Sixth Circuit Releases Remarkable Opinion on Debt Buyers, Mootness and Sanctions

Unsecured claims held by credit card companies, and in particular by debt buyers, have kept bankruptcy judges and appellate courts busy recently. In the typical case, a credit card company or debt buyer files a claim which contains a summary listing the original creditor, the last four digits of the account number and the amount of the claim. The debtor objects on the basis that the claim is not supported by the documents establishing the claims and/or that the debtor does not know who the debt buyer is. The creditor will offer varying amounts of proof ranging from none to the debtor's schedules and a business records affidavit with respect to the claim.

Some of the recent decisions include: In re Kirkland, 572 F.3d 838 (10th Cir. 2009), holding that an unsubstantiated claim may not be allowed upon objection by the trustee; In re Plourde, 418 B.R. 495 (1st Cir. BAP 2009), holding that failure of creditor to provide proof of nature of claim relegated claim to subordinated status for penalties; and In re DePugh, 409 B.R. 84 (Bank. S.D. Tex. 2009), holding that creditor who failed to include supporting documentation could not amend claim after objection was filed without leave of court.

U.S. Bankruptcy Judge Jeff Bohm (author of the DePugh decision) has adopted a Notice and Order That Federal Rule 15, As Made Applicable Bankruptcy Rule 7015, Shall Apply Whenever an Objection to a Proof of Claim is Filed," which provides that creditors who amend their claims without leave of court after an objection has been filed shall be subject to sanctions.

Suffice it to say that credit card creditors have not been feeling the love lately. However, a new decision out of the Sixth Circuit gives debt buyers a modicum of respect. In In re Wingerter, No. 08-4455 (6th Cir. 1/25/10), the Sixth Circuit reversed a bankruptcy court's sanctions order which struck at the heart of a debt buyer's business model.

The case began with a claim for $431.57 filed by B-Line, LLC, a debt buying firm. B-Line had bought the claim from Covenant Management, LLC, who in turn had purchased it from the original creditor, GTE. Unlike many of these cases, the Debtor insisted that he had never owed a debt to GTE. When B-Line could not obtain proof that the debt existed, it withdrew the claim.

However, that was not the end of the story. The Bankruptcy Court issued a series of show cause orders to B-Line to explain its business practices in general and its handling of the specific claim as well. The Court found that B-Line had violated Rule 9011(b) by failing to make a "reasonable pre-filing inquiry" that the claim was valid and supported by evidence.

The Bankruptcy Court stated:

This Court finds that B-Line did not fulfill its Rule 9011 obligations in filing the B-Line POC without having possession of the underlying transactional documents or any reliable proxy for such documents. As a prospective matter, B-Line and other purchasers in the claims trading industry should understand that this Court views the filing, without review of originating documents, of a proof of claim by an assignee/purchaser to fall short of reasonable inquiry under Rule 9011 when the obligation has not been scheduled by the debtors and the purchase of the claim was not accompanied by reliable representations of claim validity. Because of the time and energy that B-Line's senior management devoted in response to this Court's show cause order, however, the Court does not view any further sanctions to be necessary in this case.

In re Wingerter, 376 B.R. 221, 238 (Bankr. N.D. Ohio 2007).

This left B-Line in the awkward position that it had dodged the bullet on sanctions in the particular case, but would be subject to sanctions in the future if it continued to file claims based on electronic records without viewing the originating documents. B-Line appealed to the Bankruptcy Appellate Panel which dismissed the appeal as moot. With one judge dissenting, the Sixth Circuit reversed both the Bankruptcy Appellate Panel and the Bankruptcy Court.

B-Line's Business Model

One thing which is interesting about this opinion is that the court of appeals went to great lengths to explain how a debt buyer, such as B-Line, does business. This business model forms the backdrop for the opinion.

B-Line is a business entity that specializes in purchasing "consumer bankruptcy debt." It purchases such debt from both original creditors and intermediaries. B-Line then files proofs of claim in the respective debtors' bankruptcy cases, or has existing proofs of claim transferred to it.

When B-Line purchases a claim, it does not acquire the supporting documentation. Instead, it requests several pieces of information from the claim's seller that B-Line stores in an electronic database. This information typically includes the debtor's name, address, contact information, and Social Security number, as well as the original account number, the original creditor's name, the original amount owed, the date the original account was opened, and the bankruptcy case information.

B-Line relies on the sellers from whom it purchases the claims to provide accurate, truthful information, and it negotiates a purchase agreement with these sellers to protect itself in case a seller misrepresents the validity of a claim. The purchase agreement requires, in particular, a warranty that each claim sold to B-Line "represents a legal, valid and binding obligation of the related Debtor." To keep down its costs, B-Line does not request copies of a claim's originating documents unless a debtor challenges the claim.

Opinion, p. 2.

