Tuesday, December 23, 2008

2008 Was a Busy Bankruptcy Year for the Fifth Circuit

The Fifth Circuit has busy this year. They have been turning out bankruptcy opinions at a rate where they might consider changing the name of the court to the Fifth Circuit Court of Bankruptcy Appeals. So far I have written a dozen articles about their decisions this year. However, there are still a lot of interesting cases that I didn’t get around to. Here is a quick rundown of the best of 2008 (and one from 2007). Where I have already written about a case, I have provided the reference to the prior article. Some cases can be summed up in a sentence while others are more complicated and some are just plain baffling.

Appellate Practice
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Matter of Gadzooks, Inc., 2008 U.S. App. LEXIS 19339 (5th Cir. 2008). “Fifth Circuit Dismisses Gadzooks Appeal.” (10/2/08).
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Matter of Hilal, 534 F.3d 498 (5th Cir. 2008).

Substantial consummation of plan did not result in dismissal of appeal based on equitable mootness where debtor framed his appeal narrowly.
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Matter of S.I. Restructuring, Inc., 542 F.3d 131 (5th Cir. 2008).
“Equitable Mootness Fails to Prevent Disgorgement” (10/2/08).
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Attorney Fees

Matter of Babcock & Wilcox Company, 526 F.3d 824 (5th Cir. 2008).

Bankruptcy court did not abuse its discretion in reducing amounts billed for travel time in half.
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Automatic Stay/Discharge
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Matter of Bayhi, 528 F.3d 393 (5th Cir. 2008).

This case is not easy to follow, but is worth reading, for no reason other than the fact that Chief Judge Edith Jones dissented to vindicate the debtor’s discharge. The case begins with a husband and wife who consolidated their student loan debts into a single obligation. Under Louisiana law, liability was in solido meaning that the creditor could seek recovery of the entire debt from either party or both. The couple divorced and agreed that each would pay half of the debt. The wife continued to pay until she filed bankruptcy. Although the husband was listed as a creditor, he did not file an action to determine dischargeability under Sec. 523(a)(15).

Post-discharge, the husband filed a declaratory judgment action seeking a determination that the debt was a community obligation and thus solidary. This was agreed to. Subsequently, he filed a complaint for specific performance seeking to compel the wife to pay her share of the student loan directly to Sallie Mae. The state court granted a judgment in the husband’s favor.

The wife then re-opened her bankruptcy and sought to have the husband held in contempt for violation of the discharge. The bankruptcy court agreed, finding the pro se husband in contempt, but did not award any damages. Instead, it enjoined the husband from seeking to collect the wife’s share of the debt and vacated the state court judgment.

On appeal, Judge Wiener, writing for himself and Judge Barksdale, voted to reverse and remand, while Chief Judge Jones dissented in part. Section 524(a)(1) states that the discharge “voids any judgment at any time obtained, to the extent that such judgment is a determination of the personal liability of the debtor with respect to any debt discharged . . .” The judges disagreed among themselves as to what was a debt.

The majority judges concluded that the wife’s obligation to pay one-half of the student loan debt pursuant to the divorce decree was not a “debt.” Therefore, it could not be discharged. Since the student loan debt was not discharged, the husband’s attempt to compel the wife to pay a non-discharged debt did not violate the discharge.

Chief Judge Jones agreed that the husband should not be held in contempt because “in asserting that novel claim, (the husband) did not intentionally violate his ex-wife’s discharge order and should not be subject to civil contempt for violation of the 11 U.S.C. §524(a) discharge injunction.” However, the Chief Judge held that vacating the state court judgment was nothing more than an end run around the discharge. Judge Jones viewed the wife’s obligation vis-à-vis the husband to pay one-half of the student loan debt as a separate debt from the student loan itself. While the husband could have sought a determination that his contribution right was not discharged pursuant to 11 U.S.C. §523(a)(15), he did not and his rights were discharged.

This is a case where the dissent has the better side of the argument. While the wife’s obligation to Sally Mae was clearly not discharged, the husband’s right to compel the wife to pay her share of the debt is “an equitable remedy for breach of performance” which can be reduced to judgment and thus falls within the definition of a claim under 11 U.S.C. §101(5)(B).

However, the dissent evenhandedly provides a benefit to the creditor as well. Because the husband was asserting a novel claim, he did not intentionally seek to violate the discharge. Before a creditor can be held in contempt, he must intentionally violate a court order. Where the scope of the order is unclear, contempt is not available. The dissent pairs nicely with the Gervin opinion, in which the creditor was held not to violate the discharge by trying to collect from property it believed was subject to its judgment lien, but was actually owned by the co-debtor.
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Campbell v. Countrywide Home Loans, Inc., 545 F.3d 348 (5th Cir. 2008).

At the time that Debtors filed chapter 13, they owed 15 delinquent mortgage payments, owed for taxes and insurance advanced for a prior year and had not made any escrow payments in the current year. Rather than including the current year’s escrow shortage in the proof of claim, the creditor stated that the amount of the post-petition payment would be increased to recoup these amounts. The Bankruptcy Court found that Countrywide had violated the automatic stay, but allowed for an interlocutory appeal prior to assessing damages.

Under RESPA, Countrywide had the right to increase the debtors’ payment by the amount of any insufficiency in the escrow account. The Fifth Circuit held that the pre-petition escrow arrearage was a “claim” within the meaning of the Bankruptcy Code and that the automatic stay applied to efforts to collect that claim. However, where the creditor did not actually collect the increased amount stated in the proof of claim and did not take any affirmative steps to collect the increased amount other than including the statement in the proof of claim, the creditor had not taken an action which violated the stay.
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Matter of Gervin, No. 07-50099 (5th Cir. 11/21/08)(unpub).

The Bankruptcy Court affirmed the District Court finding that the creditor did not violate the discharge when it attempted to collect a debt from property that it believed to be subject to its judgment lien. The District Court opinion is discussed at “District Court Reverses Discharge Violation; Finds Some Violations Too Technical to Punish.” (7/23/07).
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In re Repine, 536 F.3d 512 (5th Cir. 2008).
“Fifth Circuit Answers Three Questions of First Impression on Automatic Stay.” (7/25/08).
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Avoidance Actions
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Matter of Bossart, 2008 U.S. App. LEXIS 21807 (5th Cir. 2008)(unpub).

This unpublished opinion affirmed a bankruptcy court opinion allowing a trustee to sue a company which issued an annuity to recover the annuity payment as a fraudulent transfer. The case was essentially an end run around the debtor's claim of the annuity as exempt.
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In re Entringer Bakeries, 2008 U.S. App. LEXIS 23313 (5th Cir. 2008).
“Fifth Circuit Explains Earmarking” (11/6/08)
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Matter of N A Flash Foundation, Inc., 541 F.3d 385 (5th Cir. 2008).

Where creditor was paid out of debtor’s general operating account, but debtor would have received funds subject to a construction trust fund claim subsequently, creditor did not receive more than it would have in a hypothetical chapter 7 liquidation. In a hypothetical liquidation case, the court presumes that the debtor would have preserved the trust funds and the creditor would have been paid in full.
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Constitutionality

Hersh v. United States, No. 07-10226 (5th Cir. 12/18/08)
“Fifth Circuit Relies on Constitutional Avoidance to Uphold Sec. 526(a)(4)(12/19/08)
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Dischargeability

Matter of Shaffer, 515 F.3d 424 (5th Cir. 2008).

Dentist had license revoked and was required to pay costs incurred in investigation in amount of $217,852.13. Fifth Circuit held that costs were in compensation of actual pecuniary loss and therefore did not fall within exception to discharge for fines and penalties under 11 U.S.C. §523(a)(7).
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Due Process

Matter of Waterford Energy, 2008 U.S. App. LEXIS 20972 (5th Cir. 2008)(unpub).

The Debtor owned oil and gas well in Oklahoma and was required to pay royalties to the State of Oklahoma. When it filed bankruptcy, it did not give notice to the State, but it did file a copy of its bankruptcy petition and draft plan in the real estate records. Under Oklahoma law, a certified copy of a bankruptcy petition filed in the real estate records constitutes constructive notice. However, the Fifth Circuit held that federal law rather than state law controlled on question of whether constructive notice to unknown creditors was adequate. Notice by filing in the real estate records was inadequate. Notice to unknown creditors should have been given by publication. As a result, the State did not receive notice complying with due process and its claims were not discharged.
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Equitable Subordination

Matter of S.I. Restructuring, Inc., 532 F.3d 355 (5th Cir. 2008).
“Fifth Circuit Rejects Equitable Subordination Claim With Deepening Insolvency Aspect; Insiders Not Liable for Stoking Fires of Sinking Ship.” (7/1/08).
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Exempt Property
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Matter of McClain, 516 F.3d 301 (5th Cir. 2008).

Debtor purchased an insurance policy with funds which were not disclosed on his schedules. When the insured died, the trustee claimed the policy proceeds under a constructive trust theory. The Fifth Circuit held that the trustee could have an interest in the policy if it could trace the undisclosed funds to the policy premiums and remanded the case for a trial to determine tracing and to determine what portion of the proceeds, if any, should go to the trustee.
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Matter of Peres, 530 F.3d 375 (5th Cir. 2008).

Where creditors’ meeting was continued but a new date was not announced at the meeting, time to object to exemptions did not start to run until creditors’ meeting was concluded eleven months later.
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Matter of Rogers, 513 F.3d 212 (5th Cir. 2008).
“Fifth Circuit Rules on Homestead Cap” (1/30/08).
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Matter of Soza, 542 F.3d 1060 (5th Cir. 2008).

Debtor bought an annuity the day before filing bankruptcy. Based on timing of purchase, fact that debtors retained control of funds and fact that annuity payment would have been sufficient to pay all creditors in full among other things, the Fifth Circuit found that the annuity was purchased “in fraud of a creditor” and denied the exemption based on Texas law.
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Interest Rate

Drive Financial Services, LP v. Jordan, 521 F.3d 343 (5th Cir. 2008).
“Fifth Circuit Releases Interest-Ing Opinion on Chapter 13 Interest Rates” (3/30/08).
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Judicial Estoppel

Kane v. National Union Fire Insurance Company, 535 F.3d 380 (5th Cir. 2008). “Trustee Avoids Judicial Estoppel Finding As Fifth Circuit Comes Full Circle” (7/25/08).
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Jurisdiction

Matter of Maples, 529 F.3d 670 (5th Cir. 2008)

This is a case where the published opinion sheds very little light on what happened. The opinion was published at the request of the dissenting judge and the majority goes to great lengths to say very little other than that there was no reversible error. It is necessary to read the unpublished District Court opinion to get some understanding of the case.

