result, the court granted the motion to dismiss.
This case raises several practice points. The first is that a proof of claim in a bankruptcy case can constitute a demand for usurious interest. As a result, alert debtors and trustees should scrutinize the claims filed to see if there are claims which could be asserted. Second, the two usury cure provisions appear to work independently. If a creditor discovers the usury, it has 60 days to cure the violation. However, if the creditor fails to do so, it has a second 60 day period once it receives notice from the obligor. Thus, although Texas has "draconian" usury penalties, a prudent creditor has an easy means to avoid liability if it acts promptly.
In this case, the creditor filed an initial claim for $89,280 on November 19, 2005. On April 24, 2007, the Trustee sought to amend an existing adversary proceeding to include a claim for usury. Ten days later, the creditor objected to the motion and filed an amended claim for $32,041.66 which eliminated the offending charges. The parties entered an agreed order which allowed the amendment but preserved the defendant's right to challenge the usury claim.
On defendant's motion to dismiss, the court considered whether the creditor's amended claim was sufficiently timely to constitute an allowable cure under the Texas Finance Code. Texas has two separate usury cure provisions. If the creditor discovers the usury violation, Texas Finance Code Sec. 305.103 allows the creditor to correct the violation within 60 days from "the date the creditor actually discovered the violation" by giving notice to the obligor. A second section, Texas Finance Code Sec. 305.006, applies when the obligor discovers the violation. It requires the obligor to give the creditor 60 days notice prior to filing suit or filing a counterclaim. During the 60 day period, the creditor may correct the violation in the same manner as under Sec. 305.103 (that is, by giving notice to the debtor).
In this case, the court found that Sec. 305.006 applied because this case involved a suit by the debtor's chapter 7 trustee. The court found that the trustee's motion for leave to amend constituted notice to the obligor of the usury violation triggering the 60 day period to cure. The court found that amending the proof of claim to exclude the allegedly usurious charges consituted an adequate cure. Because the creditor filed its amended claim well within the 60 day cure period, it was not subject to being sued for usury. As a result, the court granted the motion to dismiss.
This case raises several practice points. The first is that a proof of claim in a bankruptcy case can constitute a demand for usurious interest. As a result, alert debtors and trustees should scrutinize the claims filed to see if there are claims which could be asserted. Second, the two usury cure provisions appear to work independently. If a creditor discovers the usury, it has 60 days to cure the violation. However, if the creditor fails to do so, it has a second 60 day period once it receives notice from the obligor. Thus, although Texas has "draconian" usury penalties, a prudent creditor has an easy means to avoid liability if it acts promptly.
Monday, October 22, 2007
Court Protects Homestead Proceeds But Leaves Open Question on Tardy Objections
Texas has one of the most generous homestead exemptions in the country. However, a quirk in the law allows an exemption in homestead proceeds to be lost due to the passage of time. San Antonio Bankruptcy Judge Leif Clark recently found a creative solution to the problem created by an obstreperous creditor seeking to outlast the debtor and preclude reinvestment of the proceeds from sale of a homestead. In re Bading, No. 06-52750 (Bankr. W.D. Tex. 9/22/07). However, the opinion raises the question of why Judge Clark had to work so hard when Supreme Court precedent provided a simpler alternative.
The Vanishing Exemption and Absolute Protection of Exempted Property
Most exemption statutes are limited by the type and value of the property to be claimed as exempt, but are not limited as to time. Thus, exempt property will keep its status so long as it retains its exempt character. However, a sale or other transformation of the exempt property will usually cause it to lose its exempt character. The Texas homestead exemption extends not only to a homestead owned and occupied by the debtor, but to the proceeds from sale of a homestead as well. Tex. Prop. Code §41.001(c). The proceeds exemption is one which is limited by time. It lasts for the lesser of six months or until the debtor acquires another homestead. The purpose of the proceeds exemption is to give the debtor a limited period of time in which to acquire a new homestead. As a result, the statute creates a vanishing exemption. Homestead proceeds which were fully protected five months and 29 days after sale of the home become cash subject to claims of creditors after six months and one day.
This vanishing exemption creates a potential conflict between state and federal law in the bankruptcy context. According to 11 U.S.C. §522(c), “property exempted under this section is not liable during or after the case for any debt of the debtor that arose, or that is determined under section 502 of this title as if such debt had arisen, before the commencement of the case” (with certain exceptions). Thus, the Bankruptcy Code gives exempted property absolute protection from pre-petition claims.
This absolute protection is implemented in two ways. First, the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure provide a limited time in which to object to exempt property. 11 U.S.C. §522(l); Fed.R.Bankr.P. 4003(b). If the property is claimed as exempt and the exemption is not timely challenged, the property remains exempt regardless of whether it would have been subject to a valid objection. Taylor v. Freeland & Kronz, 503 U.S. 638 (1992). Second, the property’s exempt status is determined as of the petition date using the “snapshot” approach. Matter of Zibman, 268 F.3d 298 (5th Cir. 2001).
A Fading Snapshot
While the Zibman decision recognized the “snapshot” approach, it also noted that like a bad Polaroid, the picture could fade. According to the Fifth Circuit:
“(T)he law and facts existing on the date of filing the bankruptcy petition determine the existence of available exemptions but . . . it is the entire state law applicable on the filing date that is determinative. Courts cannot apply a juridical airbrush to excise offending images necessarily picture in the petition-date snapshot.”
Zibman at 304.
Thus, Zibman teaches that where conditions exist on the petition date which would limit the exemption, the snapshot approach does not eliminate those limitations. However, it seems important to the Fifth Circuit’s analysis that the condition must exist as of the petition date. In the Zibman case, the debtors had sold their homestead approximately two months prior to bankruptcy. Thus, the snapshot on the petition date revealed an exemption which had just four months remaining in the absence of reinvestment. Since the debtors had moved to another state, reinvestment was not a possibility.
In the Zibman case, the Trustee obtained an order extending the time to object to exemptions until after the six month reinvestment period expired. When the debtor failed to purchase a new homestead, the trustee objected and was sustained by the Fifth Circuit. Thus, although the exemption was still valid on the petition date, it was a limited exemption and was defeated by the timely filed objection.
Although the Trustee benefitted from an extension of time in Zibman, the court noted that the debtor could benefit from one as well. In a footnote, the Court noted that although the debtors could have requested tolling of the six month period, they failed to do so.
Bading Determines Calculation of Six Month Period
In Judge Clark’s Bading decision, the court examined how to calculate the six month period in the face of creditor obstruction. The debtor owned two contiguous lots which made up her homestead. Prior to bankruptcy, Gulfside Supply, Inc. recorded an abstract of judgment against the debtor. Under Texas law, an abstract of judgment creates a lien against all real estate owned by the debtor in the county, but does not attach to a homestead. Since the debtor only owned a homestead, the abstract of judgment should have been a nullity. However, as noted by the Bankruptcy Court, “title companies are notorious cowards.” When the creditor refused to release the lien, the debtor was put to a Hobson’s choice to either pay off the invalid lien or risk losing the ability to sell the property.
In this case, the debtor found a middle ground. It reached an agreement with the creditor to release its lien from one of the two tracts. The sale of the first lot closed on December 4, 2006 and the debtor received proceeds of approximately $142,000. The debtor did not reinvest these proceeds out of fear that acquiring a new homestead would void the exemption on the second tract.
Instead, the debtor then filed bankruptcy on December 29, 2006 and filed a motion to avoid lien on the second tract. The motion to avoid lien was granted. However, at this point, the debtor was faced with a timing dilemma. The creditor, which had not objected to the debtor’s exemptions, contended that it was not required to file an objection until after the property lost its exempt character and that the six month clock had begun to run on the sale of the first tract. Under the creditor’s position, there was only one month in which to complete the sale of the second tract and invest the proceeds from both tracts in a new homestead. To avoid this problem, the debtor, relying on the Zibman dicta, filed a motion to toll the reinvestment period.
After a hearing, the Bankruptcy Court came to three important conclusions:
1) The fact that Gulfside failed to file a timely objection to exemption was irrelevant. The court stated:
“Gulfside responds that a creditor should not be required to file a ‘conditional objection’ based on what might happen after the close of the time allowed for objection to exemptions, on pain of those exemptions being allowed as a matter of law under section 522(l). The court agrees with Gulfside on this issue. Were the rule otherwise, then trustees and creditors alike would have a duty to object in every proceeds case, just to make sure they preserved their rights. That strikes the court as an unnecessary formality, and one that is difficult to square with the rationale employed by the Fifth Circuit in Zibman to reach its result.”
Bading, slip op., p. 6, n. 5.
2) The six month clock did not begin to run until the second tract was sold.
The six month clock is triggered by sale of “a” homestead, not part of the homestead. Here, the debtor had a single purchaser for both parts of the homestead. The closing of the sale of the complete homestead was delayed by the creditor’s unjustified refusal to release its lien. As a result, there was not a sale of “a” homestead until the second closing, so that the six month clock did not begin to run until that date.
3) If the single sale theory did not work, the court found that equitable tolling would apply.
The court noted that both Texas law and the Zibman opinion held open the possibility that the six month period to reinvest could be tolled. Tolling is an equitable principle. Where, as here, the creditor delayed the debtor’s ability to sell through its refusal to release an invalid lien, there were sufficient grounds to toll the six month reinvestment period.
Thus, the net result was that the debtor was able to sell her homestead free of the offending judgment lien and the creditor’s stall tactics failed to achieve their desired result.
Invoking Avril Lavigne
Judge Clark’s reasoning is elegant and avoided an obvious injustice. However, it raises an obvious question: “Why do you have to make things so complicated?”* Judge Clark would never have had to reach the issues of unitary homestead sales or equitable tolling if he had simply followed Taylor v. Freeland & Kronz and ruled that failure to timely object to the claimed exemption ended the inquiry.
Judge Clark justified his failure to deem the objection waived on two grounds:
1) Practicality; and
2) Fealty to the Fifth Circuit’s reasoning in Zibman.
The practical argument questions the reasonableness of requiring conditional objections in cases involving homestead proceeds. The most reasonable response to this argument is: So what? Cases involving exemptions of homestead proceeds are relatively rare. In order to have a case involving proceeds, the sale must have taken place pre-petition. The deadline to object to exemptions occurs 30 days after the conclusion of the first meeting of creditors. Fed.R.Bankr.P. 4003(b). While the creditors’ meeting must be commenced 20-40 days after the filing of the petition, Fed.R.Bankr.P. 2003(a), there is no rule as to when the meeting must be concluded. As a result, the trustee may simply continue the meeting to a date after the conclusion of the six month reinvestment period. If that isn’t satisfactory, a creditor could move to extend the time to object or could file a conditional objection. All of these solutions are easy to accomplish. Since proceeds cases are unusual, it is reasonable to require trustees and creditors to take these nominal steps to preserve their rights rather than to argue that Supreme Court precedent should be disregarded.
The rationale of the Zibman opinion offers offers little support to the tardy creditor. In that case, the trustee obtained an order extending the time to object to exemptions. The trustee filed his objection within that time period. As a result, Zibman should not be construed as authorizing out of time objections. Indeed, the Zibman rationale simply recognizes that the debtor’s right to exempt proceeds may depend on events happening after the petition date. This is not an invitation to ignore the rules requiring timely objections to exemptions.
Finally, allowing untimely objections to exemptions based on events occurring after the petition date would lead to absurd results. Under Taylor v. Freeland & Kronz, which is an intellectual cousin to Republic Supply Co. v. Shoaf, 815 F.2d 1046 (5th Cir. 1987), failure to file a timely objection to exemption allows the debtor to retain the claimed property regardless of whether the debtor had a colorable claim of exemptions in the first place. If Zibman is read as allowing untimely objections, it means that a conditional claim to exemption of homestead proceeds would receive less protection than a debtor’s attempt to exempt a stack of gold bullion or a herd of Ethiopian hog-nosed goats** as his homestead. The legal system would be seriously out of joint if it accorded greater rights to the frivolous than the conditionally correct. The entire concept of statutes of limitation assumes that creditors must be diligent to protect their rights. If a creditor is unable to focus its attention on a claim which will be resolved in less than six months, the court should not create a judicial do-over for it.
*--This is the refrain from a recent song by semi-punk songstress Avril Lavigne.
**--A rare form of livestock found only in Bastrop County. Apologies to Joe Martinec and Eric Borsheim. For the full story of the Ethiopian hog-nosed goats, write to me at ssather@bnpclaw.com.
The Vanishing Exemption and Absolute Protection of Exempted Property
Most exemption statutes are limited by the type and value of the property to be claimed as exempt, but are not limited as to time. Thus, exempt property will keep its status so long as it retains its exempt character. However, a sale or other transformation of the exempt property will usually cause it to lose its exempt character. The Texas homestead exemption extends not only to a homestead owned and occupied by the debtor, but to the proceeds from sale of a homestead as well. Tex. Prop. Code §41.001(c). The proceeds exemption is one which is limited by time. It lasts for the lesser of six months or until the debtor acquires another homestead. The purpose of the proceeds exemption is to give the debtor a limited period of time in which to acquire a new homestead. As a result, the statute creates a vanishing exemption. Homestead proceeds which were fully protected five months and 29 days after sale of the home become cash subject to claims of creditors after six months and one day.
This vanishing exemption creates a potential conflict between state and federal law in the bankruptcy context. According to 11 U.S.C. §522(c), “property exempted under this section is not liable during or after the case for any debt of the debtor that arose, or that is determined under section 502 of this title as if such debt had arisen, before the commencement of the case” (with certain exceptions). Thus, the Bankruptcy Code gives exempted property absolute protection from pre-petition claims.
This absolute protection is implemented in two ways. First, the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure provide a limited time in which to object to exempt property. 11 U.S.C. §522(l); Fed.R.Bankr.P. 4003(b). If the property is claimed as exempt and the exemption is not timely challenged, the property remains exempt regardless of whether it would have been subject to a valid objection. Taylor v. Freeland & Kronz, 503 U.S. 638 (1992). Second, the property’s exempt status is determined as of the petition date using the “snapshot” approach. Matter of Zibman, 268 F.3d 298 (5th Cir. 2001).
A Fading Snapshot
While the Zibman decision recognized the “snapshot” approach, it also noted that like a bad Polaroid, the picture could fade. According to the Fifth Circuit:
“(T)he law and facts existing on the date of filing the bankruptcy petition determine the existence of available exemptions but . . . it is the entire state law applicable on the filing date that is determinative. Courts cannot apply a juridical airbrush to excise offending images necessarily picture in the petition-date snapshot.”
Zibman at 304.
Thus, Zibman teaches that where conditions exist on the petition date which would limit the exemption, the snapshot approach does not eliminate those limitations. However, it seems important to the Fifth Circuit’s analysis that the condition must exist as of the petition date. In the Zibman case, the debtors had sold their homestead approximately two months prior to bankruptcy. Thus, the snapshot on the petition date revealed an exemption which had just four months remaining in the absence of reinvestment. Since the debtors had moved to another state, reinvestment was not a possibility.
In the Zibman case, the Trustee obtained an order extending the time to object to exemptions until after the six month reinvestment period expired. When the debtor failed to purchase a new homestead, the trustee objected and was sustained by the Fifth Circuit. Thus, although the exemption was still valid on the petition date, it was a limited exemption and was defeated by the timely filed objection.
Although the Trustee benefitted from an extension of time in Zibman, the court noted that the debtor could benefit from one as well. In a footnote, the Court noted that although the debtors could have requested tolling of the six month period, they failed to do so.
Bading Determines Calculation of Six Month Period
In Judge Clark’s Bading decision, the court examined how to calculate the six month period in the face of creditor obstruction. The debtor owned two contiguous lots which made up her homestead. Prior to bankruptcy, Gulfside Supply, Inc. recorded an abstract of judgment against the debtor. Under Texas law, an abstract of judgment creates a lien against all real estate owned by the debtor in the county, but does not attach to a homestead. Since the debtor only owned a homestead, the abstract of judgment should have been a nullity. However, as noted by the Bankruptcy Court, “title companies are notorious cowards.” When the creditor refused to release the lien, the debtor was put to a Hobson’s choice to either pay off the invalid lien or risk losing the ability to sell the property.
In this case, the debtor found a middle ground. It reached an agreement with the creditor to release its lien from one of the two tracts. The sale of the first lot closed on December 4, 2006 and the debtor received proceeds of approximately $142,000. The debtor did not reinvest these proceeds out of fear that acquiring a new homestead would void the exemption on the second tract.
