Wednesday, January 30, 2008

Fifth Circuit Rules on Homestead Cap

The Fifth Circuit started off the new year with an opinion construing the homestead cap under 11 U.S.C. Sec. 522(p)(1). Matter of Rogers, 2008 U.S. App. LEXIS 129 (5th Cir. 1/4/08). While the case addresses a fairly narrow issue, it is significant because it appears to be the first appellate court opinion construing the new statute.

The issue in Rogers was whether a debtor triggered Sec. 522(p)(1)'s homestead cap when a property acquired more than 1,215 days prior to bankruptcy became the debtor's homestead within the statutory period. Sec. 522(p)(1) states that a debtor may not exempt "any amount of interest" in a homestead that was acquired by the debtor within 1,215 days before bankruptcy which exceeds $125,000 in value. The debtor inherited the property in 1994, but did not make it her homestead until January 2004 after she separated from her husband. The property was awarded to her in the parties' subsequent divorce in April 2004.

The debtor filed for bankruptcy in September 2005 and a creditor objected to the homestead exemption. The bankruptcy court denied the objection to exemption and the district court affirmed this ruling. However, the courts gave different reasons for their rulings. The bankruptcy court ruled that because the debtor obtained title to the property outside of the 1,215 day period that the cap did not apply. The district court ruled that it was impossible to have "a quantity of classification as homestead." As a result, it ruled that the word "interest" referred to the equity acquired by the debtor during the 1,215 day period. Because a homestead designation did not enhance the debtor's equity in the property, the district court held that the cap did not apply.

The split between the bankruptcy court and the district court mirrors a split within the cases nationally. In general, the proponents of the title and equity theories are each trying to avoid what they perceive to be a bad result. The cases which hold that the words "any amount of interest" refers to when the debtor acquired title were ruling on cases where the debtor acquired legal title more than 1,215 days prior to bankruptcy but enhanced their equity within the statutory period. The judges in these cases hold that where title is acquired outside of the statutory period that any enhancement of equity during the 1,215 days is not relevant because title is something which can be acquired, while equity is not. The equity cases generally deal with the situation where the debtor acquired a property whose equity was initially below the cap, but where passive appreciation increased the value beyond the amount of the cap. These cases reject the challenge to the homestead on the basis that the debtor did not acquire any more equity in the property during the statutory period but simply had the value increased by market forces.

The Fifth Circuit found it unnecessary to resolve the conflict. It found that at a minimum, the debtor must acquire "vested economic interests" within the 1,215 day period in order for the cap to apply. The court concluded that "A debtor acquires an interest in property, not in an exemption." As a result, it found that a property's change in status from non-homestead to homestead was not sufficient to trigger the limitation on what could be exempted.

The Fifth Circuit also dismissed as a red herring the argument that the debtor acquired her interest in the property through the divorce decree. Because the property had been inherited, it was the debtor's separate property. The divorce decree merely confirmed the property's status as her separate property rather than conveying any new interest.

Disclaimer: I have a case pending which may turn on the title vs. equity distinction. While I have tried to accurately summarize the distinctions between the two lines of cases, anyone interested in these issues should read the cases for themselves.

Wednesday, January 16, 2008

Judge Follows Legal Priority While Acknowledging "Moral Priority" Of Losing Parties

San Antonio Bankruptcy Judge Leif Clark is known as the master of the footnote. Thus, when faced with a relatively straightforward case requiring him to construe a confirmed chapter 11 plan, he held his nose and applied the law. In re Texas Pig Stands, Inc., No. 05-52336 (Bankr. W.D. Texas 1/10/08). However, he used his written opinion to let the disappointed parties know that they had "moral priority" and told them where to complain.

Texas Pig Stands is a case, like many, that didn't work out quite as well as it should have. The Debtor confirmed a liquidating plan. The Liquidation Trustee sold the Debtor's property. After the first lienholder and the property taxes were paid at closing, there was a balance of $62,655.35 left over. The parties acknowledged that some of these funds would have to go to pay the lienholder's attorney and a mechanic's lien creditor. The question was what to do with the remaining balance.

The Liquidation Trustee requested permission to pay the employees and vendors who had incurred post-confirmation claims. The State of Texas asserted that the balance should go to pay its tax claim, which had accrued pre-petition, pre-confirmation and post-confirmation. Interestingly enough, the State's claim had not been a secured claim prior to bankruptcy. However, the default language in the plan allowed the State to exercise "all right and remedies under applicable non-bankruptcy law." Of course, one of these remedies is to file a tax lien. When the Liquidation Trustee failed to pay the State under the terms of the confirmed plan, the State gave notice of default and then filed a post-confirmation tax lien. When it came time to distribute the sales proceeds, the State contended that its lien covered all taxes, whether incurred pre-petition, pre-confirmation or post-confirmation.