The Debtors owned Global Limo, Inc. Partain obtained a judgment against the Debtors and obtained a turnover order for the Debtors’ stock in the company. Partain then took possession of the assets of Global Limo. The Debtors filed bankruptcy and brought suit to set aside the turnover order as a preference. Partain, acting on behalf of Global Limo, brought a third party action against Texas State Bank alleging that it had harmed Global Limo. Somewhere there was also a claim that the Debtors and Texas State Bank had conspired to deprive Partain of his choice of counsel.

The Bankruptcy Court avoided the turnover order as a preference and denied Partain’s claims for lack of standing, since he did not have authority to act on behalf of Global Limo.

On appeal to the Fifth Circuit, the majority stated: “This case is poorly briefed, and the record is incomplete. The majority is therefore unwilling to say anything other than that the district court committed no reversible error in affirming the bankruptcy court.”

In dissent, Judge Emilio Garza argued that the Bankruptcy Court lacked subject matter jurisdiction over the claims between Partain and Texas State Bank and that the bankruptcy court had exceeded its authority in ordering the corporate assets of Global Limo brought into the bankruptcy estate of the debtors. The dissent took the majority to task for failing to consider the jurisdictional issue on the ground that the underlying claim was patently meritless. The dissent stated: “Nothing in the record suggests that TSB’s potential exposure would impact the Mapelses’ bankruptcy estate. Because this claim between third parties has no conceivable effect on the bankruptcy estate, the bankruptcy court improperly resolved this claim over which it lacked subject matter jurisdiction.” The dissent also faulted the bankruptcy court for ordering the corporate assets transferred to the estate. Although the corporate charter had been forfeited, the corporation and not its debtor shareholders still owned its assets.
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Newby v. Enron Corporation, 535 F.3d 325 (5th Cir. 2008).
“Fifth Circuit Clarifies Post-Confirmation Jurisdiction” (7/11/08).
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Property of the Estate

Matter of Seven Seas Petroleum, Inc., 522 F.3d 575 (5th Cir. 2008).

This case is the latest in a line of cases including In re MortgageAmerica Corp., 714 F.2d 1266 (5th Cir. 1983) and In re Educators Group Health Trust, 25 F.3d 1281 (5th Cir. 1994) which construe whether a cause of action belongs to the bankruptcy estate or may be asserted by individual creditors.

The Debtor owed money to unsecured bondholders. The bonds provided a formula which limited the amount of secured debt which the debtor could incur. This formula was based in part on the value of the debtor’s reserves. A consultant (Ryder Scott) calculated the reserves in an amount which proved to be highly overstated. The debtor sold $45 million in secured notes, half of which were purchased by Chesapeake. The other half were purchased by a group of investors led by the Debtor’s chairman (Hefner).

An involuntary bankruptcy was filed against the Debtor. The trustee brought various claims against Chesapeake, but dropped all claims except one seeking to re-characterize the debt as equity. All claims against Chesapeake were settled pursuant to the Debtor’s plan, which was supported by the unsecured bondholders.

The bondholders then brought a state court action against Chesapeake, Hefner and Ryder Scott alleging Conspiracy to Defraud and Aiding and Abetting Fraud. Chesapeake removed the case to the bankruptcy court. The bankruptcy court found that the claims against Chesapeake were property of the estate and had been released under the plan.

The bondholders appealed claiming that the claims belonged to them individually and were not property of the estate. The Fifth Circuit reversed and remanded. It held that the bankruptcy estate may bring claims which are typically brought by creditors outside of bankruptcy if the claims seek to recover assets which rightfully belong to the bankruptcy estate but are held by others. Thus, fraudulent conveyance claims and claims to pierce the corporate veil belong to the estate. However, claims to recover damages incurred by creditors will continue to belong to the creditors. In this case, the court found that the creditors were not seeking to recover assets belonging to the estate. As a result, the claims belonged to them and the bankruptcy court erred in dismissing the claims based on the plan.
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Sanctions and Misconduct
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Baum v. Blue Moon Ventures, LLC, 513 F.3d 181 (5th Cir. 2008).

U.S. District Judge had authority to enter pre-filing injunction preventing vexatious parties from filing litigation in any federal court, but lacked jurisdiction to enjoin state court filings.
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Cochener v. Barry, 2008 U.S. App. LEXIS 22339 (5th Cir. 2008).
“Fifth Circuit Reinstates Sanctions Award” (11/14/08).
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Matter of Pratt, 524 F.3d 580 (5th Cir. 2008).
“Fifth Circuit Clarifies Requirements of Rule 9011.” (4/8/08).
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Matter of Yorkshire, LLC, 540 F.3d 328 (5th Cir. 2008)

This is a case which is not designated for publication, but which is included in the West Reporter. Thus, it seems to be a published unpublished opinion. This case involved a business dispute between owners/managers of a business. When Knight, who was one of the managers, received notice that the other owners planned to remove him, he hired an attorney to file bankruptcy for two related entities. The bankruptcy attorney “conducted little diligence on the financial status of the entities an no diligence on their ownership and management so as to reach an informed decision as to whether a bankruptcy was warranted, and if so, who had authority to file it.” Shortly thereafter, Knight was removed from management and the new management voted to fire the attorney who had filed the bankruptcy case. After being fired by the debtor, the attorney represented Knight against the debtor. The Bankruptcy Court dismissed the cases after finding that the debtors were solvent and not in default upon their debts, but retained authority to consider sanctions. The Bankruptcy Court sanctioned both Knight and the attorney. The Fifth Circuit affirmed the Bankruptcy Court, finding that its conclusion of bad faith conduct was supported.
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Single Asset Real Estate

Matter of Scotia Pacific Company, 508 F.3d 214 (5th Cir. 2007).

Fifth Circuit considered whether debtor was a Single Asset Real Estate debtor. Test is: (1) debtor must own real property constituting a single property or project; (2) which generates substantially all of the gross income of the debtor; and (3) on which no substantial business is conducted other than the business of operating the real property and activities incidental thereto. Fifth Circuit affirmed finding that debtor conducted a substantial business on the property. Debtor employed over 60 employees and engaged in sophisticated activities such as soil conservation, road planning, design and engineering. In order to be a SARE, revenues received by the debtor must be passive rather than active.
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Standing

Matter of United Operating Company, LLC, 540 F.3d 351 (5th Cir. 2008).

Reorganized debtor lacked standing to pursue claims arising during bankruptcy, where (i) assets of estate did not revest in debtor upon confirmation and (ii) plan provided for retention of claims created under Bankruptcy Code but not common law claims.

Friday, December 19, 2008

Bankruptcy Court Limbers Up to Tackle Mental Gymnastics of Lien Avoidance

A Texas bankruptcy judge had to engage in some mental gymnastics to decide whether to avoid a lien on property exempted under the federal wildcard in In re Melissa Catherine Powell, No. 08-60204 (Bankr. W.D. Tex. 11/6/08). Powell presented some interesting facts. The debtor owned four tracts of real property. However, those properties were encumbered with a $1.1 million judgment lien. Ms. Powell had apparently been up to no good, since the judgment creditor subsequently obtained a non-dischargeable judgment against her. In the absence of bankruptcy, the debtor would have lost the three non-homestead properties. However, the debtor filed bankruptcy, claimed the property as exempt under Sec. 522(d)(1) and (5) and then sought to avoid the judgment lien as a lien impairing an exemption. While the result may raise a few eyebrows, the court faithfully followed the code sections.

The debtor was able to claim four properties as exempt because Texas allows use of the federal exemptions and each property had minimal equity. The debtor claimed total exempt equity of $7,406.43 between the four properties. The exempt values were determined based on the difference between the scheduled values and the non-judgment liens. No party objected to the exemptions, so that they became final. The debtor then moved to avoid the judgment lien as a non-purchase money lien impairing an exemption under Sec. 522(f). The creditor tried to hold the debtor to its scheduled exemption, arguing that the debtor had claimed $7,406.43 in exempt property and could not avoid the judgment lien to the extent that the equity in the properties exceeded this amount.

The Bankruptcy Court framed two issues for decision:

1. Exactly what was claimed and allowed as exempt?

2. Are the creditors, in defense of a lien avoidance motion under Sec. 522(f), foreclosed from challenging the exempt nature of the properties in question due to their failure to timely object to the Debtor's exemption claims?

The creditor's defense to the lien avoidance motion raised the question of what the debtor had claimed as exempt. Was it the property or was it a specific dollar value in equity? The court dryly noted, "Remarkably, this is an issue about which there has been some controversy."

The court pointed out that when a debtor claims an unknown amount as exempt or lists the exempt value at $1, she is putting creditors on notice that the entire value of the asset is claimed as exempt. On the other hand, when the debtor listed a specific dollar amount calculated as the difference between the scheduled value and the scheduled liens, creditors were not on notice that the debtor might claim a greater value. The court noted that there was a difference between "in kind" exemptions which apply to the entire asset and "not to exceed" exemptions which are limited to a dollar value.

The Court stated:

Section 522(d)(1) and (5) allow the Debtor to exempt her aggregate interest in the real property in question. There are not "in kind" statutes. However, when the Debtor places a value on her exemption under (d)(1) and (5) which is less than the monetary amount allowable under the statute and such value was reached by deducting the amount of debt from the value of each such listed property as set forth on Schedule A; it is clear, at least to this Court, that the Debtor's intention was to exempt the maximum allowable under the federal exemption statute. There is no intent to exempt the Properties in their entirety. Even so, this is not determinative of the issue at had as discussed below.

Slip op. at 8.

The issue is thornier because Sec. 522(f) allows the debtor to avoid a lien "to the extent that such lien impairs an exemption to which the debtor would have been entitled under subsection (b) of this section . . ." Thus, for purposes of lien avoidance, the issue is not what amount was exempted by the debtor, but what amount the debtor would have been entitled to. "For purposes of Sec. 522(f), the issue starts with the inquiry of whether we are dealing with property the debtor would have bene entitled to exempt not whether the debtor has scheduled them as such." Slip op. at 11.

Based on the "would have been entitled" language of Sec. 522(f), a debtor who under-exempts his property would be entitled to avoid the lien based on the full amount he was entitled to, while a debtor who over-exempted or claimed property which should not have been exempt at all could not resort to use of Sec. 522(f).