Instead, the debtor then filed bankruptcy on December 29, 2006 and filed a motion to avoid lien on the second tract. The motion to avoid lien was granted. However, at this point, the debtor was faced with a timing dilemma. The creditor, which had not objected to the debtor’s exemptions, contended that it was not required to file an objection until after the property lost its exempt character and that the six month clock had begun to run on the sale of the first tract. Under the creditor’s position, there was only one month in which to complete the sale of the second tract and invest the proceeds from both tracts in a new homestead. To avoid this problem, the debtor, relying on the Zibman dicta, filed a motion to toll the reinvestment period.
After a hearing, the Bankruptcy Court came to three important conclusions:
1) The fact that Gulfside failed to file a timely objection to exemption was irrelevant. The court stated:
“Gulfside responds that a creditor should not be required to file a ‘conditional objection’ based on what might happen after the close of the time allowed for objection to exemptions, on pain of those exemptions being allowed as a matter of law under section 522(l). The court agrees with Gulfside on this issue. Were the rule otherwise, then trustees and creditors alike would have a duty to object in every proceeds case, just to make sure they preserved their rights. That strikes the court as an unnecessary formality, and one that is difficult to square with the rationale employed by the Fifth Circuit in Zibman to reach its result.”
Bading, slip op., p. 6, n. 5.
2) The six month clock did not begin to run until the second tract was sold.
The six month clock is triggered by sale of “a” homestead, not part of the homestead. Here, the debtor had a single purchaser for both parts of the homestead. The closing of the sale of the complete homestead was delayed by the creditor’s unjustified refusal to release its lien. As a result, there was not a sale of “a” homestead until the second closing, so that the six month clock did not begin to run until that date.
3) If the single sale theory did not work, the court found that equitable tolling would apply.
The court noted that both Texas law and the Zibman opinion held open the possibility that the six month period to reinvest could be tolled. Tolling is an equitable principle. Where, as here, the creditor delayed the debtor’s ability to sell through its refusal to release an invalid lien, there were sufficient grounds to toll the six month reinvestment period.
Thus, the net result was that the debtor was able to sell her homestead free of the offending judgment lien and the creditor’s stall tactics failed to achieve their desired result.
Invoking Avril Lavigne
Judge Clark’s reasoning is elegant and avoided an obvious injustice. However, it raises an obvious question: “Why do you have to make things so complicated?”* Judge Clark would never have had to reach the issues of unitary homestead sales or equitable tolling if he had simply followed Taylor v. Freeland & Kronz and ruled that failure to timely object to the claimed exemption ended the inquiry.
Judge Clark justified his failure to deem the objection waived on two grounds:
1) Practicality; and
2) Fealty to the Fifth Circuit’s reasoning in Zibman.
The practical argument questions the reasonableness of requiring conditional objections in cases involving homestead proceeds. The most reasonable response to this argument is: So what? Cases involving exemptions of homestead proceeds are relatively rare. In order to have a case involving proceeds, the sale must have taken place pre-petition. The deadline to object to exemptions occurs 30 days after the conclusion of the first meeting of creditors. Fed.R.Bankr.P. 4003(b). While the creditors’ meeting must be commenced 20-40 days after the filing of the petition, Fed.R.Bankr.P. 2003(a), there is no rule as to when the meeting must be concluded. As a result, the trustee may simply continue the meeting to a date after the conclusion of the six month reinvestment period. If that isn’t satisfactory, a creditor could move to extend the time to object or could file a conditional objection. All of these solutions are easy to accomplish. Since proceeds cases are unusual, it is reasonable to require trustees and creditors to take these nominal steps to preserve their rights rather than to argue that Supreme Court precedent should be disregarded.
The rationale of the Zibman opinion offers offers little support to the tardy creditor. In that case, the trustee obtained an order extending the time to object to exemptions. The trustee filed his objection within that time period. As a result, Zibman should not be construed as authorizing out of time objections. Indeed, the Zibman rationale simply recognizes that the debtor’s right to exempt proceeds may depend on events happening after the petition date. This is not an invitation to ignore the rules requiring timely objections to exemptions.
Finally, allowing untimely objections to exemptions based on events occurring after the petition date would lead to absurd results. Under Taylor v. Freeland & Kronz, which is an intellectual cousin to Republic Supply Co. v. Shoaf, 815 F.2d 1046 (5th Cir. 1987), failure to file a timely objection to exemption allows the debtor to retain the claimed property regardless of whether the debtor had a colorable claim of exemptions in the first place. If Zibman is read as allowing untimely objections, it means that a conditional claim to exemption of homestead proceeds would receive less protection than a debtor’s attempt to exempt a stack of gold bullion or a herd of Ethiopian hog-nosed goats** as his homestead. The legal system would be seriously out of joint if it accorded greater rights to the frivolous than the conditionally correct. The entire concept of statutes of limitation assumes that creditors must be diligent to protect their rights. If a creditor is unable to focus its attention on a claim which will be resolved in less than six months, the court should not create a judicial do-over for it.
*--This is the refrain from a recent song by semi-punk songstress Avril Lavigne.
**--A rare form of livestock found only in Bastrop County. Apologies to Joe Martinec and Eric Borsheim. For the full story of the Ethiopian hog-nosed goats, write to me at ssather@bnpclaw.com.
Wednesday, October 17, 2007
Creditor Trust Fails to Revive Claims Brought by Debtor; Creditors Found to Have Derivative Standing Only
While plan trusts have many uses, overcoming res judicata is not one of them. In Medlin, Trustee v. Wells Fargo Bank, N.A., Adv. No. 04-5041 (Bankr. W.D. Tex. 7/31/07), the Bankruptcy Court considered whether claims contributed to a plan trust by investors could overcome a prior take nothing judgment entered in a suit by the debtor’s trustee. In this case, the motto try, try again proved unavailing.
In the initial action, Len Blackwell, Chapter 11 trustee for the Inverworld debtors brought claims against Wells Fargo Bank, N.A. and Wells Fargo Bank of Texas, N.A. Pursuant to a Cash Management Services Agreement, the claims were referred to arbitration. The arbitration resulted in a take nothing judgment.
Subsequently, the cases proceeded to confirmation. The plan allowed for creditors to contribute their claims to an investor claim trust. The investor claim trust then brought its own claims. Although the reference was withdrawn, the Bankruptcy Court retained preliminary matters. The Bankruptcy Court was asked to consider whether the creditor claims were barred by res judicata.
Drawing an analogy to Orson Welles who proclaimed that Gallo Wineries would sell no wine before its time, the Bankruptcy Court noted that this issue was now ripe for decision since a new opinion by the Delaware Supreme Court resolved the issue. In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, __ A.2d __, 2007 WL 1453705 (Del. Sup. 5/18/07), the Delaware Supreme Court held that creditors of an insolvent firm could assert breach of fiduciary claims; however, such claims were derivative claims just like those which could be asserted by shareholders. Because the creditor claims were derivative of the company’s claims, they were barred by res judicata based on the prior adverse ruling against the company. Thus, even though both the company and the creditors were allowed to assert clams, they were not considered to be separate parties for purposes of res judicata.
The derivative nature of these breach of fiduciary duty claims raises an interesting race to the courthouse problem. Because multiple parties have standing to pursue the same claim, it is possible that the first party to file might be the least qualified to pursue the claim or might have an actual incentive to sandbag the claims. For example, if debtor's management chooses to pursue claims against other members of management, it is possible that they might pursue the claims for the purpose of eliminating them. Thus, if management puts on a weak case and loses, the creditors would be barred. The same logic would seem to apply if management pursued the claims and then settled them on behalf of the company. There is some protection where the party sabotaging the claims is part of the debtor's management. In that case, the disingenuous pursuit of breach of fiduciary claims could give rise to new breach of fiduciary claims against the parties who caused the prior claims to be lost. However, if the claims are pursued by a small third party creditor who simply lacks the resources to put on a good case, there is no similar protection. Indeed, it is possible that a friendly creditor could bring claims for the express purpose of allowing them to go down to defeat. In that case, the creditor would not have a pre-existing fiduciary duty to the company (although it might acquire one by virtue of pursuing the claims)and its failure would bind both the debtor and its creditors.
In the initial action, Len Blackwell, Chapter 11 trustee for the Inverworld debtors brought claims against Wells Fargo Bank, N.A. and Wells Fargo Bank of Texas, N.A. Pursuant to a Cash Management Services Agreement, the claims were referred to arbitration. The arbitration resulted in a take nothing judgment.
Subsequently, the cases proceeded to confirmation. The plan allowed for creditors to contribute their claims to an investor claim trust. The investor claim trust then brought its own claims. Although the reference was withdrawn, the Bankruptcy Court retained preliminary matters. The Bankruptcy Court was asked to consider whether the creditor claims were barred by res judicata.
Drawing an analogy to Orson Welles who proclaimed that Gallo Wineries would sell no wine before its time, the Bankruptcy Court noted that this issue was now ripe for decision since a new opinion by the Delaware Supreme Court resolved the issue. In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, __ A.2d __, 2007 WL 1453705 (Del. Sup. 5/18/07), the Delaware Supreme Court held that creditors of an insolvent firm could assert breach of fiduciary claims; however, such claims were derivative claims just like those which could be asserted by shareholders. Because the creditor claims were derivative of the company’s claims, they were barred by res judicata based on the prior adverse ruling against the company. Thus, even though both the company and the creditors were allowed to assert clams, they were not considered to be separate parties for purposes of res judicata.
The derivative nature of these breach of fiduciary duty claims raises an interesting race to the courthouse problem. Because multiple parties have standing to pursue the same claim, it is possible that the first party to file might be the least qualified to pursue the claim or might have an actual incentive to sandbag the claims. For example, if debtor's management chooses to pursue claims against other members of management, it is possible that they might pursue the claims for the purpose of eliminating them. Thus, if management puts on a weak case and loses, the creditors would be barred. The same logic would seem to apply if management pursued the claims and then settled them on behalf of the company. There is some protection where the party sabotaging the claims is part of the debtor's management. In that case, the disingenuous pursuit of breach of fiduciary claims could give rise to new breach of fiduciary claims against the parties who caused the prior claims to be lost. However, if the claims are pursued by a small third party creditor who simply lacks the resources to put on a good case, there is no similar protection. Indeed, it is possible that a friendly creditor could bring claims for the express purpose of allowing them to go down to defeat. In that case, the creditor would not have a pre-existing fiduciary duty to the company (although it might acquire one by virtue of pursuing the claims)and its failure would bind both the debtor and its creditors.
Monday, September 24, 2007
Fifth Circuit Rules on Bradley Appeal; Lazarus Trust Is Not Resurrected From Bankruptcy Court Judgment
“This is the way the world ends/Not with a bang but a whimper.”
--T.S. Elliott
The long-running bankruptcy case of flamboyant Austin developer Gary Bradley came one step closer to its end with a dissertation by the Fifth Circuit Court of Appeals on . . . burden of proof. Matter of Bradley, No. 05-51626 (5th Cir. 9/20/07). The Court’s ruling upheld the decisions by the lower courts with the result that bankruptcy trustee Ronald Ingalls was able to recover certain traceable assets from the Lazarus Exempt Trust but not others, while Mr. Bradley lost his discharge.
Once Upon A Time . . .
The roots of this case go back decades. Gary Bradley and James Gressett were involved in a number of investments, including the Circle C real estate development in Southwest Austin. While Circle C was ultimately very successful, it got caught up in the real estate bust of the 1980s and proved to be financially devastating for its owners. Circle C Development Joint Venture was able to reorganize in a chapter 11 proceeding, but Mr. Bradley and Mr. Gressett were left with tens of millions of dollars of liability to the FDIC. Gressett filed for chapter 7 protection and received a discharge in the early 1990s, while Gary Bradley resolutely tried to recover without the benefit of bankruptcy.
One strategy that Mr. Bradley allegedly employed to resurrect his finances while keeping his creditors at bay involved an entity known as the Lazarus Exempt Trust. While this trust was formed by his sister, who contributed $1,000 to it, the trust came to own many assets which had been connected with Bradley and his associates in the past. Within two years, the trust had grown from its initial seed capital of $1,000 to own over $40 million in assets. The Trust and its entities paid Bradley a salary of $15,000 per month.
Finally, facing pressure from the FDIC (which was reportedly receiving pressure from Austin’s zealous environmental community) and a family court judge who found that he could afford to pay large amounts of child support, Bradley filed for chapter 7 bankruptcy protection in 2002. Trustee Ronald Ingalls focused on the Lazarus Exempt Trust and sought to recover its assets for the benefit of creditors.
The Bankruptcy Court Ruling
After a trial in April 2004, Bankruptcy Judge Frank Monroe issued a 145 page opinion in which he found that Bradley and his associates had engaged in an elaborate plan to transfer assets controlled by Bradley into the trust. Memorandum Opinion, Ingalls vs. Bradley, Adv. No. 02-1183 (Bankr. W.D. Tex. 10/28/04). Despite the fact that none of the “self-settled” assets were directly transferred into the trust by Bradley, the court found that Bradley maintained ownership of these assets through a set of informal and largely unwritten agreements. This ownership was established through memorandums, prior deposition testimony and the way that certain transactions were structured.
Of particular importance to Judge Monroe was an understanding between Bradley and Gressett that Bradley would own an 80% interest in their joint real estate investments, while Gressett would own 80% of the non-real estate investments. While Messrs. Bradley and Gressett contended that this split was more of a guideline than an agreement, Judge Monroe determined that it made sense out of a number of transactions which would have been nonsensical otherwise. Judge Monroe found that it was this 80% interest in real estate investments which was contributed to the Lazarus Exempt Trust.
Judge Monroe was not circumspect in offering his assessment about what had occurred, making comments such as “Can anyone play the shell game better than Bradley and Gresset?” and “Backdating was a way for life for them . . . .” Memorandum Opinion, pp. 58 and 71. However, despite his obvious disdain for Bradley and company, he did not give the trustee all that he requested. The Court found that certain specific assets, which could be traced into the trust and which remained within the trust, could be determined to self-settled assets and awarded them to the bankruptcy estate. However, he declined to invalidate the trust in toto. He also declined to award a remedy for self-settled assets which could be traced into the trust, but which had been subsequently dissipated. As a result, the trust lost many but not all of its assets. Judge Monroe also denied Mr. Bradley’s discharge on the grounds that he had transferred or concealed property within one year prior to bankruptcy.
Appeal to the Fifth Circuit
Both parties appealed to the Fifth Circuit, which rendered its decision on September 20, 2007. The Court spent most of its opinion explaining why Trustee Ingalls was not entitled to more relief than he received below. The Court of Appeals acknowledged that the burden of proof for tracing assets into a self-settled trust was res nova in Texas. However, based upon general principles of trust law, the Court ruled that the party seeking to recover trust assets had the burden of proof to both trace assets into the trust and to prove that those assets or their proceeds remained within the trust. The Court of Appeals declined to assign any burden of proof to the trust. The Trustee’s two-fold burden had two consequences for his ultimate recovery. The first was that where assets could be traced into the trust, but their provenance remained uncertain, that the trust could retain these assets. Second, where self-settled assets could be traced into the trust, but had been sold or dissipated such that their current form could not be determined, that the trust would not be held liable for these assets which had passed through it. In making its ruling, the Court of Appeals was careful to note that the bankruptcy trustee had been given full access to the trust’s records. Presumably, the result could have been different in a case where the transferee was less cooperative.
The Court of Appeals also affirmed the Bankruptcy Court’s decision to reject two global challenges to the trust. The Court of Appeals agreed with Judge Monroe that Texas courts have not recognized the concept of sham or illusory trust except in cases involving marital property rights. Thus, although Judge Monroe indicated that he would have found the trust to be a sham or illusory trust, there was no legal remedy available for this finding. The Fifth Circuit also found that the Bankruptcy Court properly denied an 11th hour attempt to amend the adversary proceeding to assert a constructive trust claim over the trust assets. Thus, the trust remained intact but wounded.
The Court of Appeals was fairly dismissive of the arguments raised by the Trust and the Debtor, devoting just 3 ½ pages to these issues. The Fifth Circuit rejected the argument that it would be necessary to pierce the corporate veil in order to consider transfers to entities controlled by the trust to be self-settled assets. The Court found that a trust is not a legal entity separate from its trustee. Apparently this led to the conclusion that an asset transferred to a corporation owned by the trust was the same as a transfer to the trust itself. Next, it found that the trust had waived its argument that Mr. Bradley was not a “settlor” of the trust (as opposed to his sister who made the original contribution) for the reason that this argument was not made to the District Court. Finally, the Circuit Court noted that “when the bankruptcy court’s weighing of the evidence is plausible in light of the record taken as a whole, a find of clear error is precluded, even if we would have weighed the evidence differently.” Fifth Circuit opinion, p. 17. This generic finding of plausibility avoided the need to examine the evidence in depth as Judge Monroe did.
