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.

Saturday, July 19, 2008

Tchaikovsky's Overture: How an Unremarkable Case Took on a Life of Its Own

Peter Tchaikovsky's 1812 Overture ends with a cannonade. Some commentators have viewed a recent opinion from Bankruptcy Judge Leslie Tchaikovsky as a cannon shot aimed at the irresponsible practices of the home mortgage industry. However, what is most remarkable about National City Mortgage vs. Hill, No. 07-4106 (Bankr. N.D. Cal. 5/28/08) is how unremarkable the opinion is.

The Opinion

In the Hill case, the debtors purchased a home for $220,000 twenty years ago. By the time that they filed bankruptcy, they had incurred debt of $683,000 against the house, including a second lien debt to National City Mortgage for $250,000. However, the debtors' combined income never exceeded $65,000.

When the debtors first applied for a loan with National City Mortgage in April 2006, they stated that their combined income was $145,716 on an annual basis. Six months later, they asked the bank to increase their Home Equity Line of Credit from $200,000 to $250,000. This time they stated their income as $190,800 on an annual basis. The bank either did not notice or did not care that the debtors were asserting that their income had increased by $45,000 per year in the span of just six months.

After the debtors filed for chapter 7 bankruptcy in April 2007, the first lienholder foreclosed and the second lien to National City Mortgage was wiped out. National City Mortgage brought a dischargeability action based on submitting a false financial statement under 11 U.S.C. Sec. 523(a)(2)(B). The court had little trouble finding that the first five elements of the claim were established. The debtors had made knowingly made a false financial statement with intent to deceive the lender. However, the court found that the element of reasonable reliance was missing.

Section 523(a)(2)(B) is unusual in that the statutory language expressly requires that reliance on a false financial statement be reasonable. This contrasts with Section 523(a)(2)(A) which states that debts based upon fraud are non-dischargeable but does not spell out the standard for reliance. The Supreme Court has said that reliance must be "justifiable" under Sec. 523(a)(2)(A), which is a lesser standard than "reasonable." Field v. Mans, 516 U.S. 59 (1995)("While the Court of Appeals followed a rule requiring reasonable reliance on the statement, we hold the standard to be the less demanding one of justifiable reliance, and accordingly vacate and remand."). Thus, Congress required a higher level of reliance on written statements of financial condition.

Judge Tchaikovsky set out the standad for reasonable reliance as follows:

Whether the creditor reasonably relied on the materially false statement under Sec. 523(a)(2)(B) is measured objectively by the degree of care exercised by a reasonably cautious person in the same transaction under similar circumstances. (citation omitted). Absent other factors, a creditor's reliance on a statement of financial condition is reasonable if it followed it normal business practices. (citation omitted). Other factors that may affect whether the creditor's reliance on its own standard lending practices is reasonable include the standards of the creditor's industry in evaluating creditworthiness, and the existence of any "red flags" that would alert the reasonably prudent lender of the possibility that the information was inaccurate. (citation omitted).

Memorandum of Decision at 8.

This was what is known as a stated income loan. According to the creditor's own guidelines, it did not require verification of income. However, it did require that an independent contractor verify that the amount stated was reasonable and that for a self-employed person that the borrower provide a copy of the borrower's business license, a copy of a bank statement showing a balance equal to 1/10 of the stated annual income or a letter from a CPA verifying the existence and ownership of the business. The Court found that the lender did not follow its own guidelines. There was no evidence that a third party contractor had verified that it was reasonable for an auto parts manager in the San Francisco Bay area (the husband) to earn $98,112 on an annual basis. While the wife submitted a letter on a CPA's letterhead with regard to her sole proprietorship, the person who signed the letter was not the CPA. Thus, the bank failed to follow its own guidelines. The Court also found that the bank ignored obvious red flags. In April 2006, the debtors claimed that Mr.Hill's income was $98,112 and that Mrs.Hill's income was $47,604. However, in October 2006, the debtors claimed that Mr. Hill's income was $67,200 (a 33% drop) and that Mrs. Hill's income was $123,600 (a 300% increase). Reasonable minds would have wondered about such a dramatic fluctuation in income, but the bank apparently did not.