In the specific case, the amount actually claimed as exempt by the Debtor was $7,406.43. However, the Debtor was entitled to claim exemptions of $21,275.00 based on Sec. 522(d)(1) and (5). The lien would impair the exemption to the extent that it prevented the Debtor from realizing the value of $21,275 that she "would have been entitled" to. If there was less equity in the property than the maximum which could be claimed as exempt, then the lien "should be avoided in its entirety as the Debtor's claimed exemption is totally impaired." On the other hand, if the properties were worth more than the value of the unavoidable liens plus the Debtor's maximum exemption, then the "judicial lien would be preserved to the extent of such excess value." Although the Debtor's schedules indicated that there would not be any excess value for the lien to attach to, the court gamely offered that, "if the (creditors) would like to offer such proof, the court is amenable to holding a hearing for such purpose."

There are a number of important points to take away from this opinion.

1. Just because the Debtor is a bad person does not prevent them from using the tools available under the Code. While we frequently say that the Bankruptcy Court is a court of equity and that litigants must do equity to receive equity, that will not overcome a statutory command. In this case, the court, in discussing the creditors' claim, dropped a footnote stating, "There is no indication in the Complaint as to whether the Debtor was prosecuted for her alleged misdeeds; but, if they are true, prosecution would seem most appropriate." Where else but Bankruptcy Court would a party for whom "prosecution would seem most appropriate" prevail against the wronged party?

2. There are two types of exemptions: in-kind and not to exceed. An in-kind exemption exempts the entire property, while a not to exceed exemption just protects a dollar amount. As a result, failure to object to a "not to exceed" exemption does not make the entire property exempt unless the debtor clearly stated an intent to claim the entire asset or the asset was worth less than the allowable exemption. Therefore, if the debtor claims a $5,000 wildcard exemption on a million dollar asset, the debtor gets to keep $5,000 rather than $1,000,000.

3. Lien avoidance under Sec. 522(f) is based on what the debtor should have been entitled to exempt rather than what she actually claimed as exempt. Therefore, every lien avoidance hearing is also a hearing to determine what the exemption should have been.

Fifth Circuit Relies on Constitutional Avoidance to Uphold Sec. 526(a)(4)

In a departure from rulings by the Eighth Circuit and several lower courts, the Fifth Circuit has held that Sec. 526(a)(4), which limits the advice debt relief agencies can give potential debtors "in contemplation of" bankruptcy, passes constitutional scrutiny. Susan B. Hersh v. United States of America, No. 07-10226 (5th Cir. 12/18/08). The Fifth Circuit also found that attorneys were "debt relief agencies" and upheld the constitutionality of Sec. 527.

Section 526(a)(4) is found amongst three sections regulating the activities of "debt relief agencies." It states that a debt relief agency shall not "advise an assisted person or prospective assisted person to incur more debt in contemplation of such person filing a case under this title or to pay an attorney or bankruptcy petition preparer fee or charge for services performed as part of preparing for or representing a debtor in a case under this title." Several courts, including the Eighth Circuit, have held that this statute is an overly broad restriction on protected speech because it prohibits beneficial speech as well as abusive advice. Milavetz, Gallop & Milavetz, P.A. v. United States, 541 F.3d 785 (8th Cir. 2008).

The Fifth Circuit acknowledged that if the statute were interpreted literally, it could be problematic.

If interpreted literally and broadly, section 526(a)(4) would raise serious consitutional problems because, as Hersh suggests, it would restrict some speech that is protected by the First Amendment. The statute does not expressly qualify its restriction on advice to situations in which incurring more debt would be an abuse of the bankruptcy system. Thus, if interpreted literally, section 526(a)(4) creates a blanket restriction on attorneys advising clients to incur any debt when intending, or contemplating whether to, file for bankruptcy under any circumstances. It would prohibit some attorney advice that would not be abusive to the bankruptcy system, harmful to creditors, or harmful to debtors. Thus, interpreted literally, section 526(a)(4) may apply to speech that is protected by the First Amendment.

Slip op. at 15.

However, at this point, the Fifth Circuit took a cue from the dissent in Milavetz and noted that the constitional problem could be avoided through a narrow construction. While section 526(a)(4) could prohibit some permissible speech, it also restricts malignant speech as well. Under the doctrine of constitutional avoidance, courts will decline to hold an act unconstitutional when another legitimate construction is available. The court concluded that this was possible in the case of speech in contemplation of bankruptcy.

To avoid potential constitutional questions regarding section 526(a)(4)'s restrictions on speech, this court construes the statute to prevent only a debt relief agency's advice to a debtor to incur debt in contemplation of bankruptcy when doing so would be an abuse of the bankruptcy system. In so interpreting the statute, we avoid the constitutionality questions raised by Hersh (and those relied on by the Milavetz majority) and conclude that the statute only affects unprotected speech.


Slip op. at 19.

Having decided to avoid the constitutional issue, the Fifth Circuit took some pains to explain why its construction was plausible, noting that constitutional avoidance "is not a license for the judiciary to rewrite language enacted by the legislature." The court pointed out that the "in contemplation" phrase is frequently used to connote bad intent. The court also stated that the civil remedies for violation of the section, which include recovering damages for the benefit of the debtor and enjoining bad conduct, indicate a purpose to protect debtors from abusive advice rather than to shield them from good counsel. Finally, the court found that curbing abusive attorney practices was a major concern of BAPCPA, so that such an intent could be used to inform the statute's construction.

Milavetz and Hersh represent two different approaches to the issue of regulating attorney speech. The Milavetz decision focuses primarily on not chilling protected speech. On the other hand, the Hersh opinion seeks to protect regulation of abusive speech. With a split within the Eighth Circuit and between the Fifth and Eighth Circuits, this issue may be heading for the Supreme Court.

Tuesday, December 09, 2008

Republic Windows & Doors Case Illustrates Gaps in Employee Protection

Republic Windows & Doors, the Chicago company which recently closed its doors, is not a debtor in bankruptcy, at least not yet. However, it illustrates the point that when laws designed to protect employees meet secured financing, the workers can come up short.

Republic was a company which had operated since 1965. It began losing money in 2002. It tried various strategies, including raising new capital and selling assets. However, by October 2008, management knew that they were nearing the end of the road. As a last ditch effort, they presented an offer to Bank of America, their lender, to sell their note for $3.0 million on a balance of $4.5 million. Bank of America denied the request and demanded a plan for an orderly wind down. The company presented its first plan on October 16, 2008, which was turned down a few days later. The company submitted another proposal which was also rejected. Then it asked for permission to pay its employees for their vacation pay. Finally, on December 2, 2008, the company gave its employees three days notice that it would be closing.

Under the WARN Act, companies are required to give employees 60 days notice of a plant closing in many circumstances. Additionally, the employees would be entitled to a priority claim in bankruptcy for their wages up to $10,950. However, those rights are not worth much without money to pay them. The news articles don't go into detail about the lending relationship with Bank of America. However, in an asset-based lending transaction, all receivables are paid into a lockbox controlled by the bank. If the bank does not advance the money back under the loan, there is no money to operate with. In this situation, if management is not willing to divert receivables in violation of the credit agreement, the bank has the final control over whether employees are paid or not.

The fact that employees rights can be frustrated so easily has led to some creative methods to get workers paid. Some plaintiffs lawyers have sued banks under the WARN Act under the theory that they have become the employer. In the Republic Windows & Doors case, the employees have staged a sit-in at the factory to bring attention to their cause. They have managed to get prominent politicians from Rep. Luis Gutierrez to President-elect Barack Obama to plead their cause. Some have criticised Bank of America for accepting $25 billion in federal bailout money, but turning a cold shoulder toward the unpaid workers. Illinois Gov. Rod Blagojevich has ordered all state agencies to stop doing business with Bank of America until the workers are paid. However, the fact that Gov. Blagojevich was indicted on federal corruption charges today may give him less influence than he might have had otherwise.

Friday, November 28, 2008

Employee Wage Motions Still Viable

The author of the Mirant and CoServ opinions limiting critical vendor motions has written to emphasize that his prior rulings do not preclude employee wage motions in chapter 11 cases. In re Tusa-Expo Holdings, Inc., No. 08-45057 (Bankr. N.D. Tex. 11/7/08).

In Tusa-Expo, the Debtor filed a routine motion to pay employee wages to which no one objected. However, as the Court explained, the motion was a good vehicle for clarification of the court's views.

Though the Motion is unopposed, the court considers this an appropriate occasion to clarify its rulings in In re CoServ,LLC,273 B.R. 487 (Bankr. N.D. Tex. 2002) and In re Mirant Corp., 296 B.R. 427 (Bankr. N.D. Tex. 2003). In each of those cases the court set a high bar for payment of so-called "critical vendors," i.e., creditors holding prepetition unsecured claims against the debtor. Although the court carefully distinguished in CoServ between priority wage claims and general unsecured claims, as well as recognizing the particular generically critical character of claims for wages or benefits for employees, the court is concerned lest it be perceived by some that payment of prepetition claims of employees might be subject to undue scrutiny. It is important, in the court's view, that a prospective chapter 11 debtor be confident that, absent a question as to whether continuation of its operations is appropriate, prepetition wage and benefit obligations will continue during chapter 11 to be honored on a timely basis.

Memorandum Opinion, pp. 3-4.

The Court pointed out that the priority nature of wage claims set them apart from the typical critical vendor analysis. Then it went on to state that even apart from priority status, that employee claims would meet the test for payment of critical vendors under CoServ.

The Court concluded:

A central purpose of chapter 11 is to realize on a debtor's going concern value. That going-concern value is dependent in part upon the continuity and performance of the debtor's work force--something particularly true in the case at bar. The continuity and performance of a debtor's work force is, in turn, typically dependent on timely payment of wages and benefits. As claims based on prepetition wages and benefit programs almost always--as is the true of the Prepetition Employee Obligations--are entitled to priority payment under section 507(a) of the Code, unsecured creditors are not disadvantaged by early--timely--satisfaction of those claims.

Memorandum Opinion, p. 8.