Judge Clark methodically worked through the issues, concluding that he had post-confirmation jurisdiction to hear the dispute, that the default language of the plan allowed the filing of the tax lien and that the tax lien secured all of the taxes. As a result, the Judge concluded that:

"(T)he Comptroller is entitled to distribution from the sales proceeds to the extent that the proceeds are available to satisfy the Comptroller's tax lien, subject to the payment of prior liens and claims. Unfortunately, the sale proceeds will not satisfy the Comptroller's tax lien in full. The employees, trade vendors aand all other general unsecured creditors therefore will remain unpaid."

Order Granting Authority for Liquidation Trustee to Distribute Sales Proceeds, p. 7.

However, the Court did not stop there. In a footnote, the Judge told the parties where to complain.

"This is, no doubt, an unfortunate result, but one which is mandated by the Texas Tax Code itself. The court can only refer these unpaid employees and trade vendors to Governor Rick Perry's office and to the office of the Texas Comptroller for a fuller explanation for why the state elected to deprive them of their honest, hard-earned compensation. The unpaid employees have a clear moral priority over the claims of the Comptroller for unpaid sales taxes. But for the employees' willingness to work at the restaurant and the trade vendor's willingness to extend credit to the Liquidation Trustee, there would not have been any money to pay the Comptroller. The state clearly is receiving an economic windfall, and further expects these employees to work for free to confer that windfall. Despite the employees' and vendors' moral priority, the Comptroller nonetheless holds legal priority under the Texas Tax Code and the confirmed plan. This court is bound by the latter."

Order, n. 5 (emphasis added).

With all respect to His Honor's good intentions, what else could the State have done? Under Texas law, monies collected for sales taxes are trust funds required to be held for the benefit of the State. The State apparently acquiesced in allowing the Debtor and later the Liquidation Trustee to continue to operate the business despite the fact that tax monies were being collected and not remitted to the State. When the Liquidation Trustee defaulted under the plan, over a year before the sale took place, the State could have closed the restaurant down, in which case the employees would have been unemployed and uncompensated much sooner. Instead, the State, like all the other parties in the case, waited to see whether a brighter future lay ahead. When that prospect did not fully materialize, the State insisted on its legal rights. Had the State passed on its right to get paid ahead of those with lower priorities, the elected officials who are the public face of the State would have opened themselves up to a firestorm of criticism from the public for giving away the State's money.

The Liquidation Trustee was faced with a terrible choice here. He was tasked with paying creditors under a plan and maximizing the value of the Debtor's assets. When the Debtor's business could not pay for current operations, the Trustee had a choice. He could either close the business and likely lose it to foreclosure, or he keep cross his fingers and hope that things got better. While closing the business and not incurring further post-confirmation debt was the correct legal answer (first, do no harm), all of the parties--the Liquidation Trustee, the employees, the vendors, the first lienholder, the State--apparently thought it was better to keep going. In a perfect world, the parties drafting the plan could have created a carve-out for payment of post-confirmation expenses. However, who goes into a plan anticipating that the Debtor won't be able to pay operating expenses? Also, who anticipates that the boilerplate default language contained within a plan will allow a seventh priority unsecured creditor to become a secured creditor?

While the result in this case is unfortunate for the employees who did not get paid, it is not all that unusual. To draw an analogy from George Orwell's Animal Farm, some creditors are more equal than others. Employees, vendors and customers will always rank below lienholders. When businesses fail, there are always winners and losers and those without liens are always the losers. If the Judge wanted to drop a bomb onto someone's lap, he could have directed the unpaid employees to contact their state legislators and demand to know why there is not a floating lien for unpaid wages, much like the floating lien for perishable agricultural commodities. While such a proposal would be politically infeasible, it would at least raise the issue of whether legal priorities should be more closely aligned with moral priorities.

Friday, January 11, 2008

Fifth Circuit Recommends Impeachment of Federal Judge Based on Bankruptcy Misconduct

On December 20, 2007, the Judicial Council of the Fifth Circuit entered a Memorandum Order and Certification in which it certified to the Judicial Conference of the United States its determination that U.S. District Judge G. Thomas Porteous had engaged in conduct which might constitute grounds for impeachment. In re: Complaint of Judicial Misconduct against United States District Judge G. Thomas Porteous, Jr., under the Judicial Conduct and Disability Act of 1980, Docket No. 07-05-351-0085. One of the grounds stated for possible impeachment was the Judge's misconduct while he was a Chapter 13 debtor.

Judge Porteous was appointed to the U.S. District Court bench in New Orleans in 1994. On March 28, 2001, he filed a chapter 13 bankruptcy petition in the Bankruptcy Court for the Eastern District of Louisiana. The Bankruptcy Judges for the Eastern District recused themselves on the basis that they were a unit of the District Court of which Judge Porteous was a judge. The Judicial Council of the Fifth Circuit appointed Bankruptcy Judge William Greendyke to hear the case. Judge Porteous confirmed a plan and ultimately received a discharge on July 22, 2004.

