Fifth Circuit Doesn't Save the Save Our Springs Alliance But Time May

Another chapter in the Austin development wars has played out as the Fifth Circuit affirmed the Bankruptcy Court ruling denying confirmation of the plan of reorganization proposed by the Save Our Springs (SOS) Alliance, Inc. Matter of Save Our Springs (SOS) Alliance, Inc., No. 09-50990 (1/26/11). However, intervening developments have helped to keep the feisty environmental activist group alive. You can read the opinion here.

What Happened

The Fifth Circuit described the facts this way:

S.O.S. is a nonprofit charitable organization that sues municipalities and developers to ensure what it believes is responsible use of the Edwards Aquifer in the Texas Hill Country. Two of its lawsuits resulted in sizable awards of attorney’s fees to the defendants in those suits. One of the defendants, the Lazy Nine Municipal Utility District, assigned its award to Sweetwater Austin Properties, L.L.C. (“Sweetwater”). Unable to pay the awards, S.O.S. filed for bankruptcy in April 2007.

Opinion, p. 2.

The Court's description is accurate, although couched in measured, legal language. SOS was born out of a citizen revolt at an all night city council meeting about a proposed development. Since that time, SOS has waged legal holy war against developers in sensitive areas of the Edwards aquifer. Several of those lawsuits blew up in their face, resulting in large judgments for attorneys fees.

In its plan, SOS divided unsecured creditors into three classes and proposed to pay them $60,000 on a pro rata basis. The Bankruptcy Court rejected the SOS plan on the grounds that it had not demonstrated that it would be able to raise the $60,000 and that it had impermissibly gerrmandered the unsecured creditor classes. Because SOS was a "small business debtor," it was required to confirm a plan within 300 days. By the time the case was tried and the opinion was delivered, SOS was outside the 300 day window. SOS tried to change its designation as a small business debtor, but the Court did not allow this. As a result, the Bankruptcy Court dismissed the case.

The Fifth Circuit considered three issues on appeal:

1. Did the Debtor prove that the plan was feasible, that is, that it could raise the money?

2. Was the Debtor's separation of creditors into different classes permissible?

3. Should the Court have allowed the Debtor to change its small business designation?

The Court ruled against the Debtor on all grounds.

Feasibility, Fair and Equitable and the Non-Profit Debtor's Dilemma

The case of a non-profit debtor involves an interesting application of the absolute priority rule. Under the absolute priority rule, the requirement that a plan be "fair and equitable" includes the requirement that junior interests not receive or retain any interest unless unsecured creditors are paid in full or consent to the plan. However, a non-profit does not any equity holders. As a result, this requirement does not apply. It also means that the amount that a non-profit must pay to unsecured creditors in a cram-down situation is somewhat arbitrary.

The amount that a non-profit must pay is governed by the following rules:

1. The debtor must pay more than creditors would receive in a chapter 7 liquidation. This is often an easy test to meet because many non-profits have few if any tangible assets.

2. The plan must be filed in good faith. That means that the debtor must be legitimately trying to reorganize instead of simply avoiding payment of its debts.

3. The plan must satisfy the uncodified requirements of the "fair and equitable" test. Although "fair and equitable" includes the requirement that equity not retain any interest unless unsecured creditors consent or are paid in full, it also can include the Bankruptcy Court's estimation of whether the plan is "fair and equitable" in a general sense, sort of a judicial smell test.

4. Finally, the plan must be feasible. The debtor must be able to pay what it promises to pay.

The good faith, fair and equitable and feasible standards can impose conflicting demands. If a plan proposes to pay less than the debtor is capable of paying, then the plan may not be proposed in good faith or be fair and equitable. If the debtor proposes to pay more than it is capable of, then the plan is not feasible.

In this case, it appears that the debtor was so concerned with proving that it could not afford to pay more than the $60,000 proposed that it failed to prove that it could pay this amount.

The Court of Appeals summarized the evidence on feasibility in this manner:

At the five-day confirmation hearing, S.O.S. presented evidence of its strong fundraising history, indicated that it had pledges for $20,000 of the fund after soliciting its top donors, and expressed confidence that it could raise the rest within the sixty-day period. S.O.S.’s executive director testified, however, that it would be difficult to raise the rest of the funds, because many of S.O.S.’s donors wanted to prevent their money from going to judgment creditors in bankruptcy. Moreover, the executive director noted that it would be “extremely difficult” to take money from S.O.S.’s general operating fund, because “[w]e struggle to meet our monthly overhead every month,” and S.O.S. had told its general-fund donors that their money would not go to pay judgment creditors.

Opinion, p. 3. Based on this evidence, the Bankruptcy Court concluded that SOS "offered no evidence at the hearing to show that it could [raise the $60,000]--no commitments, no evidence of relevant past performance, nothing."

The Fifth Circuit found that evidence of past fundraising was insufficient given that "raising funds during bankruptcy is more difficult than at other times" and that its donors were reluctant to contribute to pay judgment creditors.

The Fifth Circuit also dismissed the $20,000 in pledges because they were not firm commitments, only accounted for one-third of the amount required and that its major donors had been tapped.

At the Fifth Circuit, the standard of review is whether the Bankruptcy Court committed clear error. In my view, the Bankruptcy Court was overly dismissive of the evidence of past fundraising and the partial commitments. Unfortunately, the Debtor provided the Court with ammunition for this finding when it poor mouthed its ability to pay more. The Debtor could have won the feasibility battle by doing its fundraising in advance (with monies held in trust pending the court's ruling) or by having its major donors guaranty that they would make up any shortfall, but that would have opened it up to a charge that it was intentionally underpaying. By focusing on the wrong side of the equation, the debtor lost the feasibility battle.

Gerrymandering

An additional requirement for confirmation is that a plan be approved by at least one class of impaired creditors. If one creditor holds more than 33% of the unsecured claims, the debtor will not be able to obtain an impaired, accepting class unless the debtor has a secured class of creditors to accept the plan or can divide its creditors into multiple classes. In this case, the debtor apparently did not have any secured creditors, so it divided its unsecured creditors into three classes.