There is nothing earth-shattering in this opinion. However, it is reassuring to see a court go out of its way to acknowledge the pragmatic nature of chapter 11, where the first order of business is to see that the patient survives long enough to have a chance at reorganizing. The problem with critical vendor motions was that just about every vendor could claim to be critical. In the absence of Congressional authority, there was no reason to create a de facto priority category for vendors. Since CoServ and Mirant, Congress has amended the Code to create an administrative priority category for vendors in the period immediately preceeding the petition. 11 U.S.C. Sec. 503(b)(9). These claims share some of the characteristics of employee wages claims in that they are given a high priority. However, there is a distinction in that most employees live paycheck to paycheck. If there is an interruption in pay, they are highly motivated to look for another job. Vendors, on the other hand, frequently extend credit and realize that credit risk is a cost of doing business. It will be interesting to see whether courts re-examine the critical vendor concept in light of this legislative change.

Friday, November 14, 2008

Fifth Circuit Reinstates Sanctions Award

The case of a Houston attorney sanctioned based on a brief representation of a debtor in 2001 took another turn as the Fifth Circuit reinstated the judgment of the Bankruptcy Court awarding sanctions. Matter of Cochener, No. 08-20048, 2008 WL 4681579 (5th Cir. 10/23/08). I have previously written about this case in "Brief Representation Comes Back to Haunt Attorney Six Years Later" (5/7/07) and "Sanctioned Lawyer Wins Reprieve From District Court; Court Clarifies Standards for Non-9011 Sanctions" (3/21/08).

Since I have discussed the facts extensively before, I will just summarize them briefly here. In 2001, an attorney without much bankruptcy experience filed chapter 7 for a woman who claimed few assets and no income. When questions were raised about the accuracy of her schedules at the first meeting of creditors, he decided to bring in a more experienced attorney. The new attorney realized that the debtor was heading for trouble based on incomplete schedules and statements and undisclosed transfers. He filed a motion to dismiss the case under Sec. 305(a)(1), claiming that it would be in the best interest of creditors and the debtor. He also apparently advised the debtor not to show up for the continued meeting of creditors and not to produce documents which the prior counsel had already agreed to produce. He also sent the trustee a letter in which he objected to producing documents about transfers going back more than a year on the basis that Sec. 548 only allowed a one-year look back period. Eventually he requested permission to withdraw because he had lost contact with the client. The court allowed the attorney to withdraw with the proviso that the trustee would be allowed to seek sanctions. The trustee finally got around to requesting sanctions years later.

The Bankruptcy Court awarded sanctions totaling $25,121.89 consisting of disgorgement of the $2,500.00 fee paid to the attorney and $22,621.89 to compensate the trustee for attorney's fees spent opposing the motion to dismiss and in obtaining sanctions. The sanctions were awarded under Sec. 105 and 28 U.S.C. Sec. 1927 for the reason that the trustee had not complied with the procedural requirements under Rule 9011.

The District Court affirmed the disgorgement order, but reversed the attorney's fees. The District Court concluded that to award sanctions under Sec. 105 and Sec. 1927, bad faith must be present. The District Court reviewed the various actions taken by the attorney and concluded that the only action which was sanctionable was advising the debtor not to attend the continued creditors meeting and produce documents. The court found that an attorney who advised a client not to attend the creditors' meeting had not earned his fee. Thus, the court affirmed disgorgement of the fee. The court found that only the minimum amount of sanctions necessary to deter bad conduct should be awarded and reversed the remainder of the Bankruptcy Court's award.

The Fifth Circuit concluded that the parties did not disagree on the underlying facts and that the real dispute was about the inferences to be drawn from those facts. The Fifth Circuit took a deferential approach toward the Bankruptcy Court's conclusions. It stated:

Viewing the case from the bankruptcy court's perspective, whether or not we might have drawn different inferences, we ascertain plausible record evidence to support the bankruptcy court's findings that Barry acted in bad faith, especially when he asserted that dismissal of Ms. Cochener's case was in the best interest of creditors; when he determined that he would not attend the rescheduled meeting of creditors on June 20, 2001; when he instructed the Debtor not to turn over relevant documents to the Trustee; and when he knowingly misrepresented the reach-back period for evaluation of improper transfers by the Debtor. . . . The district court's critical error seems to have been is failure to recognize that even if the bankruptcy was commenced originally as a "two-party dispute" and even if such a case might ordinarily be dismissible, the debtor has no right to such relief when she has abused the privilege afforded by bankruptcy relief. . . . The bankruptcy court acted well within its authority to enforce the integrity of the process by policing the accuracy of the debtor's schedules and representations to the court.

There are two issues worth noting here. The first relates to appellate review and the second relates to the attorney's duty to the court and his client.

On an appeal of a bankruptcy court's order, factual findings must be sustained unless clearly erroneous and legal conclusions are reviewed de novo. The question here was whether the conclusion of "bad faith" was more closely a factual finding or a legal conclusion. The Fifth Circuit found that the Bankruptcy Court's "inference" that debtor's counsel had acted in bad faith had to be upheld so long as it was "plausible." The District Court, on the other hand, appeared to make an independent determination of the conclusion to be applied to the facts. Although the Fifth Circuit did not go into much detail on this point, the result seems to be that conclusions to be drawn from the facts are reviewed much like the underlying facts themselves.

The ethical issue here concerns how the attorney managed his competing duties to his client and the court. It arguably was in the best interest of the client to extricate herself from bankruptcy before her fraudulent transfers could be uncovered. An attorney who advised his client not to file bankruptcy because of the possibility that fraudulent transfers would be uncovered would be acting ethically and giving the client good advice. However, once a bankruptcy proceeding had been filed, the attorney's duty to pursue the client's interest was limited by the attorney's duty of candor to the court. While the attorney was probably more disingenuous than dishonest, the perception that the attorney had moved from being an advocate for the client to a facilitator of the client's actions proved to be costly.

Thursday, November 06, 2008

Fifth Circuit Explains Earmarking

In order for a payment to be recovered as a preference under 11 U.S.C. Sec. 547, there must be a transfer of "an interest of the debtor in property." The earmarking doctrine provides a means to negate this element where the debtor never had control over the transferred property. The Fifth Circuit re-affirmed the earmarking doctrine in Matter of Entringer Bakeries, Inc., No. 07-30499 (5th Cir. 11/6/08), but found that it did not apply in the specific case.

In Entringer Bakeries, First Bank and Trust made a short term bridge loan to the debtor with the expectation that the debtor would obtain permanent SBA-backed financing. When the debtor obtained its new financing, it deposited the funds into its account and then wrote a check to FBT to pay off the old debt. The decision to extend the new financing proved unwise for the second lender, since the debtor filed bankruptcy about six weeks later.

The Trustee sued to recover the payoff to FBT as a preferential transfer. The bank defended the claim asserting that the new financing was intended to pay off its debt so that the payment was protected under the earmarking doctrine. The Fifth Circuit agreed that earmarking was still a viable defense, but found that it did not apply in the specific case. The relevant inquiry in earmarking is whether the debtor obtains control over the funds being transferred. If the debtor has control such that it can use the funds for whatever purposes it chooses, then earmarking does not apply regardless of the subjective intent of the parties.

The court made the following critical findings:

Here, Entringer had dispositive control over the Whitney loan proceeds; the money was Entringer's property once Whitney deposited the funds into Entringer's general account. . . . That is, Entringer could have done anything it wanted to do with the money from the Whitney loan, meaning that the parties did not "earmark" it to pay off the FBT debt. Gary Lorio, Whitney's loan officer, testified that Whitney did not control the money once it went into Entringer's bank account and that Entringer could have paid any of its creditors with that money. Mark Leunissen, Entringer's chief executive officer, agreed that the money from the Whitney loan was Entringer's money once it entered Entringer's general account.

Opinion at 9.

Thus, earmarking is not alchemy which transmutes a transfer into a non-transfer based on the intent of the parties. Instead, it only applies to cases where the debtor lacked the ability to affect the manner in which the funds were applied.

Friday, October 17, 2008

BAPCPA At Three Years Old: Measuring the Statistical Impact on Texas Filings

Today is the third anniversary of the effective date of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which seemed like a good time to look at the lasting impact of this legislation on bankruptcy filings. At this point, filings remain substantially down from the period prior to adoption of the statute. In fact, BAPCPA may have eliminated over 121,000 filings in Texas over a three year period. BAPCPA has also had a smaller impact in encouraging debtors to choose chapter 13 over chapter 7. However, the fact remains that cases under both chapter 7 and chapter 13 are way down.

How to Slice the Numbers

Most bankruptcy statistics are reported based on either a calendar year or a fiscal year which coincides with a calendar month. This is not very useful for evaluating the effect of BAPCPA because its effects took place within the middle of two months. Specifically, the legislation was adopted on April 20, 2005 and took effect on October 17, 2005. During the period between adoption and the effective date, there was an historic surge in filings followed by a substantial drop-off. Thus, to accurately measure the effect of BAPCPA, it is necessary to find a "normal" period of time to compare to each of the years which began on October 17 and ended on October 16 after the effective date. Additionally, in order to gauge the true impact of the legislation, it is necessary to factor out the huge increase in filings leading up to the effective date.

To accomplish this goal, I selected the period of October 17, 2003 to October 16, 2004 as my baseline or "normal" year. In a previous article, I used the period from April 20, 2004 to April 19, 2005 as my baseline period. However, there was already evidence of increased filings during the months when Congress was debating BAPCPA so that it was necessary to step back a little further. I used the period from October 17, 2004 to October 16, 2005 as my surge period. While there was not a surge going on for all of these months, the use of an annual period made it easier to calculate the full effects of the legislation. Then I used each of the years from October 17 to October 16 as my post-BAPCPA period.

Annual Filing Rates

The following table looks at the total filing rates for the state for each of the five years being compared.



The graphics are somewhat hard to read. However, the story that the numbers tell is that in 2003-2004, there were 92,872 chapter 7 and chapter 13 filings in Texas. This surged to 135,900 in 2004-2005. In the first year after BAPCA, filings dropped to just 29,163. In the two most recent years, they have grown to 41,095 and 43,631. This means that Texas chapter 7 and chapter 13 filings had dropped 53% from the last "normal" pre-BAPCPA year of 2003-2004. This indicates that BAPCPA is having a long-term effect on filings. The decline in filings is being felt across the board. While chapter 7 filings were down 60% from the pre-BAPCPA level, chapter 13 filings were down 44% as well.