What Does It All Mean?
While the opinion from the Court of Appeals turned out to be somewhat dry and technical and largely anticlimactic, there are several lessons which can be learned from the larger saga.
1. It is better to file sooner rather than later.
In some respects, this is a tale of two partners. James Gressett took his medicine and filed bankruptcy in the early 1990s. He received a discharge and was able to start over again. Gary Bradley, on the other hand, tried to tough it out. When he filed bankruptcy some ten years later, he succeeded in attracting much more attention than if he had filed more promptly. It has long been rumored that environmental activists who did not like Bradley’s development activities exerted political pressure on the FDIC to attempt to collect from Bradley rather than settle with him. This led to Bradley’s ill-advised decision to attend a post-judgment deposition without the benefit of counsel. By the time that Bradley filed for bankruptcy, newspaper articles and the FDIC deposition provided the Trustee with a road map for his investigation.
2. The concept of a self-settled trust just got larger.
In some respects, the Fifth Circuit’s opinion on the Bradley matter is like Arthur Conan Doyle’s dog which didn’t bark (that is, the remarkable thing is what was never discussed). The Fifth Circuit never really explained how assets which had never been held in the name of the debtor could be treated as self-settled assets in the hands of the trust. Normally, a self-settled trust is easy to determine. The Debtor owns an asset and then contributes that asset to a trust under which he is the beneficiary. At this point, the trust is determined to be self-settled and any spendthrift trust restriction is unenforceable.
In the Bradley case, Judge Monroe took a very expansive view of what constituted a self-settled asset. Although his opinion is quite detailed, he still had to buy into the trustee’s theory of the debtor as puppet-master pulling the strings of his associates and their entities. Based upon the opinions, it appears that there was never a legally enforceable agreement for third parties to hold property for Mr. Bradley, but that they acted as if there was such an agreement. Whether the other parties to the alleged scheme acted out of fear, loyalty or foolishness, it doesn’t seem as though they had an obligation to act at Bradley’s direction. This raises the question of whether the fact that the parties acted as though they were dealing with Gary Bradley’s property is sufficient to establish that they were in fact dealing with Gary Bradley’s property. The Fifth Circuit responded to this tantalizing question with a shrug, dismissing the issues as mere fact finding to be upheld so long as they were plausible. The Fifth Circuit also punted on the issue of whether someone who was not the named settler of a trust could make a self-settled contribution to the trust, finding that although this issue was presented to the bankruptcy court, it had not been presented to the district court. While the court of appeals did not expressly rule on this issue, the clear implication is that they would have agreed with the bankruptcy court that anyone who contributes an asset to a trust is a settler; otherwise, the entire case would turn on a technicality of appellate procedure (namely, whether an issue raised in the bankruptcy court but not the district court is waived).
The potentially expansive reach of this case is shown by the following hypothetical. Assume that parents own a business and their children work in the business. When the children reach adulthood, the parents sell the business to the children at a favorable price with an “understanding” that the children will take care of the parents in their old age. More than four years later, the children decide to form a trust for their parents’ support. They sell the business to the trust at the same favorable price that they paid and name the parents as primary beneficiaries. Prior to the Bradley case, this transaction would have been untouchable. The original transfer occurred outside of the four year period for recovering a fraudulent transfer and the property was transferred to the trust by the children, not the parents. However, following the logic of the Bradley opinion, it could be argued that the parents retained ownership of the business through their “understanding” with the children such that the asset was self-settled when it was contributed to the trust. The main difference between this hypothetical and the Bradley case is that the parents and children would be considered sympathetic parties, while Gary Bradley failed to attract much sympathy for himself. Of course, this should not be determinative when resolving legal issues.
3. Documents are important.
In discussing one of the many transactions in his Memorandum Opinion, Judge Monroe states, “None of the trial testimony makes sense. The documents do.” Memorandum Opinion, p. 55. Although the Trustee did not win on every issue, it is clear that his success was due to his ability to process large quantities of documents and sort out the ones which helped his case. The proof of the conspiracy emerged from prior deposition testimony (which can be considered low-hanging fruit), notes from meetings and analysis of the details of a myriad of transactions. Without these documents, the Trustee would not have had a case, since the witnesses on the Bradley side all testified to a different version of the facts. Conversely, the fact that the Lazarus Trust cooperated and provided the Bankruptcy Trustee with massive amounts of documents allowed the Court to apportion the burden of proof to the Trustee with the result that the Trustee did not prevail on all of his arguments.
--T.S. Elliott
The long-running bankruptcy case of flamboyant Austin developer Gary Bradley came one step closer to its end with a dissertation by the Fifth Circuit Court of Appeals on . . . burden of proof. Matter of Bradley, No. 05-51626 (5th Cir. 9/20/07). The Court’s ruling upheld the decisions by the lower courts with the result that bankruptcy trustee Ronald Ingalls was able to recover certain traceable assets from the Lazarus Exempt Trust but not others, while Mr. Bradley lost his discharge.
Once Upon A Time . . .
The roots of this case go back decades. Gary Bradley and James Gressett were involved in a number of investments, including the Circle C real estate development in Southwest Austin. While Circle C was ultimately very successful, it got caught up in the real estate bust of the 1980s and proved to be financially devastating for its owners. Circle C Development Joint Venture was able to reorganize in a chapter 11 proceeding, but Mr. Bradley and Mr. Gressett were left with tens of millions of dollars of liability to the FDIC. Gressett filed for chapter 7 protection and received a discharge in the early 1990s, while Gary Bradley resolutely tried to recover without the benefit of bankruptcy.
One strategy that Mr. Bradley allegedly employed to resurrect his finances while keeping his creditors at bay involved an entity known as the Lazarus Exempt Trust. While this trust was formed by his sister, who contributed $1,000 to it, the trust came to own many assets which had been connected with Bradley and his associates in the past. Within two years, the trust had grown from its initial seed capital of $1,000 to own over $40 million in assets. The Trust and its entities paid Bradley a salary of $15,000 per month.
Finally, facing pressure from the FDIC (which was reportedly receiving pressure from Austin’s zealous environmental community) and a family court judge who found that he could afford to pay large amounts of child support, Bradley filed for chapter 7 bankruptcy protection in 2002. Trustee Ronald Ingalls focused on the Lazarus Exempt Trust and sought to recover its assets for the benefit of creditors.
The Bankruptcy Court Ruling
After a trial in April 2004, Bankruptcy Judge Frank Monroe issued a 145 page opinion in which he found that Bradley and his associates had engaged in an elaborate plan to transfer assets controlled by Bradley into the trust. Memorandum Opinion, Ingalls vs. Bradley, Adv. No. 02-1183 (Bankr. W.D. Tex. 10/28/04). Despite the fact that none of the “self-settled” assets were directly transferred into the trust by Bradley, the court found that Bradley maintained ownership of these assets through a set of informal and largely unwritten agreements. This ownership was established through memorandums, prior deposition testimony and the way that certain transactions were structured.
Of particular importance to Judge Monroe was an understanding between Bradley and Gressett that Bradley would own an 80% interest in their joint real estate investments, while Gressett would own 80% of the non-real estate investments. While Messrs. Bradley and Gressett contended that this split was more of a guideline than an agreement, Judge Monroe determined that it made sense out of a number of transactions which would have been nonsensical otherwise. Judge Monroe found that it was this 80% interest in real estate investments which was contributed to the Lazarus Exempt Trust.
Judge Monroe was not circumspect in offering his assessment about what had occurred, making comments such as “Can anyone play the shell game better than Bradley and Gresset?” and “Backdating was a way for life for them . . . .” Memorandum Opinion, pp. 58 and 71. However, despite his obvious disdain for Bradley and company, he did not give the trustee all that he requested. The Court found that certain specific assets, which could be traced into the trust and which remained within the trust, could be determined to self-settled assets and awarded them to the bankruptcy estate. However, he declined to invalidate the trust in toto. He also declined to award a remedy for self-settled assets which could be traced into the trust, but which had been subsequently dissipated. As a result, the trust lost many but not all of its assets. Judge Monroe also denied Mr. Bradley’s discharge on the grounds that he had transferred or concealed property within one year prior to bankruptcy.
Appeal to the Fifth Circuit
Both parties appealed to the Fifth Circuit, which rendered its decision on September 20, 2007. The Court spent most of its opinion explaining why Trustee Ingalls was not entitled to more relief than he received below. The Court of Appeals acknowledged that the burden of proof for tracing assets into a self-settled trust was res nova in Texas. However, based upon general principles of trust law, the Court ruled that the party seeking to recover trust assets had the burden of proof to both trace assets into the trust and to prove that those assets or their proceeds remained within the trust. The Court of Appeals declined to assign any burden of proof to the trust. The Trustee’s two-fold burden had two consequences for his ultimate recovery. The first was that where assets could be traced into the trust, but their provenance remained uncertain, that the trust could retain these assets. Second, where self-settled assets could be traced into the trust, but had been sold or dissipated such that their current form could not be determined, that the trust would not be held liable for these assets which had passed through it. In making its ruling, the Court of Appeals was careful to note that the bankruptcy trustee had been given full access to the trust’s records. Presumably, the result could have been different in a case where the transferee was less cooperative.
The Court of Appeals also affirmed the Bankruptcy Court’s decision to reject two global challenges to the trust. The Court of Appeals agreed with Judge Monroe that Texas courts have not recognized the concept of sham or illusory trust except in cases involving marital property rights. Thus, although Judge Monroe indicated that he would have found the trust to be a sham or illusory trust, there was no legal remedy available for this finding. The Fifth Circuit also found that the Bankruptcy Court properly denied an 11th hour attempt to amend the adversary proceeding to assert a constructive trust claim over the trust assets. Thus, the trust remained intact but wounded.
The Court of Appeals was fairly dismissive of the arguments raised by the Trust and the Debtor, devoting just 3 ½ pages to these issues. The Fifth Circuit rejected the argument that it would be necessary to pierce the corporate veil in order to consider transfers to entities controlled by the trust to be self-settled assets. The Court found that a trust is not a legal entity separate from its trustee. Apparently this led to the conclusion that an asset transferred to a corporation owned by the trust was the same as a transfer to the trust itself. Next, it found that the trust had waived its argument that Mr. Bradley was not a “settlor” of the trust (as opposed to his sister who made the original contribution) for the reason that this argument was not made to the District Court. Finally, the Circuit Court noted that “when the bankruptcy court’s weighing of the evidence is plausible in light of the record taken as a whole, a find of clear error is precluded, even if we would have weighed the evidence differently.” Fifth Circuit opinion, p. 17. This generic finding of plausibility avoided the need to examine the evidence in depth as Judge Monroe did.
What Does It All Mean?
While the opinion from the Court of Appeals turned out to be somewhat dry and technical and largely anticlimactic, there are several lessons which can be learned from the larger saga.
1. It is better to file sooner rather than later.
In some respects, this is a tale of two partners. James Gressett took his medicine and filed bankruptcy in the early 1990s. He received a discharge and was able to start over again. Gary Bradley, on the other hand, tried to tough it out. When he filed bankruptcy some ten years later, he succeeded in attracting much more attention than if he had filed more promptly. It has long been rumored that environmental activists who did not like Bradley’s development activities exerted political pressure on the FDIC to attempt to collect from Bradley rather than settle with him. This led to Bradley’s ill-advised decision to attend a post-judgment deposition without the benefit of counsel. By the time that Bradley filed for bankruptcy, newspaper articles and the FDIC deposition provided the Trustee with a road map for his investigation.
2. The concept of a self-settled trust just got larger.
In some respects, the Fifth Circuit’s opinion on the Bradley matter is like Arthur Conan Doyle’s dog which didn’t bark (that is, the remarkable thing is what was never discussed). The Fifth Circuit never really explained how assets which had never been held in the name of the debtor could be treated as self-settled assets in the hands of the trust. Normally, a self-settled trust is easy to determine. The Debtor owns an asset and then contributes that asset to a trust under which he is the beneficiary. At this point, the trust is determined to be self-settled and any spendthrift trust restriction is unenforceable.
In the Bradley case, Judge Monroe took a very expansive view of what constituted a self-settled asset. Although his opinion is quite detailed, he still had to buy into the trustee’s theory of the debtor as puppet-master pulling the strings of his associates and their entities. Based upon the opinions, it appears that there was never a legally enforceable agreement for third parties to hold property for Mr. Bradley, but that they acted as if there was such an agreement. Whether the other parties to the alleged scheme acted out of fear, loyalty or foolishness, it doesn’t seem as though they had an obligation to act at Bradley’s direction. This raises the question of whether the fact that the parties acted as though they were dealing with Gary Bradley’s property is sufficient to establish that they were in fact dealing with Gary Bradley’s property. The Fifth Circuit responded to this tantalizing question with a shrug, dismissing the issues as mere fact finding to be upheld so long as they were plausible. The Fifth Circuit also punted on the issue of whether someone who was not the named settler of a trust could make a self-settled contribution to the trust, finding that although this issue was presented to the bankruptcy court, it had not been presented to the district court. While the court of appeals did not expressly rule on this issue, the clear implication is that they would have agreed with the bankruptcy court that anyone who contributes an asset to a trust is a settler; otherwise, the entire case would turn on a technicality of appellate procedure (namely, whether an issue raised in the bankruptcy court but not the district court is waived).
The potentially expansive reach of this case is shown by the following hypothetical. Assume that parents own a business and their children work in the business. When the children reach adulthood, the parents sell the business to the children at a favorable price with an “understanding” that the children will take care of the parents in their old age. More than four years later, the children decide to form a trust for their parents’ support. They sell the business to the trust at the same favorable price that they paid and name the parents as primary beneficiaries. Prior to the Bradley case, this transaction would have been untouchable. The original transfer occurred outside of the four year period for recovering a fraudulent transfer and the property was transferred to the trust by the children, not the parents. However, following the logic of the Bradley opinion, it could be argued that the parents retained ownership of the business through their “understanding” with the children such that the asset was self-settled when it was contributed to the trust. The main difference between this hypothetical and the Bradley case is that the parents and children would be considered sympathetic parties, while Gary Bradley failed to attract much sympathy for himself. Of course, this should not be determinative when resolving legal issues.
3. Documents are important.
In discussing one of the many transactions in his Memorandum Opinion, Judge Monroe states, “None of the trial testimony makes sense. The documents do.” Memorandum Opinion, p. 55. Although the Trustee did not win on every issue, it is clear that his success was due to his ability to process large quantities of documents and sort out the ones which helped his case. The proof of the conspiracy emerged from prior deposition testimony (which can be considered low-hanging fruit), notes from meetings and analysis of the details of a myriad of transactions. Without these documents, the Trustee would not have had a case, since the witnesses on the Bradley side all testified to a different version of the facts. Conversely, the fact that the Lazarus Trust cooperated and provided the Bankruptcy Trustee with massive amounts of documents allowed the Court to apportion the burden of proof to the Trustee with the result that the Trustee did not prevail on all of his arguments.
Wednesday, August 08, 2007
Cash Value of Surrendered Policy Not Exempt In Texas
The Fifth Circuit has held that proceeds from a surrendered whole-life policy are not exempt under Texas law. Trautman vs. Milligan, No. 06-50363 (5th Cir. 8/8/07). The Trautman decision relied on both interpretation of the Texas Insurance Code and policy considerations.
In Trautman, the Debtor owned an insurance policy in which he was the insured and his wife was the beneficiary. Prior to bankruptcy, he surrendered the policy and received a check for the cash value. He claimed the un-cashed check as exempt property. The Bankruptcy Court allowed the exemption, but both the District Court and the Fifth Circuit held that the property was not exempt.
The exemption turned upon statutory language which provided that “the cash value and proceeds of an insurance policy, to be provided to an insured or beneficiary” under an insurance policy issued by a life, health or accident insurance company were exempt. Texas Insurance Code Sec. 1108.051.
The Court of Appeals noted the difference between three parties to an insurance contract: the owner, the insured and the beneficiary. In this case, the husband was both the owner of the policy and the insured, while the wife was the beneficiary. The Insurance Code protects “cash value” and “proceeds” payable to an “insured” or a “beneficiary.” At first blush, there appears to be a reasonable argument for the exemption. After all, the undisputed facts were that the policy was surrendered and that the cash value was paid to the husband, who was both owner and insured. However, the Court found that the funds were paid to the husband, not as insured, but as owner. Since amounts paid to owners are not listed as exempt, the argument failed.
