Two Wrongs and Two Rights Make a Mess
The first wrong in this case originated with the City of Arlington. It violated the Family Medical Leave Act with regard to Kim Lubke, a former firefighter. Lubke obtained a one million dollar judgment against the City.
A year later, while the judgment was on appeal, Lubke filed chapter 7. He forgot that he had a valuable judgment and apparently omitted a number of other assets as well. The Trustee closed the case as a no-asset filing.
The Fifth Circuit remanded the case for recalculation of damages. Subsequent to the remand, the City offered to enter into a Rule 68 judgment for $580,000. In discussing this offer with his client, the Debtor's non-bankruptcy attorney, Roger Hurlbut first learned about the bankruptcy. He promptly informed the Trustee's counsel. The Debtor and the Trustee successfully reopened the bankruptcy case and the Trustee sought to be substituted as plaintiff. The Debtor also agreed to have his discharge vacated.
Let's recap who behaved well and who behaved badly at this point:
The City of Arlington behaved badly when it violated the FMLA.
The Debtor behaved badly when he lied on his schedules.
The Debtor's nonbankruptcy lawyer performed blamelessly, representing the Debtor competently in the FMLA action and promptly notifying the Bankruptcy Trustee once he learned upon the bankruptcy.
The Bankruptcy Trustee did what she was supposed to do by moving promptly to reopen the bankruptcy case and pursue the litigation.
So at this point, we have two wrongs and two rights. For their part, the creditors did nothing wrong.
The District Court Tries to Follow the Fifth Circuit
The District Court considered the issue of judicial estoppel. After considering the Fifth Circuit's conflicting precedents on judicial estoppel, it found that the Debtor was subject to judicial estoppel. However, it found that the Trustee and the creditors should not be punished for the Debtor's wrongdoing. It allowed the Trustee to proceed with the case, but provided that once creditors were paid, any excess funds would go back to the City of Arlington rather than to the Debtor. Had the District Court been affirmed, the bad would have been punished and the blameless would not.
However, the Fifth Circuit chose not to affirm the District Court.
The Law of Judicial Estoppel
The Supreme Court has fashioned a three pronged test for whether judicial estoppel should apply:
(1) whether a party's later position is clearly inconsistent with its position in a prior case; (2) whether the party succeeded in persuading the first court to accept its position, creating “the perception that either the first or the second court was misled;”and (3) whether the party espousing the inconsistency has gained an unfair advantage or imposed an unfair detriment on an opposing party by that means.City of Arlington v. Reed, slip op., p. 5, discussing New Hampshire v. Maine, 532 U.S. 742 (2001).
Prior to Reed, the Fifth Circuit had completed a trilogy of cases on judicial estoppel in bankruptcy.
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 third component of the trilogy was Kane v. Nat’l Union Fire Ins. Co., 535 F.3d 380, 384 (5th Cir. 2008). That case looked a bit like Superior Crewboats, but with one major distinction. In Kane, the Debtor failed to disclose a claim. However, the Trustee did not abandon the claim. Instead, once the Trustee learned of the deception, the Trustee sought to pursue the claim on behalf of the creditors. The District Court granted summary judgment, relying on Superior Crewboats. However, the Fifth Circuit said not so fast. In its opinion, it stated:
The Fifth Circuit noted that the Kane 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:
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, quoting Biesek v. Soo Line R.R. Co., 440 F.3d 410, 413 (7th Cir. 2006).
[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.
The Fifth Circuit's Ruling in Reed
Given that Reed and Kane involved nearly identical circumstances, the Trustee could have reasonably expected a similar result. However, that was not to be.
The Court acknowledged that its precedents might be a bit hard to follow. However, it insisted that it was necessary to disregard Kane and follow Coastal Plains and Superior Crewboats. Writing for the panel, Chief Judge Edith Jones stated:
Reed at 7 (emphasis added). When one judge within the circuit contends that an opinion by another panel "purports" to distinguish a prior precedent, these are very strong words. Why does Judge Jones believe that the per curiam opinion from Judges King, Wiener and Elrod merely "purports" to distinguish the prior precedent?