Separate classification of unsecured creditors became more difficult following the Fifth Circuit's ruling in Matter of Greystone III Joint Venture, 995 F.2d 1274, 1278 (5th Cir. 1991) that "ordinarily 'substantially similar claims,' those which share common priority and rights against the debtor's estate, should be placed in the same class." The Fifth Circuit backed away from this statement somewhat in In re Briscoe Enterprises II, Ltd., 994 F.2d 1160 (5th Cir. 1993)(finding that debtor had good business reasons for separate classification of unsecured claims). However, one part of the Greystone ruling which remains sacrosanct is that to justify separate classification, a debtor must treat the separate classes differently and have good business reasons for doing so.

In this case, the Debtor sought to have each of the three classes of unsecured claims share in the same pot of $60,000 on a pro rata basis. Thus, the Court of Appeals concluded, "SOS's plan treats all its unsecured creditors identically, so they should all have been in the same class absent a legitimate reason to classify them separately." Opinion, p. 7.

The Debtor argued that it had separately classified Sweetwater because Sweetwater had non-creditor interests. The Fifth Circuit acknowledged that this reason, if proven, would have been sufficient.

S.O.S. contends that the bankruptcy court erred, because Sweetwater has two “non-creditor interests” justifying separate classification. A non-creditor interest can justify separate classification if it gives Sweetwater “a different stake in the future viability” of S.O.S. that may cause it to vote for reasons other than its economic interest in the claim. (citation omitted). If such non-creditor interests in fact exist, they would justify S.O.S.’s classification scheme

Opinion, p. 8. It is certainly plausible that Sweetwater was motivated to punish SOS for its environmental zealotry. However, Sweetwater's principal testified that he just wanted to get his claim paid. Ironically, the Fifth Circuit found that Sweetwater's vote was not motivated by a desire to avoid future litigation with the Debtor because the litigation did in fact continue notwithstanding denial of the plan and dismissal of the case.

Given these facts, it would have been almost impossible to have the Bankruptcy Court's finding set aside as clearly erroneous. However, the opinion is significant because it explicitly recognizes that non-creditor interests are a proper reason for separate classification. Thus, the argument could work in a case with better evidence, such as a creditor which readily admitted its motives or one where the creditor would gain a non-economic benefit from the debtor's demise.

The Small Business Designation and Judicial Estoppel

As noted above, the long battle over confirmation caused the Debtor to run out the 300 day clock for confirming a plan. The Debtor argued that the Court erred in not allowing it to revoke its small business designation. The Fifth Circuit noted that while debtors can typically amend filings "as a matter of course at any time before the case is closed," that judicial estoppel was properly invoked to prevent the Debtor from doing so in this case. Having received the benefits of the small business designation, the Debtor could not renounce it once it became burdensome. This finding is unremarkable.

Meanwhile Back at the Sweetwater Ranch

While the appeal of the Bankruptcy Court order was ongoing, developments continued to occur on other fronts. SOS challenged the Sweetwater judgment on the basis that the judgment was rendered by a judge who had been defeated in his primary election and was therefore ineligible to preside over the trial. A Travis County District Court agreed and vacated the judgment, prompting one of SOS's attorneys (not Weldon Ponder) to proclaim "We won" on a bankruptcy listserve. However, that victory was taken away by the Third Court of Appeals. Sweetwater Austin Properties, LLC vs. SOS Alliance, Inc., 299 S.W.3d 879 (Tex. App.--Austin, 2009, pet. den.).

In October 2010, Sweetwater lost its property in one of the largest foreclosures in Travis County. The Bank resold the development within a month. Thus, despite the setbacks, SOS outlasted its adversary. It is not clear whether Sweetwater, the Bank or the new owner controls the judgment now.

Disclosure: My firm did some work for SOS prior to the bankruptcy. We voted our unsecured claim in favor of the Debtor's plan.

Antone's Records: A Tragedy in Three Acts and 46 Pages

Austin prides itself on being the Live Music Capital of the World. While many musicians travel to Austin with stars in their eyes, the reality is that it is difficult to earn a living in the music business, either as an artist or an independent record label. For the past eighteen months Bankruptcy Judge Craig Gargotta has received an extensive education on what can go wrong in relationships between record labels and their artists. This education was on full display in a 46 page opinion he wrote in Walser v. Antone’s Records, et al, Adv. No. 09-1010 (Bankr. W.D. Tex. 1/24/11). You can find the opinion here.

However, Judge Gargotta was not the only one receiving an education. I represented the debtors and the case was a real eye opener for me. This is the story of Antone’s Records, a tragedy in three acts.

Act I: Watermelon Records

During the 1980s and 1990s, Antone’s Records and Watermelon Records were hometown competitors in the music business. Watermelon was founded by Heinz Geissler, a German immigrant. Its catalog focused on Americana music. Antone’s Records was founded by nightclub owner Clifford Antone and focused on blues music. At some point during the 1990s, Dallas investor and music lover James Heldt acquired a majority stake in Antone’s.

Watermelon Records was the first to fall. Watermelon Records filed for chapter 11 relief in 1998. At the time, many of its artists were unhappy with the label. After a contentious three year case involving competing plans and shifting alliances, Watermelon confirmed a plan in which its assets were sold to Texas Clef Entertainment Group, Inc. Texas Clef was an affiliate of Antone’s Records which was formed to make the acquisition.

Few of the artists filed claims in the Watermelon Records bankruptcy case. A group of artists was very active in the case and succeeded in having their records carved out of the sale. The plan of reorganization confusingly provided that artists who filed proofs of claim would be treated as parties to executory contracts and would receive a cure offer. Since most of the artists did not file claims, this provision applied to only a few parties. However, the artists did not receive cure offers. Instead, they received a pro rata share of the funds available to unsecured creditors.

Even though the plan was not followed, none of the parties seemed to take notice. Texas Clef re-released many of the Watermelon titles.

Act II: The Walser Suit

Antone’s, Texas Clef and sister label, Texas Music Group, drew the ire of many of their artists and publishers when they were slow to issue royalty statements and pay royalties.

In 2004, Texas yodeler Don Walser, known as the Pavarotti of the Plains, hired a lawyer and demanded that the label provide him with his royalty statements. After three tries, the label rendered an accurate statement and paid most of the royalties. However, this occurred after the expiration of a deadline to cure defaults. Nonetheless, Mr. Walser accepted the payments. Nothing more occurred until March 2005, when Mr. Walser filed a suit against the label timed to coincide with the South by Southwest Music Festival.