Appeal Not Moot

The Bankruptcy Appellate Panel ruled that because no monetary sanctions were assessed that there was no live controversy to appeal. However, the Bankruptcy Court's order found that B-Line had violated Rule 9011 but that it did not view "any further sanctions to be necessary in this case." The Court of Appeals found that this was a non-monetary sanction which could be appealed just as an attorney could appeal a non-monetary sanction which affected his reputation. The majority concluded:

Compared to the somewhat vague injury to "reputation" suffered by sanctioned attorneys, which has the potential to harm their economic interests, B-Line's injury is more direct and certain because part of the company's core business practices has been declared sanctionable. B-Line's business is thus thrown into uncertainty, either forcing the company to comply with the bankruptcy courts more stringent (and more expensive) filing requirements or placing it at risk of being sanctioned in bankruptcy courts throughout the country. The court's sanctions order, therefore, has caused direct, financial injury to B-Line. Under these particular circumstances, B-Line's appeal of the court's sanctions order is not moot.

Opinion, p. 9.

Debt Buyer's Conduct Not Sanctionable

The Court of Appeals disagreed with the Bankruptcy Court's conclusion that B-Line did not conduct an adequate pre-filing inquiry. The Bankruptcy Court found that B-Line's inquiry was insufficient because it did not review original documents and because it did not obtain representations and warranties from the seller.

The Court of Appeals found the factual conclusion that B-Line did not obtain representations and warranties as to the validity of the claim to be clearly erroneous. It pointed to specific language in the transfer documents in which Covenant warranted that the accounts were eligible for purchase.

The Court ruled that reliance on Covenant's representations and warranties, along with the due diligence of both debt buyers was sufficient to constitute reasonable pre-filing inquiry. The Court of Appeals credited testimony that B-Line had purchased over 1,000 accounts from Covenant and that only two had been found to be invalid. It also discussed the due diligence which B-Line and Covenant conducted, which included review of electronic databases and the fact that the debtor had received several validation notices from debt collectors but had never disputed the debt.

Finally, the Court of Appeals found that failure to attach documentation to the proof of claim was not sanctionable in and of itself. The Court stated:

Admittedly, as the bankruptcy court stressed, B-Line's proof of claim was submitted on an incomplete Form 10. This deficiency violated Rule 3001(c) of the Federal Rules of Bankruptcy Procedure, which requires that a proof of claim based on writing include a copy of that writing. The ramifications for this type of violation are well-established, however, and do not result in sanctions. See Heath v. Am. Express Travel Related Servs. Co., Inc. (In re Heath), 331 B.R. 424, 433 (B.A.P. 9th Cir. 2005) (explaining that a failure to comply with Rule 3001 results in the creditor's proof of claim not being prima facie evidence of the claim's validity and amount). Not complying with Rule 3001 might be a factor in determining whether a Rule 9011(b) violation has occurred under different circumstances, but it is not a relevant factor in this case given the track record and warranties between Covenant and B-Line and the efforts that both businesses undertook to validate the Wingerter claim.

Opinion, p. 13.

What It Means

Wingerter is significant because it is an appellate level decision which examined the practices of a debt buyer and did not find them wanting. B-Line did a good job of explaining how its business model worked and how it provided adequate protections. While many credit card cases are decided based upon an insufficient record, B-Line provided an extensive record. This case is also very important because the Court of Appeals considered disruption of a creditor's business model to be a relevant factor. Rather than dictating that the creditor change its business practices, the Court looked at whether the creditor's existing practices could be reconciled with the obligations under Rule 9011. Finally, the court of appeals refused to get on the lack of documentation bandwagon, finding that failure to attach supporting documents deprives a claim of prima facie validity, but does not indicate bad conduct by the creditor.

This is a case where the system worked. A creditor filed a claim which probably was not valid. The debtor challenged it. When the creditor could not obtain verification, it withdrew the claim. However, you can't help but notice that an awful lot of ink was devoted to one claim for $431.57.

Court of Appeals Wades Through Mootness Maze

You know that an opinion is going to be challenging when the first sentence reads:

The procedural background is a bit of a maze, but it is a facet of the appeal that we need to keep straight in our minds.

Opinion, p. 1. Thus begins the Fifth Circuit's recent opinion on equitable mootness and section 1127(b). In re Blast Energy Services, Inc., No. 08-20702 (5th Cir. 1/7/10).

The Procedural Maze

While the issue decided by the Fifth Circuit was equitable mootness, the underlying dispute concerned an executory contract. In 2006, the Debtor and Alberta Energy Partners entered into a contract where Alberta transferred a 50% interest in its technology to the Debtor and the parties agreed to "work together to develop and manage the technology."

In January 2007, the Debtor filed for chapter 11 reorganization. Alberta filed several motions seeking to compel the Debtor to reject the executory contract on the basis that it could not be assumed over Alberta's objection. Those motions were denied and an appeal ensued. Meanwhile, on February 26, 2008, the Bankruptcy Court confirmed the Debtor's plan which provided for assumption of the contract.

Alberta appealed that order as well. However, the Debtor substantially consummated its plan and the District Court dismissed the appeal of the Confirmation Order based on equitable mootness. Alberta moved for rehearing, which was denied. The parties stipulated that dismissal of the confirmation appeal would not affect the appeal of the executory contract orders. The District Court rejected the parties' stipulation and dismissed the earlier appeal as well. Alberta appealed both the denial of the motion to reconsider the order dismissing the confirmation appeal and the order dismissing the executory contract appeal.