In denying the complaint, the court concluded:

Based on the foregoing, the Court concludes that either the Bank did not rely on the Debtors representations concerning their income or that its relaiance was not reasonable based on an objective standard. In fact, the minimal verification required by an 'income stated' loan, as established by the Guidelines, suggestes that this type of loan is essentially an 'asset-based' loan. In other words, the Court surmises that the Bank made the loan principally in reliance on the value of the collateral: i.e., the House. If so, the Bank obtained the appraisal upon which it principally relied in making the loan. Subsequent events strongly suggest that the appraisal was inflated. However, under these circumstances, the Debtors cannot be blamed for the Bank's loss, and the Bank's claim should be discharged.

Memorandum of Decision at 13.

The Response

While the opinion was rather unremarkable, one line in it drew a lot of attention. Near the beginning of the opinion, the Court stated, "This adversary proceeding is a poster child for some of hte practices that have led to the current crisis in the housing market." Memorandum of Decision at 2. According to one blogger who wrote the day after the opinion was released, "This is a big deal, and will no doubt strike real fear in the hearts of stated-income lenders everwhere." BK Judge Rules Stated Income HELOC Debt Dischargeable, This comment was picked up on and repeated by dozens of bloggers. The Wall Street Journal ran a story with the headine "Are borrowers free to lie?" Amir Efrati, "Are Borowers Free to Lie?," Wall Street Journal, May 31, 2008, p. B2. An article on MSN Money on June 30, 2008 amplified the story, claiming that, "In a little-noticed decision, U.S. Bankruptcy Judge Leslie J. Tchaikovsky let a California couple off the hook for debt they owed their home-equity lender because the incomes they had listed on their applications were obvious "red flags" that the lender had ignored." Liz Pulliam Webster, "Lenders create a bankruptcy monster,"

By this point, the focus on the legal definition of reasonable reliance had been lost. From the comments being circulated, it appeared that a crazy bankruptcy judge had declared war on the stated-income lenders, was countenancing lying by debtors and was letting borrowers off the hook for their misdeeds. One email which I received from a colleague asked me if I had heard about a case “in which the good judge held that despite the mendacity of the debtors, Mr. and Mrs. Hill (In Re Hill), National City Bank could not enforce, post petition, a home equity type of loan against the debtors post discharge.” He asked “Is this a case that you are aware of?” However, the debtors were not let off the hook. They lost their home of 20 years. What they did get was a discharge, something that debtors are entitled to if their creditors do not object or do not prove an exception to discharge.

We have been through this before. During the 1990s and early years of the 2000s, credit card lenders made a concerted effort to object to dischargeability in cases where debtors irresponsibly ran up their credit card debt. Many of these decisions focused on reliance or the lack thereof. E.g., In re Mercer, 246 F.3d 391 (5th Cir. 2001)(no reliance where creditor sent debtor pre-approved credit card);In re Eashai, 87 F.3d 1082 (9th Cir. 1996)(reliance justifiable where no red flags appeared).

In one noteworthy case, the court stated:

There is no reliance in this case. There is not even a scintilla of reliance in this case. . . .

The Plaintiff's extension of credit to the Defendant in this case was a result of their own negligent lending practices and the industry's negligent use of a faulty FICO score system which has been engineered to create the greatest amount of credit for the greatest number of working people in this country with artificially low monthly repayment requirements so that credit card companies can make the greatest amount of interest and profits possible. Losses such as this are simply a cost of doing business in such a greedy manner.

In re Akins, 235 B.R. 866, 874 (Bankr. W.D. Tex. 1999).

As long as lenders continue to make high risk loans, it is inevitable that some borrowers will default and file bankruptcy. If the loss results from the lender's own negligence, the debt will be dischargeable. This is nothing remarkable.