While many of the artists would dispute this, my belief is that the Antone’s labels were guilty not of malice, but failure to keep up with rapidly changing technology. During the 2000s, the sale of music began to shift from cassettes and compact discs to digital downloads. This new distribution channel multiplied the label’s reporting requirements exponentially. Compact discs are sold as a unit containing all the tracks. The record label generally used one domestic distributor and one or more foreign distributors. With digital downloads, consumers could purchase individual tracks or albums. In the early days of digital downloads, there were many competing digital download sites who often provided their reporting in inconsistent formats. It required many man hours to assemble all of this data into a statement. Having downsized its operation to save costs after Mr. Heldt was unwilling to continue subsidizing the labels’ losses, the labels were simply unable to keep up with reporting for over 100 releases. It was not until 2009, after chapter 11 had been filed, that in-house computer wiz Tristan Ader developed an automated database which synthesized the information received into a statement.

Meanwhile, the Walser lawsuit rocked along in Texas state court. The suit metastasized to include six defendants, including the three record labels, James Heldt, Heinz Geissler (now an Antone’s employee) and label president, Randolph Clendenen.

Act III: The Antone’s Bankruptcy

On November 18, 2008, on the eve of trial in the state court action, the three labels filed for chapter 11 relief. Ironically, it was during the bankruptcy case that the labels first began to generate timely statements and make timely royalty payments.

The Walser case was removed to bankruptcy court. The suit remained on hold for a lengthy period while the U.S. District Court considered a Motion to Withdraw Reference.

History repeated itself as competing plans were once again filed. The debtors filed a plan based on payments from cash flow and a new capital contribution from James Heldt. The Official Creditors’ Committee filed a plan proposing to sell the debtor’s assets to a new label for $125,000. At the last moment, the Creditors’ Committee sought to move up the auction from after confirmation to the confirmation hearing itself. An auction was held at the confirmation hearing with James Heldt making the high bid. However, the court rejected his bid and accepted the next highest bid, which came from New West Records. During the bidding process, the sale price doubled from the original offer.

In a mediated settlement, the Debtors, the Official Creditors’ Committee and James Heldt agreed to allow the New West sale to go forward at a slightly higher price with several other concessions. At this point, it became clear that Antone’s would not continue as an independent label. However, there was still the Walser suit to try. This trial was held in bankruptcy court over three days in May 2010. Although Mr. Walser’s estate had filed a proof of claim for $300,000, the estate’s attorney asked for damages of $1 million in closing argument.

On January 24, 2011, the Bankruptcy Court rendered its opinion denying substantially all of the relief requested by the Walser estate.

The Court’s opinion methodically analyzed and rejected the claimant’s theories. Among other findings:

· The Walser estate could not claim the masters embodying his recordings. When a record company pays for the recording of a musical performance, that recording belongs to the record company. The Court found that any claim for rescission of the recording agreement was pre-empted by the Copyright Act and that the Walsers had failed to meet the high standard for imposing a constructive trust under Texas law.

· The record company did not owe a fiduciary duty to the artist. Where Mr. Walser had representation from both an agent and an attorney, he did not rely on the record company to act on his behalf. There was not a relationship of trust and confidence under state law where he affirmatively distrusted the record company. In its ruling, the Court distinguished a case involving Apple Records and the Beatles.

· The record company did not commit fraud when it failed to provide royalty statements in a timely manner. As the Court stated, “No evidence exists that demonstrates actual fraud.”

· The Walsers could not recover damages for emotional distress or punitive damages on a breach of contract claim.

· The Walsers could not pierce the corporate veil to impose liability on the individuals associated with the record labels. Under Texas law, mere failure to observe corporate formalities was not a ground for piercing the corporate veil. On a contract claim, it was necessary to show actual fraud rather than merely constructive fraud to pierce the corporate veil. Where James Heldt had loaned millions of dollars to the company and had never taken a salary, there were no grounds for piercing the corporate veil.

The Court’s opinion is a valuable resource for cases involving constructive trusts, rescission, breach of fiduciary duty and piercing the corporate veil. Many of these issues involve routine Texas state law questions. However, there are so many questions addressed in this opinion that there is something for many people.

In the end, the Walser estate was awarded an unsecured claim for $28,161.41, an amount conceded by the Debtors and which had been tendered prior to bankruptcy, together with pre-judgment interest of $1,025.15, which was the amount the Debtors conceded was owed. The Court also allowed the Walser estate to apply for an award of attorney’s fees, but cautioned that it must segregate out the time spent on relief which was not granted.

This is a case brimming with ironies. The suit which pushed the debtors into bankruptcy was ultimately rebuffed. However, because the artist and publisher creditors did not support the plan proposed by the Debtors, the assets of the Debtors were sold to a new label. Hopefully for the artists, the third time will be the charm.

Fifth Circuit Adopts Literal Reading of Exemption Statute

One of the reforms adopted by BAPCPA was to increase the amount of time a person had to spend in a state before he could take advantage of that state's exemptions. Under 11 U.S.C. Sec. 522(b)(3)(A), a person must live in a state for 730 days to claim that state's exemptions. If the debtor does not satisfy the 730 day requirement, the law of the state where the debtor lived for the greater portion of the 180 days prior to the 730 days applies. This provision was meant to make it harder for a debtor to enhance his exemptions by moving to a new state prior to bankruptcy. However, a new opinion from the Fifth Circuit shows that the statute can have some unintended consequences. Ingalls v. Camp, No. 09-50852 (5th Cir. 1/21/11). You can find the opinion here.

The debtor moved from Florida to Texas during the 730 days before bankruptcy. As a result, he was required to use exemptions available under Florida law. The debtor claimed federal exemptions. However, Florida law prohibits "residents" from using federal exemptions. The trustee objected, contending that the court should apply Florida law as if the debtor were still a resident of Florida. The Bankruptcy Court agreed and sustained the objection. In re Camp, 396 B.R. 194 (Bankr. W.D. Tex. 2008).

The District Court reversed and was affirmed by the Fifth Circuit. The basis for its reasoning was straightforward. "Residents" of Florida could not use federal exemptions. Camp was not a "resident" of Florida. Therefore, he could select federal exemptions even though his exemptions were determined under Florida law.