The Judicial Council made the following findings about the Judge's bankruptcy case:

"Judge Porteous filed numerous false statements under oath during his and his wife's Chapter 13 bankruptcy, including filing the petiiton under a false name; concealing assets of the bankruptcy estate; failing to identify gambling losses; and failing to list all creditors. Judge Porteous additionally violated bankruptcy court orders forbidding him from incurring debt during the course of the Chapter 13 cse without approval of the trustee or bankruptcy judge, in that he continued regularly to incur short-term extensions of credit from various casinos. Judge Porteous additionally made unauthorized and undisclosed payments to preferred creditors after the commencement of the bankruptcy case."

Memorandum Order, p. 3.

In addition to the bankruptcy grounds stated, the Judicial Council found that the Judge had engaged in deceptive conduct concerning a debt he owed to Regions Bank prior to bankruptcy, that he received gifts and things of value from attorneys who had cases pending before him and that he failed to report the gifts on his financial disclosures.

According to an article in The New Orleans Times-Picayune, there were 7,462 complaints filed against federal judges in the decade ending September 30, 2006. Out of those complaints, eight required action by a judicial council and none was referred to the Judicial Conference for possible impeachment. Meghan Gordon, "Move to impeach federal judge a rarity," The Times-Picayune, December 23, 2007. Since the current law was passed in 1981, three federal judges have been removed from office through impeachment, all of them during the 1980s.

From this point, the Judicial Conference of the United States will review the case and will make a recommendation to the House of Representatives. If the House of Representatives votes for impeachment, there will be a trial before the Senate.

Thursday, January 10, 2008

Texas Supreme Court Limits Penalties for Invalid Home Equity Loan

Texas has a long tradition of protecting its homesteads. Texas was the last state in the nation to allow home equity lending. When it did, the loans came with a host of technical requirements and draconian penalties for failing to meet those requirements. In certain circumstances, failure to comply with the home equity laws results in forfeiture of principal and interest. However, under a new opinion from the Texas Supreme Court, the forfeiture to be suffered does not extend to any constitutionally valid liens which were refinanced with the invalid home equity loan.

In LaSalle Bank National Association vs. Geistweidt, No. 06-1016 (Tex. 12/21/07), the borrowers owned a 53.722 acre homestead property which had a prior purchase money lien for $185,010.51 and also a valid lien for ad valorem taxes in the amount of $9,410.96. The lender advanced $260,000.00 to the borrowers which paid off the prior liens and paid the borrowers $57,518.50 in additional money. The borrowers defaulted after making only five payments on the loan. When the lender tried to foreclose, the borrowers claimed that the lien was secured by property designated for agricultural use and thus invalid. The trial court and the court of appeals both agreed and ruled that the lender had to forfeit all principal and interest with the result that the borrowers would get to keep their homestead free and clear. This would be a substantial benefit for the borrowers, since it would mean that they could keep the $57,000 in new money which they had received and would be excused from paying nearly $200,000 in liens which had been validly established against the homestead prior to the refinance.

On petition for review to the Texas Supreme Court, LaSalle Bank did not dispute that they had made an invalid home equity loan. Instead, they took the more modest position that the constitutional provisions relating to home equity loans did not displace the prior case law allowing for equitable subrogation. It has long been the law in Texas that a party that pays off a valid lien against a homestead is subrogated to the position of the prior lender.

The Texas Supreme Court agreed with the lender. They looked at Tex. Const. Art. XVI, sectin 50(e), which states that a refinance that includes the advance of additional funds "may not be secured by a valid lien against the homestead" unless the refinance was an advance of credit authorized by the home equity provisions or was to pay reasonable costs necessary to the refinance.

One way to read the statute is to look at the words "a refinance of debt secured by a homestead ... may not be secured by a valid lien" unless the conditions are met. Reading this language literally, it would appear that the refinanced debt could not be secured by a valid lien in any event. However, the state Supreme Court found that the statute "contains no language that would indicate displacement of common law remedies was intended, and we decline to engraft such a prohibition onto the constitutional language." Slip Op. at 4. Thus "not be secured by a valid lien" was read as "not be secured by a valid lien except under equitable principles."

While this reading may appear to strain the text, another way to look at the constitional language is to say that the home equity loan itself would not be secured by a valid lien, but that the lender would still have the rights that any other person paying off a valid lien against a homestead would have. This seems to be the direction that the court was going.

From an equitable point of view, this result makes sense. The homestead is not burdened by any more debt than it had before the invalid home equity loan was placed upon it and the lender's penalty for not following the law is the loss of over $57,000.