Difference in Filings Because of BAPCPA

One way to look at the numbers is to project what filings would have been under the old law and compare them to filings under the new law. I started with the 2003-2004 filings of 92,872. Over three years, it could be predicted that there would have been 278,816 filings in Texas. There were actually 113,889 filings during the three years of 2005-06, 2006-07 and 2007-08. However, to get an accurate picture, it is necessary to subtract out the excess "surge" filings from 2004-05. Most likely, many of these debtors accelerated their decision to file bankruptcy. There were 43,028 filings in 2004-05 in excess of the baseline year. When these figures are added together, they indicate a net loss of almost 122,000 cases over three years.

Predicted Three Year Filings:
278,816
Less Actual Filings:
113,889
Less "Surge" Filings:
43,028
Net Loss:
121,699

While BAPCPA was intended to encourage debtors to file chapter 13, it has resulted in a dramatic decrease in the number of chapter 13 cases filed. Chapter 13 filings in Texas during 2007-08 were 44% below their level in 2003-04. Using the same calculation, the number of chapter 13 filings lost can be estimated as follows:

Predicted Three Year Filings:
119,661
Less Actual Filings:
61,732
Less "Surge" Filings:
1,231
Net Loss of Chapter 13 Cases:
56,698

Change in Chapters Filed

Although BAPCPA resulted in a net drop in the overall number of chapter 13 cases filed, it did result in a shift in the relative percentage of each chapter of cases filed.

In 2003-04, 57% of the cases were filed under chapter 7 and 43% were filed under chapter 13. Two years later in the first post-BAPCPA year of 2005-06, this had changed to 40% chapter 7 cases and 60% chapter 13s. In the most recent year of 2007-08, the breakdown was 49% for chapter 7 to 51% for chapter 13. Thus, one effect of BAPCPA has been to make chapter 13 the more commonly used chapter, although the gap has narrowed substantially.

Thursday, October 16, 2008

Bankruptcy Court Stakes Out Unique Position on Sec. 522(b)(3)(A) as Choice of Law Rule, Relies on Former State's Law Without Regard to Actual Residenc

A new decision from Bankruptcy Judge Craig Gargotta is likely to prompt discussion as the court held that a debtor could be prohibited from using federal exemptions based on the law of his prior residence even though that state's law only prohibited "residents" of the state from using the federal exemptions. In re Camp, No. 08-11056 (Bankr. W.D. Tex. 9/25/08). In so ruling, Judge Gargotta disagreed with the opinion in In re Battle, 366 B.R. 636 (Bankr. W.D. Tex. 2006) from his Western District colleague Leif Clark.

The Facts

Melvin Camp moved to Texas from Florida. Under 11 U.S.C. Sec. 522(b)(3)(A), his choice of exemptions was governed by the law of Florida because he had not resided in Texas for the requisite 730 days. Mr. Camp was a prime candidate to use the federal exemptions. His paltry possessions added up to only $24,205, but included cash of $3,100, a lot which was not his homestead valued at $4,500 and a pickup truck worth $13,750. Under the federal exemptions, he would be able to keep all of these assets.

The Debtor's lawyer had no doubt read In re Battle, which held that Sec. 522(b)(3)(A)'s mandate to apply Florida law meant to apply it exactly as written. Since Florida law prohibited residents of Florida from using the federal exemptions and Mr. Camp was NOT a resident of Florida, he should be able to claim federal exemptions and keep his property.

The Trustee objected to the Debtor's exemptions claiming that In re Battle was incorrectly decided. The Bankruptcy Court agreed with the Trustee and denied the exemption.

When Does A Statute Not Mean What It Says? When It is a Choice of Law Provision.

The Florida statute appears clear. It states that "residents of this state shall not be entitled to the federal exemptions provided in s. 522(d) of the Bankruptcy Code of 1978." Based on this language, Judge Clark's Battle opinion held that where Florida had adopted a limitation applicable to residents of Florida and Congress had deemed that the statute apply to persons who no longer resided in Florida, that the statute should be applied exactly as written--in other words, that Texans subject to Florida exemption law were not prohibited from using the federal exemptions.

Judge Gargotta acknowledged that, "At first blush, these courts' reasoning appears sound. It relies exclusively on the language of the applicable opt-out statute." Opinion, p. 4.

However, Judge Gargotta went on to consider Congress's intent in adopting these provisions and how they should be applied.

Florida has thus expressed its judgment that its residents who file bankruptcy should be restricted to claiming Florida exemptions. Congress decided when it enacted the 1978 Bankruptcy Code to honor such decisions by the states that have made them, by expressly incorporating such "opt-out" provisions by reference in Sec. 522(b)(2).

Residency restrictions in a state's exemption laws, including residency restrictions applicable to its opt-out statute, are equivalent to choice of law provisions--they address the question of what state's laws should determine the exemptions of a debtor who has moved from one state to another. (citation omitted). However, by adopting Sec. 522(b)(2) and (3)(A), congress expressed its own judgment that, in instances where a debtor moves from one state to another within 730 days before filing bankruptcy, his exemptions should be determined by the laws (including any opt-out law) of his former domiciliary state. Thus, the issue in this case (and in Battle and similar cases) arises because of the conflict between a state law choice of law provision and the federal choice of law provision contained in Sec. 522(b)(2) and (3)(A). Such conflicts are traditionally resolved by applying the doctrine of preemption. (citations omitted).

The courts deciding Battle and similar cases, however, did not address this conflict between the applicable state opt-out statute and the federal statute, Sec. 522(b)(3)(A), or the question of preemption. Instead, those courts assumed, without discussion, that Sec. 522(b)'s incorporation of each state's substantive exemption laws also incorporated the state law choice of law provisions that each state applies to its exemption laws outside of bankruptcy (e.g., the residency restriction in its opt-out statute). In doing so, those courts have effectively written out of Sec. 522(b)(3)(A) Congress's own considered policy judgment on which state's law should apply when a debtor moves before filing bankruptcy.

Opinion, pp. 4-5.

The resourceful Judge Gargotta came up with an interesting example to make his point about how literally following a state's laws could frustrate the intent of Congress. Idaho law provides that residents of Idaho are entitled to use the Idaho exemptions and that nonresidents are entitled to use the law of the state of their residence. If this provision were applied literally, a debtor who moved from Idaho to another state would automatically be allowed to use the law of the new state despite Congress's mandate to apply Idaho law.

Judge Gargotta ultimately concluded that the proper approach was to apply the laws of the prior state "as if he had not moved for purposes of determining what property he may claim as exempt." Opinion, p. 8. Indeed, he adopted the position that in applying Sec. 522(b)(3)(A), the court must disregard the reality that the debtor actually resides in the state where he lives.

For example, if thirty days before filing bankruptcy a debtor moved from Texas to Louisiana and purchased a home, Sec. 522(b)(3)(A) requires the bankruptcy court to "disregard the element of reality" of the actual state of the debtor's residence (Louisiana), and instead engage in the fiction of considering the state of his or her former residence (Texas) to be the state where he or she currently resides. If the debtor chooses state exemptions, Texas exemption laws would apply to the debtor's home and other property located within the state--in this case, within "Louisiana qua Texas." This is not, however, the extraterritorial application of Texas's exemption laws. It is not under the authority of the State of Texas that its exemption laws are being applied to property outside Texas. Rather, it is a federal choice of law statute--Sec. 522(b)(3)(A)--that has expressly provided that the exemption laws of a particular state--Texas--are applicable to a debtor who, by definition, is no longer a domiciliary of that state and so whose property is almost certainly no longer located within that state.

Opinion, p. 11.

What Does It All Mean?
This is a difficult opinion to digest. It will likely result in the death of many trees (or perhaps the consumption of many electrons) as law professors try to sort this out. Judge Gargotta acknowledged that, "(N)o other court has yet expressly held that a state residency restriction in an opt-out statute is a choice of law provision that is preempted by Sec. 522(b)(3)(A)." Opinion, p. 7.

However, despite the density of the reasoning, there is a simple logic to the result--namely, that a debtor should neither be advantaged or disadvantaged by a move within 730 days before bankruptcy. While Sec. 522(b)(3)(A) has often been viewed as a measure designed to punish debtors who move to exemption friendly states, it can also have the reverse effect. If a debtor moves from Texas with its unlimited exemption to Maryland which has no homestead exemption, the Debtor could enjoy the benefits of the Texas exemption in Maryland.

Wednesday, October 08, 2008

First Circuit Reverses Massive Damage Award Based on Application of Chapter 13 Mortgage Payments

Application of mortgage payments in chapter 13 is a thorny problem. Although the Debtor may not modify the terms of a mortgage on a primary residence, she may cure the arrearages while remaining current on the post-bankruptcy mortgage payments. However, if the Debtor defaults on the post-petition payments, those may be rolled into the plan as well. Thus, the mortgage company may simultaneously be receiving payments on pre-petition arrearages, current post-petition payments and post-petition arrearages. If these various payments are not posted correctly, the Debtor may face late charges and default notices which are not warranted. In one recent case, the Bankruptcy Court awarded massive damages to a debtor who received a misleading payment history, but did not suffer any other adverse actions. That award has now been reversed by the First Circuit, which found that Section 1322(b) does not impose duties on lenders. However, the First Circuit offered some suggestions on how the legal issue could be addressed in the future. In re Nosek, No. 07-2173 (1st Cir. 10/3/08).

What Happened

The Nosek case started with a $90,000 mortgage against a home in Massachusetts. After the Debtor defaulted, she filed several chapter 13 proceedings. The Debtor defaulted on her post-petition payments and entered into a stipulation with the lender to bring these amounts current. The Debtor confirmed a plan which provided for her to make her arrearage payments to the chapter 13 trustee and to make her regular payments directly to her mortgage company, Ameriquest.

The Plan did not specifically address how payments made under the plan should be credited. Apparently, Ameriquest used a dual system for recording bankruptcy payments. Under its regular accounting system, payments were applied to the oldest payment due first. If a payment was not sufficient to cover a full payment, it was held in a suspense account until it could be applied to a full payment. Ameriquest also kept a manual ledger where it tracked whether post-petition payments were being received on a timely basis.

Problems arose when Ms. Nosek sought to refinance her mortgage. In connection with her proposed refinancing, she requested a payment history. The history which she received was the general one which applied payments received to the oldest payment due. While it is not completely clear from the court's opinion, it appears that Ms. Nosek was not charged any extra fees or charges based upon the erroneous accounting. Indeed, the manual accounting (which the Debtor did not receive) showed her to be current on post-petition payments. Upon receiving the payment history, the Debtor became very distressed. This in turn distressed her attorney, who pragmatically filed a "Motion to Determine the Amount of Liens." The Bankruptcy Court ordered Ameriquest to provide the Debtor with an explantion of its accounting. When Ameriquest failed to do so, the Bankruptcy Court awarded sanctions of $500 and ordered the Debtor to file an adversary proceeding.

