Tuesday, July 13, 2010

Ninth Circuit BAP Finds Wells Fargo Freeze Policy Violates Automatic Stay

Breaking with judges in Texas and New Mexico, the Ninth Circuit Bankruptcy Appellate Panel has found that an administrative freeze policy utilized by Wells Fargo Bank violates the automatic stay. No. 09-1408, Mwangi v. Wells Fargo Bank, N.A. (Ninth Cir. BAP 6/30/10). The opinion can be found here.(PACER access required).

Wells Fargo's Policy

Every night, Wells Fargo compares cases filed in CM/ECF against its account holders. If one of its account holders files chapter 7 bankruptcy, Wells Fargo places an administrative freeze upon the account and sends a letter to the chapter 7 trustee requesting instructions on disposition of the funds. In the Mwangi case, the debtors initially disclosed that they had only $1,300.00 in their Wells Fargo accounts. After Wells Fargo froze the accounts, they amended their schedules to disclose $17,075.06 and claimed 75% of this amount as exempt. The Debtors then demanded that Wells Fargo release the funds based upon their claim of exemption. When Wells Fargo refused, the Debtors filed a motion for sanctions. By the date of the hearing, the exemption had become final. The Bankruptcy Court ruled that Wells Fargo had not violated the stay because the funds were property of the estate and that Wells Fargo had not attempted to collect a debt.

The BAP Doesn't Like the Bank's Policy

The Bankruptcy Appellate Panel disagreed. It held that once the Debtors claimed the funds as exempt, they had an inchoate interest in the funds. This gave them standing to assert a violation of Sec. 362(a)(3), which prohibits acts to "exercise control over property of the estate." The Court found that continuing to hold the funds constituted exercise of control over property of the estate. The Panel wrote:

Wells Fargo asserts that it did not exercise control over property of the estate. We disagree. Wells Fargo could have paid the account funds to the trustee; it did not. Wells Fargo could have released the account funds claimed exempt to the Appellants when demand was made; it did not. Wells Fargo could have sought direction from the bankruptcy court, by way of a motion for relief from stay or otherwise, regarding the account funds; it did not. Instead, it chose to hold the funds until a demand was made for payment that it alone deemed appropriate. If that is not "exercising control over" the funds, we don't know what is. (emphasis added).

. . .

The impact of Wells Fargo's national policy is to turn on its head the balance between rights of parties legislatively created. As a result of the policy, every party, except Wells Fargo, whose rights are impacted by the administrative freeze will need to take action.
Slip Op. at 19, 20.

The BAP remanded for a determination of whether the violation of the stay was willful and whether the debtors were entitled to damages.

The BAP Disagrees With Other Courts

The Ninth Circuit BAP's opinion contrasts with the decisions in Wells Fargo Bank v. Jimenez, 406 B.R. 935 (D. N.M. 2008) and In re Calvin, 329 B.R. 589 (Bankr. S.D. Tex. 2005). In each of those cases, the courts found that until the funds became exempt, they were property of the estate. As a result, the debtors lacked standing to complain that the bank was withholding funds from the trustee. Judge Jeff Bohm was sympathetic to the dilemma faced by the bank, writing:

Under the Bankruptcy Act of 1898, entities owing debts, such as the Bank were shielded from liability even if they paid a debtor post petition as long as the entities were "acting in good faith." (citation omitted). The Bankruptcy Reform Act of 1978 eliminated this provision with the passage of Sec. 542. Entities owing a debt now have exposure to Chapter 7 trustees if payment on the debt is made to the debtor because that debt is owed to the estate until such time as it is abandoned or any exemption becomes final. Under these circumstances, it makes good business sense for the Bank to have instituted a policy that freezes the accounts of depositors who file a Chapter 7 petition. In this manner, the Bank can shield itself from any liability to a trustee while that trustee determines whether the funds are exempt, or nonexempt (or, even if nonexempt, of inconsequential vale to the estate). It is its potential exposure to trustees, not to debtors upon which the Bank must properly focus.
In re Calvin at 604.

A Big Mess

These cases point out an enormous practical problem. Sec. 541 provides that money in the debtor's bank account is property of the estate. Sec. 542 provides that an entity holding property of the estate "shall deliver to the trustee" the property. However, as a practical matter, most funds held by debtors will be exempt or of inconsequential value to the trustee so that the trustee will not administer the asset. Debtors have the expectation that they will continue to be allowed access to the funds since the odds are that they will ultimately receive them. From the Trustee's point of view, it is burdensome to hold funds which will not be administered, but potentially more burdensome to recover those funds from the debtor once they have been spent.

At first blush, the bank appears to be an officious intermeddler. It freezes the funds even when it has no claim to them. Instead of turning them over to the trustee, it holds them. However, Judge Bohm (who was a banker prior to attending law school), has a legitimate point. The Code says turn over the funds. Recognizing that the trustee might not want the funds, the Bank agrees to hold the funds pending direction from the trustee. Of course, trustees rarely provide that direction because it would be burdensome in administering large numbers of cases.

The Ninth Circuit BAP outlined what it believed to be the Bank's options in this situation:

1. It could have turned the funds over to the trustee. This would be appropriate under the Code, but would overwhelm trustees.

2. It could have turned the funds over to the debtor. This would violate the Code and expose the bank to liability.

3. It could have sought direction from the court. While this would be appropriate, it would be very burdensome to the bank when it had to be done in tens of thousands of cases.

Under the Ninth Circuit BAP's opinion, the only viable option for the bank is to transfer the funds to the trustee whether the trustee wants them or not. Of course, there is another option. Trustees could agree to hold banks harmless for allowing debtors access to funds unless directed otherwise. There is no chance that banks will be able to negotiate agreements with hundreds of panel trustees or the the U.S Trustee's office would allow them to agree to it.

