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.

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.

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.