The Court of Appeals began with the canon that "courts must presume that a legislature says in a statute what it means and means in a statute what it says there." Opinion. p. 3. The Court found it to be pretty clear that the Florida legislature did not intend for non-residents to be precluded from using federal exemptions.

Therefore, Florida’s opt-out statute, by its own express terms, does not apply to nonresident debtors, who remain eligible to use the federal exemptions because nothing in Florida law specifically disallows them from doing so. (citations omitted). Here, because Camp was not a Florida resident at the time he filed his bankruptcy petition, Florida law does not restrict his access to the federal exemptions.

Opinion, p. 5.

The Fifth Circuit's analysis appears pretty clear, at least as a matter of Florida law. After all, why would Florida care if non-residents claimed federal exemptions? The difficulty with the opinion is that Sec. 522(b)(3)(A) expresses a federal policy that mobile debtors should receive the same exemptions that they would have received if they had stayed put.

States naturally draft their exemption laws to apply to their residents, since that is who they have authority over. It would be simply incomprehensible for Florida to draft an exemption statute to apply to residents of Texas. Florida could have drafted its law to refer to persons to whom Florida law applies, but why would it? Florida is interested in Floridians, while Congress has the responsibility for looking after the broader, national interest.

Congress said to look to Florida law to determine the exemptions of the debtor in this case. Congress could have been more clear and said that the debtor's exemptions would be determined under Florida law as though the debtor still resided in Florida. However, it seems pretty clear that that is what they meant.

In this particular case, the debtor received exemptions which would not have been available to him if he had remained in Florida. However, it is easy to imagine a case where state exemptions depended on residency of the state so that the peculiar wording of a state exemption law could deprive the debtor of exemptions he would otherwise have been entitled to if he had remained in the prior state.

I am a strong proponent of plain meaning analysis. However, this may well be a case where the plain meaning isn't so plain. We know what Congress was trying to accomplish. For those who are not enamored of BAPCPA it is easy to chortle at Congress for shooting for a specific result and falling short through poor drafting. However, in this particular case, the drafting was not particularly obtuse, inelegant or contradictory.

This case is somewhat ironic because of the manner in which it resolved a split between bankruptcy judges in the Western District of Texas. Judge Leif Clark articulated the position adopted by the Fifth Circuit in In re Battle, 366 B.R. 635 (Bankr. W.D. Tex. 2006). Judge Craig Gargotta wrote the opinion which was reversed in the Camp case. Judge Clark has a reputation for being a deep thinker who will go out on a limb in support of a contrarian position. Judge Gargotta has a reputation as being a straightforward by the numbers jurist. Thus, it is ironic that Judge Gargotta took the more nuanced, intellectual position, while Judge Clark said plain meaning full speed ahead. This is the nature of BAPCPA. Reasonable minds can and will disagree and sometimes the results will be surprising.

Disclosure: I represented the Trustee in this case in the appeal to the Fifth Circuit. I was the attorney who did not prevail.

While I am uneasy with the result here, I wish to commend my colleague, Robert W. Berry, who represented the debtor. Mr. Berry has a consumer bankruptcy practice. After receiving an unfavorable ruling from the bankruptcy court, it would have been easy to let the result lie. Instead, Mr. Berry stuck with his client and took the case through two levels of appellate review. That is what good lawyers do.

Bankruptcy, BAPCPA and the Social Contract

Once upon a time, I had a client tell me that he loathed bankruptcy because bankruptcy was socialism and he only believed in market solutions. While his use of terminology was imprecise, it is beyond dispute that bankruptcy represents government changing the terms of privately negotiated contracts. If you substitute government action for socialism and substitute private contract for the market, his point is well taken but wrong.

Government Intervention in Private Decision Making: It Cuts Both Ways

While bankruptcy constitutes government interference with private contracts, private contracts would be of limited enforceability without the assistance of government. We are so accustomed to the idea that contracts may be enforced through government action, whether it be through suit on a promissory note or laws governing secured credit, that it is easy to forget that enforceability of contracts depends on the collective agreement that contracts should be enforced against the will of the non-complying party.

It is possible to imagine a contract regime which operated entirely without the intervention of government. In that instance, credit would only be extended based on trust or force. If a debtor did not pay, the creditor's recourse would be limited to not extending any more credit in the future, social pressure such as shunning or in the extreme case, violence. Alternatively, credit could be extended based on the creditor taking possession of collateral and not giving it back until the debt was paid.

While you can imagine a contract system that functioned without the help of government it would be inefficient. As a result, we have laws allowing enforcement of contracts and recognizing secured transactions because they facilitate the extension of credit, encourage economic growth and avoid violence as a means of contract enforcement. In other words, laws enforcing contracts improve the general welfare.

The Social Contract (No, It's Not the Movie About Facebook)

Collective action to enforce contracts is an example of the social contract. The framers of the Constitution were inspired by the social contract theories of Hobbes, Locke and Rousseau. According to Hobbes, life would be "nasty, brutish and short" absent political authority. Under social contract theory, people band together and surrender some of their autonomy in return for security, protection of property rights and the general welfare.

Because enforcement of contracts is a creature of the social contract, government will not blindly enforce all contracts. You cannot go to court and enforce a contract to put a hit on someone or sell a child. In Texas at least, the courts will not enforce a gambling debt. While we believe generally in freedom of contract, there are some contracts which should not be enforced because they are bad. There are also some methods of enforcing contracts which are not allowed. Shakespeare notwithstanding, you cannot secure a debt with a pound of flesh or other body part. The reason is simple. If you could use a writ of execution to actually execute someone , the state would be implicated in using violence to enforce private contracts. Generally we think that is a bad idea.

Bankruptcy Laws and the Social Contract

Bankruptcy laws are an example of the state saying we will enforce private contractual rights but only so far. The power to enact uniform bankruptcy laws is one of the enumerated powers granted to Congress, but it is not a power which must be utilized or utilized in any particular form. For the first hundred years of the nation, bankruptcy laws were utilized to respond to specific crises and were often focused on punishing debtors rather than helping them. It was not until the Bankruptcy Act of 1898 that we had a permanent law which placed limits on how debts could be enforced.

The discharge and fresh start are based on the idea that a person who is faced with crippling levels of debt will not be a productive member of society and will not be able to take care of his or her family. Reorganization laws benefit society by preserving jobs, equitably distributing insufficient assets and minimizing loss of going concern value. Bankruptcy laws are not an example of government interfering with the right of private contract, but a limitation on the extent to which government will facilitate the right of private contract.