The Court of Appeals also noted that cash values had not always been protected from creditors. The Court surmised that the legislature allowed exemption of cash values in order to prevent creditors from seizing the value of the policy and thwarting the interest of the beneficiary. However, the Court did not feel that allowing the debtor to use a whole-life policy as a savings account free from the claims of creditors was a worthy goal. Indeed, the court noted that under the debtor’s proposed interpretation, a person could transfer funds into an insurance policy and then immediately surrender the policy and shelter the proceeds from creditors. The Court succinctly remarked that “That can’t be the law.”
This case points out an important bankruptcy planning consideration. Cash value contained within an existing insurance policy is protected by statute, while cash value in a surrendered policy is not. As a result, a financially distressed debtor will be better off waiting until after bankruptcy (and after the period for objecting to exemptions has passed) before accessing the cash value of a policy. Additionally, a debtor who needs temporary access to policy cash values will be better served by borrowing against the policy rather than surrendering it.
While the Court of Appeals was concerned about debtors fraudulently transferring their cash into an insurance policy, this possibility is addressed by the statute itself. Under Texas Insurance Code Sec. 1108.053(1), the exemption does not apply to “a premium payment made in fraud of a creditor, subject to the applicable statute of limitations for recovering the payment.”
In Trautman, the Debtor owned an insurance policy in which he was the insured and his wife was the beneficiary. Prior to bankruptcy, he surrendered the policy and received a check for the cash value. He claimed the un-cashed check as exempt property. The Bankruptcy Court allowed the exemption, but both the District Court and the Fifth Circuit held that the property was not exempt.
The exemption turned upon statutory language which provided that “the cash value and proceeds of an insurance policy, to be provided to an insured or beneficiary” under an insurance policy issued by a life, health or accident insurance company were exempt. Texas Insurance Code Sec. 1108.051.
The Court of Appeals noted the difference between three parties to an insurance contract: the owner, the insured and the beneficiary. In this case, the husband was both the owner of the policy and the insured, while the wife was the beneficiary. The Insurance Code protects “cash value” and “proceeds” payable to an “insured” or a “beneficiary.” At first blush, there appears to be a reasonable argument for the exemption. After all, the undisputed facts were that the policy was surrendered and that the cash value was paid to the husband, who was both owner and insured. However, the Court found that the funds were paid to the husband, not as insured, but as owner. Since amounts paid to owners are not listed as exempt, the argument failed.
The Court of Appeals also noted that cash values had not always been protected from creditors. The Court surmised that the legislature allowed exemption of cash values in order to prevent creditors from seizing the value of the policy and thwarting the interest of the beneficiary. However, the Court did not feel that allowing the debtor to use a whole-life policy as a savings account free from the claims of creditors was a worthy goal. Indeed, the court noted that under the debtor’s proposed interpretation, a person could transfer funds into an insurance policy and then immediately surrender the policy and shelter the proceeds from creditors. The Court succinctly remarked that “That can’t be the law.”
This case points out an important bankruptcy planning consideration. Cash value contained within an existing insurance policy is protected by statute, while cash value in a surrendered policy is not. As a result, a financially distressed debtor will be better off waiting until after bankruptcy (and after the period for objecting to exemptions has passed) before accessing the cash value of a policy. Additionally, a debtor who needs temporary access to policy cash values will be better served by borrowing against the policy rather than surrendering it.
While the Court of Appeals was concerned about debtors fraudulently transferring their cash into an insurance policy, this possibility is addressed by the statute itself. Under Texas Insurance Code Sec. 1108.053(1), the exemption does not apply to “a premium payment made in fraud of a creditor, subject to the applicable statute of limitations for recovering the payment.”
Monday, July 23, 2007
District Court Reverses Discharge Violation; Finds Some Violations Too Technical to Punish
Are some violations of the discharge injunction too technical or trivial to justify enforcement? According to a U.S. District Court Judge in Texas, the answer is yes, and the holding, if correct, may highlight an important distinction between the penalties for violation of the stay and the discharge. No. SA-06-CV-0439-RF, Cadles of Grassy Meadows II, LLC v. Joyce Gervin (W.D. Tex. 11/21/06)(Royal Ferguson, D.J.).
20+ Years of Background (That’s Over a Fifth of a Century!)
The facts in the Gervin case are pretty complex and span over 20 years of time. However, a thumbnail sketch should be able to capture the essentials. Back in 1983, George Gervin was granted a 50% interest in a partnership called the 401 Group. In both 1984 and 1992, George assigned half of his interest in the 401 Group to his wife Joyce Gervin. While the 401 Group was informed of this transfer, Joyce was never formally admitted as a partner.
In 1986, he was sued by TCAP on a $2 million debt, which resulted in an agreed judgment in 1989. For nine years, TCAP and various assignees tried to chase George and succeeded in obtaining a charging order against George’s interest in the 401 Group.
George and Joyce filed for chapter 7 bankruptcy in San Antonio in 1998. The Gervins did not disclose their separate interests in the 401 Group, referring to it as community property. While the Gervins received a discharge, the Bankruptcy Court also determined that TCAP and its successor held a valid lien against George’s interest in the 401 Group.
Cadles of Grassy Meadows acquired the debt in 2000. Some four years later, on September 15, 2004, Cadles asked the Washington state court to compel the sale of the 401 Group, so that it could attach and sell George’s 50% partnership interest. On September 21, 2004, Joyce’s counsel informed Cadles that she owned a 25% interest in the 401 Group. Then on September 24, 2004, Joyce filed an action in Bankruptcy Court seeking to prevent the sale of her interest as being in violation of the discharge. She succeeded in obtaining a preliminary injunction. Notwithstanding the bankruptcy court injunction, the Washington state court entered an order compelling the sale of George’s interest in the 401 Group; however, the state court did not determine the extent of George’s interest.
Meanwhile, back in Texas, the Bankruptcy Court entered summary judgment finding that Joyce did in fact own a 25% interest in the 401 Group and that Cadles had violated Joyce’s discharge by trying to collect from her property. After a trial on damages, the Bankruptcy Court awarded Joyce $25,000 for emotional distress and $18,190 in attorney’s fees.
The District Court Ruling
Cadles was not very happy with this result and appealed. On appeal, the U.S. District Court sustained the Bankruptcy Court’s ruling that Joyce had a valid 25% interest in the 401 Group. However, it reversed the contempt judgment, finding that either there was not a violation of the discharge at all, or that the violation was so insignificant as to be unworthy of recompense.
While the Bankruptcy Court granted summary judgment that the discharge injunction had been violated, the District Court could not discern any detailed findings as to how the discharge had been violated. Indeed, Cadles contended that the Bankruptcy Court had initially intended to hold a separate hearing on the discharge violation, but instead signed an order finding the violation had occurred. This left the District Court to make its own examination.
Initially, the District Court noted that Bankruptcy Courts have the power to enforce their orders through contempt and that damages may be awarded. However, in order to find contempt, there must be an unambiguous order and an obvious violation of the order. Here, there was a prior order allowing pursuit of George’s interest in the 401 Group, but no determination of the extent of that interest. The District Court found that this made “it difficult for Cadles to assess if its actions were violating the order.” Order Granting in Part and Denying in Part, p. 17.
The Court found that this alone was sufficient to negate the finding of contempt. However, the Court went on to find that there was not an obvious violation of a court order either. In this case, Cadles sought the charging order on September 15, 2004, but did not learn about Joyce’s claimed interest in the 401 Group until September 21, 2004. Three days later, Joyce filed the adversary proceeding. Thus, when Cadles began pursuing the charging order on the 15th, it had no basis for knowing that this action would violate the discharge at the time.
The Court went on to state that even if there had been a violation, it was too minor to warrant damages. Judge Ferguson stated:
“While the Bankruptcy Code provides bankruptcy courts with the power to find a party in contempt, the code does not require such a finding. As the Supreme Court notes, ‘[the Bankruptcy Code] does not provide bankruptcy courts with a roving writ, much less a free hand. The authority bestowed thereunder may be invoked only if, and to the extent that, the equitable remedy dispensed by the court is necessary to preserve an identifiable right conferred elsewhere in the Bankruptcy Code.’ Cadle’s violation of the discharge injunction, if one existed at all, was technical, trivial, and most certainly not the kind of action contempt findings were meant to prevent.”
Order Granting in Party and Denying in Part, pp. 18-19.
Both parties were dissatisfied with the District Court’s split decision and an appeal to the Fifth Circuit is currently pending.
What is the Relevant Time Period?
There is a serious disconnect between the way in which the Bankruptcy Court and the District Court viewed the undisputed facts. The District Court essentially looked at three different time periods. First, there was the period from September 15, 2004, the date on which Cadles requested the sale order, until September 21, 2004, the date on which Joyce gave notice of her interest in the 401 Group. Because Cadles had no notice prior to this date, it could not be held charged with violation of the discharge. There was a second period from September 21, 2004 until September 24, 2004 in which Cadles knew of Joyce’s interest but did not withdraw its request. The District Court found that this inaction was either a non-violation or a technical violation. Finally, there was the period after September 24, 2004 in which the parties were litigating the issue of Joyce’s interest in Bankruptcy Court. The District Court did not consider this to be a violation.
The Bankruptcy Court did not divide its analysis into periods. However, in its Memorandum Decision on damages, No. 04-5138, (Bankr. W.D. Tex. 11/12/05), the Court was clearly considering a much lengthier period of violation. In assessing damages, the Court recounted that Joyce made 20 panicked calls to her accountant over the period of a year and that she did not sleep well for a period of two years. Memorandum Decision, p. 13. However, it is difficult to discern either a one year period or a two year period from any of the documents in the record. The earliest date on which Cadles took action was September 15, 2004. The Bankruptcy Court entered summary judgment finding that Cadles was in contempt on May 17, 2005. The Bankruptcy Court entered its Memorandum Decision on damages on November 12, 2005. Thus, the only way a period of a year or more could apply is if the Bankruptcy Court found that Cadles was in contempt for violating the discharge during the entire period from its first filing to the Bankruptcy Court’s ruling on damages. However, during all but nine days of this period the parties were litigating the extent of Joyce’s interest in the 401 Group in Bankruptcy Court. It seems likely that the Bankruptcy Court assessed damages for the period in which the parties were litigating the extent of Joyce's property interest and therefore the extent of her protection under the discharge.
What Standard Did the Courts Apply?
Although both the Bankruptcy Court and the District Court ruled on the discharge issue, neither court explicitly set out the legal standard it was applying. The Bankruptcy Court appeared to apply a strict liability standard. The unstated premise of the Bankruptcy Court ruling seems to be that because Cadles tried to levy on Joyce’s property, Cadles violated Joyce’s discharge regardless of whether Cadles had actual knowledge of Joyce’s interest and that this violation continued during the entire period in which Cadles disputed Joyce’s ownership interest in the 401 Group. The District Court, on the other hand, applied a knowing violation standard. The District Court did not charge Cadles with a duty to act until it had knowledge of Joyce’s claimed interest and therefore, knowledge that collection efforts would violate her discharge. From that point, there was a delay of a mere three days before Joyce initiated proceedings to declare her interest in the Bankruptcy Court. While Cadles proceeded subsequent to the Bankruptcy Court filing, it was careful to limit its action to proceeding against George’s interest, whatever that might be.
The difference between the courts’ rulings may well reflect their differing perspectives. The Bankruptcy Court, which deals with the automatic stay on a day in, day out basis, appeared to apply the same standard which would apply to a stay violation. By contrast, the District Court, which issues and enforces injunctions on a regular basis, applied a more conventional contempt standard. The distinction between the two is critical because the stay and the discharge, while both expressed as injunctions, have different scopes and remedies attached to them.
The automatic stay of section 362 includes a private right of action contained in §362(h). Section 362(h) allows any individual harmed by a willful violation of the stay to recover damages and allows additional relief if appropriate. A violation can be “willful” without a specific intent to violate the stay. A willful violation occurs where there is knowledge of the stay and intent to commit the act which violated the stay. Brown v. Chesnut, 422 F.3d 298 (5th Cir. 2005); Fleet Mortgage Group, Inc. v. Kaneb, 196 F.3d 265 (1st Cir. 1999).
On the other hand, there is no private right of action contained in the discharge injunction. Walls v. Wells Fargo Bank, 276 F.3d 502 (9th Cir. 2002). Instead, the discharge may be enforced under the Bankruptcy Court’s inherent contempt powers under §105. As suggested by the District Court, the civil contempt powers should not be applied where the application of the order (in this case the discharge injunction) is not clear. On the other hand, the automatic stay, which operates like a sheriff trying to maintain order in a midst of a saloon brawl, has a stricter application.
The distinction between the statutes rests on more than a simple happenstance of drafting. The automatic stay serves a broader purpose than the discharge injunction. As noted by the Fifth Circuit in Chesnut, the automatic stay is designed to protect creditors as well as debtors. The stay exists to preserve the estate, as well as to protect the debtor from collection efforts. The discharge injunction, on the other hand, exists solely to protect the debtor.
The Chesnut case provides a good counterpoint to the present one. In Chesnut, a creditor was informed that the debtor had an interest in real property titled in the name of his non-filing spouse. The creditor made a determination that this claim was erroneous and proceeded to foreclose. The U.S. District Court subsequently concluded that the creditor was correct in its assessment that the debtor lacked an interest in the property. However, the Fifth Circuit reversed, finding that the stay extended to an arguable interest in property, even if that interest was subsequently found to be lacking. The Court found that it was important to allow the Bankruptcy Court to examine the merits of the claim prior to allowing the creditor to proceed and noted the broad latitude given to the court to modify the stay upon request.
In the Gervin case, however, the creditor began by proceeding against property which appeared to be property which the Bankruptcy Court had expressly ruled was subject to the creditor’s non-dischargeable lien. Upon being informed that another party claimed an unrecorded interest in this property, the creditor paused and then amended its request to seek only the husband’s interest. This decision proved to be wise, since the interest of the other party was later validated. The important distinction here is that the creditor, faced with a possibly spurious claim, did not blindly proceed in the face of a dispute. While the creditor could be faulted for failing to immediately disclaim an interest in Joyce’s property, this delay was more technical or trivial and did not impugn the integrity of the court.
Gervin may prove to be an unusual case dependent upon unusual facts. In the typical discharge violation case, the application of the discharge is clear and the violation is obvious. However, Gervin certainly raises the possibility that some incidental violations of the discharge may not justify the invocation of the contempt power. An isolated collection letter may not be enough to suggest that the creditor is contemptuous of the authority of the Bankruptcy Court and its orders. If a violation could have been remedied by something less drastic, such as a phone call or a cease and desist letter, then perhaps resort to a full-blow adversary proceeding is premature. However, if a creditor is given fair warning that its actions violate the discharge and chooses to continue its efforts, then it would be contemptuous in both the popular and the legal sense of the word.
Disclaimer: One part of my practice involves representing creditors accused of violating the discharge. As a result, I have an interest in the arguments being advanced here. However, I do not represent the Cadle Company or its affiliates.
20+ Years of Background (That’s Over a Fifth of a Century!)
The facts in the Gervin case are pretty complex and span over 20 years of time. However, a thumbnail sketch should be able to capture the essentials. Back in 1983, George Gervin was granted a 50% interest in a partnership called the 401 Group. In both 1984 and 1992, George assigned half of his interest in the 401 Group to his wife Joyce Gervin. While the 401 Group was informed of this transfer, Joyce was never formally admitted as a partner.
In 1986, he was sued by TCAP on a $2 million debt, which resulted in an agreed judgment in 1989. For nine years, TCAP and various assignees tried to chase George and succeeded in obtaining a charging order against George’s interest in the 401 Group.
George and Joyce filed for chapter 7 bankruptcy in San Antonio in 1998. The Gervins did not disclose their separate interests in the 401 Group, referring to it as community property. While the Gervins received a discharge, the Bankruptcy Court also determined that TCAP and its successor held a valid lien against George’s interest in the 401 Group.
Cadles of Grassy Meadows acquired the debt in 2000. Some four years later, on September 15, 2004, Cadles asked the Washington state court to compel the sale of the 401 Group, so that it could attach and sell George’s 50% partnership interest. On September 21, 2004, Joyce’s counsel informed Cadles that she owned a 25% interest in the 401 Group. Then on September 24, 2004, Joyce filed an action in Bankruptcy Court seeking to prevent the sale of her interest as being in violation of the discharge. She succeeded in obtaining a preliminary injunction. Notwithstanding the bankruptcy court injunction, the Washington state court entered an order compelling the sale of George’s interest in the 401 Group; however, the state court did not determine the extent of George’s interest.