So, does Alberta get to appeal or not? The Fifth Circuit said yes.

Which Order Should Have Been Appealed?

At first, the Debtor argued that the appeal was moot because Alberta had appealed the order denying the motion for rehearing, rather than the order dismissing the confirmation appeal. The mootness argument was that reversing the rehearing order would not have affected the dismissal order so that no relief could be granted. The Fifth Circuit rejected this argument, finding that if the rehearing order was reversed, the District Court could be ordered to grant rehearing and vacate dismissal of the appeal. The circuit also found that despite the fact that the notice of appeal only pertained to the rehearing order, it was clear that Alberta was appealing both rulings.

Equitable Mootness

The Fifth Circuit opinion has a good explanation of equitable mootness. The opinion stated:

Equitable mootness authorizes an appellate court to decline review of an otherwise viable appeal of a Chapter 11 reorganization plan, but only when the re-organization has progressed too far for the requested relief practicably to be granted. (citation omitted). Unlike Article III mootness, equitable mootness is pru-dential, not jurisdictional. (citation omitted). In addressing whether an appeal of a confirmation plan is equitably moot, the Fifth Circuit considers a three-pronged analysis: “(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.”

There is no set weight given to the respective prongs. In some cases, a single prong may be determinative, but more often the first two are relevant only insofar as they affect the answer to the third question; if no stay has been obtained and the plan has been substantially consummated, the more likely the third prong indicates equitable mootness. Nevertheless, although substantial consummation is a “momentous event,” it is not necessarily fatal to the appeal of a confirmed reorganization plan. (citation omitted).

Only when the relief that a party requests will likely unravel the plan does it become impracticable and inappropriate for a court to grant such relief; in such a case, the court abstains from reviewing the appeal. (citation omitted). However, when a court applies the doctrine of equitable mootness, it does so “with a scalpel rather than an axe.” (citation omitted). To that end, a court may “fashion whatever relief is practicable” instead of declining review simply because full relief is not available. (citation omitted). Similarly, a court considering whether an appeal is equitably moot should “scrutinize each individual claim, testing the feasibility of granting the relief against its impact on the reorganization scheme as a whole.”

Opinion, at 7-8 (paragraph breaks added).

Reduced to its essence, equitable mootness asks whether it is possible to grant relief without affecting the rights of third parties. This was also the prong that the District Court relied upon in dismissing the appeal. While the District Court concluded generally that assumption or rejection of executory contracts was central to the plan and would affect third parties, it did not make specific findings. The Fifth Circuit noted that the Debtor was not using the technology, had no plans to do so and that the Debtor had stipulated that the executory contract issue would not affect the plan. As a result, the Fifth Circuit reversed and remanded the order for reconsideration by the District Court. The Court of Appeals suggested that the District Court "should articulate in detail the reasons for its conclusion, with references to the record."

Modification Under Section 1127(b)

Finally, the Fifth Circuit rejected the District Court's alternate conclusion that 11 U.S.C. Sec. 1127(b) barred the appeal. Section 1127(b) bars modification of a plan which has been substantially consummated. The Circuit made clear that appealing a confirmation order is not the same as attempting to modify a confirmed plan.

Just How Far Does "Related-To" Jurisdiction Go?

The Fifth Circuit has a new opinion in which it finds that a dispute between two non-bankrupt parties fell within "related-to" jurisdiction based upon a contractual indemnification clause. Lone Star Fund V (US), LP v. Barclays Bank, PLC, No. 08-11038 (5th Cir. 1/11/10).

The Lone Star Fund V case involved a suit over alleged fraud in the sale of mortgage-backed securities. New Century sold mortgages to Barclays, which packaged them into mortgage-backed securities. Barclays sold some of them to Lone Star Fund. Lone Star claimed that the mortgages were bad and sued Barclays. Meanwhile, New Century was in bankruptcy in Delaware. Barclays removed the action to federal court asserting "related to" jurisdiction. The District Court found that it had jurisdiction and dismissed the action for failure to state a claim. Lone Star appealed to the Fifth Circuit.

The Fifth Circuit affirmed on all grounds, including jurisdiction. It noted that related to jurisdiction exists where the "outcome could alter, positively or negatively, the debtor's rights, liabilities, options, or freedom of action or could influence the administration of the bankruptcy estate." In this case, New Century had agreed to indemnify Barclays for claims arising from the sale of the mortgages. Thus, a judgment against Barclays would give rise to liability of New Century under the indemnification clause.

The court distinguished In re Federal-Mogul Global, Inc., 300 F.3d 368 (3rd Cir. 2002), in which the court found that a tort suit in which further litigation would be required to establish a right of contribution against the debtor did not confer related-to jurisdiction. The difference is when a right of contribution "accrues." With a contractual indemnification, the right of indemnification was already accrued because it was provided for in a contract. Thus, a judgment against Barclays would be a judgment against the debtor. However, in the tort context, a judgment against the non-debtor party would not automatically translate to a claim against the Debtor absent further litigation. As a result, the underlying suit was not "related to" the bankruptcy case.