So, my argument is that bankruptcy is no more socialist than opening the courthouse to breach of contract suits. In either case, the state is lending its power to the enforcement of private agreements within defined limits.

That brings us to BAPCPA. How well does BAPCPA fulfill the social contract? I would argue that substantively, BAPCPA is a perfectly appropriate drawing of the boundaries of the social contract. The Means Test, limits on homestead exemptions and treatment of 910 vehicles are all ways in which lines are drawn in favor of more personal responsibility. However, there are many parts of BAPCPA which add burdens on the system with no corresponding benefits. Credit counseling and the Debt Relief Agency rules were intended to serve a consumer protection function, but do not in practice. The means test is so ambiguously worded that even the Supreme Court has difficulty figuring out what it means. It also encourages gamesmanship to arrive at a desired result. Sections 362 and 523 have had so many exceptions and clauses grafted onto them that it is impossible to read through them in one sitting.

Trying to Make Sense of An Imperfect Essay

I don't think that I have completely succeeded in tying the social contract ideas of Hobbes, Locke and Rousseau to private contracts and bankruptcy. However, I hope that I have at least suggested the following points:

1. Enforcement of private contracts does not involve man in a state of nature unhindered by the state, but rather involves the state intervening in the private affairs of men to further the common good.

2. Just as the state can act to enforce private contracts, so can the state place limits on the extent to which it will enforce private contracts.

3. When the state acts to limit the freedom of private contract, it does so based on improving the general welfare at the expense of some individuals.

4. Bankruptcy laws further the social contract when they advance some aspect of the general welfare, such as encouragement of risk taking, support of the family unit, preserving economic value or promoting individual responsibility.

5. Bankruptcy laws hinder the social contract when they impose costs without corresponding benefits or reward the use of resources to get around the policies that the laws were intended to promote.

Third Circuit Holds That Attorney Letter Can Form Basis for FDCPA Claim

A new opinion from the Third Circuit Court of Appeals could lead to more claims under the Fair Debt Collection Practices Act being filed in Bankruptcy Court. Allen v. LaSalle Bank, N.A., No. 09-1466 (3^rd Cir. 1/12/11) held that correspondence from a debt collector to a consumer’s attorney could be actionable under the FDCPA. You can find the opinion here. Although Allen did not arise in a bankruptcy case, it involves a fact pattern likely to be seen in bankruptcies.

The Facts

The case began when Dorothy Rhue Allen failed to make the final payment on her 30 year mortgage. LaSalle Bank retained Fein, Such, Kahn & Shephard, P.C. (“FSKS”) to file a foreclosure action. At the request of Allen’s attorney, FSKS provided a payoff letter. Less than three weeks later, Allen filed a class action counterclaim and third party complaint asserting that FSKS’s response violated the FDCPA. LaSalle promptly released the mortgage and dismissed the foreclosure action.

Not content with this result, Allen filed a class action against FSKS, LaSalle and the servicer for the loan in the U.S. District Court for the District of New Jersey. Although she initially made other arguments, she later conceded that her complaint was based solely on a violation of 15 U.S.C. §1692f(1), which prohibits “the collection of any amount (including any interest, fee, charge, or expense incidental to the principal obligation) unless such amount is expressly authorized by the agreement creating the debt or permitted by law.” She alleged that the amounts charged to her exceeded the actual charges or the amounts allowed by court rule. For example, she alleged that FSKS demanded $910 in attorney’s fees when a court rule permitted only $15.43, $335 for searches when court rule permits only $75, $160 for recording fees when the actual fee was only $60 and $475 for service of process when statute and court rule limited reimbursement to $175.

The defendants moved to dismiss. The District Court, relying on precedent from the Seventh Circuit, held that a communication from a debt collector to a consumer’s attorney should be analyzed under the standard of a competent attorney. Because a competent attorney would have recognized the charges as being excessive and objected to them, the District Court held that the complaint failed to state a cause of action.

The Third Circuit’s Opinion

The Court of Appeals reversed. It found that §1692f(1) was a strict liability statute which did not depend upon the nature of the recipient (which would be the least sophisticated consumer or competent attorney under other FDCPA provisions). Attorneys who regularly collect debts through litigation are considered to be debt collectors. The FDCPA defines “communication” as “the conveying of information regarding a debt directly or indirectly to any person through any medium.” Thus, the attorneys were debt collectors and the letter to the consumer’s attorney constituted an indirect communication with the consumer herself.

The Court wrote:

The FDCPA is a strict liability statute to the extent it imposes liability without proof of an intentional violation. If an otherwise improper communication would escape FDCPA liability simply because that communication was directed to a consumer’s attorney, it would undermine the deterrent effect of strict liability.

In this case, the District Court sub silentio concluded that a communication from a debt collector to a consumer’s attorney was generally covered by the FDCPA but that it is to be analyzed from the perspective of a competent attorney. The District Court, however, did not have the benefit of Allen’s concession that her claims were predicated only upon § 1692f(1), which defines the collection of an unauthorized debt as a per se “unfair or unconscionable” debt collection method. The only inquiry under § 1692f(1) is whether the amount collected was expressly authorized by the agreement creating the debt or permitted by law, an issue we leave for the District Court.

Opinion, pp. 8-9.

The Third Circuit’s ruling places it in agreement with the Fourth Circuit, Sayyed v. Wolfpoff & Abramson, 485 F.3d 226, 232-33 (4th Cir. 2007) and in conflict with the Second and Ninth Circuits, Guerrero v. RJM Acquisitions LLC, 499 F.3d 926, 934-39 (9th Cir. 2007); Kropelnicki v. Siegel, 290 F.3d 118, 129-31 (2d Cir. 2002).

The Third Circuit also rejected a claim that New Jersey’s litigation privilege claim would bar the claim.

Nonetheless, the FDCPA does not contain an exemption from liability for common law privileges. “[C]ommon law immunities cannot trump the [FDCPA]‟s clear application to the litigating activities of attorneys,” (citation omitted), and, like the Fourth Circuit, we will not “disregard the statutory text in order to imply some sort of common law privilege.”

Opinion, p. 9.