Meanwhile, back in Texas, the Bankruptcy Court entered summary judgment finding that Joyce did in fact own a 25% interest in the 401 Group and that Cadles had violated Joyce’s discharge by trying to collect from her property. After a trial on damages, the Bankruptcy Court awarded Joyce $25,000 for emotional distress and $18,190 in attorney’s fees.
The District Court Ruling
Cadles was not very happy with this result and appealed. On appeal, the U.S. District Court sustained the Bankruptcy Court’s ruling that Joyce had a valid 25% interest in the 401 Group. However, it reversed the contempt judgment, finding that either there was not a violation of the discharge at all, or that the violation was so insignificant as to be unworthy of recompense.
While the Bankruptcy Court granted summary judgment that the discharge injunction had been violated, the District Court could not discern any detailed findings as to how the discharge had been violated. Indeed, Cadles contended that the Bankruptcy Court had initially intended to hold a separate hearing on the discharge violation, but instead signed an order finding the violation had occurred. This left the District Court to make its own examination.
Initially, the District Court noted that Bankruptcy Courts have the power to enforce their orders through contempt and that damages may be awarded. However, in order to find contempt, there must be an unambiguous order and an obvious violation of the order. Here, there was a prior order allowing pursuit of George’s interest in the 401 Group, but no determination of the extent of that interest. The District Court found that this made “it difficult for Cadles to assess if its actions were violating the order.” Order Granting in Part and Denying in Part, p. 17.
The Court found that this alone was sufficient to negate the finding of contempt. However, the Court went on to find that there was not an obvious violation of a court order either. In this case, Cadles sought the charging order on September 15, 2004, but did not learn about Joyce’s claimed interest in the 401 Group until September 21, 2004. Three days later, Joyce filed the adversary proceeding. Thus, when Cadles began pursuing the charging order on the 15th, it had no basis for knowing that this action would violate the discharge at the time.
The Court went on to state that even if there had been a violation, it was too minor to warrant damages. Judge Ferguson stated:
“While the Bankruptcy Code provides bankruptcy courts with the power to find a party in contempt, the code does not require such a finding. As the Supreme Court notes, ‘[the Bankruptcy Code] does not provide bankruptcy courts with a roving writ, much less a free hand. The authority bestowed thereunder may be invoked only if, and to the extent that, the equitable remedy dispensed by the court is necessary to preserve an identifiable right conferred elsewhere in the Bankruptcy Code.’ Cadle’s violation of the discharge injunction, if one existed at all, was technical, trivial, and most certainly not the kind of action contempt findings were meant to prevent.”
Order Granting in Party and Denying in Part, pp. 18-19.
Both parties were dissatisfied with the District Court’s split decision and an appeal to the Fifth Circuit is currently pending.
What is the Relevant Time Period?
There is a serious disconnect between the way in which the Bankruptcy Court and the District Court viewed the undisputed facts. The District Court essentially looked at three different time periods. First, there was the period from September 15, 2004, the date on which Cadles requested the sale order, until September 21, 2004, the date on which Joyce gave notice of her interest in the 401 Group. Because Cadles had no notice prior to this date, it could not be held charged with violation of the discharge. There was a second period from September 21, 2004 until September 24, 2004 in which Cadles knew of Joyce’s interest but did not withdraw its request. The District Court found that this inaction was either a non-violation or a technical violation. Finally, there was the period after September 24, 2004 in which the parties were litigating the issue of Joyce’s interest in Bankruptcy Court. The District Court did not consider this to be a violation.
The Bankruptcy Court did not divide its analysis into periods. However, in its Memorandum Decision on damages, No. 04-5138, (Bankr. W.D. Tex. 11/12/05), the Court was clearly considering a much lengthier period of violation. In assessing damages, the Court recounted that Joyce made 20 panicked calls to her accountant over the period of a year and that she did not sleep well for a period of two years. Memorandum Decision, p. 13. However, it is difficult to discern either a one year period or a two year period from any of the documents in the record. The earliest date on which Cadles took action was September 15, 2004. The Bankruptcy Court entered summary judgment finding that Cadles was in contempt on May 17, 2005. The Bankruptcy Court entered its Memorandum Decision on damages on November 12, 2005. Thus, the only way a period of a year or more could apply is if the Bankruptcy Court found that Cadles was in contempt for violating the discharge during the entire period from its first filing to the Bankruptcy Court’s ruling on damages. However, during all but nine days of this period the parties were litigating the extent of Joyce’s interest in the 401 Group in Bankruptcy Court. It seems likely that the Bankruptcy Court assessed damages for the period in which the parties were litigating the extent of Joyce's property interest and therefore the extent of her protection under the discharge.
What Standard Did the Courts Apply?
Although both the Bankruptcy Court and the District Court ruled on the discharge issue, neither court explicitly set out the legal standard it was applying. The Bankruptcy Court appeared to apply a strict liability standard. The unstated premise of the Bankruptcy Court ruling seems to be that because Cadles tried to levy on Joyce’s property, Cadles violated Joyce’s discharge regardless of whether Cadles had actual knowledge of Joyce’s interest and that this violation continued during the entire period in which Cadles disputed Joyce’s ownership interest in the 401 Group. The District Court, on the other hand, applied a knowing violation standard. The District Court did not charge Cadles with a duty to act until it had knowledge of Joyce’s claimed interest and therefore, knowledge that collection efforts would violate her discharge. From that point, there was a delay of a mere three days before Joyce initiated proceedings to declare her interest in the Bankruptcy Court. While Cadles proceeded subsequent to the Bankruptcy Court filing, it was careful to limit its action to proceeding against George’s interest, whatever that might be.
The difference between the courts’ rulings may well reflect their differing perspectives. The Bankruptcy Court, which deals with the automatic stay on a day in, day out basis, appeared to apply the same standard which would apply to a stay violation. By contrast, the District Court, which issues and enforces injunctions on a regular basis, applied a more conventional contempt standard. The distinction between the two is critical because the stay and the discharge, while both expressed as injunctions, have different scopes and remedies attached to them.
The automatic stay of section 362 includes a private right of action contained in §362(h). Section 362(h) allows any individual harmed by a willful violation of the stay to recover damages and allows additional relief if appropriate. A violation can be “willful” without a specific intent to violate the stay. A willful violation occurs where there is knowledge of the stay and intent to commit the act which violated the stay. Brown v. Chesnut, 422 F.3d 298 (5th Cir. 2005); Fleet Mortgage Group, Inc. v. Kaneb, 196 F.3d 265 (1st Cir. 1999).
On the other hand, there is no private right of action contained in the discharge injunction. Walls v. Wells Fargo Bank, 276 F.3d 502 (9th Cir. 2002). Instead, the discharge may be enforced under the Bankruptcy Court’s inherent contempt powers under §105. As suggested by the District Court, the civil contempt powers should not be applied where the application of the order (in this case the discharge injunction) is not clear. On the other hand, the automatic stay, which operates like a sheriff trying to maintain order in a midst of a saloon brawl, has a stricter application.
The distinction between the statutes rests on more than a simple happenstance of drafting. The automatic stay serves a broader purpose than the discharge injunction. As noted by the Fifth Circuit in Chesnut, the automatic stay is designed to protect creditors as well as debtors. The stay exists to preserve the estate, as well as to protect the debtor from collection efforts. The discharge injunction, on the other hand, exists solely to protect the debtor.
The Chesnut case provides a good counterpoint to the present one. In Chesnut, a creditor was informed that the debtor had an interest in real property titled in the name of his non-filing spouse. The creditor made a determination that this claim was erroneous and proceeded to foreclose. The U.S. District Court subsequently concluded that the creditor was correct in its assessment that the debtor lacked an interest in the property. However, the Fifth Circuit reversed, finding that the stay extended to an arguable interest in property, even if that interest was subsequently found to be lacking. The Court found that it was important to allow the Bankruptcy Court to examine the merits of the claim prior to allowing the creditor to proceed and noted the broad latitude given to the court to modify the stay upon request.
In the Gervin case, however, the creditor began by proceeding against property which appeared to be property which the Bankruptcy Court had expressly ruled was subject to the creditor’s non-dischargeable lien. Upon being informed that another party claimed an unrecorded interest in this property, the creditor paused and then amended its request to seek only the husband’s interest. This decision proved to be wise, since the interest of the other party was later validated. The important distinction here is that the creditor, faced with a possibly spurious claim, did not blindly proceed in the face of a dispute. While the creditor could be faulted for failing to immediately disclaim an interest in Joyce’s property, this delay was more technical or trivial and did not impugn the integrity of the court.
Gervin may prove to be an unusual case dependent upon unusual facts. In the typical discharge violation case, the application of the discharge is clear and the violation is obvious. However, Gervin certainly raises the possibility that some incidental violations of the discharge may not justify the invocation of the contempt power. An isolated collection letter may not be enough to suggest that the creditor is contemptuous of the authority of the Bankruptcy Court and its orders. If a violation could have been remedied by something less drastic, such as a phone call or a cease and desist letter, then perhaps resort to a full-blow adversary proceeding is premature. However, if a creditor is given fair warning that its actions violate the discharge and chooses to continue its efforts, then it would be contemptuous in both the popular and the legal sense of the word.
Disclaimer: One part of my practice involves representing creditors accused of violating the discharge. As a result, I have an interest in the arguments being advanced here. However, I do not represent the Cadle Company or its affiliates.
Tuesday, June 26, 2007
Judge Isgur Refuses to Apply Vicarious Disqualification
Judge Marvin Isgur of the Southern District of Texas has rejected application of a per se vicarious disqualification rule in a case involving Bracewell Giuliani. No. 07-32417, In re Cygnus Oil and Gas Corporation, (Bankr. S.D. Tex. 5/29/07). In the Cygnus case, a Bracewell partner owed 100,000 shares of the debtor and has served as a director for four months during the year prior to bankruptcy. Under the language of 11 U.S.C. §101(14), the individual partner was clearly not a disinterested person entitled to be employed. If the interested status of the partner was imputed to the firm, then the firm itself would not be disinterested and could not be employed.
Judge Isgur noted that the Delaware Bankruptcy Court had applied the per se rule of vicarious disqualification. In re Essential Therapeutics, Inc., 295 B.R. 203 (Bankr. D. Del. 2003). That court found that in the “current climate of distrust of officers and directors” the corporate leadership could be subjected to interrogation for their role making it “impossible” for a firm employing such an officer or director to adequately represent the debtor’s interests.
Going out on a limb, Judge Isgur pointed out that the Ninth Circuit BAP had rejected a per se approach to vicarious disqualification. In re S.S. Retail Stores Corp., 211 B.R. 699 (9th Cir. BAP 1997). Moving on to more solid ground, the court found that the statutory language did not support the pre se rule. Judge Isgur stated:
“Rules of statutory interpretation direct the Court to ‘presume that a legislature says in a statute what it means and means in a statute what it says there.’ (citation omitted). On examination of §101(14), this Court, in accordance with the majority of circuits addressing this issue, finds that no per se rule of disqualification exists under the Bankruptcy Code. ‘Person’ is defined in §101(41) as including an ‘individual, partnership, and corporation.’ (citation omitted). The Code is unambiguous. Section 101(14) by its plain language applies to any ‘person.’ ‘Person’ specifically refers to Bracewell. McBride is the equity holder and was the Cygnus director—not Bracewell. Had Congress intended to impute a single member’s disqualification to her entire firm, it would have done so. (citation omitted). Accordingly, the Court find that based on a plain reading of the statute, Bracewell is not disqualified . . . “
Memorandum Opinion at 5.
However, the Court did not stop at this conclusion. It went on to note that under §101(14)(C), a firm could be disqualified if it possessed “an interest materially adverse to the estate . . . by reason of a direct or indirect relationship to . . . the debtor.” The firm clearly had an indirect relationship to the debtor because of the interest of its partner. However, Bracewell established that (i) its partner no longer maintained a role with the debtor, (ii) that he owned 0.3% of the debtor’s stock, (iii) that he agreed not to vote his shares, (iv) that shareholders were unlikely to receive anything from the debtor’s estate and (v) and that the former director had been “walled off” from the reorganization team. The Court found that no evidence had been presented that the firm would have a materially adverse interest based on the fact that one of its many partners had served as a director for a brief period of time.
Judge Isgur should get credit for reading the statute the way Congress wrote it. Section 101(14)(A) and (B) absolutely exclude certain specified “persons” from the definition of “disinterested person,” while Section 101(14)(C) applies to both direct and indirect relationships. Thus, the per se rule applies to direct relationships, while the “materially adverse” standard applies to indirect relationships as well. Indirect relationships require a factual inquiry, while direct relationships invoke per se disqualification. This standard is sensitive enough to identify actual conflicts (for example, if a firm employing Jeffrey Skilling had applied to represent Enron), while weeding out technical ones (as in the Cygnus Oil case).
Bracewell also gets credit for making the proper disclosures. Unlike the John Gellene case (discussed in this blog last year), Bracewell was prompt to point out its “connections” with the debtor as required by Fed.R.Bankr.P. 2014. As a result, the court was able to examine the evidence and render a decision on the front end of the case. The Cygnus case certainly provides a powerful case for the benefits of making full disclosure up front.
While Cygnus Oil certainly upholds the canon of strict statutory construction, its benefits are more likely to flow to mega-firms than small ones. In a firm where one litigation partner out of many hundreds of overall partners had been a director of the debtor, it is easy to avoid finding a materially adverse interest. However, where one out of three lawyers in a firm had been intimately involved with the debtor, disqualification would be more difficult to avoid.
As a post-script, it is worth noting that the employment rules exclude firms which fail the disinterested test, but do not require the employment of the most qualified firms. The quality of the firm employed is governed by both the open market and the court’s ability to approve the fees requested. If a firm is disinterested but mediocre, it could be hoped that an efficient market place would not employ that firm or that the court would reduce the fees awarded to that firm causing the inefficient firm to withdraw from the marketplace.
Judge Isgur noted that the Delaware Bankruptcy Court had applied the per se rule of vicarious disqualification. In re Essential Therapeutics, Inc., 295 B.R. 203 (Bankr. D. Del. 2003). That court found that in the “current climate of distrust of officers and directors” the corporate leadership could be subjected to interrogation for their role making it “impossible” for a firm employing such an officer or director to adequately represent the debtor’s interests.
Going out on a limb, Judge Isgur pointed out that the Ninth Circuit BAP had rejected a per se approach to vicarious disqualification. In re S.S. Retail Stores Corp., 211 B.R. 699 (9th Cir. BAP 1997). Moving on to more solid ground, the court found that the statutory language did not support the pre se rule. Judge Isgur stated:
“Rules of statutory interpretation direct the Court to ‘presume that a legislature says in a statute what it means and means in a statute what it says there.’ (citation omitted). On examination of §101(14), this Court, in accordance with the majority of circuits addressing this issue, finds that no per se rule of disqualification exists under the Bankruptcy Code. ‘Person’ is defined in §101(41) as including an ‘individual, partnership, and corporation.’ (citation omitted). The Code is unambiguous. Section 101(14) by its plain language applies to any ‘person.’ ‘Person’ specifically refers to Bracewell. McBride is the equity holder and was the Cygnus director—not Bracewell. Had Congress intended to impute a single member’s disqualification to her entire firm, it would have done so. (citation omitted). Accordingly, the Court find that based on a plain reading of the statute, Bracewell is not disqualified . . . “
Memorandum Opinion at 5.
However, the Court did not stop at this conclusion. It went on to note that under §101(14)(C), a firm could be disqualified if it possessed “an interest materially adverse to the estate . . . by reason of a direct or indirect relationship to . . . the debtor.” The firm clearly had an indirect relationship to the debtor because of the interest of its partner. However, Bracewell established that (i) its partner no longer maintained a role with the debtor, (ii) that he owned 0.3% of the debtor’s stock, (iii) that he agreed not to vote his shares, (iv) that shareholders were unlikely to receive anything from the debtor’s estate and (v) and that the former director had been “walled off” from the reorganization team. The Court found that no evidence had been presented that the firm would have a materially adverse interest based on the fact that one of its many partners had served as a director for a brief period of time.
Judge Isgur should get credit for reading the statute the way Congress wrote it. Section 101(14)(A) and (B) absolutely exclude certain specified “persons” from the definition of “disinterested person,” while Section 101(14)(C) applies to both direct and indirect relationships. Thus, the per se rule applies to direct relationships, while the “materially adverse” standard applies to indirect relationships as well. Indirect relationships require a factual inquiry, while direct relationships invoke per se disqualification. This standard is sensitive enough to identify actual conflicts (for example, if a firm employing Jeffrey Skilling had applied to represent Enron), while weeding out technical ones (as in the Cygnus Oil case).