Thursday, July 17, 2008

In Memory of Gray Byron Jolink, 1946-2008

The Central Texas bankruptcy community lost a valued friend and colleague when Gray Byron Jolink passed away unexpectedly on June 23, 2008. Gray graduated from the University of Texas Law School in 1974 and was a solo practitioner in Austin. Much of his practice involved representing the debtor in small chapter 11 cases.

Gray is survived by his mother Bette; wife Kathy; children Luke, Radkey, Georgia, Tatum and Willa; daughter-in-law Christine; brother, Dirk; sister-in-law Carol; mother-in-law Bea Cromack; grandchildren, Mason and Miles; eight nieces and nephews; and numerous other relatives and friends.

Gray’s obituary did a good job of summarizing his life. It stated:

“He was many things during his full life: pilot, photographer, attorney, birder, coach and nature lover. But the titles of which he was most proud were husband, father, grandfather, son, uncle, brother, cousin and friend.”

“He spent the last thirty years practicing bankruptcy law in Austin. His passion for the law lay in his desire to help others, and he saw his bankruptcy practice as a means to help those who struggled financially to get back on their feet.”

After Gray’s death, his colleagues shared memories of his life.

I first met Gray in the late 1980s at a hearing on a motion for relief from the automatic stay. I managed to show up after the court had already called my case and ruled without me. I located Gray in the back of the courtroom and asked him if he would object to a motion for reconsideration. He went up to the podium with me and asked the judge to let me go forward. Afterward he told me, “One of these days someone may need a favor from you. Be sure to remember when the time comes.” For a young associate, it meant a lot that a more experienced lawyer went out of his way to be nice.

Ronnie Hornberger of San Antonio said:

“Gray was one of the good guys; he was knowledgeable, gracious, easy to work with and you could always count on a hand shake deal to be honored. He truly will be missed.”

Joe Martinec recalled:

“Gray called me just about every Friday to ask ‘what are you seeing?’, at which time we would discuss the state of the Austin bankruptcy market and the crazy, outrageous or comical things the ‘young pups’ were doing. Gray was someone whose call I was always happy to take because it was almost invariably upbeat and informative. He was a great fan of history, he knew all about my distant relative being defenestrated in Prague, and he was an avid birder. I hate that I did not call him last week to tell him I had just seen a nesting pair of black-bellied whistling ducks on my brother’s stock tank. He would have told me their range, mating habits and maybe their call. I always envied Gray’s ability to get an adverse ruling or criticism without over-reacting. Most of the time, he would just chuckle and say, ‘You may be right. I’ll think about that.’ I could learn from that. He will be especially missed by those of us who are his contemporaries (a dwindling number).”

Steve Ravel said:

“I tried the first contested bankruptcy matter of my career against Gray before Judge Elliott in 1983. He was unfailingly gracious that time and every time since. When my twins were born only about 3 years after his, he went out of his way to share tips and wisdom. He coined the phrase, ‘Twins, twice as much work and four times as much fun.’”

Gray’s funeral was held at the Episcopal Church of the Good Shepherd on June 27, 2008. The church was packed to capacity as friends,family, members of his church, clients, lawyers and court staff gathered to remember him. Bankruptcy Judge Frank Monroe gave one of the eulogies. He said:

“I’m not sure that I ever met a man that enjoyed life more fully or exuded more joy in his life than Gray Jolink. Gray was a man who drew others to himself. He had a magnetic and upbeat personality. You knew instinctively that he was a person you could trust—with anything. In many ways he lived his life with the heart of a child—every new discovery was viewed with great delight and excitement.

“The last time I talked with Gray was after a Court hearing one day last week. He wanted to tell me about his experience of seeing the people who ‘danced’ on the side of the federal courthouse and the federal building. He had gone to the performance with Kathy and was obviously greatly impressed by the performance. The excitement in his eyes as he told me of his experience reminded me of a young child seeing some new wonder for the first time—not fully understanding how it could have been done but fully appreciating what he had seen.