Other courts have split over whether there is a litigation privilege defense to FDCPA claims. Newburger & Barron, Fair Debt Collection Practices, ¶1.07[11][k] (A.S. Pratt & Sons 2009).

Bankruptcy Implications

The Third Circuit’s holding has tremendous implications for bankruptcy cases. Debt collectors regularly communicate information regarding consumer debts in bankruptcy cases. Proofs of claims, motions for relief from the automatic stay and objections to plans all involve as “the conveying of information regarding a debt directly or indirectly to any person through any medium.” It is not unknown for these documents to include charges prohibited for law, such as post-petition interest or attorney’s fees on an unsecured or under secured debt. Under the Allen decision, it is possible that courts could impose strict liability on creditor communications and filings in bankruptcy court.

It is important to note that the Second Circuit recently held that “the filing of a proof of claim in bankruptcy court cannot form the basis for an FDCPA claim.” Simmons v. Roundup Funding, LLC, 622 F.3d 93 (2^nd Cir. 2010). This is just one facet of the ongoing debate over the relationship between bankruptcy law and the Fair Debt Collection Practices Act. While Allen does not directly address this controversy, it seems likely that it will add fuel to the fire.

Supreme Court Rules That Debtor Must Have Loan or Lease Payment for Means Test Deduction

In an 8-1 decision authored by Justice Kagan, the Supreme Court ruled today that an ownership expense is not "applicable" under the Means Test unless the Debtor has an actual payment. Ransom v. FIA Card Services, No. 09-907 (1/11/11). You can read the opinion here.

Justice Kagan framed the issue in this manner:

This case concerns the specified expense for vehicle-ownership costs. We must determine whether a debtor like petitioner Jason Ransom who owns his car outright, and so does not make loan or lease payments, may claim an allowance for car-ownership costs (thereby reducing the amount he will repay creditors). We hold that the text, context, and purpose of the statutory provision at issue preclude this result. A debtor who does not make loan or lease payments may not take the car-ownership deduction.

Opinion, pp. 1-2.

Justice Kagan described the means as designed to "help ensure that debtors who can pay creditors do pay them." Opinion, p. 2.

The Dictionary Approach to Ordinary Meaning

Justice Kagan used an ordinary meaning analysis and a dictionary to conclude that the ownership expense was not applicable.

The key word in this provision is “applicable”: A debtor may claim not all, but only “applicable” expense amounts listed in the Standards. Whether Ransom may claim the $471 car-ownership deduction accordingly turns on whether that expense amount is “applicable” to him.

Because the Code does not define “applicable,” we look to the ordinary meaning of the term. (citation omitted). “Applicable” means “capable of being applied: having relevance” or “fit, suitable, or right to be applied: appropriate.”Webster’s Third New International Dictionary 105 (2002). See also New Oxford American Dictionary 74 (2d ed. 2005) (“relevant or appropriate”); 1 Oxford English Dictionary 575 (2d ed. 1989) (“[c]apable of being applied” or “[f]it or suitable for its purpose, appropriate”). So an expense amount is “applicable” within the plain meaning of the statute when it is appropriate, relevant, suitable, or fit.

What makes an expense amount “applicable” in this sense (appropriate, relevant, suitable, or fit) is most naturally understood to be its correspondence to an individual debtor’s financial circumstances. Rather than authorizing all debtors to take deductions in all listed categories, Congress established a filter: A debtor may claim a deduction from a National or Local Standard table (like “[Car]Ownership Costs”) if but only if that deduction is appropriate for him. And a deduction is so appropriate only if the debtor has costs corresponding to the category covered by the table—that is, only if the debtor will incur that kind of expense during the life of the plan. The statute underscores the necessity of making such an individualized determination by referring to “the debtor’s applicable monthly expense amounts,” (citation omitted)—in other words, the expense amounts applicable (appropriate, etc.) to each particular debtor. Identifying these amounts requires looking at the financial situation of the debtor and asking whether a National or Local Standard table is relevant to him.

If Congress had not wanted to separate in this way debtors who qualify for an allowance from those who do not, it could have omitted the term “applicable” altogether. Without that word, all debtors would be eligible to claim a deduction for each category listed in the Standards. Congress presumably included “applicable” to achieve a different result.

Opinion, pp. 6-8.

This passage is the heart of the opinion. One word used according to its ordinary meaning decides the issue.

Making Sense of BAPCPA

As additional support for her conclusion, Justice Kagan noted that:

• this interpretation furthered the goals of BAPCPA; and
  

• this interpretation was consistent with the way in which the IRS applied the standards (although she was careful to point out that the "guidelines . . . cannot control if they are at odds with the statutory language")

You Have to Decide What Should Be Applicable to Determine What Applicable Means

Justice Kagan rejected the Debtor's argument that "applicable" referred to the applicable number of vehicles which the Debtor had in reference to the standards. Her approach was a functional one.

On this approach, the word “applicable” serves a function wholly internal to the tables; rather than filtering out debtors for whom a deduction is not at all suitable, the term merely directs each debtor to the correct box (and associated dollar amount of deduction) within every table.

This alternative reading of “applicable” fails to comport with the statute’s text, context, or purpose.

Opinion, pp. 11-12.

Actual vs. Applicable

Justice Kagan also pointed out that her approach avoided making "actual" and "applicable" mean the same thing. She noted that if a person's actual expense exceeded the standard, it would be capped. However, she refused to opine on whether a person who had less than the standard would be limited to the actual amount. She noted that both the debtor and the United States believed that the debtor received the full standard as long as any amount was incurred, while FIA Card Services contended that the debtor received the lesser of the standard or the actual amount. She said that because the debtor had no ownership expense, it was unnecessary to determine whether the debtor received the full standard or just the actual amount. See Opinion, p. 13, n. 8.

Overall, Justice Kagan's approach the statute is a pragmatic one. She ties her conclusion to a plausible reading of the text but shores up her interpretation with the purpose of the statute. She rejected the invitation to incorporate the IRS guidelines into the statute while allowing that they could be consulted so long as they didn't conflict with the text.

A Minority of One Says Stop Making Sense

Predictably, Justice Scalia dissented. In his typical eloquent manner, he did not agree with Justice Kagan's grammar lesson or use of canons of statutory construction.