Bracewell also gets credit for making the proper disclosures. Unlike the John Gellene case (discussed in this blog last year), Bracewell was prompt to point out its “connections” with the debtor as required by Fed.R.Bankr.P. 2014. As a result, the court was able to examine the evidence and render a decision on the front end of the case. The Cygnus case certainly provides a powerful case for the benefits of making full disclosure up front.
While Cygnus Oil certainly upholds the canon of strict statutory construction, its benefits are more likely to flow to mega-firms than small ones. In a firm where one litigation partner out of many hundreds of overall partners had been a director of the debtor, it is easy to avoid finding a materially adverse interest. However, where one out of three lawyers in a firm had been intimately involved with the debtor, disqualification would be more difficult to avoid.
As a post-script, it is worth noting that the employment rules exclude firms which fail the disinterested test, but do not require the employment of the most qualified firms. The quality of the firm employed is governed by both the open market and the court’s ability to approve the fees requested. If a firm is disinterested but mediocre, it could be hoped that an efficient market place would not employ that firm or that the court would reduce the fees awarded to that firm causing the inefficient firm to withdraw from the marketplace.
Wednesday, June 13, 2007
Assigned Credit Card Debt: A Problem of Paper, Electronic Images and Faith
Two recent decisions from Texas Bankruptcy Courts highlight the practical problems inherent in proving up a claim based on assigned credit card debt. However, they also illustrate the tenuous connection between trust and value in the electronic age.
The Cases
The two cases involved a common fact pattern but different outcomes. In both cases, a debtor incurred credit card debt and then filed bankruptcy. In the bankruptcy case, a third party filed a proof of claim as the assignee of the original creditor. The Debtor then objected on the basis that the entity claiming to hold the claim was unknown to it and that the documentation attached to the claim was insufficient. In In re Tran, No. 05-82180 (Bankr. S.D. Tex. 9/6/06)(Brown, Ch.B.J.) aff’d, eCast Settlement Corporation v. Tran, No. H-06-2965 (S.D. Tex. 5/14/07)(Miller, .J.) , the Court required the assignee to meet the same burden of proof which would apply to a suit on a contract in state court and the claims were denied. In In re Joe Ray Griffin, No. 06-11130 (Bankr. W.D. Tex. 5/17/07)(Monroe, B.J.), the Court allowed the claim on a finding that the underlying claim was undisputed without requiring the assignee to establish its provenance.
Lack of Evidence Dooms Tran Creditor
The Tran opinion takes a very methodical approach to the claims objection. The Court started with the question of whether the objection raised by the Debtor fell within a ground established under §502(b). The Court found that the Debtor’s objection that it did not owe any money to eCast Settlement Corporation fell within the statutory language that the claim should be allowed unless it was enforceable under any agreement or applicable law.
The Court then sought to determine who had the burden of going forward under Fed.R.Bankr.P. 3001. Under Rule 3001(f), a properly filed proof of claim is entitled to prima facie validity. If the claim is entitled to prima facie validity, the objecting party must go forward with evidence to rebut the prima facie case, at which point the burden shifts to the creditor. On the other hand, if the claim is not properly filed, it is not entitled to prima facie validity and the creditor bears both the burden of going forward with the evidence and the burden of persuasion. The Court noted that in order to be entitled to prima facie validity, a claim based on a writing must be supported by a copy of the writing or by a statement that the writing has been lost or destroyed. Fed.R.Bankr.P. 3001(c). The Court then found that under Texas law, a claim on a credit card is treated as a claim for breach of a written contract so that a copy of the written contract was necessary to give the claim prima facie validity. Since the assignee attached only a summary of a few pertinent details relating to the contract, the Court concluded that the claim was not entitled to prima facie validity and placed the entire burden on the putative claimant. The Court rejected the argument that the creditor could substitute a summary for voluminous documents on the basis that the creditor had not shown that the underlying contract was voluminous.
In this case, allocating the burden was tantamount to determining the objection. Because the creditor had the entire burden, it had to prove the existence of a contract. The Court discussed the types of evidence which could prove the existence of a contract under Texas law.
“Under Texas law, the affidavit of a custodian of the creditor’s records, whose duties include having custody and control of records related to the debtor’s account which purports to: (1) authenticate the credit card agreement documents and monthly statements; and (2) state the account balance due and unpaid, may be sufficient to prove the formation or the terms of the agreement. (citation omitted). The elements of breach of contract may be proved by introduction of debtor’s signatory reply to the bank’s predecessor in interest’s revolving credit offer; bank’s subsequent issuance of new credit cards to debtor with proof of use; monthly statements billed to debtor and debtor’s payment including a copy of a canceled check showing a payment to the bank based upon the debtor’s unique identifying revolving credit account number; admission of the debtor in debtor’s discovery responses; and subsequent absence of payment. (citation omitted). Where one bank has purchased the revolving account from another bank, the custodian of the purchaser bank’s records is competent to testify about the predecessor bank’s records in the purchaser’s possession. (citation omitted). “
Order Regarding Objection to Claims, p. 8.
Here, the creditor did not offer any of these forms of proof. Instead, the creditor sought to have the debtor prove up certain credit card statements relating to the account. The court found these statements to be insufficient to prove the existence of a contract and also insufficient to establish the Debtor’s liability to eCast. As a result, the Court denied the claims.
The Tran case was appealed to the U.S. District Court which entered an order affirming the Bankruptcy Court on May 14, 2007. The District Court opinion brought out an additional fact not apparent from the Bankruptcy Court opinion. Apparently eCast Settlement Corporation had produced general assignments from various banks to it, which did not specifically reference the Tran account. However, these assignments were excluded from evidence as hearsay.
The District Court agreed with the Bankruptcy Court that failure to attach the writing that the claims were based upon deprived the claims of their prima facie validity. The District Court noted that eCast’s “boilerplate” statement about summarizing voluminous documents might satisfy the proof of claim form but did not satisfy Rule 3001(c). The District Court also agreed with the Bankruptcy Court that failure to establish prima facie validity under Rule 3001(f) left the entire burden on eCast.
The District Court agreed that eCast had failed to satisfy its burden of proof. The Court’s discussion is very illuminating as to what evidence would have been sufficient.
“ECast had the opportunity to introduce evidence during the evidentiary hearing held June 20, 2006 before Chief United States Bankruptcy Judge Karen Brown to support its claim beyond what was attached to its proofs of claim. As discussed above, eCast introduced evidence and examined Teresa Tran at that hearing. The court found that there were several key documents, any of which could have satisfied eCast’s burden of proof had they been entered into evidence. An affidavit from the custodian of records: (i) authenticating the credit card agreement; (ii) authenticating monthly statements; or (iii) certifying the unpaid balance and balance due could have met eCast’s burden. (citation omitted). More relevant to eCast’s situation, the court found that one who has purchased an account from a bank may rely upon the custodian of the purchaser’s records to fulfill the requirements above. (citation omitted). Rather than introduce any of the types of evidence discussed above, eCast attempted to introduce general assignment agreements from three banking institutions which were excluded on evidentiary grounds. (citation omitted). The Court notes that eCast offered no witness to establish the validity of their claim as discussed above and no affidavit to authenticate documents as discussed above. Furthermore, eCast failed to offer any evidence beyond a few monthly statements—clearly insufficient on their own—to establish the existence of a contract or the amount owed under Texas law. The court proceeded a step further showing that even if eCast had established the validity of their claim, they still failed to establish the amount of their claim pursuant to Texas law.”
Memorandum and Order, pp. 11-12. The District Court approved of the Bankruptcy Court’s reasoning in this regard and thus affirmed the decision to deny the claims.
In a curious ruling, the District Court held that eCast was not required to prove that it was the assignee of the original creditors. It stated, “It was not assigned the burden to prove it rightfully acquired the claim. There are specific elements that ECast must establish to show an enforceable contract. . . . However, eCast was not required to produce assignments or transfer documents, and doing so would not alone have established a valid and enforceable claim under Texas law.” Memorandum and Order, p. 12.
Finally, the District Court ruled that eCast should not have been allowed to amend its claims to include the required proof. The Bankruptcy Court had denied an oral motion to continue the hearing on the basis that the hearing had been long scheduled. The District Court found that undue delay was a proper ground for denying a request for leave to amend.
As a result, the District Court affirmed the Bankruptcy Court in all respects.
Statements Good Enough For Griffin Creditor
The creditor in the Griffin case was able to prevail because it managed to amend its claim to point that it reached prima facie validity. In Griffin, the creditor filed a claim in the name of “B-Real, LLC/Chase Bank, N.A.” According to the court, the original claim was “woefully deficient” in that it was supported only by a summary reflecting the closing balance, but did not even include an account number. Upon receiving an objection, the creditor amended its proof of claim to attach account statements for the debt for several months prior to bankruptcy. However, it did not include any documentation showing a transfer of the debt from Chase Bank, N.A. to B-Real, LLC.
Judge Monroe found that in order for a claim filed by the original creditor to have prima facie validity, it must include the following elements:
the name and account of the debtor or debtors;
the amount of the debt;
it must be in the form of a business record or other reliable format; and
if the claim includes charges such as interest, late fees and attorney’s fees, the summary must include a statement giving a break-down of those elements.
Judge Monroe found that the account statements attached to B-Real’s claim satisfied these elements, stating “They are sufficient for all parties to assure themselves that the claim that is being asserted in the amended claim appears valid…” As a result, Judge Monroe found that the claim was entitled to prima facie validity. However, from there, the court had to decide whether the creditor asserting the claim had to prove its ownership of the claim. The Court noted that Fed.R.Bankr.P. 3001(e)(1) required evidence of transfer of the claim only if the claim is transferred after the original creditor files a proof of claim. The Court declined to impose an additional requirement not found in the rules (i.e., that a assignee who is the first person to file a claim on the account must prove the transfer). The Debtor did not produce any evidence. As a result, the court found that the prima facie validity of the claim carried the day and denied the objection.
Reconciling the Two Cases
Although the two cases arrived at different results, they share some common reasoning:
Both cases agree that a mere summary attached in support of a proof of claim is insufficient;
Both cases appear to agree that a properly proven up account statement may be sufficient for some purposes; and
Both cases agree that an assignee is not required to prove how it acquired the claim if the original creditor has not previously filed a proof of claim.
The key distinction between the two cases appears to be that in Griffin, account statements attached to the amended proof of claim were found to be adequate to give the claim prima facie validity. In Tran, the Bankruptcy Court expressly stated that “The writing required by Rule 3001(c) which must be filed with a claim in order to entitle that claim to prima facie evidentiary effect is, under Texas law, the written contract between the parties.” Because the District Court held that eCast’s “boilerplate” was not sufficient to convey prima facie evidentiary value, it did not reach the issue of what would have been adequate. However, the District Court went on to state that a business records affidavit proving up the account statement would be sufficient to satisfy the creditor’s burden of persuasion. But did the District Court really mean this? In Tran, the Debtor admitted to owing at least one of the debts in the approximate amount claimed by the creditor. An admission from the Debtor should have had the same evidentiary value as a properly proven account statement (which the District Court suggested would have been adequate). However, the District Court did not acknowledge this evidence. Thus, while the District Court opinion in Tran seems to suggest that a properly proven account statement would be adequate to prove the debt, it is not clear that the District Court intended to depart from the Bankruptcy Court’s insistence on producing the contract. As a result, the ultimate meaning of Tran is pretty murky.
Contracts, Account Statements and Faith
One summer during college, I worked in the installment loan department of a bank. My duties included typing up promissory notes and security agreements. After a loan officer personally met with the customer to execute the documents, they would come back to the installment loan department where they were kept in a vault. Under this model of credit, the obligations of the parties were easy to determine. All someone needed to do was to go to the vault and find the promissory note (assuming that I had not misfiled it). The customer’s signature appeared on the operative documents and an actual bank officer was present at the time that it was executed.
Credit cards used to be one step removed from this paradigm. Back in the old days, a person would present their credit card, which would be imprinted onto a form and signed by the customer. The credit card slip was like a miniature promissory note. Critically, it was a document signed by the customer. The charge slip would be mailed into the credit card issuer who would enter all of the charges onto a statement and send it to the customer. When the customer received the statement, he could compare it to his copies of the charge slips and dispute any items which were not correct. However, as to any other terms, such as interest or fees, he pretty much had to trust the credit card company to accurately implement the contract. While the customer may have received a copy of the contract at some point, it is unlikely that he ever kept a copy. Thus, credit cards required a higher degree of trust than a traditional promissory note.
Credit cards have continued to evolve from hard copy miniature promissory notes to electronic impulses. Today customers may or may not sign a credit card slip. If the charge statement is signed at all, it is likely to be stored as a digital image. More likely, the credit card is swiped through an electronic reader, entered into an online form or given out over the telephone. The electronic data representing the charges is stored in a computer somewhere and converted into a statement. Customers may elect to receive their statements electronically and have their payments automatically withdrawn from their bank accounts. As a result, both paper and human involvement have been greatly reduced. Credit card issuers merge, change names or sell portfolios with great frequency so that statements are likely to appear from unfamiliar parties. As a result, the element of trust or perhaps blind faith assumes a greater and greater role. The ordinary customer must have faith that the company sending out the statement indeed owns the account, that the customer’s transactions have been accurately converted into electronic data and that the issuer has accurately applied the contract.
When accounts enter charge-off or bankruptcy status, any connection to the signed promissory note sitting in a vault at the bank is long gone. Companies purchase large portfolios of accounts with minimal documentation. Accounts may change hands multiple times as they are sold and resold for progressively less. At the end of the process, the account may be reduced to a series of numbers reflecting the account number and the amount claimed to be owed. Neither the customer nor the final creditor are likely to have a copy of the original agreement or the original statements. At this point, there is little more than faith to connect the series of numbers with an actual commercial transaction that occurred at some point in the past.
The transition from paper documents to faith-based electronic data has significant consequences for the legal system. At one end of the spectrum is the original Tran opinion, which requires the creditor to produce its contract and its statements, much like the bank which could take the note out of the vault. Under this model, the debtor can scrutinize every transaction against the contract and verify that the calculations are correct. Of course, there is really no way for the debtor to know whether the document being produced as the contract bears any semblance to the original, since the customer likely did not read or retain that document. In this instance, producing the contract is a well-meaning but largely empty gesture.
Judge Monroe’s opinion in Griffin places a higher emphasis on the role of faith. The debtor receives a statement each month. Under federal law, the debtor can dispute the charges on the statement. If the debtor does not dispute the charges, then the parties have chosen to believe that the information contained on the statement is correct. The numbers on the statement become the reality for the parties regardless of what the contract actually provided. When a debtor completes her schedules, she is likely to rely on the account statements. If there is a congruence between the debt claimed and the debt scheduled, it is reasonable for the court to assume that amount is correct. If the parties have a substantive dispute, it is more likely to involve whether a charge was incurred or even whether the debtor ever opened the account. However, the parties are unlikely to litigate about interest rates or over limit fees for the simple reason that it is not practical to do so.
Assignees and Faith
The truly curious aspect of both the Bankruptcy Court opinion in Griffin and the District Court opinion in Tran is that neither court thought that it was important for the person claiming to be the creditor to prove that they actually owned the debt. Part of the standard prove-up for a promissory note is that a creditor show that they are the owner and holder of the note. However, in both of the recent cases, this element was treated as irrelevant. Indeed, only Judge Monroe sought to justify his position.
Judge Monroe relied on the fact that Rule 3001(e) required a transferee to provide evidence of the transfer if someone else had already filed a proof of claim. He stated that “this court should not impose any additional requirement on a claim transferee that does not appear in the Rules of Bankruptcy Procedure or the statute itself.” This argument fails to recognize the difference between the two circumstances. Where one creditor has already filed a claim and a second creditor also files the same claim, there must be a procedure to choose between the two competing claimants. Rule 3001(e) serves to resolve disputes between creditors.
On the other hand, when a stranger appears claiming to own the debt, the issue is whether the putative claimant is the rightful creditor or an imposter. If the legitimate creditor fails to file a claim, this should not mean that any opportunistic party should be able to step in and file a claim for their own account. Owning the claim is the central fact of being a creditor so that this should not be too much to ask.
Judge Monroe was apparently willing to take it on faith that a person in possession of the account statements was a legitimate assignee rather than an interloper. If a person claiming to be an assignee files a claim and includes copies of the account statements, there are four likely possibilities:
(1) The person is a legitimate assignee and obtained the statements from the original creditor;
(2) The person received a legitimate assignment of the claim but then assigned it on to a third party;
(3) The person hacked into the legitimate creditor’s computer and appropriated the data; or
(4) The person obtained the statements from the debtor (either through trickery or through more low tech methods such as going through the debtor’s trash).