Since all of the options under existing law are bad, it might make sense to go back to the "acting in good faith" standard under the Bankruptcy Act of 1898 and leave the bank out of the picture.

Tuesday, July 06, 2010

Trustee Held Liable for Failure to Remit Sales Taxes

Failure to remit trust fund taxes is a common cause of bankruptcy and personal liability for the owners of a business. Far less common is the case of a bankruptcy trustee held responsible for the same violation. However, that is what happened in the case of Texas Comptroller of Public Accounts v. Liuzza, No. 09-50544 (5th Cir. 7/6/10). The opinion can be found here.

The case arose out of the bankruptcy of Texas Pig Stands, described by the court as a "venerable San Antonio restaurant company." Despite its venerable status, it wound up in chapter 11. The court appointed a chapter 11 trustee after the debtor failed to remit post-petition sales taxes to the Comptroller. Then the chapter 11 trustee failed to remit the taxes. The court confirmed a plan which required the trustee to pay all delinquent post-petition taxes on the effective date of the plan and to remain current on the sales taxes. The trustee did neither. Shortly thereafter, the Comptroller froze the company's bank accounts and revoked its sales tax permit, after which the case was converted to chapter 7.

The Comptroller brought an adversary proceeding seeking to hold the trustee liable for the taxes. The Bankruptcy Court ruled that the trust agreement limited the trustee's liability to gross negligence and ruled against the Comptroller. The District Court reversed. The Fifth Circuit agreed with the District Court that the trustee was liable.

The Court found that the trustee was personally liable for the taxes under state law. However, it also found that if the confirmed plan of reorganization protected the trustee from liability, this would override state law. The Court stated:

The Comptroller is bound to any liability limitations imposed by the Plan, which included the Trust Agreement. The Plan and Trust Agreement are contracts that must be read in their entirety to be given full meaning. (citation omitted). Further, under the governing law of Texas, "exculpatory clauses are strictly construed, and the trustee is relieved of liability only to the extent to which it is clearly provided that he shall be excused."

Opinion, p. 8.

The Trust had inconsistent provisions. On the one hand, it stated that "persons dealing with the Trustee in matters relating to the Trustee have recourse only against the Trust Assets to satisfy any liability incurred by the Trustee to such person in carrying out the terms of this Agreement or the Plan, and the Trustee shall have no personal or individual obligation to satisfy such obligation. . . ." However, the Trust Agreement also provided that "Except in the case of fraud, willful misconduct or gross negligence, the Trustee shall not be liable for any loss or damage by reason of any action taken or omitted by him pursuant to the discretion, power and authority conferred on him by this Agreement or the Plan." Reading the two provisions together, the Court found that the Trustee had no personal liability so long as he followed the plan and did not commit fraud or willful misconduct. The Court concluded:

Luizza exceeded his authority, violated the Plan, and committed willful misconduct. Accordingly the Trust Agreement does not limit his liability.
Opinion, p. 9.

There are two lessons here.

The first is that entrepreneurs and fiduciaries occupy much different realms. Entrepreneurs take big risks in the hope of big gains. Occasionally it might make rational sense for an entrepreneur to gamble on not paying trust fund taxes in the hope of preserving the enterprise(although usually not). However, fiduciaries don't get paid extra to take risks. Therefore, it will never make sense for a fiduciary to incur personal liability in the hope of making the case work.

Second, this was not a case where better drafting could have saved the day. While the fatal language was probably boilerplate carried over from another document, it would be hard to draft around this problem. The exculpatory provision of the trust document contained exceptions for fraud, willful misconduct and gross negligence. It also limited the exculpatory provision to actions taken "pursuant to the discretion, power and authority conferred on him by this Agreement or the Plan." Thus, the Court was able to find liability because failure to pay the taxes was not authorized by the plan and constituted willful misconduct. It would have been a closer case if the trust had simply stated that the Trustee would not be liable absent fraud or gross negligence or even limited it to just fraud. However, the more broadly the exculpatory provision is drafted, the more likely it would be to draw objection. Further, in order to avoid the problem, the trust's drafters would have to have contemplated that the trustee would continue to misappropriate trust funds. If that were the case, they should not have supported him for trustee.

This is a harsh result for a trustee who received no personal benefit and thought he was doing the right thing for the estate. However, it is often said that insanity is doing the same thing over and over and expecting a different result. In this case, both the debtor in possession and the chapter 11 trustee failed to remit taxes. When this happened, the Comptroller became upset and demanded relief from the Bankruptcy Court. Thus, a reasonable person would have been on notice that continued failure to pay the taxes could lead to bad results. Bankruptcy is a court of second, third and fourth chances. However, eventually the chances run out, even for a trustee.

Thursday, July 01, 2010

Kagan on Christmas Day

I am not sure whether this is amusing or appalling or just weird. Sen. Lindsay Graham starts talking about the Christmas Day Bomber, but ends up asking "where were you at on Christmas Day." Ms. Kagan gamely tries to make sense out of the question before the Senator clarifies that he just wants to know where she was.

While Sen. Graham sets Ms. Kagan up for a good applause line, his subsequent attempt to equate Christmas and Hanukkah is a bit awkward. For those who are a little unsure about the reference, I am told that it is a Jewish-American tradition to eat Chinese food on Christmas day because a) it is a day off and b) Chinese restaurants are open on Christmas Day. However, it has no religious significance.

It is worth noting that once she understood the question, Ms. Kagan answered directly and unequivocally.