The Debtor filed an adversary proceeding containing multiple causes of action. At trial, the Debtor failed to prove that she had suffered any economic damages from the accounting she received. She did not show that she had been charged any unearned fees and failed to prove that she was denied her refinancing based upon the payment history. The Bankruptcy Court awarded nominal damages under RESPA and the Massachusetts Consumer Protection Act. The Bankruptcy Court also found that Ameriquest had violated the duty of good faith and fair dealing by failing to credit the payments properly. It awarded actual damages of $250,000 for emotional distress and punitive damages of $500,000. The duty of good faith and fair dealing ruling was based upon a violation of 11 U.S.C. Sec. 1322(b)(5), which allows a debtor to include provisions in a plan providing for the cure of a default.

On appeal, the District Court reversed the awards under RESPA and the duty of good faith and fair dealing, finding them to be pre-empted. It remanded for the Bankruptcy Court to consider damages under Sec. 105(a) and to reconsider its award under the Massachusetts Consumer Protection Act. On re-hearing, the Bankruptcy Court determined that the Consumer Protection Act claim was also pre-empted but awarded the same damages as before, but this time under Sec. 105(a). The District Court affirmed this judgment.

The Court of Appeals Ruling

The First Circuit reversed and directed that the judgment be vacated and the case dismissed. The main conclusion of the opinion was that Sec. 105(a) did not provide a basis for damages, since Sec. 1322(b) did not impose any duties upon the lender. The Court referred to Sec. 105(a) as a statutory contempt remedy, but pointed out that it must be used in the enforcement of another provision of the Bankruptcy Code. Since Sec. 1322(b) addresses provisions which a Debtor may include in a plan, it does not impose any duties upon creditors. The Court stated:


Ameriquest contests the bankruptcy court's conclusion that the company defied the text of Sec. 1322(b). It argues that the language of Sec. 1322(b) does not impose obligations on any party, let alone a lender. We agree. The plain language of Sec. 1322(b), relied upon by the bankruptcy court to find a violation of the code, does not impose any specific duties on a lender. It merely lists elements that a Chapter 13 debtor may include in her plan.

* * *

Because Sec. 1322(b) merely provides optional elements that a debtor may incorporate into her Chapter 13 Plan, the provision has no meaning separate and apart from the choices the Debtor makes and incorporates into her Chapter 13 Plan. In other words, to determine whether and how Nosek took advantage of the cure opportunity provided by Sec. 1322(b)(5), and whether her excercise of her cure rights was threatened by Ameriquest's accounting, we must look to the terms of Nosek's Plan itself.

Opinion, at 22, 24

The Court of Appeals found that the Plan did not contain any provisions governing accounting for payments. It merely stated that the Debtor would continue to make her regular payments and would cure the arrearage by making 60 payments of $313.52 per month. The Court found that this language did not impose any duties on the creditor.

Like the text of Sec. 1322(b), this language does not place any specific obligations on Ameriquest, accounting or otherwise. Although we agree that the statement must be read in light of the purposes of Sec. 1322(b)(5) and Chapter 13 more generally--that a debtor can sure a default by paying off her pre-petition arrearages in a reasonable amount of time--this purpose along does not change the nature of appellant's obligations in this case. The Plan language says nothing about how Ameriquest must account for pre- and post-petition payments during the course of the repayment period if payments are short, late, or not made at all. Simply put, the terms of the Plan itself do not provide the specificity required to invoke the enforcement authority of Sec. 105(a).
Opinion, page 25.

The Court also faulted the Debtor for failing to prove injury.

Although a debtor need not show proof of economic damages to establish that her cure rights have been violated, she must at least establish that her right to cure the pre-petition default provided by the Chaper 13 Plan has been impaired or threatened by the creditor's actions. Nosek's subjective fear of such impairment, based on a document prepared by Ameriquest for internal purposes only, and in the absence of any evidence that the company regarded her as in default on the basis of its accounting practices, does not suffice. Indeed, Ameriquest stated that its internal records showed that Nosek was considered current in her payment history.

Opinion, page 27.

Finally, the Court of Appeals made clear that its ruling was not an endorsement of sloppy accounting practices.

Notwithstanding these legal conclusions, we are not unsympathetic* to Nosek's predicament as a debtor seeking to satisfy the terms of her Chapter 13 Plan and stave off foreclosure of her home. Her circumstances are all too common today. Given their prevalence, it is troubling that Ameriquest had not established a more efficient and accurate way of handling the accounting issues revealed by this case at the time of trial. We fully understand the bankruptcy court's concerns about the practices that it described.

Nevertheless, the bankruptcy court's legitimate concerns did not justify the remedy that it invoked. Nosek did not demonstrate here that Ameriquest's accounting practices caused her any economic harm or threatened her right to cure her pre-petition default. Moreover, even if such threat had been demonstrated by those practices, there was no language in Nosek's Plan, as it was confirmed, or in Sec. 1322(b), that addressed how Ameriquest was to apply the payments it received from Nosek or from the Trustee. Under such circumstances, the Plan would have to be amended to prescribe the accounting practices necessary to protect Nosek's right to cure before Ameriquest could be sanctioned for a violation of an order of the bankruptcy court.


Opinion, pages 29-30.

What to Make of This

There is a saying that pigs get fat and hogs get slaughtered. Certainly the fact that the Debtor almost recovered $750,000 for failure to correctly apply several thousand dollars worth of payments and did not suffer any economic damages suggests that the Debtor, with the aid of the Bankruptcy Court, had become a hog. As distressing as this must have been for the Debtor, this particular case did not present an abuse which would shock the conscience. Indeed, this fuss could easily have been cleared up once the Debtor got Ameriquest's attention (which appears to have been a little slow in coming).

Having said all that, the Court of Appeals did a good job of keeping its eye on the ball. It focused on the plain language of the statute and the plan and pointed out what could have been done differently. For Debtor's lawyers, the message is clear: draft your plans carefully. A plan which required that payments be applied separately to arrearages and regular payments and required notice of additional fees and charges being incurred would have put more teeth in the Debtor's plan. Since many districts use form plans, this is an excellent opportunity for the bankruptcy bar to cooperatively design plan language which addresses this issue.

In a footnote, the Court of Appeals also noted that BAPCPA added Sec. 524(i), which provides that a creditor violates the discharge injunction if it willfully fails to credit payments received under a plan in the manner specified by the plan if the failure to act causes material injury to the debtor. Under this subsection, Debtor's attorneys would be well advised to seek an accounting for payments made once the plan is completed. That way, if there is a problem, it can be addressed promptly with Sec. 524(i) as an attention getter.

Friday, October 03, 2008

Vice-Presidential Candidates Debate Bankruptcy Reform

Bankruptcy reform received attention at the Vice-Presidential debate last night as viewers witnessed a gaffe from the moderator and Sen. Biden staked out a bold position on modifying home mortgages.

Moderator Gwen Ifill asked Gov. Palin about bankruptcy reform, but managed to muddle her question:


IFILL: Next question, Governor Palin, still on the economy. Last year, Congress passed a bill that would make it more difficult for debt-strapped mortgage-holders to declare bankruptcy, to get out from under that debt. This is something that John McCain supported. Would you have?

Of course, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was not passed "last year." Also, while the legislation made it more difficult to file bankruptcy in general, it did not make any substantive changes to home mortgages. It just goes to show that even smart people from PBS can get their facts wrong.

Initially both candidates dodged the question. Gov. Palin said that she would have supported the legislation at the time, but intimated that she would not support it today--and then changed the subject.


PALIN: Yes, I would have. But here, again, there have -- there have been so many changes in the conditions of our economy in just even these past weeks that there has been more and more revelation made aware now to Americans about the corruption and the greed on Wall Street.

We need to look back, even two years ago, and we need to be appreciative of John McCain's call for reform with Fannie Mae, with Freddie Mac, with the mortgage-lenders, too, who were starting to really kind of rear that head of abuse.

And the colleagues in the Senate weren't going to go there with him. So we have John McCain to thank for at least warning people. And we also have John McCain to thank for bringing in a bipartisan effort people to the table so that we can start putting politics aside, even putting a campaign aside, and just do what's right to fix this economic problem that we are in.

It is a crisis. It's a toxic mess, really, on Main Street that's affecting Wall Street. And now we have to be ever vigilant and also making sure that credit markets don't seize up. That's where the Main Streeters like me, that's where we would really feel the effects.
When Sen. Biden was asked about his support for BAPCPA, he initially gave a disjointed answer, but then dropped a bombshell.


IFILL: Senator Biden, you voted for this bankruptcy bill. Senator Obama voted against it. Some people have said that mortgage- holders really paid the price.

BIDEN: Well, mortgage-holders didn't pay the price. Only 10 percent of the people who are -- have been affected by this whole switch from Chapter 7 to Chapter 13 -- it gets complicated.

But the point of this -- Barack Obama saw the glass as half- empty. I saw it as half-full. We disagreed on that, and 85 senators voted one way, and 15 voted the other way.

But here's the deal. Barack Obama pointed out two years ago that there was a subprime mortgage crisis and wrote to the secretary of Treasury. And he said, "You'd better get on the stick here. You'd better look at it."

John McCain said as early as last December, quote -- I'm paraphrasing -- "I'm surprised about this subprime mortgage crisis," number one.

Number two, with regard to bankruptcy now, Gwen, what we should be doing now -- and Barack Obama and I support it -- we should be allowing bankruptcy courts to be able to re-adjust not just the interest rate you're paying on your mortgage to be able to stay in your home, but be able to adjust the principal that you owe, the principal that you owe. (emphasis added). That would keep people in their homes, actually help banks by keeping it from going under. But John McCain, as I understand it -- I'm not sure of this, but I believe John McCain and the governor don't support that. There are ways to help people now. And there -- ways that we're offering are not being supported by -- by the Bush administration nor do I believe by John McCain and Governor Palin.
Until recently, the Obama-Biden ticket's support for bankruptcy reform has been somewhat tepid. Earlier this year, both Sens. Obama and Biden voted for a proposal to allow bankruptcy judges to modify home mortgages, although that proposal was defeated. The Obama-Biden campaign's website, which is laden in detailed proposals does not mention modifying home mortgages in its section on Bankruptcy Reform. However, it does contain this proposal within its section titled Protect Home Ownership and Crack Down on Mortgage Fraud. No doubt this is a case of poor editing and not an attempt to confuse bankruptcy junkies.