“Gray was the consummate gentleman attorney. He was always prepared, always well mannered, polite and respectful of his fellow attorneys, the parties, the witnesses, the Court and the Court’s staff. He was unfailingly honest and forthright and always looked for a solution that would be fair to both sides. He was also an excellent litigator and cross-examiner of adverse witnesses. He was exceptionally bright, and he was an absolute joy to have in one’s courtroom.

“Gray viewed the practice of law as a profession—a way to help people—and not just a business to be run for profit, and he always conducted himself in that mode—always the gentleman.”

Judge Monroe was kind enough to type up the complete eulogy and provide me with a copy. I would be happy to send copies to anyone who asks.

Donations can be made to the Gray Jolink Memorial Fund, P.O. Box 5516, Austin, TX 78763 or to the Travis Audubon Society.

Friday, July 11, 2008

Fifth Circuit Clarifies Post-Confirmation Jurisdiction

The Fifth Circuit has written a new opinion in which it holds that once "related to" jurisdiction attaches, confirmation of the plan will not divest that jurisdiction. The opinion reconciles an apparent conflict with its holding in Craig's Stores that post-confirmation jurisdiction is limited to enforcing the plan. Newby v. Enron Corporation, No. 07-20051 (5th Cir. 7/10/08).

In the Newby case, nine actions against Enron-related parties were removed to federal court based upon "related-to" jurisdiction. Seven cases were removed prior to confirmation of Enron's plan and two were removed between plan confirmation and the plan's effective date. The cases were consolidated in U.S. District Court where they were dismissed with prejudice. The plaintiffs appealed the dismissal on the basis that the U.S. District Court lacked jurisdiction subsequent to plan confirmation.

The Fifth Circuit noted an apparent conflict in its opinions.

"We previously have stated that 'Section 1334 does not expressly limit bankruptcy jurisdiction upon plan confirmation.' (citation omitted). Other Circuits agree, holding that 'if ‘related to’ jurisdiction actually existed at the time of . . . removal” subsequent events '[can]not divest the district court of that subject matter jurisdiction.” (citation omitted). But at the same time, this Court has stated that '[a]fter a debtor’s reorganization plan has been confirmed, the debtor’s estate, and thus bankruptcy jurisdiction, ceases to exist, other than for matters pertaining to the implementation or execution of the plan.' (citations omitted). Although these statements may seem contradictory, they are easily reconciled."

Slip Opinion, at 14-15.

The Fifth Circuit clarified its holding in Craig's Stores as one relating to claims brought post-confirmation. Thus, if bankruptcy jurisdiction attaches to a claim prior to confirmation, the court retains jurisdiction over that claim post-confirmation.

"(Plaintiffs)cannot point to a single case in which we have held that plan confirmation divests a District Court of bankruptcy jurisdiction over preconfirmation claims based on pre-confirmation activities that properly had been removed pursuant to 'related to' jurisdiction. We likewise find none. Accordingly, we hold that the District Court had bankruptcy jurisdiction over the Fleming plaintiffs’ claims at the time it issued its decision dismissing them with prejudice."

Slip Opinion at 16.

Tuesday, July 01, 2008

5th Circuit Rejects Equitable Subordination Claim With Deepening Insolvency Aspect; Insiders Not Subordinated for Stoking the Fires of a Sinking Ship

The Fifth Circuit has ruled that insiders who “grabbed for as much as they could get” were not subject to equitable subordination where the bankruptcy court did not find sufficient harm resulting from their conduct. The court rejected a theory of damages which it equated to deepening insolvency. Matter of S.I. Restructuring, Inc., 2008 U.S. App. LEXIS 13140 (5th Cir. 6/20/08).