What are the bankruptcy courts, which confront these problems regularly in our circuit, to make of these decisions? The grounds on which Kane distinguished In re Coastal Plains are that, in In re Coastal Plains, a corporate officer's misdeeds detrimentally influenced the corporate reorganization process as well as depriving creditors of the concealed cause of action. Id. Kane purports to distinguish In re Superior Crewboats, moreover, based on the differing procedural consequences between a trustee's abandonment of a claim (to the debtor) and the non-disclosure of assets that are not administered although still within the debtor's estate. Id. at 386-87. Whether these distinctions are correct in principle or on the facts are matters for another debate. Absent en banc harmonization, we must endeavor to reconcile the authorities. We are also guided by the principle that one panel of this court cannot overrule another panel decision. (citation omitted). Thus, judicial estoppel remains applicable to litigation claims that are undisclosed in bankruptcy, and the doctrine's essential ingredients remain the same.
Judge Jones makes it seem as though it were a mere procedural distinction, the difference between abandonment and non-abandonment. However, it rests on something much more substantive. In order for judicial estoppel to apply, the case must involve the same parties. The trustee is not the same party as the debtor. Therefore, judicial estoppel should NEVER apply to the trustee based on the Debtor's actions.
However, Judge Jones believes that the distinction between the trustee and the debtor is inconsequential. She writes:
Reed, at 7. Judge Jones does not provide any further analysis as to why the Trustee is bound by the Debtor's actions. Since this was the primary focus of the Kane opinion, a little more explanation would have been helpful.
(I)t is not sufficient to distinguish the debtor’s conduct from that of the trustee in applying judicial estoppel. Even though Reed herself takes no inconsistent legal positions, she succeeds to the debtor’s claim with all its attributes, including the potential for judicial estoppel.
While Judge Jones's statement is true in the abstract, it is disingenuous in the specific case. A trustee succeeds to the debtor's rights as of the petition date. Thus, a trustee would be bound by the fact that the debtor did not preserve his cause of action by filing suit within the period allowed by the statute of limitations. A trustee would also be bound if the debtor had settled the case on an arms length basis and squandered the proceeds before filing bankruptcy.
However, the facts constituting judicial estoppel do not exist on the petition date. Even if the debtor filed the false schedules with the bankruptcy petition, the element of receiving a benefit from the inconsistent position cannot occur until after the petition date.
When a debtor files bankruptcy, all of his legal rights become property of the estate under Section 541. The Trustee is the representative of the Estate. Therefore, if the claim had not been invalidated as of the petition date, the Trustee has the right to pursue it. When the Trustee closes a case, any properly scheduled assets which are not administered revert to the Debtor. However, undisclosed assets remain property of the estate subject to future administration by the Trustee. Since judicial estoppel cannot arise until after the bankruptcy filing and the Debtor is not the representative of the estate and the undisclosed asset never reverts to the Debtor, it should be clear that the Debtor cannot prejudice the rights of the Trustee subsequent to the petition.
This should be pretty obvious. However, the court dismissed it with one sentence and no further elucidation.
Judge Jones offers an alternate explanation of how judicial estoppel works. She writes:
The lowest common denominator appears to lie in a holistic, fact-specific consideration of each claim of judicial estoppel that arises from litigation claims undisclosed to a bankruptcy court.
Reed, at 6.
The Court then went on to find that the equities favored the City of Arlington.
The creditors are not materially advantaged if this case proceeds further. Only about one-sixth of the original creditors (reckoned in amount of claims) timely refiled when the case was re-opened a year after they were informed there were no non-exempt assets to distribute. See supra note 2. The untimely filers have little if any hope of recovery from the bankruptcy estate; the timely filers' recovery will be contingent on the payment of large priority administrative expenses caused by the ongoing litigation. True, Lubke agreed to revoke his discharge, but most creditors will have foregone alternative collection strategies at this point. The rincipal remaining bankruptcy “claimants” are Reed herself and Lubke's trial attorney Roger Hurlbut, who has already received from Lubke some payment for his services. Reed’s claim has been substantially increased because of this judicial estoppel litigation. Here, equity does not favor ignoring Lubke’s misuse of the court system for the primary benefit of attorneys.