Of these possibilities, the first is the most likely and the others are likely to be smoked out by appearance of a competing creditor. Additionally, the criminal penalties for filing a false proof of claim combined with the probability of getting caught should deter most scam artists. On the other hand, requiring a legitimate assignee to prove its ownership of the claim may cause some proper claims to be denied due to lack of documentation. As a matter of efficiency (rather than strict legal construction), using possession of the account statements as a substitute for proof of assignment will probably lead to allowance of more legitimate claims than the alternative.
The Cases
The two cases involved a common fact pattern but different outcomes. In both cases, a debtor incurred credit card debt and then filed bankruptcy. In the bankruptcy case, a third party filed a proof of claim as the assignee of the original creditor. The Debtor then objected on the basis that the entity claiming to hold the claim was unknown to it and that the documentation attached to the claim was insufficient. In In re Tran, No. 05-82180 (Bankr. S.D. Tex. 9/6/06)(Brown, Ch.B.J.) aff’d, eCast Settlement Corporation v. Tran, No. H-06-2965 (S.D. Tex. 5/14/07)(Miller, .J.) , the Court required the assignee to meet the same burden of proof which would apply to a suit on a contract in state court and the claims were denied. In In re Joe Ray Griffin, No. 06-11130 (Bankr. W.D. Tex. 5/17/07)(Monroe, B.J.), the Court allowed the claim on a finding that the underlying claim was undisputed without requiring the assignee to establish its provenance.
Lack of Evidence Dooms Tran Creditor
The Tran opinion takes a very methodical approach to the claims objection. The Court started with the question of whether the objection raised by the Debtor fell within a ground established under §502(b). The Court found that the Debtor’s objection that it did not owe any money to eCast Settlement Corporation fell within the statutory language that the claim should be allowed unless it was enforceable under any agreement or applicable law.
The Court then sought to determine who had the burden of going forward under Fed.R.Bankr.P. 3001. Under Rule 3001(f), a properly filed proof of claim is entitled to prima facie validity. If the claim is entitled to prima facie validity, the objecting party must go forward with evidence to rebut the prima facie case, at which point the burden shifts to the creditor. On the other hand, if the claim is not properly filed, it is not entitled to prima facie validity and the creditor bears both the burden of going forward with the evidence and the burden of persuasion. The Court noted that in order to be entitled to prima facie validity, a claim based on a writing must be supported by a copy of the writing or by a statement that the writing has been lost or destroyed. Fed.R.Bankr.P. 3001(c). The Court then found that under Texas law, a claim on a credit card is treated as a claim for breach of a written contract so that a copy of the written contract was necessary to give the claim prima facie validity. Since the assignee attached only a summary of a few pertinent details relating to the contract, the Court concluded that the claim was not entitled to prima facie validity and placed the entire burden on the putative claimant. The Court rejected the argument that the creditor could substitute a summary for voluminous documents on the basis that the creditor had not shown that the underlying contract was voluminous.
In this case, allocating the burden was tantamount to determining the objection. Because the creditor had the entire burden, it had to prove the existence of a contract. The Court discussed the types of evidence which could prove the existence of a contract under Texas law.
“Under Texas law, the affidavit of a custodian of the creditor’s records, whose duties include having custody and control of records related to the debtor’s account which purports to: (1) authenticate the credit card agreement documents and monthly statements; and (2) state the account balance due and unpaid, may be sufficient to prove the formation or the terms of the agreement. (citation omitted). The elements of breach of contract may be proved by introduction of debtor’s signatory reply to the bank’s predecessor in interest’s revolving credit offer; bank’s subsequent issuance of new credit cards to debtor with proof of use; monthly statements billed to debtor and debtor’s payment including a copy of a canceled check showing a payment to the bank based upon the debtor’s unique identifying revolving credit account number; admission of the debtor in debtor’s discovery responses; and subsequent absence of payment. (citation omitted). Where one bank has purchased the revolving account from another bank, the custodian of the purchaser bank’s records is competent to testify about the predecessor bank’s records in the purchaser’s possession. (citation omitted). “
Order Regarding Objection to Claims, p. 8.
Here, the creditor did not offer any of these forms of proof. Instead, the creditor sought to have the debtor prove up certain credit card statements relating to the account. The court found these statements to be insufficient to prove the existence of a contract and also insufficient to establish the Debtor’s liability to eCast. As a result, the Court denied the claims.
The Tran case was appealed to the U.S. District Court which entered an order affirming the Bankruptcy Court on May 14, 2007. The District Court opinion brought out an additional fact not apparent from the Bankruptcy Court opinion. Apparently eCast Settlement Corporation had produced general assignments from various banks to it, which did not specifically reference the Tran account. However, these assignments were excluded from evidence as hearsay.
The District Court agreed with the Bankruptcy Court that failure to attach the writing that the claims were based upon deprived the claims of their prima facie validity. The District Court noted that eCast’s “boilerplate” statement about summarizing voluminous documents might satisfy the proof of claim form but did not satisfy Rule 3001(c). The District Court also agreed with the Bankruptcy Court that failure to establish prima facie validity under Rule 3001(f) left the entire burden on eCast.
The District Court agreed that eCast had failed to satisfy its burden of proof. The Court’s discussion is very illuminating as to what evidence would have been sufficient.
“ECast had the opportunity to introduce evidence during the evidentiary hearing held June 20, 2006 before Chief United States Bankruptcy Judge Karen Brown to support its claim beyond what was attached to its proofs of claim. As discussed above, eCast introduced evidence and examined Teresa Tran at that hearing. The court found that there were several key documents, any of which could have satisfied eCast’s burden of proof had they been entered into evidence. An affidavit from the custodian of records: (i) authenticating the credit card agreement; (ii) authenticating monthly statements; or (iii) certifying the unpaid balance and balance due could have met eCast’s burden. (citation omitted). More relevant to eCast’s situation, the court found that one who has purchased an account from a bank may rely upon the custodian of the purchaser’s records to fulfill the requirements above. (citation omitted). Rather than introduce any of the types of evidence discussed above, eCast attempted to introduce general assignment agreements from three banking institutions which were excluded on evidentiary grounds. (citation omitted). The Court notes that eCast offered no witness to establish the validity of their claim as discussed above and no affidavit to authenticate documents as discussed above. Furthermore, eCast failed to offer any evidence beyond a few monthly statements—clearly insufficient on their own—to establish the existence of a contract or the amount owed under Texas law. The court proceeded a step further showing that even if eCast had established the validity of their claim, they still failed to establish the amount of their claim pursuant to Texas law.”
Memorandum and Order, pp. 11-12. The District Court approved of the Bankruptcy Court’s reasoning in this regard and thus affirmed the decision to deny the claims.
In a curious ruling, the District Court held that eCast was not required to prove that it was the assignee of the original creditors. It stated, “It was not assigned the burden to prove it rightfully acquired the claim. There are specific elements that ECast must establish to show an enforceable contract. . . . However, eCast was not required to produce assignments or transfer documents, and doing so would not alone have established a valid and enforceable claim under Texas law.” Memorandum and Order, p. 12.
Finally, the District Court ruled that eCast should not have been allowed to amend its claims to include the required proof. The Bankruptcy Court had denied an oral motion to continue the hearing on the basis that the hearing had been long scheduled. The District Court found that undue delay was a proper ground for denying a request for leave to amend.
As a result, the District Court affirmed the Bankruptcy Court in all respects.
Statements Good Enough For Griffin Creditor
The creditor in the Griffin case was able to prevail because it managed to amend its claim to point that it reached prima facie validity. In Griffin, the creditor filed a claim in the name of “B-Real, LLC/Chase Bank, N.A.” According to the court, the original claim was “woefully deficient” in that it was supported only by a summary reflecting the closing balance, but did not even include an account number. Upon receiving an objection, the creditor amended its proof of claim to attach account statements for the debt for several months prior to bankruptcy. However, it did not include any documentation showing a transfer of the debt from Chase Bank, N.A. to B-Real, LLC.
Judge Monroe found that in order for a claim filed by the original creditor to have prima facie validity, it must include the following elements:
the name and account of the debtor or debtors;
the amount of the debt;
it must be in the form of a business record or other reliable format; and
if the claim includes charges such as interest, late fees and attorney’s fees, the summary must include a statement giving a break-down of those elements.
Judge Monroe found that the account statements attached to B-Real’s claim satisfied these elements, stating “They are sufficient for all parties to assure themselves that the claim that is being asserted in the amended claim appears valid…” As a result, Judge Monroe found that the claim was entitled to prima facie validity. However, from there, the court had to decide whether the creditor asserting the claim had to prove its ownership of the claim. The Court noted that Fed.R.Bankr.P. 3001(e)(1) required evidence of transfer of the claim only if the claim is transferred after the original creditor files a proof of claim. The Court declined to impose an additional requirement not found in the rules (i.e., that a assignee who is the first person to file a claim on the account must prove the transfer). The Debtor did not produce any evidence. As a result, the court found that the prima facie validity of the claim carried the day and denied the objection.
Reconciling the Two Cases
Although the two cases arrived at different results, they share some common reasoning:
Both cases agree that a mere summary attached in support of a proof of claim is insufficient;
Both cases appear to agree that a properly proven up account statement may be sufficient for some purposes; and
Both cases agree that an assignee is not required to prove how it acquired the claim if the original creditor has not previously filed a proof of claim.
The key distinction between the two cases appears to be that in Griffin, account statements attached to the amended proof of claim were found to be adequate to give the claim prima facie validity. In Tran, the Bankruptcy Court expressly stated that “The writing required by Rule 3001(c) which must be filed with a claim in order to entitle that claim to prima facie evidentiary effect is, under Texas law, the written contract between the parties.” Because the District Court held that eCast’s “boilerplate” was not sufficient to convey prima facie evidentiary value, it did not reach the issue of what would have been adequate. However, the District Court went on to state that a business records affidavit proving up the account statement would be sufficient to satisfy the creditor’s burden of persuasion. But did the District Court really mean this? In Tran, the Debtor admitted to owing at least one of the debts in the approximate amount claimed by the creditor. An admission from the Debtor should have had the same evidentiary value as a properly proven account statement (which the District Court suggested would have been adequate). However, the District Court did not acknowledge this evidence. Thus, while the District Court opinion in Tran seems to suggest that a properly proven account statement would be adequate to prove the debt, it is not clear that the District Court intended to depart from the Bankruptcy Court’s insistence on producing the contract. As a result, the ultimate meaning of Tran is pretty murky.
Contracts, Account Statements and Faith
One summer during college, I worked in the installment loan department of a bank. My duties included typing up promissory notes and security agreements. After a loan officer personally met with the customer to execute the documents, they would come back to the installment loan department where they were kept in a vault. Under this model of credit, the obligations of the parties were easy to determine. All someone needed to do was to go to the vault and find the promissory note (assuming that I had not misfiled it). The customer’s signature appeared on the operative documents and an actual bank officer was present at the time that it was executed.
Credit cards used to be one step removed from this paradigm. Back in the old days, a person would present their credit card, which would be imprinted onto a form and signed by the customer. The credit card slip was like a miniature promissory note. Critically, it was a document signed by the customer. The charge slip would be mailed into the credit card issuer who would enter all of the charges onto a statement and send it to the customer. When the customer received the statement, he could compare it to his copies of the charge slips and dispute any items which were not correct. However, as to any other terms, such as interest or fees, he pretty much had to trust the credit card company to accurately implement the contract. While the customer may have received a copy of the contract at some point, it is unlikely that he ever kept a copy. Thus, credit cards required a higher degree of trust than a traditional promissory note.
Credit cards have continued to evolve from hard copy miniature promissory notes to electronic impulses. Today customers may or may not sign a credit card slip. If the charge statement is signed at all, it is likely to be stored as a digital image. More likely, the credit card is swiped through an electronic reader, entered into an online form or given out over the telephone. The electronic data representing the charges is stored in a computer somewhere and converted into a statement. Customers may elect to receive their statements electronically and have their payments automatically withdrawn from their bank accounts. As a result, both paper and human involvement have been greatly reduced. Credit card issuers merge, change names or sell portfolios with great frequency so that statements are likely to appear from unfamiliar parties. As a result, the element of trust or perhaps blind faith assumes a greater and greater role. The ordinary customer must have faith that the company sending out the statement indeed owns the account, that the customer’s transactions have been accurately converted into electronic data and that the issuer has accurately applied the contract.
When accounts enter charge-off or bankruptcy status, any connection to the signed promissory note sitting in a vault at the bank is long gone. Companies purchase large portfolios of accounts with minimal documentation. Accounts may change hands multiple times as they are sold and resold for progressively less. At the end of the process, the account may be reduced to a series of numbers reflecting the account number and the amount claimed to be owed. Neither the customer nor the final creditor are likely to have a copy of the original agreement or the original statements. At this point, there is little more than faith to connect the series of numbers with an actual commercial transaction that occurred at some point in the past.
The transition from paper documents to faith-based electronic data has significant consequences for the legal system. At one end of the spectrum is the original Tran opinion, which requires the creditor to produce its contract and its statements, much like the bank which could take the note out of the vault. Under this model, the debtor can scrutinize every transaction against the contract and verify that the calculations are correct. Of course, there is really no way for the debtor to know whether the document being produced as the contract bears any semblance to the original, since the customer likely did not read or retain that document. In this instance, producing the contract is a well-meaning but largely empty gesture.
Judge Monroe’s opinion in Griffin places a higher emphasis on the role of faith. The debtor receives a statement each month. Under federal law, the debtor can dispute the charges on the statement. If the debtor does not dispute the charges, then the parties have chosen to believe that the information contained on the statement is correct. The numbers on the statement become the reality for the parties regardless of what the contract actually provided. When a debtor completes her schedules, she is likely to rely on the account statements. If there is a congruence between the debt claimed and the debt scheduled, it is reasonable for the court to assume that amount is correct. If the parties have a substantive dispute, it is more likely to involve whether a charge was incurred or even whether the debtor ever opened the account. However, the parties are unlikely to litigate about interest rates or over limit fees for the simple reason that it is not practical to do so.
Assignees and Faith
The truly curious aspect of both the Bankruptcy Court opinion in Griffin and the District Court opinion in Tran is that neither court thought that it was important for the person claiming to be the creditor to prove that they actually owned the debt. Part of the standard prove-up for a promissory note is that a creditor show that they are the owner and holder of the note. However, in both of the recent cases, this element was treated as irrelevant. Indeed, only Judge Monroe sought to justify his position.
Judge Monroe relied on the fact that Rule 3001(e) required a transferee to provide evidence of the transfer if someone else had already filed a proof of claim. He stated that “this court should not impose any additional requirement on a claim transferee that does not appear in the Rules of Bankruptcy Procedure or the statute itself.” This argument fails to recognize the difference between the two circumstances. Where one creditor has already filed a claim and a second creditor also files the same claim, there must be a procedure to choose between the two competing claimants. Rule 3001(e) serves to resolve disputes between creditors.
On the other hand, when a stranger appears claiming to own the debt, the issue is whether the putative claimant is the rightful creditor or an imposter. If the legitimate creditor fails to file a claim, this should not mean that any opportunistic party should be able to step in and file a claim for their own account. Owning the claim is the central fact of being a creditor so that this should not be too much to ask.
Judge Monroe was apparently willing to take it on faith that a person in possession of the account statements was a legitimate assignee rather than an interloper. If a person claiming to be an assignee files a claim and includes copies of the account statements, there are four likely possibilities:
(1) The person is a legitimate assignee and obtained the statements from the original creditor;
(2) The person received a legitimate assignment of the claim but then assigned it on to a third party;
(3) The person hacked into the legitimate creditor’s computer and appropriated the data; or
(4) The person obtained the statements from the debtor (either through trickery or through more low tech methods such as going through the debtor’s trash).
Of these possibilities, the first is the most likely and the others are likely to be smoked out by appearance of a competing creditor. Additionally, the criminal penalties for filing a false proof of claim combined with the probability of getting caught should deter most scam artists. On the other hand, requiring a legitimate assignee to prove its ownership of the claim may cause some proper claims to be denied due to lack of documentation. As a matter of efficiency (rather than strict legal construction), using possession of the account statements as a substitute for proof of assignment will probably lead to allowance of more legitimate claims than the alternative.