S.I. Restructuring involved the Schlotzsky’s sandwich chain. At the time, John and Jeffrey Wooley were officers, directors and the largest shareholders of the company. In April 2003, the Wooleys made a secured loan to the company for $1 million. The company and the Wooleys were each represented by separate counsel, the transaction was approved by the company’s audit committee and board of directors and the loan was reported in the company’s SEC filings.

The company’s finances continued to deteriorate and in October 2003, it sought financing from International Bank of Commerce. IBC declined to make a loan to Schlotzsky’s, but agreed to loan the money to the Wooleys for them to loan to the company. The board of directors was given just three days notice of the meeting to approve the loan, but were provided with copies of the proposed loan documents along with emails from the company’s assistant general counsel.

In mid-2004, the Wooleys were removed as officers and directors and the company for chapter 11 shortly thereafter. The unsecured creditors committee brought a complaint for equitable subordination against the Wooleys. The bankruptcy court found that John and Jeffrey Wooley, as fiduciaries, engaged in inequitable conduct in relation to the November transaction and that their conduct conferred an unfair advantage upon them. Specifically, the court found that the Wooleys breached their fiduciary duties by: (i) presenting the loan proposal to the board as a fait accompli; (ii) by securing the loan with the “crown jewel” of the Debtor’s assets; and (iii) by securing their contingent liability as guarantors. As a result, the bankruptcy court subordinated the secured claims to the level of the unsecured creditors.

Fifth Circuit Ruling

The Fifth Circuit reversed and rendered. The Fifth Circuit characterized equitable subordination as an “extraordinary remedy” and recited the following test from In re Mobile Steel Corp., 563 F.2d 692 (5th Cir. 1977): “(1) the claimant must have engaged in inequitable conduct; (2) the misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant; and (3) equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Code.” The Court also noted an additional requirement that “a claim should be subordinated only to the extent necessary to offset the harm which the debtor or its creditors have suffered as a result of the inequitable conduct.”

Applying this test to the April 2003 transaction, the appellate court found that the bankruptcy court had not made any findings of inequitable conduct or unfair advantage. As a result, it was necessary to reverse the subordination of this debt.

When examining the November 2003 transaction, the Fifth Circuit assumed without deciding that the record supported the findings of inequitable conduct and unfair advantage. The court went on to state, “However, the bankruptcy court made no finding of harm, and the record does not support a finding that either the debtor or the unsecured creditors were harmed by the November transaction.”

The Plan Administrator argued that the securing of the loan harmed the Debtor by diminishing the pool of assets available to unsecured creditors. On a certain level, the Plan Administrator was correct. Creditors would have been better off if the Wooleys had made unsecured loans to the company. However, the Fifth Circuit did not penalize the Wooleys for protecting their own interest. Instead, the court noted that the bankruptcy court had expressly found that the debtor needed the money and that the money had been used to pay unsecured claims. The Court stated:

“Because the loan proceeds were used to pay current unsecured creditors, unsecured creditors as a class, were not harmed when the Wooleys obtained security for for the November loan. The general unsecured creditors who were paid from the proceeds of the November loan may have benefitted to the detriment of another group of unsecured creditors, but this does not mean that unsecured creditors were harmed when the Wooleys obtained security for their loan.”

The Fifth Circuit also rejected the argument that the Wooleys harmed the company by loaning it additional funds which allowed it to continue operating until its condition worsened. Although the Appellee denied that it was relying upon deepening insolvency, the court found that this was exactly what was being alleged and rejected the theory. The Court stated that, “Deepening insolvency has been defined as prolonging an insolvent corporation’s life through bad debt, causing the dissipation of corporate assets.” The Court went on to state that:

“A deepening insolvency theory of damages has been criticized and rejected by many courts. We agree with the Third Circuit Court of Appeals, which recently concluded that deepening insolvency is not a valid theory of damages. The court recognized that deepening insolvency as a measure of harm depends on how the company uses the proceeds of the loan in question and ‘looks at the issue through hindsight bias.’”