The Court believes, however, that unless the IRS’s Collection Financial Standards are imported into the Local Standards, the word “applicable” would do no work,violating the principle that “‘we must give effect to every word of a statute wherever possible.’” (citation omitted). I disagree. The canon against superfluity is not a canon against verbosity. When a thought could have been expressed more concisely, one does not always have to cast about for some additional meaning to the word or phrase that could have been dispensed with. This has always been understood. A House of Lords opinion holds, for example, that in the phrase “‘in addition to and not in derogation of’” the last part adds nothing but emphasis. (citation omitted).

It seems to me that is the situation here. To be sure, one can say “according to the attached table”; but it is acceptable (and indeed I think more common) to say “according to the applicable provisions of the attached table.” That seems to me the fairest reading of “applicable monthly expense amounts specified under the National Standards and Local Standards.” That is especially so for the Ownership Costs portion of the Local Standards,which had no column titled “No Car.” Here the expense amount would be that shown for one car (which is all the debtor here owned) rather than that shown for two cars;and it would be no expense amount if the debtor owned no car, since there is no “applicable” provision for that on the table. For operating and public transportation costs, the“applicable” amount would similarly be the amount provided by the Local Standards for the geographic region in which the debtor resides. (The debtor would not first be required to prove that he actually operates the cars that he owns, or, if does not own a car, that he actually uses public transportation.) The Court claims that the tables “are not self-defining,” and that “[s]ome amount of interpretation” is necessary in choosing whether to claim a deduction at all, for one car, or for two. (citation omitted). But this problem seems to me more metaphysical than practical. The point of the statutory language is to entitle debtors who own cars to an ownership deduction, and I have little doubt that debtors will be able to choose correctly whether to claim a deduction for one car or for two.

Dissent, pp. 2-3.

Making Sense of BAPCPA


Here, Justice Scalia echoes his dissent in Hamilton v. Lanning where he unsuccessfully argued for a literal reading rather than a practical one. The difference here is that the word "applicable" here truly is ambiguous. Where either meaning is persuasive, one that is consistent with the purpose of the statute probably should carry more weight.

As with last term's opinions in Milavetz and Lanning, the majority wants to construe BAPCPA in a manner which avoids extreme results. Thus, the Court will not apply the DRA sections to require a creditor's lawyer to say "I am a Debt Relief Agency." Similarly, the Court will neither require a debtor to recognize phantom income or allow a debtor to take a phantom deduction.

From Bankruptcy Trustee to Orthodox Priest

As a bankruptcy lawyer and trustee, Ronald Ingalls helped troubled debtors absolve their financial sins. As Father Methodios Ronald Ingalls, he will now be able to deal with sins of a broader nature. Today, on January 6, 2011, Ronald Ingalls was ordained to the Holy Priesthood of the Antiochian Orthodox Church. His story is one that shows that the distance between the sacred and the secular is often smaller than we imagine.

For Ron Ingalls, his sacred/legal journey began as he entered law school in 1985. It was at this time that he converted to the Orthodox faith. As a result, there was a strong connection between the law and Orthodoxy in his personal life.

He drew a parallel between his legal and priestly studies. He that, "It's not about you. It's about the client. Now I have the most important client of all."

He graduated from the University of Texas Law School in 1988, served as a law clerk to Judge Glen Ayers, and became a chapter 7 panel trustee in 1994. As a trustee, he administered cases ranging from the missing atheist Madalyn Murray O'Hair to bankrupt developer Gary Bradley.

He also drew parallels between his service as a trustee and a priest. He noted that in both instances, he was commissioned to act on behalf of someone who was not physically present. He also drew the parallel of trying to salvage something for everyone else.

Ron's ordination was a moving three hour service. For those not familiar with the Orthodox Church, it involved a lot of solemn ritual. The service took place on Theophany, which means appearance of God. The service remembers the baptism of Jesus by John and the holy spirit appearing in the shape of a dove. The service included hymns in Greek, Romanian and Arabic. It also included the blessing of the holy water. Shortly after the service, the Bishop and clergy went to bless Barton Springs.

Ron will return for a final semester in seminary and then will spend a year in a mission congregation in Fredericksburg.

Godspeed.

Diocese of Milwaukee Seeks Chapter 11 Protection From Sexual Abuse Claims

The Diocese of Milwaukee filed a petition for chapter 11 relief on January 4, 2011 after twenty years of dealing with sexual abuse claims and an unfavorable ruling on its insurance coverage. In re Diocese of Milwaukee, Case No. 11-20059 (Bankr. E.D. Wisc. 1/4/11). Milwaukee is the eighth U.S. Catholic Diocese out of 194 to seek bankruptcy protection as the result of sex abuse claims. The Catholic Diocese bankruptcies illustrate how bankruptcy can help to resolve complex social problems as well as mere contractual disputes.

The Diocese bankruptcies share several common factors.

1. They are precipitated by overwhelming tort claims involving horrific crimes perpetrated by persons in positions of authority. According to the Diocese of Milwaukee, "A tragedy that runs contrary to every teaching and tradition of the Church has unfolded in the Church as a whole and in the Archdiocese in particular: a small number of clergy and others took advantage of their positions of trust and respect in the community to sexually abuse children. ("The Abuse")." The website of the Archdiocese lists 44 priests who have "substantiated reports of abuse of a minor." Whether this is a "small number" can be debated.

2. Many of these incidents happened a long time ago. Of the 44 priests listed on the website, 17 are deceased. According to the Archdiocese, it took formal steps to address the abuse problem in 1989. According to published reports in other cases, much of the abuse dates back to the 1950s and very little has occurred since the 1980s.

3. The financial cost of the tort claims is substantial. According to the Archdiocese, it had incurred costs of $29,564,678 based upon claims resulting from abuse of a minor as of June 30, 2010. There are currently claims from 17 plaintiffs pending with another seven who have given notice.

4. The Catholic Diocese bankruptcies pose a perplexing social problem. Who should pay for the abuse? Almost half of the priests who committed the abuse are deceased. The Diocese itself is an artificial entity. It is dependent upon the 657,519 registered Catholics for its income. It employs 177 persons, many of whom are engaged in good works. How do you apportion the blame for at least 24 persons who may have been wronged among 657,519 registered Catholics and 177 employees, many of whom were not even born when the abuse took place?

