Saturday, January 30, 2010

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.

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