Tuesday, June 05, 2007
Bad Debtors Find Limited Homestead Protection
When Congress amended the bankruptcy laws, one of its goals was to eliminate the practice of pouring money into an exempt homestead prior to filing bankruptcy. Due to the inviolability of the homestead under Texas law, this had been a time-honored practice. One Fifth Circuit opinion referred to paying off the mortgage prior to filing bankruptcy as “legitimate pre-bankruptcy planning.” Matter of Bowyer, 932 F.2d 1100 (5th Cir. 1991). The legislative history to the Bankruptcy Code noted that, “As under current law, the debtor will be permitted to nonexempt property into exempt property prior to filing a bankruptcy petition.” H.R. Rep. No. 95-595 (1977), at 361. However, two recent opinions demonstrate just how far things have changed.
For Mr. Green, Things Are Not So Serene
In In re Henry Alan Green, 2007 Bankr. LEXIS 1296 (Bankr. W.D. Tex. 4/9/07) and In re Teresa M. Green,(Bankr. W.D. Tex. 4/9/07) (Monroe, B.J.), the prediction that involuntary bankruptcy cases would be filed to attach homestead assets came to fruition. The Greens were not the most sympathetic debtors. While being sued by a relative (who subsequently recovered a judgment for over $500,000), the Greens liquidated their California assets and bought a Texas home for $1.44 million. As noted by the Court, the amount which they sunk into their new home was over three times what it would have taken to pay the judgment creditor. They then filed for chapter 7 in January 2005. The justifiably angry aunt objected to their discharge and prevailed. Under prior law, this would have resulted in a Mexican standoff where the Greens could not discharge their debts but would remain secure that their homestead was their castle.
However, then the law changed. Under the new law, it the Debtor acquires a homestead within 1,215 days prior to filing, the amount of the exemption is limited to $125,000. See 11 U.S.C. §522(p)(1)(B) and (D). As a result, the justifiably angry aunt wanted to see the Greens in bankruptcy so that the homestead property could be liquidated.
This is where some clever strategizing came in. If a debtor has 12 or more creditors, three creditors must join in hte petition; however, for less than 12 creditors, only a single petitioning creditor is required. Taken together, Mr. and Mrs Green had over twelve creditors, so that a single petitioning creditor could not institute an involuntary petition against them jointly. The petitioning creditor initiated separate cases against each of the spouses. The Bankruptcy Court rejected the argument that both debtors were liable upon each other's debts just because they were married. Instead, the court did an analysis of each debt as to each debtors. The court concluded that Mr. Green had eleven countable creditors and that Mrs. Green had eight. As a result, a single creditor could initiate the separate involuntary petitions against each of them. This opinion, like Judge Monroe’s prior opinion in In re Sadler, No. 06-10091 (Bankr. W.D. Tex. 10/18/06), contains a good discussion of how to count creditors for purposes of an involuntary petition.
The Green opinion is devoted to counting creditors for purposes of an involuntary bankruptcy petition. However, the issue of allowing the judgment creditor to access the homestead overshadows the more mundane issues written on by the court.
Debtor Snared By Sec. 522(o)
Another feature initiated by BAPCPA was the 10-year look back period for amounts invested into a homestead with intent to hinder, delay or defraud. 11 U.S.C. §522(o). In In re (Name Withheld by Request), 366 B.R. 677 (Bankr. S.D. Tex. 5/11/07)(Bohm, B.J.), Bankruptcy Judge Jeff Bohm waded through a lot of facts to deliver a 69 page opinion finding that $50,000 invested into a homestead on the eve of bankruptcy could not be claimed as exempt, while denying various other objections to exemptions.
Prior to filing bankruptcy, the Debtor sold stock which he owned and deposited $50,000 of the proceeds to his wife’s account. His wife then used these funds as the down payment for a residence in Bastrop County in her name. The Debtor and his wife then sold their existing residence. When the Debtor filed bankruptcy, he initially did not schedule the Bastrop County property, but subsequently amended his schedules and claimed it as exempt.
The Trustee objected to the exemption. At some point, Debtor’s counsel decided that the Debtor was not cooperating with her and withdrew. The Debtor represented himself at the exemption hearing.
Judge Bohm found that there were four elements to sustain an objection to exemption under §522(o).
"(1) the debtor disposed of property within ten years preceding the bankrutpcy filing; (2) the property that the debtor disposed of was nonexempt; (3) some of the proceeds from the sale of nonexempt property were used to buy a new homestead, improve an existing homestead, or reduce the debt associated with an existing homestead, or, alternatively, to buy a new principal residence used by dependents of the debtor, improve an existing principal residence used by dependents of the debtor, or reduce the debt associated with a principal residence used by dependents of the debtor; and (4) the debtor disposed of the nonexempt property with the intent to hinder, delay or defraud a creditor."
366 B.R. at 688.
The Court did not have much difficulty with the first three elements. The Debtor sold stock which was nonexempt within the year prior to the bankruptcy. $50,000 of those proceeds could be traced into the Bastrop property. Although the Debtor himself did not reside on the Bastrop property, neither the Trustee nor any creditor had challenged the property’s status as homestead. As a result, the proceeds had been used to purchase a homestead for the debtor or alternatively for his dependents, since his two minor children were living there.
In discussing intent to hinder, delay or defraud, the Court relied on a badges of fraud analysis. The Court noted thirteen possible badges of fraud based on several cases and the Texas Uniform Fraudulent Transfer Act. The Court found that eleven of these badges of fraud were present with regard to the $50,000 transfer. While the Court engaged in an extensive discussion, the facts that the Debtor sold nonexempt property at a time that he was being threatened with suit, invested those funds in exempt property in his wife’s name, promptly filed bankruptcy and failed to accurately disclose the transactions on his schedules and statement of financial affairs should have been more than enough. Interestingly enough, in finding that the Debtor “absconded,” the Court relied on testimony from the Debtor’s former counsel about his failure to appear at the 341 meeting and her difficulties in locating and communicating with him. While this testimony may indicate a problem client, it is a little bit of a stretch to construe this as absconding.
The Court rejected the Debtor’s defense that he had effectively partitioned the funds when he deposited them in his wife’s account. The provision of the Texas Constitution allowing for a partition of martial assets has an express exception for transfers made with intent to hinder, delay or defraud creditors.
Things were not all bad for the Debtor. Judge Bohm ruled in his favor with regard to an additional payment of $11,540.99 which was paid on the Bastrop property. The Court found that $2,540.49 of these funds could be traced to the earnest money which the Debtor received for sale of his existing homestead, so that that this portion of the payment did not come from nonexempt property. As to the remaining $9,000, the Trustee was unable to show the source of the funds. The Trustee had the burden to prove that the property used was nonexempt (See Fed.R.Bankr.P. 4003). Because the Trustee could not show where the funds came from, he could not show that they came from nonexempt property. As a result, the Debtor's ability to obfuscate protected him in part.
The Court granted the Trustee an equitable lien on the Debtor’s Bastrop property in the amount of $50,000 and provided that the Trustee could enforce his lien if the Debtor did not repay the funds within 120 days.
The Court also rejected an objection to purchase of consumer goods used to furnish the new residence on the eve of bankruptcy. While §522(o) refers to “real or personal property that a debtor uses as a residence or claims as a homestead,” the reference to personal property involves the residence itself (for example, a mobile home) rather than the broader category of personal property used in connection with the residence. As a result, the Trustee’s objection failed.
As an added benefit, the Court included a section on credibility of the witnesses who testified before him. Trustee Ron Summers has now been found to be a credible witness in a written opinion. The Court also found that Debtor’s original attorney Barbara Rogers was “forthright and very knowledgeable” and “a very credible witness.” Given the encounters between Houston judges and other Houston Debtor’s attorneys in some recent cases, Ms. Rogers must be relieved to have represented a difficult client and emerged with her reputation judicially affirmed.
The Bottom Line
The box score for these cases should read Creditors 2 Homesteads 0. While Judge Monroe’s case was not about the homestead per se, the decision to allow the involuntary petitions made the loss of the homestead all but inevitable. These cases also illustrate the greater danger faced by Debtors who manipulate their homesteads on the eve of bankruptcy. In the Green case, the Debtors had already lost the discharge in their initial case. In the (Name Withheld by Request) case, there is now a judicial finding that the Debtor transferred property with intent to hinder, delay or defraud creditors during the year prior to bankruptcy. As a result, it appears probable that both debtors will lose their discharge and have the value of their homestead tapped.
The recent reform legislation enacted by Congress was named the Bankruptcy Abuse Prevention and Consumer Protection Act. While the consumer protection moniker has engendered snickers of sarcasm, Congress appears to have been successful in blocking one particular abuse of the bankruptcy process. Of course, it is yet to be known whether the net cast by the amendments to §522 will catch more innocent debtors unaware of the law's complexities than unscrupulous abusers of the system.
For Mr. Green, Things Are Not So Serene
In In re Henry Alan Green, 2007 Bankr. LEXIS 1296 (Bankr. W.D. Tex. 4/9/07) and In re Teresa M. Green,(Bankr. W.D. Tex. 4/9/07) (Monroe, B.J.), the prediction that involuntary bankruptcy cases would be filed to attach homestead assets came to fruition. The Greens were not the most sympathetic debtors. While being sued by a relative (who subsequently recovered a judgment for over $500,000), the Greens liquidated their California assets and bought a Texas home for $1.44 million. As noted by the Court, the amount which they sunk into their new home was over three times what it would have taken to pay the judgment creditor. They then filed for chapter 7 in January 2005. The justifiably angry aunt objected to their discharge and prevailed. Under prior law, this would have resulted in a Mexican standoff where the Greens could not discharge their debts but would remain secure that their homestead was their castle.
However, then the law changed. Under the new law, it the Debtor acquires a homestead within 1,215 days prior to filing, the amount of the exemption is limited to $125,000. See 11 U.S.C. §522(p)(1)(B) and (D). As a result, the justifiably angry aunt wanted to see the Greens in bankruptcy so that the homestead property could be liquidated.
This is where some clever strategizing came in. If a debtor has 12 or more creditors, three creditors must join in hte petition; however, for less than 12 creditors, only a single petitioning creditor is required. Taken together, Mr. and Mrs Green had over twelve creditors, so that a single petitioning creditor could not institute an involuntary petition against them jointly. The petitioning creditor initiated separate cases against each of the spouses. The Bankruptcy Court rejected the argument that both debtors were liable upon each other's debts just because they were married. Instead, the court did an analysis of each debt as to each debtors. The court concluded that Mr. Green had eleven countable creditors and that Mrs. Green had eight. As a result, a single creditor could initiate the separate involuntary petitions against each of them. This opinion, like Judge Monroe’s prior opinion in In re Sadler, No. 06-10091 (Bankr. W.D. Tex. 10/18/06), contains a good discussion of how to count creditors for purposes of an involuntary petition.
The Green opinion is devoted to counting creditors for purposes of an involuntary bankruptcy petition. However, the issue of allowing the judgment creditor to access the homestead overshadows the more mundane issues written on by the court.
Debtor Snared By Sec. 522(o)
Another feature initiated by BAPCPA was the 10-year look back period for amounts invested into a homestead with intent to hinder, delay or defraud. 11 U.S.C. §522(o). In In re (Name Withheld by Request), 366 B.R. 677 (Bankr. S.D. Tex. 5/11/07)(Bohm, B.J.), Bankruptcy Judge Jeff Bohm waded through a lot of facts to deliver a 69 page opinion finding that $50,000 invested into a homestead on the eve of bankruptcy could not be claimed as exempt, while denying various other objections to exemptions.
Prior to filing bankruptcy, the Debtor sold stock which he owned and deposited $50,000 of the proceeds to his wife’s account. His wife then used these funds as the down payment for a residence in Bastrop County in her name. The Debtor and his wife then sold their existing residence. When the Debtor filed bankruptcy, he initially did not schedule the Bastrop County property, but subsequently amended his schedules and claimed it as exempt.
The Trustee objected to the exemption. At some point, Debtor’s counsel decided that the Debtor was not cooperating with her and withdrew. The Debtor represented himself at the exemption hearing.
Judge Bohm found that there were four elements to sustain an objection to exemption under §522(o).
"(1) the debtor disposed of property within ten years preceding the bankrutpcy filing; (2) the property that the debtor disposed of was nonexempt; (3) some of the proceeds from the sale of nonexempt property were used to buy a new homestead, improve an existing homestead, or reduce the debt associated with an existing homestead, or, alternatively, to buy a new principal residence used by dependents of the debtor, improve an existing principal residence used by dependents of the debtor, or reduce the debt associated with a principal residence used by dependents of the debtor; and (4) the debtor disposed of the nonexempt property with the intent to hinder, delay or defraud a creditor."
366 B.R. at 688.
The Court did not have much difficulty with the first three elements. The Debtor sold stock which was nonexempt within the year prior to the bankruptcy. $50,000 of those proceeds could be traced into the Bastrop property. Although the Debtor himself did not reside on the Bastrop property, neither the Trustee nor any creditor had challenged the property’s status as homestead. As a result, the proceeds had been used to purchase a homestead for the debtor or alternatively for his dependents, since his two minor children were living there.
In discussing intent to hinder, delay or defraud, the Court relied on a badges of fraud analysis. The Court noted thirteen possible badges of fraud based on several cases and the Texas Uniform Fraudulent Transfer Act. The Court found that eleven of these badges of fraud were present with regard to the $50,000 transfer. While the Court engaged in an extensive discussion, the facts that the Debtor sold nonexempt property at a time that he was being threatened with suit, invested those funds in exempt property in his wife’s name, promptly filed bankruptcy and failed to accurately disclose the transactions on his schedules and statement of financial affairs should have been more than enough. Interestingly enough, in finding that the Debtor “absconded,” the Court relied on testimony from the Debtor’s former counsel about his failure to appear at the 341 meeting and her difficulties in locating and communicating with him. While this testimony may indicate a problem client, it is a little bit of a stretch to construe this as absconding.
The Court rejected the Debtor’s defense that he had effectively partitioned the funds when he deposited them in his wife’s account. The provision of the Texas Constitution allowing for a partition of martial assets has an express exception for transfers made with intent to hinder, delay or defraud creditors.
Things were not all bad for the Debtor. Judge Bohm ruled in his favor with regard to an additional payment of $11,540.99 which was paid on the Bastrop property. The Court found that $2,540.49 of these funds could be traced to the earnest money which the Debtor received for sale of his existing homestead, so that that this portion of the payment did not come from nonexempt property. As to the remaining $9,000, the Trustee was unable to show the source of the funds. The Trustee had the burden to prove that the property used was nonexempt (See Fed.R.Bankr.P. 4003). Because the Trustee could not show where the funds came from, he could not show that they came from nonexempt property. As a result, the Debtor's ability to obfuscate protected him in part.
The Court granted the Trustee an equitable lien on the Debtor’s Bastrop property in the amount of $50,000 and provided that the Trustee could enforce his lien if the Debtor did not repay the funds within 120 days.
The Court also rejected an objection to purchase of consumer goods used to furnish the new residence on the eve of bankruptcy. While §522(o) refers to “real or personal property that a debtor uses as a residence or claims as a homestead,” the reference to personal property involves the residence itself (for example, a mobile home) rather than the broader category of personal property used in connection with the residence. As a result, the Trustee’s objection failed.
As an added benefit, the Court included a section on credibility of the witnesses who testified before him. Trustee Ron Summers has now been found to be a credible witness in a written opinion. The Court also found that Debtor’s original attorney Barbara Rogers was “forthright and very knowledgeable” and “a very credible witness.” Given the encounters between Houston judges and other Houston Debtor’s attorneys in some recent cases, Ms. Rogers must be relieved to have represented a difficult client and emerged with her reputation judicially affirmed.
The Bottom Line
The box score for these cases should read Creditors 2 Homesteads 0. While Judge Monroe’s case was not about the homestead per se, the decision to allow the involuntary petitions made the loss of the homestead all but inevitable. These cases also illustrate the greater danger faced by Debtors who manipulate their homesteads on the eve of bankruptcy. In the Green case, the Debtors had already lost the discharge in their initial case. In the (Name Withheld by Request) case, there is now a judicial finding that the Debtor transferred property with intent to hinder, delay or defraud creditors during the year prior to bankruptcy. As a result, it appears probable that both debtors will lose their discharge and have the value of their homestead tapped.
The recent reform legislation enacted by Congress was named the Bankruptcy Abuse Prevention and Consumer Protection Act. While the consumer protection moniker has engendered snickers of sarcasm, Congress appears to have been successful in blocking one particular abuse of the bankruptcy process. Of course, it is yet to be known whether the net cast by the amendments to §522 will catch more innocent debtors unaware of the law's complexities than unscrupulous abusers of the system.
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