As a result, the Fifth Circuit reversed and rendered.

What About Herby’s Foods?

S.I Restructuring has some factual similarities to Matter of Herby’s Foods, 2 F.3d 128 (5th Cir. 1993), an earlier decision which upheld equitable subordination. How then to reconcile the two cases?

In Herby’s Foods, the parent company purchased the debtor less than two years before it failed. Part of the consideration was payment of a debt to another entity. In return for this payment, the parent company took a lien against the debtor’s assets. Another related entity extended a secured line of credit to the company. Another insider made unsecured advances to the company. The secured claims were not perfected until shortly before bankruptcy. During the time between the acquisition and the bankruptcy filing, unsecured claims grew from about $900,000 to $4,600,000. The unsecured creditors’ committee sought to avoid the liens as preferential, to recharacterize the loans as equity and to subordinate the insider debts to the level of equity. The bankruptcy court granted all of the relief requested. On appeal, the Fifth Circuit affirmed, finding that the requisites for equitable subordination had been established, but did not reach the issue of recharacterization.

The Fifth Circuit found that a combination of undercapitalization, failure to disclose the existence of unfiled liens and advancing funds as loans rather than capital constituted inequitable conduct. The Fifth Circuit found that unsecured creditors were harmed by the fact that the amount of unsecured debt owed to third parties increased dramatically.

“The bankruptcy court found that the Insiders’ conduct harmed Herby’s outside creditors by significantly increasing their trade credit exposure and by reducing their ultimate dividend in the liquidation. Most importantly, the court found that the Insiders had secured an unfair advantage by structuring their cash contributions to Herby’s as loans, rather than as equity capital. If the Insiders were allowed to retain their ranking as unsecured creditors, they would have gained an advantage in the priority scheme by encouraging outside creditors to increase their credit to Herby’s. Their efforts were successful; those trade creditors substantially increased their credit to Herby’s during the period in question.”

Herby’s at 134.

The Court in Herby’s accepted the “deepening insolvency” model of damages which was expressly rejected in S.I. Restructuring. However, they did not call it deepening insolvency, a term which was not in vogue in 1993. Instead, the court analyzed the case as one involving deception and trickery. The bad Insiders (referred to with a capital I in the opinion) tricked the trade creditors into advancing more credit by advancing debt rather than infusing equity, by failing to timely record their liens and by failing to adequately record the loans on the company’s books, thus giving the appearance that the company was adequately capitalized. This caused the unsecured creditors to extend trade credit. The court did not cite any evidence that creditors had relied on the company’s books. It simply found that an increase in trade debt was enough to prove harm. However, the court in S.I. Restructuring expressly rejected an argument that an increase in trade debt standing alone was evidence of harm.

Scott Ritcheson (see Acknowledgement below) suggests that Herby’s Foods is best understood as a recharacterization case which was decided based upon equitable subordination. Section 510(b) allows the court to recharacterize a debt as equity without regard to inequitable conduct, while Section 510(c) is based upon principles of equitable subordination which courts have interpreted to require proof of inequitable conduct. In the Herby’s case, the evidence of inadequate capitalization, failure to record loans on the books and failure to treat the insider loans as debts would be evidence to support a finding of recharacterization (which was one of the grounds found by the bankruptcy court but not addressed by the court of appeals). On the other hand, in S.I. Restructuring, the company was publicly traded and the transactions were approved by an audit committee of outside directors and the full board and were reported as loans to the SEC. This greater level of formality may be the factor which reconciles the two apparently contradictory opinions.


My analysis in this article was strongly influenced by an excellent paper presented by Scott Ritcheson to the Annual Meeting of the Bankruptcy Section of the State Bar of Texas on June 26, 2008 entitled “Issues and Trends in Equitable Subordination.” Anyone litigating an equitable subordination issue would benefit significantly from reading Scott’s scholarly, comprehensive article. Scott can be reached at