5. Chapter 11 provides a structure for resolving the claims. Claimants must come forward within a reasonable period of time so that claims do not continue to show up decades later. Assets can be mobilized to pay claims. In the case of the Archdiocese of Milwaukee, the courts have absolved their insurance carriers and the Archdiocese claims that the assets of individual parishes are held in separate corporations. As a result, donations from the faithful are the most likely source of compensation to the victims. On the one hand, it is horribly unfair. Parishioners who had no complicity in the abuse must voluntarily pay for its consequences. On the other hand, it is at least somewhat fair. The faithful take responsibility for their shepherds. If the clergy betray the faithful, the faithful have an obligation to make it right. Therein lies the dilemma. The faithful didn't cause the problem. The faithful don't have unlimited resources. How do you strike a balance between the interest of those who have faced horrific wrongdoing and those have committed no wrong? Chapter 11 provides a framework for answering these questions.

Judge Rules That Home is Where the Heart Is

In 2000, Natalie Portman starred in "Where the Heart Is," a movie about a pregnant 17 year old girl who makes her home in a Walmart. Judge Stacey Jernigan recently had to decide a quite different case about home and the heart. The case involved whether a modern day cowpoke's heart was down on the ranch or in town in his wife's bedroom. Fortunately, like a character in a John Wayne movie, the Debtor fended off every attack and saved the ranch. In re Tinsley, No. 09-36036 (Bankr. N.D. Tex. 11/16/10). The opinion can be found here.

The Story

Our story goes back to 1979, when the Debtor's father purchased 116 acres located in Kaufman, Texas. In 2004, the Debtor moved into the Kaufman property to take care of his father. From 2004 to 2008, the Debtor stayed at the property full time and operated his own business, which consisted of running cattle and growing hay.

On September 24, 2008, the Debtor's father passed away and left the ranch to the Debtor. under his will A few days later on October 14, 2008, the Debtor married. After marriage, he d spent his days at the Kaufman property and his nights at his wife's home. The Debtor generously allowed his adult son and his family to live at the Kaufman property.

On September 10, 2009, the Debtor filed bankruptcy. Title to the Kaufman property remained in the name of his deceased father because the probate case had not been concluded. The Debtor used his wife's address as his address on the bankruptcy petition, but claimed the Kaufman property as his homestead.

The Objections

The Trustee and a creditor objected to the claimed homestead exemption on the grounds that:

a. The Kaufman property was not his homestead under Texas law; and
b. The homestead exemption was capped at $136,875 because the Debtor acquired his interest within 1,215 days before bankruptcy.

Texas Homestead Exemption

In order to establish a Texas homestead, a person must show that he has a present possessory interest in the property and must show a combination of both overt acts and intent to make the property his homestead.

The objecting parties claimed that the Debtor did not have a present possessory interest in the property because he did not hold legal title. The Court rejected this argument, finding that legal title was not necessary. The Court found that the Debtor was a tenant at will of the probate estate. While his continued possession of the property "depends upon the will and whim of the fee simple owner (i.e., the probate estate of his father)," the fact that he was the devisee under the will made it unlikely that he would lose his possessory interest.

The next issue was thornier. The homestead "is a possessory right which inures to the benefit of a family unit." The Debtor and his wife occupied two separate properties. Therefore, the Court had to determine whether the Debtor showed sufficient overt acts and intent to make the Kaufman property his homestead. The Court noted the possibility that the couple could claim both properties as a noncontiguous rural homestead, but found that this theory had not been pled.

The court found that in a dual residence scenario, the first step is to determine whether one residence was objectively the only homestead. If the usage is sufficiently ambiguous, then the court may honor the Debtor's subjective intent.

While finding that the case was extremely close, the Court found enough ambiguity to take the Debtor's subjective intent into account.

1. The Debtor spent almost every day at the Kaufman property.
2. The Debtor intended to move his bride onto the Kaufman property once it was renovated.
3. "While his new bride is eight miles down the road, the Debtor's horses, boots, tools, livelihood the past 17 years and now extended family are at the Kaufman property 365 days a year." Judge Jernigan shows real discernment here. The real test of a cowboy's residence is where he keeps his boots.

Homestead Cap

However, the ranch was not out danger yet. The creditors argued that because the Debtor acquired his interest in the Kaufman property under his father's will and his father passed away less than 1,215 days before bankruptcy, that the exemption was capped at $136,875.

The Court found that the Debtor had acquired a "vested economic interest" under the will. While noting that she "had grave doubts whether section 522(p) should apply at all in the context of a homestead 'acquired' by devise in a will within 1,215 days of the debtor filing for bankruptcy," she found that the Fifth Circuit had assumed without discussion that an inherited property was acquired. She also noted that Black's Law Dictionary defined "acquire" to mean "to gain by any means."

While it looked like a bad result, the Court was willing to hold her nose and apply the cap. However, there is an exception to the cap for the principal residence of a family farmer. After an exhaustive analysis, the Court found that: the Kaufman property was the Debtor's principal residence; that the Debtor was engaged in farming operations even though he no longer grew crops and didn't have any cattle on the property at the time of the filing (the Court found it compelling that he had operated a ranching operation on the property since 1993 and had resumed his ranching operation after recovering from a heart attack), the Debtor's debts were less than $3,544,525 and that the Debtor received more than 50% of his gross income from farming during the three years prior to bankruptcy.

The end result was that the Debtor got to keep the ranch without being subject to a cap.

Conclusion

In conclusion, Judge Jernigan remarked:

The court would conclude with the old saying that “home is where the heart is,” and, although the Debtor may have spent his nights with his new bride at the Kemp Property, rather than the Kaufman Property, the facts and circumstances in this case certainly show that the Kaufman Property is the Debtor’s true home and where his “heart” is. This case is certainly unique in that it implicates section 522(p)(1) for reasons not originally contemplated by Congress (i.e., this is hardly a case of letting a debtor get through a “mansion loophole,” in that no non-exempt property was put in a large, luxurious mansion on the eve of bankruptcy). Fortunately, for this Debtor, even though he “acquired” property which he used as his homestead within 1,215 days of filing bankruptcy, Congress anticipated certain situations to which they did not want section 522(p)(1) to apply and drafted section 522(p)(2)(A).

Opinion, p. 35. In the final analysis, a bad unintended consequence was avoided due to the fortuitous intervention of an exception that happened to fit the Debtor to a t.