In published accounts, Sen. Obama has championed incremental change, such as exempting military families, senior citizens, victims of national disasters and persons filing due to medical bills from credit counseling and means testing, supporting a minimum national homestead exemption for senior citizens and proposing a 120 day moratorium on foreclosures and credit reporting (although some reports have also mentioned modifying home mortgages in passing). In his acceptance speech in August, Sen. Obama mentioned reforming bankruptcy laws to protect people's pensions. Finally, just last week, Sen. Obama opposed adding bankruptcy reform to the Wall Street rescue plan.

Now that Sen. Biden stressed modifying home in the debate, the issue is likely to take on a higher profile. Thus far, the McCain-Palin ticket has railed against Wall Street greed, but has not taken a stand on bankruptcy reform (at least not that I have been able to find). It will be interesting to see whether this issue is addressed further in the upcoming debates between the presidential candidates.

Thursday, October 02, 2008

Equitable Mootness Fails to Prevent Disgorgement

The Schlotzsky's case got a little woolier as the Fifth Circuit ordered that an appeal over funds disbursed from a reserve account could not be dismissed based upon equitable mootness. Wooley v. Faulkner, No. 07-50912 (5th Cir. 8/28/08).

The Schlotzsky's case involved disputes between John and Jeffrey Wooley and the Debtor. Prior to a change in management, the Wooleys (who had been officers and directors) had made secured loans to the company with the approval of the then Board of Directors. After bankruptcy, the Unsecured Creditors' Committee brought suit for equitable subordination. In an elaborate mechanism, the Wooleys received a distribution of $2,867,600 on their secured claim, but had to post a letter of credit for $2,939,200 in case the equitable subordination case went against them. Additionally, the plan created a $500,000 reserve to pay any additional secured claims allowed. After the Bankruptcy Court rendered judgment subordinating the secured claims, the Plan Administrator moved to disburse the funds in the reserve account, which the Bankruptcy Court approved. Some of the funds were used to pay the Plan Administrator's attorneys. The Wooleys appealed the adverse orders on equitable subordination and disbursement of the reserve fund.

The Fifth Circuit reversed the judgment granting equitable subordination. Wooley v. Faulker, 532 F.3d 355 (5th Cir. 2008); see "5th Circuit Rejects Equitable Subordination Claim with Deepending Insolvency Aspect," A Texas Bankruptcy Lawyer's Blog (7/1/08).

Having disposed of the first appeal, the Fifth Circuit then turned its attention to the reserve fund account. The Plan Administrator raised several arguments, but the most interesting one was equitable mootness. There are numerous instances in which equitable mootness will prevent an appeal from proceeding where a stay pending appeal is not obtained and the parties have acted in reliance on the order. In those cases, the appeal may be dismissed for equitable mootness. Plan confirmations are the type of order to which equitable mootness may apply.

The Fifth Circuit described the doctrine as follows:

'The concept of [equitable] 'mootness' from a prudential standpoint protects the interest of non-adverse third parties who are not before the reviewing court but who have acted in reliance on the plan as implemented.' The ultimate question to be decided is whether the Court can grant relief without undermining the plan and thereby, affecting third parties. For the doctrine of equitable mootness to apply, the Court must determine: "...(i) whether a stay has been obtained, (ii) whether the plan has been 'substantially consummated,' and (iii) whether the relief requested would affect either the rights of parties not before the court or the success of the plan.'
Opinion, p. 6.

At first blush, the requirements seemed to be satisfiable. The Wooleys had asked for a stay pending appeal, which was denied and the plan had been substantially consummated. The difficult question was whether the appeal would affect the rights of parties not before the court or the success of the plan. The Wooleys made a wise tactical decision to limit their appeal to seeking disgorgement only of the fees paid to the Plan Administrator's counsel. The Fifth Circuit was quick to point out that they were not seeking the return of money paid to third party creditors.

In an interesting use of a double negative, the Fifth Circuit stated that the Plan Administrator's counsel "is not a party who is not before the court." (italics in original). In other words, even though the Plan Administrator's counsel was not a formal party to the appeal, they were before the court in a very practical sense of the term. The Fifth Circuit also noted that equitable mootness should not be used to prevent the disgorgement and return to the estate of attorney's fees.

In the final analysis, the Fifth Circuit remanded the case for a determination of the additional secured claim held by the Wooleys and ordered that the Plan Administrator's attorneys disgorge their attorney's fees paid out of the reserve to the extent necessary to satisfy whatever secured claim was allowed.

Fifth Circuit Dismisses Gadzooks Appeal

Practitioners waiting for further illumination of the Fifth Circuit's Pro-Snax decision will have to continue waiting. The Gadzooks case involves whether Hughes & Luce will be compensated for nearly a million dollars worth of legal work done for an equity security holders' committee in a case where subsequent, unforeseen events negated the value of the committee's work.

The Bankruptcy Court found an exception to the requirement in Matter of Pro-Snax Distributors, Inc., 157 F.3d 422, 426 (5th Cir. 1998) that services yield “an identifiable, tangible and material benefit to the bankruptcy estate.” The District Court reversed and an appeal was taken to the Fifth Circuit.

The Fifth Circuit has now dismissed the appeal for lack of jurisdiction. Kaye v. Hughes & Luce, LLP, No. 07-10813 (5th Cir. 9/9/08). When the District Court ruled, it reversed and remanded the case to the Bankruptcy Court for further proceedings. Under 28 U.S.C. Sec. 158(d), the Fifth Circuit has jurisdiction over "final decisions, judgments, order and decrees." When a case is remanded for "significant further proceedings," the order is not final. Instead, the parties must obtain leave for an interlocutory appeal under 28 U.S.C. Sec. 1292.

Now that the appeal has been dismissed, the parties must proceed with the remand and then take the case back up the appellate chain. As a result, it is not likely that the Fifth Circuit will resolve the apparent conflict between Pro-Snax and 11 U.S.C. Sec. 330(a)(3)(C) for some time.

Update on Possible Impeachment of U.S. District Judge for Bankruptcy Fraud

There has been a new development in the case of a U.S. District Judge facing possible impeachment based in part upon his conduct as a Chapter 13 debtor. On September 10, 2008, The Judicial Council of the Fifth Circuit issued an Order and Public Reprimand in Docket No. 07-05-351-0085, In re Complaint of Judicial Misconduct Against Judge G. Thomas Porteous, Jr. under the Judicial Conduct and Disability Act of 1980. The Order publicly reprimands the Judge for conduct including perjury and violation of ethical canons, orders that no new cases be assigned to him for two years or until Congress completes impeachment proceedings and suspends his authorization to employ staff.

I previously wrote about this case last January after the Fifth Circuit recommended that Judge Porteous be referred for possible impeachment proceedings. Now the Judicial Conference of the United States has accepted the Report and Recommendation from the Judicial Conference fo the Fifth Circuit.

While the Order details substantial misconduct, the following item pertains to his personal bankruptcy case.

Judge Porteous repeatedly committed perjury by signing false statements under oath in a personal bankruptcy proceeding in violation of 18 U.S.C. Sec. 152(1)-(3), 1621 as well as Canons 1 and 2A of the Code of Conduct for United States Judges. This perjury allowed him to obtain a discharge of his debts while continuing his lifestyle at the expense of his creditors. His systematic disregard of the Bankruptcy Court's orders also implicates 11 U.S.C. Sec. 521(a)(3) and 18 U.S.C. Sec. 401(1).

Order and Public Reprimand, pp. 2-3.

While a public reprimand and suspension from receiving new cases may sound mild, the Circuit stressed that it was taking the maximum action available to it.

In issuing this Order and Public Reprimand and executing the actions contained herein, the Council is taking the maximum disciplinary steps allowed by law against Judge Porteous. Any further action to remove Judge Porteous from office and the emoluments thereof is the responsibility of Congress.

Order and Public Reprimand, p. 5.

The House Judiciary Committee has formed a task force to investigate the possible impeachment of Judge Porteous.

Sunday, September 28, 2008

Practicing Law and Having a Life

This weekend, the firms that I work for hosted a celebration for the 25th anniversary of Barbara Barron and Manny Newburger practicing together, as well as the 2nd anniversary of Barron, Newburger, Sinsley & Wier, PLLC. We joined several hundred of our friends and clients (some of whom were the same people) for barbecue and country music at the Salt Lick in Driftwood, Texas. What does any of this have to do with bankruptcy? Not much directly. However, it is a reminder to heed Shakespeare’s admonition to “do as adversaries do in law, strive mightily, but eat and drink as friends.” (The Taming of the Shrew Act I, Scene 2).

Twenty-five years is a long time. While I wasn’t there for all of it, there is still a strange sensation of waking up in another time and place. Over 25 years, we have gone through the real estate bust/S & L crisis which spawned the RTC, the leveraged buyout bust which gave rise to mega-bankruptcies, credit card defaults leading to personal bankruptcy filings topping 1.6 million, Enron, bankruptcy reform and now the sub-prime mortgage crisis. During that time, newlyweds had children grow up, our hair grew thinner and our waistlines grew larger (at least mine did). The baby boomers who hoped to transform the world now look forward to retirement.

Over the years, we have met a lot of interesting people and many of them were at the festivities. Politicians and judges mingled with real estate developers, reorganized debtors and debt collectors. Lawyers, clerks and support staff drank margaritas together. However, the best story of the night was probably the entertainment (and I am not just talking about Barbara Barron gracefully two-stepping and doing the cha-cha).

The headliner for the evening was Brian Turner and His Redneck Band. Brian is proof that only in Austin, Texas can a Jewish solo practitioner pursue his dream of being a snuff-dipping country music sensation. (While Kinky Friedman is more famous, that’s only because Brian hasn’t been discovered yet). Brian represented a significant bloc of creditors in a contentious chapter 11 case that our firm handled. As we were wrapping up the case, Brian shared one of his CDs with us. His music hits traditional country music themes such as patriotism, fatherhood and failed relationships, but does so with a wry sense of humor.

With songs like “I Miss That Dog More Than You,” “If Love Is Blind Why Do You See My Faults See Clearly” and “If You Won’t Leave Me, I’ll Find Someone Who Will,” Brian harnesses a traditional country music vibe with just a little tongue in cheek. Even his tribute to his father contains the refrain, “So here’s to my dad/ who taught me all my bad habits/ some of my good ones, too/ Like to be a great dad/ believe in your country and never turn my back on you.”