Reed, at 8.
Equity is like pornography in that a person should be able to know it when they see it. Here, the court's view of equity is that the City of Arlington should be excused from liability for its wrongdoing because many of the creditors did not file timely claims and because the benefit of the case might go to attorneys.
Let's analyze the relative rights and wrongs here. The creditors who filed timely claims did not do anything wrong. However, under the Court's opinion, they will not stand any chance of recovery. The Debtor's nonbankruptcy attorney did everything right. However, he will lose out on the vast majority of his compensation. The Trustee did everything right. However, she will not receive any compensation. Indeed, the Debtor's nonbankruptcy attorney and the Trustee are placed in a suspect class because they are attorneys (just like the judge who wrote the opinion). The most charitable thing which can be said about the court's equitable analysis is that it is not obvious when you see it.
The Need for En Banc Review
The opinion in Reed was justified by the fact that one panel of the circuit cannot overrule another one absent en banc review. Judge Jones believes that the Kane court overruled Superior Crewboats and that its opinion should not be respected. An equally valid argument can be made that Reed overrules Kane. Of the four Fifth Circuit opinions dealing with judicial estoppel in the bankruptcy context, only two involved claims asserted by trustees. Those two opinions are diametrically opposed. This is a case where the en banc court needs to step in and resolve the inconsistency.
Integrity and Incentives
The en banc court should also consider whether this ruling promotes or hinders the integrity of the bankruptcy system and the larger federal court system. The integrity of the bankruptcy system is policed by multiple parties. At the outset, it depends upon the honesty of the debtor and the professionalism and ethics of the debtor's counsel. It also depends upon the trustee, creditors and the U.S. Trustee to ferret out wrongdoing.
Under Reed, the Debtor is given a perverse incentive to dishonesty. If the Debtor commits fraud and does not get caught, he keeps the benefits of his wrongdoing. If the Debtor commits fraud and does get caught, he has no opportunity to mitigate the damage. While there is no excuse for dishonesty, the Kane opinion gives the ethically wavering debtor the opportunity to make amends, while Reed does not.
The Reed opinion also removes the incentive for Debtor's counsel to bring fraud to light. The real hero in this case is Roger Hurlbut, the Debtor's nonbankruptcy counsel. When he learned about his client's omission, he immediately brought it to the Trustee's attention. His reward for displaying high ethics is that he loses the fee that he had earned. A less ethical lawyer knowing the penalty for disclosure might have been tempted to keep his mouth shut.
The Trustee also is deprived of any incentive to go after undisclosed assets. If the Trustee learns of an undisclosed asset which is being stealthily being pursued by the Debtor, the Trustee will have little motive to go after it. Trustees get paid on a commission. They succeed if the creditors succeed. However, under Reed, the diligent Trustee gets nothing for her effort. Indeed, the fact that she is a lawyer is cited as a reason why it would be inequitable to allow the case to proceed.
Finally, in the context of the larger federal court system, wrongdoers are given an opportunity to escape responsibility. Congress passed the FMLA because it beileved that its policies served an important goal in society. The City of Arlington apparently flouted those policies. The City was ready to settle until it learned that it had an out. What incentive does the City have to change its ways under this decision?
Here is what should happen in the case of an undisclosed asset. First, the parties to the case should have an incentive to discover the fraud and bring it to the trustee's attention. Second, the trustee should be given the first opportunity to pursue the claim. If the trustee does not elect to pursue the claim, then judicial estoppel should apply as to the debtor and the claim should be dismissed. However, if the trustee elects to pursue the claim, the alleged wrongdoer is in no worse position and may even be in a better position. As a fiduciary for the benefit of the creditors, the trustee may be willing to cut a better deal with the defendant so as to minimize the risk and delay to the creditors.
Hat Tip to Steve Roberts and St. Clair Newbern.
UPDATE: The Commercial Law League of America has submitted an amicus brief in support of the Trustee's motion for rehearing en banc. You can read it here.