I admire Brian for managing to practice law and pursue his dream as well. Let’s hope that the rest of us can find a way to harnish our dreams and creativity outside the workaday world.

Friday, July 25, 2008

Fifth Circuit Answers Three Questions of First Impression on Violation of Automatic Stay

The Fifth Circuit answered at least three questions of first impression in a recent case regarding violation of the automatic stay. In re Repine, No. 06-20807 (5th Cir. 7/22/08).

The facts of this case sound straight out of a made for TV movie, including love gone bad, prison and a renegade lawyer. Ronald Repine was married to Elizabeth Pollard Repine. Although he had made as much as $147,000 per year at one point, he was unemployed during part of the period from 2001 to 2003. He managed to get behind on his child support to the extent of $22,859. The family court sentenced him to 180 days in jail for criminal contempt and also ordered that he be held in civil contempt indefinitely until he paid the past due support and paid $2,027 to his ex-wife’s attorney Patsy Young.

Shortly after being incarcerated, Ronald did what anyone would do: he filed for chapter 13 bankruptcy. Elizabeth then retained separate counsel to represent her in the bankruptcy. Notwithstanding the automatic stay, Elizabeth made a deal with Ronald to pay the back support and get him out of jail. Ronald agreed to deed his house to Elizabeth who would be allowed to sell it and apply the proceeds to the back child support. There was just one problem: the agreement did not provide for payment of Patsy’s attorney’s fees. Elizabeth’s bankruptcy lawyer came up with a practical solution. He obtained an order from the Bankruptcy Court allowing the transfer of the house to Elizabeth and for the proceeds to be applied to the child support debt, including attorney’s fees. The order also provided that any unpaid attorney’s fees would be paid under Ronald’s Chapter 13 plan.

Elizabeth complied with her part of the deal and asked that Ronald be released from jail. However, Patsy objected because she wanted to be paid her attorney’s fees. As a result, the family court denied the motion. Shortly thereafter, Ronald completed the criminal portion of his contempt sanction and started serving the civil contempt portion. Patsy refused to submit an agreed order for Ronald’s release unless she received certified checks for her attorney’s fees. Elizabeth and Ronald then went to Bankruptcy Court to enforce the agreed order. The Bankruptcy Court ordered Patsy to appear and show cause why she should not be held in contempt for violation of the automatic stay. Despite being served with the order by a U.S. Marshall, Patsy did not appear. As a result, the Bankruptcy Court caused a warrant to be issued and Patsy was taken into custody by the U.S. Marshall’s Service.

The Bankruptcy Court ordered Patsy released but told her to stop trying to collect her attorney’s fees. Undeterred, Patsy refused to submit the order providing for Ronald’s release. Because of Patsy’s actions, Ronald was unable to attend his father’s funeral. Finally, Patsy moved to withdraw from the family law case and Elizabeth’s bankruptcy counsel substituted in. Ronald was finally released after having served about six weeks of his civil contempt sentence.

Once he got out, Ronald filed a complaint for violation of the automatic stay against Patsy. The Bankruptcy Court awarded Ronald total damages of $27,280, including $4,400 for emotional distress and $5,000 in punitive damages plus $33,720. Thus, Patsy’s efforts to collect $2,027 in attorney’s fees caused her to incur liability of $61,000.

The Court of Appeals did not have any difficulty finding that the Bankruptcy Court’s determination that Patsy had violated the automatic stay should be affirmed. While child support may be collected from property which is not property of the estate, Patsy’s demand to be paid or else Ronald could not be released from jail did not distinguish between being paid from property of the estate or non-property of the estate. Patsy just wanted to get paid and she didn’t care where the money came from. Additionally, the Court of Appeals found that Patsy’s determined refusal to submit the order agreed to by her client extended the period of Ronald’s incarceration.

When it came to damages, the Fifth Circuit plowed new ground. Section 362(k) allows punitive damages in “appropriate circumstances,” a rather indefinite mandate. The Fifth Circuit had not previously decided what constituted “appropriate circumstances” to award punitive damages. It accepted the Eighth Circuit’s standard of “egregious intentional misconduct on the violator’s part” and found that Patsy met the standard. Ignoring the Bankruptcy Court's admonition to stop collecting as well as your own client’s wishes is enough to constitute egregious intentional misconduct.

Next, the Fifth Circuit had to consider whether damages for emotional distress could be awarded for a violation of the automatic stay. This was also an issue of first impression. The Court found that a debtor seeking to recover damages for emotional distress must set forth “specific information” rather than “generalized assertions.” The Court found that testimony that he was “very upset” at what his sons would think about him being incarcerated, that it was “very traumatic” to miss his father’s funeral and that he had dreams about missing his father’s funeral and worried about it when interacting with other people all fell within the category of “generalized assertions” which would not give rise to emotional distress. As a result, the Court vacated the award for emotional distress.

Finally, the Fifth Circuit considered whether fees incurred in prosecuting an action for violation of the automatic stay were recoverable as damages. This was also an issue of first impression. The Fifth Circuit agreed that fees incurred in prosecuting an action for violation of the stay were recoverable and rejected a requirement that there be proof that the fees incurred had actually been paid.

At the end of the day, all of the damages except for $4,400 in emotional distress were affirmed.

Trustee Avoids Judicial Estoppel Finding As Fifth Circuit Comes Full Circle

Good things come in threes. Think of the first Star Wars trilogy or Lord of the Rings. Now the Fifth Circuit has completed a trilogy of cases on judicial estoppel which brings its exposition of the doctrine full circle. Kane v. National Union Fire Insurance Company, No. 07-30611 (5th Cir. 7/14/08).

Judicial estoppel “is a common law doctrine that prevents a party from assuming inconsistent positions in litigation.” In re Superior Crewboats, Inc., 374 F.3d 330 (5th Cir. 2004). The elements of judicial estoppel are: (1) the party is judicially estopped only if its position is clearly inconsistent with the previous one; (2) the court must have accepted the previous position; and (3) the non-disclosure must not have been inadvertent. In bankruptcy, the doctrine is frequently applied to prevent parties from pursuing undisclosed claims. The doctrine enforces the debtor’s duty to make full disclosure of all assets on his schedules.

The first of the recent Fifth Circuit cases was In re Coastal Plains, Inc., 179 F.3d 197 (5th Cir. 1999). In that case, the Debtor’s CEO formed a company which acquired the assets of the debtor corporation. The insider purchaser then filed suit on a claim which had not been disclosed in the schedules. The purchaser recovered $3.6 million on the undisclosed claim. The Fifth Circuit reversed on appeal, finding that accepting the argument that the claims were inadvertently left off the schedules “would encourage bankruptcy debtors to conceal claims, write off debts, and then sue on undisclosed claims and possibly recover windfalls.” In re Coastal Plains at 213.

Next came In re Superior Crewboats, 374 F. 330 (5th Cir. 2004). In that case, it was the debtor who was estopped. In that case, one of the debtors was injured prior to bankruptcy. During their chapter 13 case, they filed suit on a claim which was not listed in their schedules. After their case was converted to chapter 7, the debtors told the trustee about their claim, but represented that it was barred by limitations. As a result, the trustee abandoned the claim which the debtors continued to pursue. When the trustee learned about the case, he attempted to substitute in. However, the court granted summary judgment for the defendant.

The trend of ruling in favor of defendants continued with the lower court opinion in Kane. In Kane, the debtor filed a personal injury suit prior to bankruptcy. However, he did not list it on his schedules. Once the debtor received his discharge, the defendant moved for summary judgment based on judicial estoppel. The debtors then tried to do the right thing by asking that their bankruptcy case be re-opened so that the trustee could administer the undisclosed lawsuit. The case was reopened and the trustee asked to be substituted as real party in interest. Relying upon Superior Crewboats, the District Court granted the defendants’ motion for summary judgment and denied the trustee’s request to substitute in as real party in interest.

While Kane looked a lot like Superior Crewboats, the Fifth Circuit found an important distinction. The Court stated:

There, because the trustee had abandoned the claim, he was not the real party in interest and was not entitled to be substituted as such. Rather, following the trustee’s abandonment, the interest in the claim had reverted to the debtors, who stood to collect a windfall from the asset at the expense of the creditors. In the case before us, the Kanes’ personal injury claim became an asset of their bankruptcy estate when they filed their Chapter 7 petition. The Trustee became the real party in interest in the Kanes’ lawsuit at that point and never abandoned his interest therein.
Kane at 8.

The Fifth Circuit noted that the present case did not present any equitable concerns. Indeed, the creditors would be harmed if judicial estoppel was applied to preclude the trustee from pursuing the claims. The court quoted from a great Seventh Circuit opinion which made the obvious point:

[The debtor’s] nondisclosure in bankruptcy harmed his creditors by hiding assets from them. Using this same nondisclosure to wipe out [the debtor’s claim against the defendant] would complete the job by denying creditors even the right to seek some share of the recovery. Yet the creditors have not contradicted themselves in court. They were not aware of what [the debtor] was doing behind their backs. Creditors gypped by [the debtor’s] maneuver are hurt a second time by the district judge’s decision. Judicial estoppel is an equitable doctrine and using it to land another blow on the victims of bankruptcy fraud is not an equitable application.

Kane at 10, quoting Biesek v. Soo Line R.R. Co., 440 F.3d 410, 413 (7th Cir. 2006).

Thus, the Fifth Circuit reversed the summary judgment based on judicial estoppel and remanded to consider whether the trustee should be permitted to substitute as real party in interest (an issue which had not been considered by the district court).

In any good trilogy, things appear darkest after the second part. Here, the Superior Crewboats decision appeared to foreclose even a suit by the trustee. This was much like saying that the creditors had to be punished to protect the integrity of the system which was intended to protect the creditors, or to put it another way, it was necessary to destroy the village in order to save it.

Kane corrects this misimpression by pointing out that judicial estoppel only applies against the party who took the inconsistent position, namely the debtor; it does not apply against the trustee as the representative of the innocent creditors. Kane has an added bonus in that it encourages debtors to correct their mistakes. If the debtor omits a cause of action, but later repents, the trustee is not prejudiced. The debtor protects himself by mitigating the effects of his previous non-disclosure. The debtor also stands to benefit directly if the litigation proceeds are used to pay non-dischargeable claims or if there estate produces a surplus.

Thanks to St. Clair Newbern for the pointer on this case.